Question Tag: Shareholder Wealth

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  • 14 Marks

AFM – Nov 2016 – L3 – Q1b – Business reorganisation | Valuation of acquisitions and mergers

Calculate and analyze the effects of a proposed spin-off on shareholder wealth and discuss reasons and disadvantages of a spin-off.

Last Chance Limited operates various manufacturing and retail operations throughout Ghana and has 400 million GH¢0.25 ordinary shares in issue. For the year that has just ended, the directors reported total after-tax profits of GH¢300 million and the P/E ratio of the company is 11.4 times.

The company has developed sophisticated computer software over the years and now considers ‘spinning-off’ its subsidiary, Ananse Systems Limited. Ananse Systems Limited has contributed GH¢40 million of the total after-tax profits of Last Chance Limited. After the spin-off, Last Chance Limited’s P/E ratio is expected to reduce to 11.0 times, while Ananse Systems Limited is expected to attract a P/E ratio of either 17 or 18 times.

Required:
i) Suggest THREE reasons why Last Chance Limited may wish to ‘spin-off’ part of its operations. (3 marks)
ii) Discuss THREE possible disadvantages of a ‘spin-off’ for the shareholders of Last Chance Limited. (3 marks)
iii) Calculate the likely effect of the proposed ‘spin-off’ on the wealth of a shareholder holding 10,000 ordinary shares in Last Chance, assuming that Ananse Systems Limited trades at a P/E ratio of 17 times and 18 times. (8 marks)
(Ignore taxation)

i) Three reasons for ‘spin-off’:

  • Market sentiment: Investors may feel more confident in separate, specialized companies rather than a conglomerate, increasing shareholder value.
  • Market valuations: The market may undervalue a particular operation. A spin-off can help unlock the value of that operation.
  • Strategic objectives: Directors may wish to focus on the core business, spinning off non-core operations for better strategic alignment.
    (3 marks)

ii) Three disadvantages of ‘spin-off’:

  • Increased vulnerability to takeover: After the spin-off, Last Chance may become a smaller, more attractive acquisition target.
  • Reduced ability to raise finance: A smaller company post-spin-off may struggle to raise finance through debt or equity.
  • Loss of economies of scale: With reduced size, Last Chance may lose advantages like bulk purchasing and shared administrative costs.
    (3 marks)

iii) Effect of spin-off on shareholder wealth:

  • Before spin-off:
    Value of one share in Last Chance Ltd = GH¢300 million × 11.4 / 400 million = GH¢8.55
    Value of 10,000 shares = 10,000 × GH¢8.55 = GH¢85,500
  • After spin-off:
    Earnings available to Last Chance Ltd after spin-off = GH¢300 million – GH¢40 million = GH¢260 million
    Value of one share in Last Chance Ltd after spin-off = GH¢260 million × 11.0 / 400 million = GH¢7.15
    Value of 10,000 shares = 10,000 × GH¢7.15 = GH¢71,500

Ananse Systems Ltd (P/E ratio of 17 times):
Value of one share in Ananse Systems = GH¢40 million × 17 / 64 million = GH¢10.625
Value of 10,000 shares = (1/8 × 10,000) × GH¢10.625 = GH¢13,281
Total wealth of the shareholder = GH¢71,500 + GH¢13,281 = GH¢84,781

Ananse Systems Ltd (P/E ratio of 18 times):
Value of one share in Ananse Systems = GH¢40 million × 18 / 64 million = GH¢11.25
Value of 10,000 shares = (1/8 × 10,000) × GH¢11.25 = GH¢14,062
Total wealth of the shareholder = GH¢71,500 + GH¢14,062 = GH¢85,562

Comment on findings:
The shareholder’s wealth after the spin-off is nearly equal to or slightly higher than before the spin-off, indicating a marginal benefit at best. There is a risk that shareholder wealth could be reduced, depending on the P/E ratio achieved by Ananse Systems.

 

  • 8 Marks

AFM – Nov 2018 – L3 – Q3a – Acquisitions and mergers versus other growth strategies

Discuss when takeovers make financial and economic sense and reasons why takeovers may fail to increase shareholder wealth.

Despite substantial evidence, drawn from different countries and different time periods, that suggests the wealth of shareholders in a bidding company is unlikely to be increased as a result of taking over another company, takeovers remain an important part of the business landscape.

