Plainview Farms Limited is considering acquiring Cottage Industries Limited. The extracts of the financial statement of the two companies is as follows:
The two companies retain the same proportion of profits each year and this is expected to continue into the future. Plainview Farms Limited return on investment is 16%, while that of Cottage Industries Limited is 21%. One year after the post-acquisition period, Plainview Farms will retain 60% of its earnings and expects to earn a return of 20% on new investment.
The dividends of both companies have been paid. The required rate of return of ordinary shareholders of Plainview Farms Limited is 12% and Cottage Industries Limited 18%. After the acquisition, the required rate of return will become 16%.
Required:
a) If the acquisition is to proceed immediately, calculate the;
i) Pre-acquisition market values of both companies. (5 marks)
View Solution
Market Value of Plainview Farm Limited:
Using the Gordon’s growth model: g = rb
Where, r = return on investment
. b = retention ratio
. g = rb, r = 0.16, b = 0.25
. g = 0.16 x 0.25 = 4%
Future Dividend in 1 year
= D1 (1 + g)
= 600 (1.04) = GH¢624million
Market Value (MV) = d/(r-g)
. = GH¢624m/(0.12-0.04)
. = GH¢7.8 billion
Market Value of Cottage Industries Limited:
r = 0.21, b = 2/3
g = rb = 0.21 x 2/3
= 14%
Future Dividend in 1 year
100 (1.14) = GH¢114 million
Market Value (MV) = d/(r-g)
. = GH¢114m/(0.18-0.14)
. = GH¢2,850 billion
ii) Maximum price Plainview Farms Limited will pay for Cottage Industries Limited. (5 marks)
View Solution
Plainview Farm Limited earning in 1 year GH¢m
. GH¢800 million x 1.04 832
Cottage Industries Limited
. GH¢300 million x 1.14 342
. 1,174
Dividend in 1 year GH¢1,174 million @ 40% = GH¢469.60m
If r = 0.2 and b = 0.6
g = 0.2 x 0.6 = 0.12
Post-Acquisition Market Value:
MV = GH¢469.6m/(0.16 – 0.12) = GH¢11740 billion
Maximum Price = GH¢11,740billion – GH¢2,850 billion
. = GH¢8,890 billion
Payable for Cottage Industries Limited is GH¢8,890 billion
b) As a Finance Manager in your company, you have been asked to produce an explanatory memo to Senior Management on the subject Mergers and Acquisition. Your memo should clearly outline what actions a target company might take to prevent a hostile takeover bid. (5 marks)
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- White Knight: A situation in which the target company looks for a friendly company where offer is more appealing for the takeover bid.
- Shark Repellant: This involves amending the company’s memorandum and articles of association in such a way that makes the takeover difficult for the acquiring company. An example is increasing the margin of majority votes required at an Annual General meeting called to approve such a takeover.
- Pac-man Defence: An anti-takeover strategy in which the target company tries to buy up the share of the acquiring company.
- Golden Parachutes: This refers to provision in the executives’ employment contract that call for payment of severance pay or other compensation should they lose their job as a result of a successful takeover.
- Poison-Pill: A strategy sometimes employed by target companies in a takeover bid to reduce the attractiveness of their securities/assets to the prospective acquiring firm. This is often done by enlarging the outstanding shares of a target company through a new issue of shares to its shareholders at a discount to the market price, thus making the takeover quite expensive to the prospective acquiring firm