Menu
- 20 Marks
Question
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 policymakers into amending labour regulations, particularly those relating to pensions and minimum wages, 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 mechanized.
Below are summarized financial data for the two companies immediately before acquisition:
| Two-Pack (GHS’m) | Anas-Expo (GHS’m) |
|---|---|
| Sales revenue | 285.8 |
| Net operating income | 85.8 |
| Interest charges | 14.2 |
| Net income before tax | 71.6 |
| Corporate tax | 15.8 |
| Net income after tax | 55.8 |
| Dividends | 22.3 |
| Addition to retained earnings | 33.5 |
Two-Pack has 40 million shares and a P/E ratio of 18, while Anas-Expo has 25 million shares and a 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 share they hold. They have also decided that Two-Pack mechanizes Anas-Expo’s production process immediately at the cost of GHS18 million, replacing work currently done by hand. It is estimated that operational efficiency arising from the acquisition and integration of the two companies would yield after-tax benefits of GHS25 million per 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.
(b) Analyze the effect of the acquisition on the earnings per share (EPS) of Two-Pack following the successful acquisition of Anas-Expo.
(c) Analyze the effect of the acquisition on the wealth of the shareholders of each company.
(d) Advise the directors of Two-Pack on three likely sources of conflict in relation to the acquisition of Anas-Expo and the mechanization of its production process, and suggest ways through which the conflict could be avoided or resolved.
Answer
a) Evaluation of the Acquisition Proposal
The net present value (NPV) of the acquisition can be computed by evaluating the synergy benefits and acquisition costs. The present value of the synergy is:
The cost of the acquisition is calculated as the market value of the shares issued by Two-Pack to acquire Anas-Expo. Anas-Expo has 25 million shares, and the share price after acquisition will be:
Post-acquisition share price=
Post-acquisition share price=
=22.94 GHS
The cost of acquisition is then:
Cost of acquisition=22.94 GHS×25 million shares=573.5 million
Therefore, the NPV of the acquisition is:
NPV=100 million GHS−(573.5 million GHS−404.4 million GHS=−87.1 million GHS
Recommendation: Since the NPV is negative, the acquisition should not proceed unless the acquisition price or synergy benefits can be improved.
(b) Effect on Earnings per Share (EPS)
The post-acquisition EPS is computed by summing the earnings of both companies and dividing by the new number of shares.
- Total earnings after acquisition = GHS55.8m + GHS33.7m + GHS25m = GHS114.5m
- Number of shares = 40m (Two-Pack) + 25m (Anas-Expo) = 65m shares
- Post-acquisition EPS = GHS114.5m / 65m = GHS1.76
The EPS will increase from GHS1.395 to GHS1.76, an increase of GHS0.365.
(c) Effect on Shareholders’ Wealth
For Two-Pack shareholders, the value of their shares will drop from:
- Pre-acquisition price = GHS25.11
- Post-acquisition price = GHS22.94
This results in a loss of GHS86.8 million in market value for Two-Pack shareholders.
For Anas-Expo shareholders, the value of their shares will increase from GHS16.176 to GHS22.94, a gain of GHS169.1 million.
(d) Likely Sources of Conflict
- Impact on Employees: The mechanization will likely lead to job losses, creating resistance from employees and unions. This can be mitigated by offering adequate compensation and retraining opportunities.
- Cultural Clash: The integration of the two companies may lead to conflicts between management teams due to differences in corporate cultures. A smooth integration process with clear communication and shared goals can help manage this.
- Quality Concerns: Anas-Expo’s handmade products are well-known for their quality, and mechanization may reduce product quality, leading to dissatisfaction among customers. A phased approach to mechanization, along with efforts to maintain product quality, can help resolve this issue.
- Topic: Valuation of acquisitions and mergers
- Series: NOV 2015
- Uploader: Joseph