Acquisition of a Company - Assignment Example

Investment appraisal report for acquisition of another company. Prepared for the board of directors of M/s Rozana plc. Executive Summary(This Report is an analysis of the capital investment proposal of M/s Rozana Plc. The report discusses the various Valuation methods available for the managers for financial appraisal, their merits and demerits. It critically evaluates each valuation methods and make recommendation on the acquisition choice and the price to be paid. It also looks into the possible sources of finance that Rozana plc may use to finance the acquisition) (Total Word count 2427 word count for tables 285, Nett word count 2142) (INTRODCUTION) M/s Rozana Plc. is a UK based company. It has an investment plan of acquisition of another company and has short listed two companies namely Sukna Ltd. And Badra Plc for acquisition. This report 1. Calculates the prospective value for the target companies using different valuation methods. 2. It critically evaluates the valuation methods applied in (1) and recommends on the acquisition choice and derives the price to be paid. 3. It critically evaluates the possible sources of finance that Rozana plc may use to finance the acquisition. It also evaluates the impact of additional borrowing on Rozana's capital structure. Calculation of prospective value of both the companies and various methods of valuation: The methods of appraisal available for a manager are: 1. Pay Back: In this method of appraisal, the payback period is defined by the no. of years required for the annual cash flow to equalize the initial investment of the project. Payback Period = Where, A = Cumulative Cash Balance for year before cumulative balance becomes positive B = Cumulative Cash Balance for year after cumulative balance becomes negative X = no of years before the cumulative cash balance becomes positive Advantages: It is very easy to understand It is very simple to use It surmises on the fact that the longer time forecast of a company leads to more uncertainty. Shorter Pay back will involve less uncertainty in forecasting of future cash flow. Disadvantages: It ignores the cash flows after the end of the Payback period. It ignores the time value of Money. This drawback can be overcome by the use of discounted Payback in which the cash flows are discounted prior to the calculation of payback period. 2. Accounting Rate of Return: Accounting Rate of Return is based on accounting profit. Accounting Rate of Profit (ARR) can be defined as the percentage of Average Annual Profit of an Investment to the Average Investment. Where, Average Investment = (Initial investment + scrap value) / 2 Advantages: By using Profit figures, this technique relates to the return on capital employed directly. The result of this calculation is in percentage, which is easily understandable by most business people. Disadvantage: Here also it ignores the time value of money It uses the accounting profit rather than cash flows. Cash flows represent solid power over resources, whereas Accounting profits are subjected to the application of accounting concepts. 3. Net Present Value: It is a discounted cash flow method of investment appraisal. It uses the method of discounting future cash flows to its present values. The sum of the future cash flows less the initial investment gives the Net Present value of a Project. Advantages: Its main strength is its recognition of time value of money. As it considers cash flow for calculation, it is not affected by the accounting policy of a particular company. As it takes account of the costs of raising finance, a positive NPV reflects the increase in shareholders' wealth, which is supposed to be the main consideration of Project appraisal. Disadvantages: This is a bit cumbersome process of calculating the discount rate with the nature of finance available. It gives result in absolute figures, and does not allow for the size of the project. 4. Internal Rate of Return: Internal Rate of Return is the discount rate that gives a zero NPV. The acceptance criteria of this method of appraisal are; IRR should be greater than the discount rate on the presumption that a project with higher IRR than the discount rate generates higher returns. Advantages: Like NPV it gives due consideration to time value of money. The percentage nature of the IRR gives it some added advantage over NPV. Calculation of IRR is easier as it does not require precise cost of capital discount rate. To accept a project it is enough to see that the IRR sufficiently higher than the approximate cost of capital. It provides additional information in the shape of differences between IRR and the cost of capital indicates additional return of risk. The first two are called non-discounting cash flow method whereas the last two are called discounted cash flow method. Calculation of PAYBACK PERIOD for Badra Investment needed to acquire Badra = 370 pence X 5000000 