You are the Finance Manager of a growing clothing company, Two-Pack Fashion Ltd (Two-Pack). Two-Pack has enjoyed significant growth in recent years using an internal growth strategy. Two-Pack is now seeking to acquire other companies to speed up its growth drive. It has identified Anas-Expo Clothing Ltd (Anas-Expo) as a suitable candidate for takeover. Both companies have the same level of risk.
Anas-Expo produces high quality handmade clothes, with which it has earned several awards. The company has recorded considerable profits in the past, but its output has dwindled over the past two years due to increasing labour costs. Labour unions have pressured policy makers into amending labour regulations, particularly those relating to pension and minimum wage, to provide more benefits and protection for workers. Directors of Two-Pack believe that production and profitability of Anas-Expo will be enhanced if its production process is mechanised.
Below are summarised financial data for the two companies immediately before acquisition:
Two-Pack has 40 million shares and a P/E ratio of 18 while Anas-Expo has 25 million shares and P/E ratio of 12. Directors of Two-Pack have decided that Two-Pack takes up all the equity shares in Anas-Expo by offering to its shareholders one new share for every one share they hold. They have also decided that Two-Pack mechanises Anas-Expo’s production process immediately at the cost of GHS18 million, and thus replace work currently done by hand. It is estimated that operational efficiency that would arise from the acquisition and integration of the two companies would rake in after-tax benefits of GHS25 million every year to perpetuity.
The cost of capital of Two-Pack is 25%.
Required:
(a) Evaluate the acquisition proposal, and recommend whether the acquisition should go ahead. (7 marks)
View Solution
The value of an acquisition can be assessed using the net present value of the acquisition and integration.
𝑁𝑃𝑉 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 = 𝑃𝑉 𝑜𝑓 𝑠𝑦𝑛𝑒𝑟𝑔𝑦−𝐶𝑜𝑠𝑡 𝑜𝑓𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛−𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑒𝑐ℎ𝑎𝑛𝑖𝑠𝑎𝑡𝑖𝑜𝑛
𝑁𝑃𝑉 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 = 𝐺𝐻𝑆100𝑚−𝐺𝐻𝑆169.1𝑚−𝐺𝐻𝑆18𝑚 = 𝐺𝐻𝑆−87.1𝑚
The NPV of the acquisition is negative. Two-Pack should not go ahead with the acquisition.
Workings:
1. PV of synergy
Synergy = GHS25m per year
Discount rate = 25%
𝑃𝑉 𝑜𝑓 𝑠𝑦𝑛𝑒𝑟𝑔𝑦 = 𝐺𝐻𝑆25𝑚/0.25 = 𝐺𝐻𝑆100𝑚
2. Cost of acquisition
The cost of acquisition is the purchase consideration less the value of the target.
Purchase consideration = Value of share offer = Post-acquisition share price x Shares
EPS, Two-Pack = GHS55.8/40m = GHS1.395
Current share price, Two-Pack = P/E ratio x EPS = 18 x GHS1.395 = GHS25.11
Current value of equity, Two-Pack = GHS25.11 x 40m = GHS1, 004.4m
EPS, Anas-Expo = GHS33.7/25m = GHS1.348
Current share price, Anas-Expo = P/E ratio x EPS = 12 x GHS1.348 = GHS16.176
Current value of equity, Anas-Expo = GHS16.176 x 25m = GHS404.4m
Purchase consideration = GHS22.94/share x 25m shares= GHS573.5m
Cost of acquisition = GHS573.5m – GHS404.4m = GHS169.1m
Note: Post-acquisition value may be estimated as the product of the post-acquisition EPS and P/E ratio.
(b) Analyse the effect of the acquisition on the earnings per share of Two-Pack following the successful acquisition of Anas-Expo. (2.5 marks)
View Solution
Earnings after acquisition = GHS55.8m + GHS33.7m + GHS25m = GHS114.5m
EPS = GHS114.5m / 65 = GHS1.762
The EPS of Two-Pack will increase by GHS0.367 (GHS1.762 – GHS1.395) if the expected benefit of additional GHS25m in annual after-tax net income is achieved.