Required:
i) Explain briefly when a takeover will make economic and financial sense.
(3 marks)

ii) Discuss briefly FIVE (5) reasons why a takeover may fail to deliver an expected increase in wealth for the bidding company’s shareholders.
(5 marks)

i) When a takeover makes economic and financial sense
A takeover makes economic and financial sense when it creates value through synergies. The value of the combined business must exceed the sum of the values of the individual businesses. This can be expressed as:

PV Combined business > PV Bidding business + PV Target business

This means that the takeover should generate benefits such as cost savings, revenue enhancement, or improved efficiency, which would not have been realized if the companies operated independently. The combined entity should deliver a higher net present value (NPV) or enhanced future cash flows, justifying the merger or acquisition.
(3 marks)

ii) Five reasons why a takeover may fail to deliver the expected increase in wealth for the bidding company’s shareholders

  1. Overpayment for the target company:
    Management of the bidding company may pay too much for the target company. Often, a premium is paid to convince shareholders of the target to sell their shares. This premium might not be justified by the future gains from the merger, leading to wealth transfer from the bidding company’s shareholders to the target’s shareholders.
  2. Hidden problems in the target company:
    Problems that were hidden or undiscovered during the due diligence process may emerge after the acquisition. These issues could be financial, operational, or legal, and they may erode the anticipated benefits from the takeover.
  3. Integration challenges:
    Integrating the operations, culture, and management of the two companies may prove difficult. Differences in organizational cultures, management styles, and systems can lead to inefficiencies and prevent the realization of expected synergies.
  4. Management complacency:
    After the takeover, management may become complacent, believing that the takeover itself guarantees success. Without continuous effort to integrate and improve operations, the anticipated benefits may not materialize, leading to underperformance.
  5. Errors in valuing the target company:
    Misjudgment in valuing the target company may lead to the bidding company overpaying for the acquisition. This often results from incorrect assumptions about future cash flows or failure to account for the risk associated with the acquisition.
  • 4 Marks

AFM – May 2018 – L3 – Q3a – Acquisitions and mergers versus other growth strategies

Discussing strategic issues that arise from pursuing growth through mergers, acquisitions, and organic growth.

Expansion by organic growth or by acquisition should only be undertaken if it leads to an increase in the wealth of the shareholders.

Required:
i) Discuss TWO strategic issues that arise from pursuing growth through mergers and acquisitions. (4 marks)
ii) Discuss TWO strategic issues that arise from pursuing growth through organic growth. (4 marks)

i) Strategic Issues in Mergers and Acquisitions:

  1. Time: Mergers or acquisitions allow a firm to increase its market share or enter a new market more quickly than if the firm tried to expand organically. Since “time is money,” the ability to enter a market or increase market share fast through mergers or acquisitions can be the cheapest way to expand.
  2. Cost: While cost savings can be achieved due to synergies, mergers or acquisitions may also be the most expensive way to expand due to the “premium for control.” Acquisitions might be expensive if they face resistance from target companies or government regulations under competition laws.
  3. Regulation/Legislation/Culture: Mergers or acquisitions can ease entry into markets with regulatory restrictions, but they might lead to cultural issues or backlash from local customers or governments.
  4. Assimilation and Integration: Integrating new employees, systems, and processes can lead to strains on the management, and handling a larger number of products or markets can cause “corporate indigestion.”
  • 25 Marks

FM – MAY 2018 – L2 – Q2 – Cost of capital

This question involves calculating the cost of equity, WACC before and after a bond issue, the ex-rights price, and evaluating the impact of a rights issue on a shareholder's wealth.

a) The Finance Director of Vista Hotel has heard that the market value of the company will increase if the weighted average cost of capital of the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex-div ordinary share price is GH¢2.50 per share. Vista Hotel also has in issue bonds with a book value of GH¢60 million and their current ex-interest market price is GH¢104 per GH¢100 bond. The current after-tax cost of debt of Vista Hotel is 7% and the tax rate is 30%. The recent dividends per share of the company are as follows:

The Finance Director proposes to decrease the weighted average cost of capital of Vista Hotel and hence increase its market value by issuing GH¢40 million of bonds at their par value of GH¢100 per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after 10 years.

Required:

i) Determine the cost of equity capital of the company.
(4 marks)

ii) Calculate the weighted average cost of capital of Vista Hotel in the following circumstances:

  • Before the new issue of bonds takes place;
    (3 marks)
  • After the new issue of bonds takes place.
    (3 marks)

b) The Moorgate Company has issued 100,000 GH¢1 par equity shares which are at present selling for GH¢3.00 per share. It has also issued 50,000 warrants, each entitling the holder to buy one equity share. The warrants are protected against dilution. The company has plans to issue rights to purchase one new equity share at a price of GH¢2 per share for every four shares.

Required:

i) Calculate the theoretical ex-rights price of Moorgate’s equity shares.
(4 marks)

ii) Calculate the theoretical value of a Moorgate right, before the shares sell ex-rights.
(3 marks)

c) The chairman of the company receives a phone call from an angry shareholder who owns 1,000 shares. The shareholder argues that he will suffer a loss in his personal wealth due to this rights issue because the new shares are being offered at a price lower than the current market value.

The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the shareholder takes appropriate action.

Required:

Prepare a statement showing the effects of the right issue on this particular shareholder’s wealth, assuming:

i) He sells all the rights.
(3 marks)

ii) He exercises one half of the rights and sells the other.
(3 marks)

iii) He does nothing.
(2 marks)

ex-rights price has been calculated as a weighted average of the old price
and the price of the right.
(2 marks)

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