At GH¢6.50 per share Bee is not an attractive merger partner.

A merger will only be worthwhile for a company that is committed to maximising shareholder wealth, if gains arise that would not otherwise arise if the bidding and target businesses had not been combined. The value of a business may be defined as
the present value of its future cash flows. This means that a takeover will make economic sense if the present value of the combined business exceeds the aggregate of the present values of each business when taken separately.
Thus: PV Combined business > PV Bidding business + PV Target business

Paying too much for the target company
The management of the bidding company may pay too much for the target company. It is quite common for a premium to be paid to the shareholders of the target company in order to encourage them to sell their shares. Unless there are benefits accruing from the takeover, this premium paid will simply transfer wealth from the shareholders of the bidding company to the shareholders in the target company.

Hidden problems
Problems that were hidden at the time of the takeover may emerge later to eliminate any gains that were anticipated. These problems may have been deeply buried and so may have been difficult to unearth, even where proper due diligence procedures were carried out prior to a takeover agreement.

Integration issues
Integrating the two businesses following takeover may prove a difficult task. There may be differences in culture, management style, and organisational methods and systems that cannot be easily reconciled. Integration problems are most acute where
there is an attempt to impose a common style and common systems following takeover. Where the former target company is allowed to maintain its own identity and its own systems, integration problems are likely to be much less of an issue.

Management attitudes and motivation
Once the takeover has been completed, managers may expect the enlarged business to achieve success without the need for much effort. They may feel that the takeover was the most important ingredient for success and expect that future operations will run smoothly. In some cases, an exhausting takeover struggle may leave managers with little energy or enthusiasm for ensuring that things go according to plan.

Errors in valuing a target firm
Managers of the bidding firm may advise their company to bid too much as they do not know how to value an essentially recursive problem. A risk-changing acquisition cannot be valued without revaluing your own company on the presupposition that the acquisition has gone ahead. The value of an acquisition cannot be measured independently. As a result, the merger fails as the subsequent performance cannot compensate for the high price paid.

The target being too large relative to the acquirer
A literature review suggests that the difficulties associated with a merger or acquisition increase as a function of the relative size of the target. This tends to happen because the target becomes more and more difficult to absorb as it becomes relatively larger. A target equal in size to the acquirer can only be effectively absorbed in a merger of equals.

Number of shares of Dasco Limited                                    4,000,000
Price per share of Dasco Limited                                                ¢3.30
Value of Dasco Limited ¢3.3 x 4,000,000 =               GH¢13,200,000

Number of shares to offer for Dasco Limited’s shares:
= (¢13,200,000/¢2.20) = 6,000,000 shares

For each of Vasco Limited’s shares, Okumkom Limited will offer:
= (¢6,000,000/¢4,000,000) = 1.5

That is 3 shares to be issued for 2 shares in Dasco Limited.
Effect of the takeover on Okumkom Limited’s EPS note P/E = 15
EPS of Okumkom Limited before takeover = (2.20/15) = 14.67 p

Earnings of Okumkom Limited before takeover
0.146 x 10,000,000 shares                                                                      ¢1,467,000

Earnings of Dasco Limited  =  (330/10) x 4,000,000                             ¢1,320,000
Combined earnings after takeover                                                      ¢2,787,000

Shares of Okumkom Limited before takeover                   10,000,000
Shares issued to Dasco Limited’s shareholders                  6,000,000
Total number of shares after takeover                             16,000,000
EPS after takeover = (2,787,000/16,000,000) = 17.4 p

Share price of Okumkom Limited after takeover
P/E = 15
Price = 15 x 0.174 = 261p

Comments:
The takeover has been considerably favourable to Okumkom Limited because it has an improved Earnings Per Share as well as an enhanced share price by 2.73p and 41p respectively. The takeover has not been favourable to the shareholders of Dasco Limited in terms of the reduction in their EPS by 15.6p which is very substantial and also a reduction in the share price. The number of shares allotted to them might however compensate for the reduction as shown below.
Now, suppose a shareholder has 1,000 shares in Dasco Limited, the effect:
.                                                                                                      GH¢
Value in Dasco Limited before 1,000 x ¢3.30                          3,300
Value after takeover 1,500 x GH¢ 2.61                                     3,915
Increase in value                                                                         615

The shareholder will gain GH¢615 in value of his investment by the takeover.
The shareholders of Okumkom Ltd would suffer a dilution of control as a result of the takeover. They would be conceding 37.5% of their control to the shareholders of Dasco Ltd.