shares = 18,500,000 However the directors of Badra indicated a value of 22,000,000. There will be cash inflow of 800000 by selling land. The investment will become 22000000 - 800000 = 21200000 However the payment to 50 employees to remove them will add up which will make the investment to = 21200000 + 1200000 = 22400000 Net annual cash flow 3551000 , We add the expected wage saving of 750000 and advertising and distribution saving of 150000 to this profit. So the cash inflow annually will be = 3551000 + 750000 + 150000 = 4451000 However 100,000 each needs to be paid to the three directors for 3 years. Hence the cash inflow for the first three years will be 4451000 - 300000 = 4151000 we assume it remains constant for the whole period. Year Annual Cash Flow in 000 Cumulative Cash Balance in 000 0 (today) - 22,400 (22,400) 1 4151 (18249) 2 4151 (14098) 3 4151 (9947) 4 4451 (5496) 5 4451 (1045) Payback 5.235 4451 0 6 4451 3406 Payback Period = Where, A = Cumulative Cash Balance for year 5 = 1045000 B = Cumulative Cash Balance for year 6 = 3406000 X = no of years before the cumulative cash balance becomes positive = 5 years Therefore, Payback Period = 5+ 1045000/(1045000+340600) = 5.235 years PAYBACK PERIOD for Sukna As the present market price for Sukna shares is not available, we assume the amount needs to be invested for acquiring Sukma Total cost of shares at par + Reserves + Bank Term loan = 47000000 Year Annual Cash Flow in 000s Cumulative Cash Balance in 000s 0 (today) - 47000 (47000) 1 7705 (39295) 2 7705 (31590) 3 7705 (23885) 4 7705 (16180) 5 7705 (8475) 6 7705 (770) 6.0999 Payback 7705 0 8 7705 6935 Payback Period = Where, A = Cumulative Cash Balance for year 6 = 770000 B = Cumulative Cash Balance for year 7 = 6935000 X = no of years before the cumulative cash balance becomes positive = 3 years Therefore, Payback Period = 6+ 770000/(770000+6935000) = 6.0999 years FORMULA TO CALCULATE NPV Net Present Value = Discount Factor x Cash Flow In this case of M/s Badra the 22 million will be entirely financed by the cash balance available with M/s Rozana which is presently invested in short term money market deposits. Hence we can take the discount factor as Inflation 2.4% + risk free market return of 6% = 8.4% say 9% Now; Net Present Value = Discount Factor x Cash Flow Net Present Value for Badra Year Year 0 (Today) End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 Initial Investment (Expenditure) 22,400,000 0 0 0 0 0 Annual Operations Cash Flow (Income) 0.00 4151000 4151000 4151000 4451000 4451000 Total Cash Flow (Income - Expenditure) -22400,000 4151000 4151000 4151000 4451000 4451000 Discount Factor (at a rate of 9%) 1.0000 0.917 0.842 0.772 0.708 0.650 Present Value for Annual Cash Flow (Total Cash Flow X Discount Factor) -22,400,000 3806467 3495142 3204572 3151308 2893150 Total Net Present Value over 5 years at 9% Discount Rate = (3806467+3495142+3204572+3151308+2893150) - 22400,000 = 16550639 - 22400,000 = (-) 5849361 Net Present Value for Sukna The finance will be done as follows: The 23 million at discount rate of 9% And balance 19 million has to be borrowed loan 14% The average discount rate = (23 X 9 + 19 X 14) / 44 = 10.75%, say 11% Year Year 0 (Today) End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 Initial Investment (Expenditure) 44,000,000 0 0 0 0 0 Annual Operations Cash Flow (Income) 0.00 7705000 7705000 7705000 7705000 7705000 Total Cash Flow (Income - Expenditure) -2000,000 7705000 7705000 7705000 7705000 7705000 Discount Factor (at a rate of 11%) 1.0000 0.901 0.812 0.731 0.659 0.593 Present Value for Annual Cash Flow (Total Cash Flow X Discount Factor) -44,000,000 6942205 6256460 5632355 5077595 4569065 Total Net Present Value over 5 years at 11% Discount Rate = (6942205+6256460+5632355+5077595+4569065) - 44000,000 = (-) 20086816 The facts and figures available with us allow us to compare the two companies by Ratio analysis also. Ratio Analysis: To summerize complex accounting information into relatively small no. of key indicators ratios are used. This also makes comparison easier. As we are now going to make comparison between the performance of M/s Sukna and M/s Badra we should utilize the ratio analysis method. Traditionally ratios are classified into five groups. We should look into the ratios for which data is available with us. Profitability Ratios: These ratios are concerned with the effectiveness of firms in generating profit. Return on net assets = Net profit before long term interest and tax / Total assets less current liabilities X 100%. This is known as primary ratio as it goes to the heart of what most private sector firms try to achieve. This ratio gives the effectiveness of the assets financed both by shareholders and long term creditors. This ratio should be as high as possible. For M/s Sukna - 11,500,000 / 47,000,000 X 100% = 24.47% For M/s Badra - 5,300,000 / 9,200,00 X 100% = 57.6% Return on Equity = Net profit after long-term interest