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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.

 

  • 15 Marks

FM – MAY 2018 – L2 – Q5 – Business valuations

Explains the degrees of stock market efficiency and involves calculating the value of a company based on expected earnings and discussing the limitations of using the P/E method for valuation.

a) The directors of Clear Tel Ltd, a private telecommunication company, are considering a proposed resolution for converting the company to a public company and listing its equity stock on the stock exchange. The directors expect that the stock market listing can enhance Clear Tel’s ability to raise large amounts of capital from the public. However, they fear that stock market inefficiencies could have a negative effect on the price of Clear Tel’s equity stock.

Required:

Explain the THREE degrees of stock market efficiency, and how the price of Clear Tel is expected to move in each case.
(6 marks)

b) Restwell Ltd, a hotel leisure company, is currently considering taking over a smaller private limited company, Staygood Ltd. The board of Restwell is in the process of making a bid for Staygood, but first needs to place a value on the company. Restwell has gathered the following data:

The company’s earnings yield is 12%.

Required:

i) As a Finance Manager, calculate the value of the company based on the present value of expected earnings.
(6 marks)

ii) Explain THREE problems associated with using the P/E method for valuing firms.
(3 marks)

a) The Three Basic Forms of the EMH
The efficient market hypothesis assumes that markets are efficient. However, the
efficient market hypothesis (EMH) can be categorized into three basic levels:
Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market
information. This hypothesis assumes that the rates of return on the market
should be independent; past rates of return have no effect on future rates. In this
event that the stock market has weak-form efficiency, the price of Clear Tel will
move in line with historical changes.
Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all
publicly available information. This hypothesis assumes that stocks adjust
quickly to absorb new information. The semi-strong form EMH also incorporates
the weak-form hypothesis. Given the assumption that stock prices reflect all new
available information and Clear Tel purchase stocks after this information is
released, Clear Tel cannot benefit over and above the market by trading on new
information.
Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all
information both public and private, building and incorporating the weak-form
EMH and the semi-strong form EMH. Given the assumption that stock prices
reflect all information (public as well as private) Clear Tel would not be able to
profit above the average investor even if he was given new information.

b) Restwell Ltd

The value of the company based on the present value of expected earnings is
GH¢18,791,800.

ii) Problems associated with P/E method for valuing firms

  •  Doesn’t account for growth- The price to earnings ratio doesn’t account for any
    type of growth or the lack of growth. The fact that growth isn’t factored in means
    that older more mature stocks are typically going to appear cheaper even if they
    aren’t growing if you use the P/E ratio. For many investors growth is a variable
    they do not want to exclude.
  • Backward looking- The P/E ratio is actually a backward looking indicator if you
    use the company’s most recent full year earnings number. A backward looking
    number can be of very little help to the investor during a period where economic
    conditions have changed significantly in a short period of time.
  • Quality of earnings not considered- The last several months have been the
    perfect example of how a company can really inflate their earnings to look better
    than they really are. Many banks were able to do this for months, and because of
    that investors that solely used the P/E ratio would have thought they were great
    buys. In retrospect if the investor had been looking at other parts of the balance
    sheet they may have seen inflated earnings as a real issue.
  • The Price doesn’t consider debt- Companies with major debt issues are
    obviously higher risk investments, but the P in the P/E ratio only considers the
    equity price and does nothing with the debt that the business has to continue
    with operations. As we have found out over time, excess debt can be a real
    problem, and the market price of a stock isn’t always a good gauge of fair value.
  • Uses profit which is not cash

 

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