Nov 2019 Q2
Global companies continuously explore ways to be more efficient and effective to survive the challenging global competition. Some resort to mergers and acquisitions to survive. In the light of this, Carsley Ltd and Powell Ltd are planning to merge to form Stimac Ltd. It has been agreed that Powell’s shareholders will accept three shares in Carsley for every share in Powell they hold. Other details are as follows:
. Carsley Ltd Powell Ltd
Number of shares 40m 10m
Annual earnings GH¢10m GH¢5.8m
P/E ratio 8 10
Post-merger annual earnings of the enlarged company are expected to be eight per cent higher than the sum of the earnings of each of the companies before the merger, due to economies of scale and other benefits. The market is expected to apply a P/E ratio of 9 to Stimac Plc.
Required:
a) Explain to the stakeholders of both companies the justification on for the following integration strategies in mergers and acquisitions.
i) Horizontal take-over. (4 marks)
View Solution
- Economies of scale
The major justification put forward to explain horizontal mergers centre on the fact that the merging companies are in the same industry and so are likely to benefit from economies of scale. They may also benefit from synergy between operations as well. - Breaking entry barriers
Horizontal mergers can also be justified as a way of breaking into new geographical markets. - Obtaining Monopoly Power
Market share can also be a viable reason, so that companies can earn monopoly profits, but the bidder must beware of referral to the MMC. - Enhanced Shareholder value
There may be financial economies and tax benefits from mergers, but increasing EPS is not a valid justification.
ii) Vertical backward and forward take-overs. (4 marks)
View Solution
- Control of Raw Materials
Here the major justification is that a company can either secure control of vital raw material or guarantee an outlet for, and control the distribution of its product. - Control of Distribution Channels
This helps companies to reduce the power of suppliers or to decrease the revenue lost to distributors. Economies of scale or synergy are less likely to occur than with horizontal take-overs.
iii) Conglomerate mergers. (2 marks)
View Solution
It is very difficult to see the rationale for conglomerate take-overs, as there will be few economies of scale or synergy due to the unrelated nature of the merging businesses. The take-over cannot be justified from the point of view of risk reduction, as shareholders are likely to hold diversified portfolios. Nor can the take-over be justified as the acquisition of a bargain, since if capital markets are efficient; the target’s share price will reflect its true value.
b) Determine the extent to which the shareholders of Powell will benefit from the proposed merger. (10 marks)
View Solution
- Powell’s market value, using its P/E ratio and earnings, is 5.8m x 10 = ¢58m
- The earnings of Stimac Ltd will be (¢10m + ¢5.8m) x 1.08 =¢17.06m
- Using a P/E ratio of 9, the value of Stimac is ¢17.06m x 9 = ¢153.54m
- The 10m shares of Powell will be swapped for 30m Carsley shares, making 70m shares in the new company in total. Therefore the wealth of Powell’s shareholders will now be ¢153.54m x (30m/70m) = ¢65.8m.
- Powell’s shareholders are ¢7.8m better off (78 cedis per share).