Question

Alpha Corp is a mature firm in the manufacturing sector and currently has a market capitalization of $ 500 million with 100 million shares outstanding. The firm has an annual cash flow earnings of $60 million and its cost of capital is 12%. Alpha Corp is considering taking over Beta Corp which has done reasonably well in the recent past. Beta Corp currently has 10 million shares outstanding with a market capitalization of $ 20 million and annual cash flow earnings of $2 million. The cost of capital for Beta Corp is 10%. The takeover is expected to result in annual additional cash flow of $ 0.75 million in the first year, which are expected to remain constant in perpetuity. The cost of capital for synergies is 12%. Alpha Corp is considering two different options to finance the take over (i) a cash offer with a 20% premium relative to its market price (ii) a share swap of 1 share of Alpha Corp for every 2 shares of Beta Corp .

1. Calculate (i) overall gain (ii) gain to Alpha shareholders and (iii) gain to Beta shareholders if the cash offer is made (2.5 marks).
2. Calculate (i) gain to Alpha shareholders and (ii) gain to Beta shareholders if the share-swap offer is made (2.5 marks).
3. At what cash offer price (cash offer) would this be a zero NPV investment for Alpha Corp? (1 mark)

Answer 1

Value of Synergy = $0.75 million/0.12 = $6.25 million

Cash offer with 20% premium

i) The Overall gain will be that of the synergies from the takeover = $6.25 million

ii) The total cash paid to Shareholders of Beta = $20 million *1.2 = $24 million

So, gain to Shareholders of Alpha = $6.25 -$(24-$20) million =$2.25 million

iii)   Gain to Shareholders of Beta = $(24-$20) million =$4 million

share-swap offer

Before the takeover,

Alpha share price = Market capitalisation/No of shares = $500 million/100 million shares =$5 per share

Beta share price = $20 million/$10 million = $2 per share

In the share swap, Beta shareholders will get 10 million/2 = 5 million shares of Alpha against their 10 million shares

Effective cost of takeover = 5 million shares * $5 =$25 million

i) So, gain to Shareholders of Alpha = $6.25 -$(25-$20) million =$1.25 million

iii)   Gain to Shareholders of Beta = $(25-$20) million =$5 million

For NPV to be zero. the total cash offered must include the market value of Beta plus the synergies value

So, cash offered = $20 million + $6.25 million = $26.25 million