Question

Navidale, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years ago, Navidale Limited purshed a strategy of organic growth. Since then, it has followed an aggressive policy of acquiring smaller engineering companies, which it feels have developed new technologies and methods, which could be used in its manufacturing process. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have successfully increased the company's shareholder value. Navidale Limited is currently considering acquiring Lochinvar, an unlisted company, which has three departments. Department A manufactures machinery for industrial companies, Department B produces electrical goods for the retail market, and the smaller Department C operates in the construction industry. Upon acquisition, Department A will become part of Navidale, as it contains the new technololgies which Navidale is seeking, but Departments B and C will be unbundled, whith the assets attached to Department C sold and Department B being spun off into a new company called Ndege Co.

Given below extracts of financial information for the two companies for the year ended 30 April 2014.

Navidale Co   Lochinvar Co

R Million R Million

Sales revenue: R790-2 R124.6

Profit before depreciation, interest and tax (PBDIT) R244.4    R37.4 million;

Interest R 13.8 R 4.3

Depreciation R 72.4 R 10.1

Pre tax profit R 158.2 R23.0

Non-current assets R723.9 R98.2

Current assets R142.6 R46.5

7% unsecured bond - R40.0

Other non-current and current liabilities R212.4 R20.2

Share capital (50c/share) R190.0 R20.0

Reserves R464.1 R64.5

Share of current and non-current assets and profit for Navidale Co's three departments:

Department A Department B Department C

Share of current and non-current assets 40% 40% 20%

Share of PBDIT and pre-tax profit 50% 40% 10%

Other information

(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value, but its current assets' realisable value is only 90% of their book value. The costs related to closing Department C are estimated to be R3 million.

(ii) The funds raised from the disposal of Department C will be used to pay off Lonchivar Co's other non-current and current liabilities.

(iii)The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of the bond is equal to its book value.

(iv) At present, around 10% of the Department B's PBDIT come from sales made to Department C.

(v) Ndege Co's cost of capital is estimated to be at 10%. It is estimated that in the first year of operation Ndege Co's free cash flows to firm will grow by 20% and then by 5-2% annually thereafter.

(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation on its non-current assets. It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to maintain Ndege Co's operations.

(vii) Navidale Co's current share price is R3 per share and it is estimated that Lochinvar Co's price-to-earnings (PE) ratio is 25% higher than Navidale Co's PE ratio. After the acquisition, when Department A becomes part of Navidale Co, it is estimated that Navidale Co's PE ratio will increase by 15%.

(viii) It is estimated that the combined company's annual after-tax earnings will increase by R7 million due to the synergy benefits resulting from combining Navidale Co and Department A.

Required:

4.1 Discuss the possible reasons why Navidale Co may have switched its strategy of organic growth to one of growing by acquiring companies.(4)

4.2 Discuss the possible actions Navidale Co could take to reduce the risk that the acquisition of Lochinvar Co fails to increase shareholder value (7)

4.3 Estimate, showing all relevant calculations, the maximum premium Navidale Co could pay to acquire Lonchivar Co, explaining the approach taken and any assumptions made. (14)

Answer 1

Part 1

If due to switch and implementing any of the acquiring options would have been presented the possibility to increase or maximize the shareholders’ value, then Navidale may have switched the strategy of organic growth to one of growing by acquiring companies.

There are two acquisition options: horizontal acquisitions and vertical acquisitions. To develop new products, markets, expertise, technologies, etc. internally from the scratch is difficult and time consuming. Rather it is easy to gain access on these by mode of acquiring the company possessing these features. Thus, horizontal acquisitions might have helped Navidale to gain access on technologies, expertise, etc. without investing huge amount and time. Moreover, it may help to reduce the number of competitors, rivalry and the problem of overcapacity. The number of small rivals will reduce due to expansion in market and it will get opportunity to compete with large rivals. Due to huge production, it is likely to get benefits of economies of scale. On the other hand, it may possible for Navidale to improve supply chain by going with the option of vertical acquisitions. The improvement in supply chain would lead to maximize the value chain returns.