and tax / Share Capital and reserves X 100%. This ratio directly gives figure relevant to shareholders point of view. For M/s Sukna - 7,705,000 / (4,000,000 + 35,000,000) X 100% = 19.75% For M/s Badra - 3,551,000 / (500,000 + 5,200,000) X 100% = 62.29% Gross Profit Margin = Gross Profit / Sales X 100%. This ratio does not give a clear picture but it can give some trend. It gives an idea to compare with other similar industries, whether the target organization is operaqting in more profit margin compared to its competitor, which in the long run may not be sustainable For Sukna - 11,500,000 / 85,000,000 X 100% = 13.53% For Badra - 5,300,000 / 38,000,000 X 100 % = 13.95% We find that both the companies are giving almost similar amount of margin which makes our task easier to find that though M/s Bdra is well ahead of M/s Sukna in various other retios, it is not operating on abnormal profit margin. Activity Ratios: These ratios are used to assess the effectiveness of the firms in using their assets. Net Asset Turnover = Sales / Total assets less current liabilities. This ratio is used as measure of the size of the firm. This ratio is a measure of the effectiveness with which the firm is using its assets to generate sales. For Sukna - 85,000,000 / 47,000,000 = 1.8 For Badra - 38,000,000 / 9,200,000 = 4.13 We find that M/s Badra is utilizing its assets more efficiently. Liquidity Ratios: These ratios are used to assess how well the firms are managing their working capital. Current Ratio: Current assets / Current liabilities. This should be higher than 1, which gives confidence to creditors that current liabilities are entirely financed by current assets. This provides some measure of how the organization balances its two aspects of working capital. The ideal situation should be 1:1 For Sukna - 28000000 / 20000000 = 1.4 For Badra - 4700000 / 3900000 = 1.2 Here we find that M/s Badra with 1.2 is balancing better than M/s Sukna. Capital Gearing ratios: This is concerned with the relative sizes of the funds provided by the shareholders and the creditors. Loan financing is cheaper than equity financing, but it exposes the shareholders to greater risks. Debt to equity ratio = Long-term and short term borrowings / total equity (shares plus reserve) For Sukna - 8000000 / (4000000+35000000) = 0.2 For Badra - 3500000 / (500000+5200000) = 0.61 The high Debt to equity ratio of M/S Badra makes it less riskier, whereas it also tells that the financing is quite expensive. Investors' ratios: Earning per share = Profit after tax and interest / no. of ordinary shares. For Sukna - 7705000/4000000 = 1.926 (of 1 par) For Badra - 3551000 / 5000000 = 0.71 (of 0.1 par) It shows that return to shareholders of M/s Badra is far greater compared to M/s Sukna. From all the above figures and details it is found that the acquisition of M/s Badra will be more beneficial in comparison with M/s Sukna. Evaluation of possible source of Finance that Rozana plc may use to finance the acquisition. The considerations to be taken into account in deciding the source of finance any organization should take: 1) The administration and legal costs of actually raising the finance 2) Interest rate 3) The level of obligation to make the interest payment 4) The level of obligation to repay the finance 5) The tax deductibility factor related to the finance. 6) The effect of the new finance on the control of the existing organsiation. The options available are: 1) Equity Capital - In the long run the equity capital is expensive way of financing as it entails commitment of dividends and lots of care needs to be taken for maintaining the control of the company and shareholding pattern. However it is the least risky financing option available. 2) Retained Profit - The profit accrued can be retained and be used as a source of finance. It have least cost. However the retention of profit involves withholding dividends from shareholders, which may not be taken kindly by the shareholders. 3) Loan Stocks and debentures - These are market borrowing by issuing securities with fixed interest rates and with a pre-stated redemption date. Some loan stocks are secured and some are non-secured. These are less expensive than term loan from financial institutions. However costs of issue handlings are involved. 4) Convertible Loan stocks - These are similar to the Loan stocks except of a pre-stated option of conversion to equity at a later date. 5) Warrants - These are loan stocks that give the right to subscribe for ordinary shares at some time and price, in some predetermined quantity. 6) Term Loans - Mainly from financing companies like banks, insurance companies etc/ Term loans are relatively cheap to negotiate We have given brief outline of the possible sources of finances available. However for Rozana, as it is advised to go for acquisition of M/s Badra and as the fund of 23 million is available, there is no need for going for external finance. Read More