Question

Elimu Co, a listed company, is a major supplier of educational material, selling its products in many countries. It supplies schools and colleges and also produces learning material for business and professional exams. Elimu Co has exclusive contracts to produce material for some examining bodies. Elimu Co has a well-defined management structure with formal processes for making major decisions.

Although Elimu Co produces online learning material, most of its profits are still derived from sales of traditional textbooks. Elimu Co’s growth in profits over the last few years has been slow and its directors are currently reviewing its long-term strategy. One area in which they feel that Elimu Co must become much more involved is the production of online testing materials for exams and to validate course and textbook learning.

Elimu Co has recently made a bid for Mtandao Co, a smaller listed company. Mtandao Co also supplies a range of educational material, but has been one of the leaders in the development of online testing and has shown strong profit growth over recent years. All of Mtandao Co’s initial five founders remain on its board and still hold 45% of its issued share capital between them. From the start, Mtandao Co’s directors have been used to making quick decisions in their areas of responsibility. Although listing has imposed some formalities, Mtandao Co has remained focused on acting quickly to gain competitive advantage, with the five founders continuing to give strong leadership.

Elimu Co’s initial bid of five shares in Elimu Co for three shares in Mtandao Co was rejected by Mtandao Co’s board. There has been further discussion between the two boards since the initial offer was rejected and Elimu Co’s board is now considering a proposal to offer Mtandao Co’s shareholders two shares in Elimu Co for one share in Mtandao Co or a cash alternative of Kshs.22.75 per Mtandao Co share. It is expected that Mtandao Co's shareholders will choose one of the following options:

1. i. To accept the two-shares-for-one-share offer for all the Mtandao Co shares; or,
2. ii. To accept the cash offer for all the Mtandao Co shares; or,
3. iii. 60% of the shareholders will take up the two-shares-for-one-share offer and the remaining 40% will take the cash offer.

In case of the third option being accepted, it is thought that three of the company's founders, holding 20% of the share capital in total, will take the cash offer and not join the combined company. The remaining two founders will probably continue to be involved in the business and be members of the combined company's board.

Elimu Co’s finance director has estimated that the merger will produce annual post-tax synergies of Shs. 20 million. He expects Elimu Co’s current price-earnings (P/E) ratio to remain unchanged after the acquisition.

Extracts from the two companies’ most recent accounts are shown below:

                                            Elimu                                                                                     Mtandao

           Kshs. m                                                                                   Kshs. m

Profit before finance cost and tax                     446                                                                                            182

Finance costs                                                     (74)                                                                                            (24)

––––                                                                                           ––––

Profit before tax                                            372                                                                                               158

Tax                                                               (76)                                                                                               (30)

––––                                                                                              ––––

Profit after tax                                                296                                                                                                128

––––                                                                                              ––––

Issued Kshs.1 nominal shares 340 million 90 million

P/E ratios, based on most recent accounts 14 15·9

Long-term liabilities (market value) (Kshs.m) 540 193

Cash and cash equivalents (Kshs.m) 220 64

The tax rate applicable to both companies is 20%.

Assume that Elimu Co can obtain further debt funding at a pre-tax cost of 7·5% and that the return on cash surpluses is 5% pre-tax.

Assume also that any debt funding needed to complete the acquisition will be reduced instantly by the balances of cash and cash equivalents held by Elimu Co and Mtandao Co.

Required:

Evaluate the funding required for the acquisition of Mtandao Co and the impact on Elimu Co’s earnings per share and gearing, for each of the three options given above.

Answer 1

Option 1.

2 shares for 1 share

Shares held Mtandao Co.= 90 million

So shares allotted will be = 90 million*2 = 180 million

Option 2.

Settlement full in cash at Kshs 22.75 per share

90 million*22.75 = Kshs. 2047.50 million

Option 3.

60% shares and 40% cash

Shares allotted would be = 108 million

40% cash would be = Kshs 819 million

Elimu co will need a funding of cash Kshs 2047.50 million if option 2 is opted or Kshs 819 million if option 3 is opted

EPS of Elimu Co before aquisition = Kshs 296 million/340 million = Kshs 0.8706 per share

EPS after aquisition =

Under option 1

(Profit after tax of both companies + synergies)/Equity shares post aquisition = [(Kshs 296 million+Kshs 128 million)+Kshs 20 million]/(340 million+180 million)

= Kshs 444 million/520 million = Kshs 0.8538 per share

Under Option 2

Debt cost would increase if company is to pay cash

(Kshs 444 million - After tax interest cost(7.5%-20% tax))/340 million

= (Kshs 444 million- Kshs. 2047.50 million*6%)/340 million = Kshs 290.4375 million/340 Million

= Kshs 0.9446 per share

Under option 3

=(Kshs 444 million - Kshs 819 million*6%)/(340 million+108 million) = Kshs 0.8814 per share

Observation,

Under all the options, option 2 has highest EPS of Kshs 0.9446 per share if Elimu Co settles in all cash

Gearing ratio = Long term liability/Capital employed*100

Under option 1,

Gearing ratio will remain same as no funds will be borrowed to settle aquisition

Under option 2 and 3,

Gearing ratio will be up as amount will be borrowed to settle aquisition. However percentage increase will be high under option 2 than 3.