The application of organic growth strategy is time consuming as well as expensive. Besides, Navidale is an already established company, and thus the organic strategy is likely to offer little competitive advantage. The idea of implementing organic growth strategy in new market would require the company to incur costs to gain knowledge and expertise for expanding business in new market.

Part 2

The possible actions Navidale co. could take are as follows:

• Firstly it need to conduct a post-audit after this acquisition to figure out the reason due to which Navidale holds a bad record of adding value from its acquisitions.
• It needs be ensure that it has sufficient and accurate data on the basis of which cost-benefit analysis is undertaken. Here any carelessness would cost a lot.
• Navidale should carefully examine the sources of synergy and what efforts are need to achieve them. standards should be clearly defined for all areas of synergy with the allocation of senior management team to look after it.
• Navidale should need to get ensure that this acquisition would increase the value of shareholders and it needs to define the amount of maximum premium, it is willing to pay for synergy benefits.
• Giving acquired company a large autonomy may reduce the synergy benefits and thus it is necessary to get ensure that Navidale has proper resources and process to handle the integration of to-be-acquired company’s staff and systems
• It needs to establish a good policy to retain key employees of to-be-acquired company. Their roles and responsibilities should be predefined properly.

Part 3

The additional benefit generated from acquisition of Lochinvar Co, is same as the maximum payable premium without any increment in share value of Navidale Co.

Since shareholders of Navidale are not getting any benefits from acquisition, they would not approve it and would surely deny the bid in excess to this.

The additional benefits would be:

• Total cash gained ( or loss ) from selling the assets of Department C
• Spinning of Department B and integrating Department A
• Subtracting the total values of both companies (as a separate companies), etc.

Navidale Co.

Estimation of cash gained from selling the assets of Department C

Non-current Assets (20% of $92.8)
Current Assets (20% of 46.5 X 0.9)
Liabilities and closure costs (20.2 + 3)	(23.2)
Total	4.81

Free cash flow (FCF) of Ndege Co

Current share of PBDIT (40%*37.4)	14.96
Less: PBIT attributable to Department C (10%*14.96)	(1.50)
Less: allowable depreciation (40%*98.2*10%)	(3.93)
Profit before tax	9.53
Tax (20%)	(1.91)
Free cash flows	7.62

Value of Ndege Co

Present value of free cash flow growing at 20% in the first year = 7.62*(1+20%)+(PV n=1, i=10%) = 7.62*120*0.909 = $8.31m

present value of cash flows from year 2 onwards = (9.14 *1.052)/(0.1 – 0.052) * 0.909 = $182.11m

bond taken over by Ndege = $40 m

Value of Ndege Co to shareholders = 8.31+182.11-40 = $150.42m

Navidale Co's current value = $3 * 380 = $1,140m

Navidale Co.’s profit after tax = $158.2 * 0.8 = $126.56m

Navidale Co.’s PE ratio before acquisition = $1,140.0/$126.56 = 9.01 = 9

Navidale Co.’s PE ratio after acquisition = 9 * 1.15 = 10.35

Lochinvar Co.’s PE ratio before acquisition = 9 * 1.25 = 11.25

Lochinvar Co.’s post tax profit = $23 * 0.8 = $18.4m

Lochinvar Co's current value = 11.25 * $18.4 = $207 m

50% of Lochinvar 's earnings [department A] after the disposal of department C and the spin-off of department B = 126.56+(0.56*18.4)+7 = $142.76m

Value of combined company = 10.35*142.76 = $1477.57m

Value of combined company	1477.57
Value of Nedge Co.	150.42
Value for disposal of department C	4.81
Less: current value (1140+207)	(1347)
Maximum premium	$285.80m

According to the calculations presented here, the value credited will be 64.9 %( $285.8m).

For confirmation about these calculations, Navidale Co has to check and verify the values used in the calculations and test the assumptions (they should be reasonable), for example,

• It should be checked if assumption of growing future cash flows with extra investment.
• How increased PE ratio is derived
• Sensitivity analysis to check the impact with reference to value changes

Due to past performance in generating value, special care should be taken for figures.