Using the dividend valuation model the value of ordinary shares is given by:

• The calculations in part (a) are based on the dividend valuation model which depends on the belief that share prices are the discounted present value of the future dividend stream. There are strong theoretical justifications for this model in the context of a perfect capital market. However, in a less than perfect market the failure of the model to take any account of short run earnings (i.e. accounting profits) or underlying asset values, may limit its usefulness. There are further practical problems in applying the model which relates to determining the values of the constituent variables. Of these ‘g’ the anticipated growth rate and Ke, the cost of capital or required return, present particular problems. ‘g’ the anticipated future dividend growth. It is usually estimated by extrapolating past growth or by using the Gordon Growth Model. Whichever approach is taken the resulting estimate is inevitably suspect.
• Selecting an appropriate discount rate to convert future cash flows to a capital value also present special difficulty. Generally the appropriate rate reflects the risk-free rate and a premium for risk suitable for the share being valued. It is obviously difficult to determine such a rate. In this question the required return is given as 15%. This is used for both Red and Yellow and for all time periods. This in turn assumes that the risks associated with both companies over all relevant time periods are identical. This seems unlikely, particularly in view of the differences in growth rates for Red and Yellow. It would be more usual to assume that the very high growth in Yellow’s dividends during the first four years would result in riskier cash flows.
• Further practical difficulties would include the management organization of the post-merger company, competitive response and arranging the finance for the takeover.
• Finally, in transactions of this type there are inevitably tax consequences that would have to be carefully considered.
  

Add  cash flows from sale of machines  GH¢100,000                                      = GH¢0.1
Total value of Jacobs Ltd after acquisition                                                        = GH¢10.0

The maximum price Jacobs Ltd should pay to acquire Idowu Ltd should be the difference between its value after and its value before the acquisition = GH¢10m – GH¢7m  = GH¢3.0

The minimum price that ordinary shareholders of Idowu Ltd should accept for their shares is the market value = GH¢1.5m

Take-over price agreed at GH¢ 1.5m
Let x represent the number of new shares to be issued to Idowu Ltd.
Total number of shares in issue will become 2m + x shares
Total value of Jacobs Ltd after acquisition = 10m.
For the entire benefit from the acquisition to accrue to all the present shareholders of Jacobs Ltd, value of Jacobs shares issued to Idowu’s shareholders must equal the agreed take-over price.

 OR

The take-over ratio is 35.2941 shares in Jacobs Ltd for each 100 shares held in Idowu Ltd.
The market value per share after the acquisition or take-over
= (GH¢10,000,000/2,352,941)  = GH¢4.25

Jacobs Ltd shareholders will have an increase in the market value of their shares from GH¢3.50 to GH¢4.25 = GH¢0.75 per share. The 2m shares would have increased by 2m × GH¢0.75= GH¢1,500,000

Idowu shareholders have 352,941 shares at GH¢4.25 each = GH¢1.5m (same as their previous value).
Thus the entire benefit from the take-over will accrue to the present shareholders of Jacobs Ltd.

