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:
i.
To accept the two-shares-for-one-share offer for all the Mtandao Co shares; or,
ii.
To accept the cash offer for all the Mtandao Co shares; or,
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% pretax.
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:
a) Argue the case for and against the acquisition of Mtandao Co from the viewpoint of Elimu Co.

b) 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.

(Total: 15 marks)

Answer 1

a. Since Emilu Co is a listed entity, Acquisition can provide a host of benefits for the company. Some of these benefits are listed below -

i. New Competencies and resources - By acquiring a company operating in a similar line, organization can tap into to gain competencies and resources that it currently lacks. Mtandao has well prominance in selling and marketing online testing resources and has steady growth in the frontline figures. As such it is a breakthrough for Emilu Co and has a potential to revive the company back to its feet.

ii. Reduced entry barriers - One of the potential disadvantages faced by small companies is the cost of enetering a new market which enatils cost of R&D, time to build substantial client base and other running costs. By acquiring a company that already has a well established place in the market, market entry barriers could be overcone that were previously challanging. Had if the developed online materials on their own (which is a shift from the production of hard copy materails), Emilu company could have high market entry costs. But by acquiring Mtandao Co, which has proven record in producing top notch online materials, it could ease the burden of Emilu Co.

However Acquisition can also prove deterimental for the acquiring Company if there is no proper plan for acquisition. Some of the cons are listed below -

i. Conflicting opinions and clashes - One of the uphill tasks that acquiring companies encounter is convincing its own shareholders and acquiree's board to to give consent to acquisition. This could be a bit probalmatic and one of the groups may decline other's proposal. This could be proven from the Mtandao's rejection of Emilu Co's 1st proposal for bidding 5 shares for every three shares in Mtandao's. Further rejection entails next round of dicussions and meetings which could be costly affair as assent is required amongst shareholders of acquirer. Integration problems could aso be a bit challenging.

ii. Apprehensions amongst employees - Emilu Co also need to convince its own employees and their agreement to acquire a new business. If they are apprehensive, they may be unwilling to work in a new dynamic environment. Emilu also need to consider the training and other personnel development costs for the same.

iii. Increased - In the last point, it is stated that the debt financing is required to fund the acquisition. This could add to the leverage and could cause pressure on the earnings of the firm