Question

Delta wants to take over Fire ltd considering the financial data as follows:

Balance sheets as at 31 December 2019

	£’000
Non-current assets	54,500
Current-assets	6,450
Total assets	60,950
Equity and liabilities
Ordinary share capital (£1 shares)	10,000
Retained profits	18,950
10% Debentures	24,500
Trade payables	7,500
Total equity and liabilities	60,950

Notes
The long-term liabilities of Fire ltd are 10% Debentures.

Dividends were 15p per share in 2019 with a 5.5% dividend yield

Operating profits in 2019 £18,750,000
Net cash flow in 2019   £13,040,000
Predicted growth in profits after tax from 2019 0%

P/E ratio at 31 December 2019 8

The estimated required return on equity 12% (based on industry average)

You may assume that corporation tax is chargeable on profits before tax at a rate of 20%; Tax is paid in the year charged.

Net investment in non-current assets is stable, so cash expended each year is approximately equal to depreciation.

Required:

Prepare briefing notes in order to advise the main board of KE on the following matters:

1. (a) The possible price that the shareholders of Risky might expect (per share and in total) using each of the following methods:

   1. (i) Net assets

   2. (ii) P/E ratio

   3. (iii) Dividend yield

   4. (iv) Discountedcashflows

   Round the share price to the nearest penny.

2. (b) What are the main motives of mergers and acquisitions?

3. (c) Critically discuss the possible reasons that many mergers and acquisitions cannot achieve their initial expectations.

Answer 1

(a) The possible price that the shareholders of Risky might expect (per share and in total) using each of the following methods:

(i) Net assets

Net assets= Total assets-Outside liabilities

ie. 60950000-(24500000+7500000)=

28950000

for 10000000 shares o/s( $ 10000000/$ 1)

so,Price/share=28950000/10000000=

2.895

& total   28950000

(ii) P/E ratio

After-tax earnings (with 0% growth) predicted=

After-tax Earnings=(Operating profits-Debenture interest)*(1-Tax rate)

ie.(18750000-(24500000*10%))*(1-20%)

13040000

given P/E= 8

Price=13040000*8=

104320000

price/ share=104320000/10000000=

10.432

iii. Dividend yield method

Dividend yield= $ dividend/Price per share

ie. 0.15/Price= 5.5%

So, price per share=0.15/5.5%=

2.727

total price= 2.727* 10000000=

27270000

(iv) Discountedcashflows

Price of equity shares =PV of net after-tax cash flows at the reqd. return on equity- Long-term debentures

ie. (13040000/12%)-24500000=

84166667

Price /share= 84166667/10000000=

8.417

(b) Main motives of mergers and acquisitions

1. to reap benefits of mergers like oil production & refinery , where one can get raw material from another , ie. Be a market to the other.

2. To add value to the business , by effecting synergies or diversification

3.Tax planning to gain incentives

4. Using extra money to acquire assets

c..Possible reasons that many mergers and acquisitions cannot achieve their initial expectations.

1. Wrong reading of the market /financial statements

2. Misjudging/ wrong forecasting of the synergy effects & other after-merger financial implications.

3. Missing important financial points , while finalising the deal.

4.Judging wrongly about post-merger sales quantum ---one of the leading errors.

5. Entering into it, just for the sake of drawing industry's attention , due to excess cash , without proper home-work.