• The shareholders in Idowu Ltd should try to get a take-over price higher than the GH¢1.5m agreed in (b) above since this is their value and they would not benefit at all from the take-over at that price. In practice, they would have to be offered an amount in excess of their market value to induce them to sell.
• The directors of Idowu Ltd might believe from the proposal that the increase in profits after the acquisition and the sale of assets are indications that they are not effectively utilizing their assets hence may decide to put them (the assets) to better usage rather than sell them.
• The directors of Jacobs Ltd will have to reassess their estimates. How realistic is the increase in sales revenue of GH¢60,000 p.a. and at the same time a reduction in expenses of GH¢50,000. Will reduction in expenses involve retrenchment of staff and what effect will this have in morale of the remaining staff? An increase in value of GH¢3m from an investment of GH¢1.5m seems rather too high.
• What of the transaction costs of the acquisition? They have not been considered. If the take-over is resisted by the directors of Idowu Ltd or other interested buyers, then the cost of the acquisition could be quite high. Also the position of the shareholders of Idowu Ltd should be considered since their control will be greatly reduced, eg. A holder of 51% interest in Idowu Ltd will find himself owning only 7.6% in Jacobs Ltd after the acquisition.
• Whether there would be increased market power and economies of scale and scope.
• Furthermore, Jacobs and Idowu both manufacture and sell autoparts; the attitude of the government or trade unions to forestall a monopoly situation has not been considered. Finally, in as much as the acquisition looks attractive a lot more detailed information to answer the questions raised must be obtained before a final decision is taken.
• Attitude of government and trade unions must be considered.
• Elimination of inefficiencies, use of surplus cash and increased debt capacity must be considered.        (Any 4 points)
  

Appraisal of the proposed acquisition
.                                                                          Mama Ltd                Papa Ltd
Shares in issue                                                 10 million                  5 million
Market price                                                     GHS6.00                   GHS4.50
Value of equity (10,000,000 x 6.0)                 60,000,000
.                         (5,000,000 x 4.5)                                                      22,500,000
Value of debt                                                   40,000,000
After-tax cost of debt                                           22%

NPV and post-acquisition value
Computation of NPV:
The NPV of an acquisition is the gain from the acquisition less the cost of the acquisition:
The gain from the acquisition is the PV of synergy from the acquisition:

Cost saving = given as GHS600,000 every year perpetually
As the firm has both equity and debt in its capital structure, the appropriate cost of capital to use as discount rate is the WACC.

Cost of equity, ke is estimated from the CAPM:

𝑘𝑒=𝑟𝑓+𝛽𝑖(𝐸(𝑟𝑚)−𝑟𝑓)

𝑘𝑒=0.2+1.2(0.05)=0.26
Cost of the acquisition is the excess of the purchase consideration over the value of the target:

𝐶𝑜𝑠𝑡=𝐶𝑎𝑠ℎ 𝑜𝑓𝑓𝑒𝑟−𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑎𝑝𝑎

𝐶𝑜𝑠𝑡=𝐺𝐻𝑆25,000,000−𝐺𝐻𝑆22,500,000=𝐺𝐻𝑆2,500,000

The NPV is then computed as Gain less Cost:

𝑁𝑃𝑉 = 𝐺𝑎𝑖𝑛 − 𝐶𝑜𝑠𝑡=𝐺𝐻𝑆2,459,016−𝐺𝐻𝑆2,500,000= (𝐺𝐻𝑆40,984)

Advice based on NPV:
The negative NPV suggests that if the acquisition happens, the value of Mama would reduce by GHS 40,984. Therefore, the directors of Mama should discard the acquisition plan.

𝑃𝑜𝑠𝑡−𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒

𝑃𝑜𝑠𝑡−𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 𝐺𝐻𝑆60,000,000+𝐺𝐻𝑆22,500,000+𝐺𝐻𝑆2,459,016−𝐺𝐻𝑆2,500,000

𝑃𝑜𝑠𝑡−𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 = 𝐺𝐻𝑆82,459,016𝑚

The number of shares Mama should issue to shareholders of Papa can be calculated based on market price as under:

The share exchange ratio between Mama and Papa may be expressed as 3:4 or 0.75:1. That is Mama should issue 3 shares of its ordinary stock for every 4 shares in Papa (or 75 shares of Mama for every 100 shares in Papa).

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

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

• 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
  

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.

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:

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.

(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.