Assuming the synergy is not achieved, the EPS of Two-pack will drop by GHS0.018:
(c) Analyse the effect of the acquisition on the wealth of the shareholders of each company. (4.5 marks)
View Solution
Shareholders of Two-Pack:
Current value of shares = 40m x GHS25.11 = GHS1,004.4m
Value after acquisition = 40m x GHS22.94 = GHS917.6m
Potential loss in value = GHS86.8m
Shareholders of Anas-Expo:
Value of current shareholding in Anas-Expo = GHS16.176 x 25m = GHS404.4m
Value of shareholding in Two-Pack = 25m x GHS22.94 = GHS573.5m
Potential gain in value = GHS169.1m
If the acquisition takes place, existing shareholders of Two-Pack would lose value while shareholders of Anas-Expo would gain value.
(d) Advise the directors of Two-Pack on three likely sources of conflict in relation to the acquisition of Anas-Expo and mechanization of its production process, and suggest ways through which the conflict could be avoided or resolved. (6 marks)
View Solution
(1) Impact of acquisition on shareholder’s wealth
*Potential conflict: As rational investors, shareholders of Two-Pack will prefer investments that enhance their value to those that reduce their value. Any acquisition that presents a negative NPV and reduction in value of existing shareholders would be resisted. The NPV of the acquisition is negative and the post-acquisition value of existing shareholders’ shares will be lower than their value now. What is more, the acquisition appears to serve directors’ interest because as the larger profits of a larger post-acquisition company implies bigger compensation packages for them.
*Solution: The conflict may be avoided if the acquisition proposal is discarded. The value of existing shareholders may be enhanced if Anas-Expo is acquired at a lower P/E ratio (may be offer 1 share for every two shares in Anas-Expo). In this case, EPS of post-acquisition company will be higher than Two-Pack’s current EPS and given the P/E ratio, the value of shares post-acquisition will be higher than now.
(2) Impact of mechanization on employees
*Potential conflict: The mechanization of the production process will enhance production efficiency and, at least in the short-term, yield additional profits. This will serve the interest of directors if their compensation is based on earnings. However, employees at Anas-Expo may resist the planned mechanization because of the associated job losses. Shareholders, on the other hand, may resist high redundancy packages demanded by employees.
*Solution: Employees should be consulted and educated on the mechanization programme. Those who would lose their job should be given adequate compensation and retraining to pursue opportunities elsewhere. The implementation of the mechanization programme could be delayed or done in phases to reduce tension, spread the cost of the programme over a period, and to give employees enough time to adjust.
(3) Mechanization and product quality
*Potential conflict: The mechanization of the production process implies that clothes will now be mass-produced with machines. The quality of the mass-produced clothes may fall below that of the handmade clothes. Besides, the product of Anas-Expo may have won those awards because of its quality as a handmade product. Customers may be unhappy if their cherished handmade clothes are replaced with lower-quality mass-produced versions.
*Solution: Instead of a full-scale mass production with machines, directors may consider producing a proportion of total output using machines and a proportion using hand. This middle-ground approach will enhance operational efficiency for lower cost while maintaining some level of production for the celebrated handmade products. Also, the company should make additional investment in R&D to obtain a production technology that would maintain the quality of the clothes when produced with machines.
(4) Impact of mechanization on larger society
*Potential conflict: Mechanization of the production process may enhance efficiency and reduce production costs. But since the purpose of the mechanization is to replace work done by hand, the larger society, including the community in which the factory is located and the government, may resist the programme as it will result in job losses and increase unemployment rate. Besides, if the additional net income that would result from the mechanization does not compensate for the reduction in employment income due to job losses, government will lose tax revenue.
*Solution: JB should manage the impact of the mechanization well by providing adequate redundancy package, education and training for employees who would be affected to help them adjust; phase in the implementation of the programme; and secure production technology that would enhance quality of the products to achieve higher demand, lower operating costs, and superior profits.