Syllabus C: 

Acquisitions And MergersC1. Acquisitions and mergers versus other growth strategies

C1b. Strategy Development

Q3a - June 2014

Vogel Co, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years
ago, Vogel Co pursued a strategy of organic growth. Since then, it has followed an aggressive policy of acquiring smaller
engineering companies, which it feels have developed new technologies and methods, which could be used in its manufacturing
processes. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have
successfully increased the company’s shareholder value.

Vogel Co is currently considering acquiring Tori Co, an unlisted company, which has three departments.  Department A
manufactures machinery for industrial companies, Department B produces electrical goods for the retail market, and the smaller
Department C operates in the construction industry. Upon acquisition, Department A will become part of Vogel Co, as it contains
the new technologies which Vogel Co is seeking, but Departments B and C will be unbundled, with the assets attached to
Department C sold and Department B being spun off into a new company called Ndege Co.
Given below are extracts of financial information for the two companies for the year ended 30 April 2014.
vogel co tori co

sales revenue

profit before depreciation, and tax (pbdit)

interest

depreciation

pre- tax profit

vogel co tori co

$ million $ million

non current interest

current assets

7% unsecured bond

other non-current and current liabilities

share capital (50c cent share)

reserves

share of current and non-current assets and profit of

tori co`s three departments:

department a department b department c

share of current and non-current assets 40% 40% 20%

share of pbdit and pre-tax profit 50% 40% 10%

Other information
(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value, but its current
assets’ realisable value is only 90% of their book value. The costs related to closing  Department C are estimated to be $3 million.
(ii) The funds raised from the disposal of Department C will be used to pay off Tori Co’s other non-current and current liabilities.
(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of the bond is
equal to its book value.
(iv) At present, around 10% of Department B’s PBDIT come from sales made to Department C.
(v) Ndege Co’s cost of capital is estimated to be 10%. It is estimated that in the first year of operation Ndege Co’ s free cash flows
to firm will grow by 20%, and then by 5•2% annually thereafter.

(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation on its non-
current assets. It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to
maintain Ndege Co’s operations.
(vii) Vogel Co’s current share price is $3 per share and it is estimated that Tori Co’s price-to-earnings (PE) ratio is 25% higher than
Vogel Co’s PE ratio. After the acquisition, when Department A becomes part of Vogel Co, it is estimated that Vogel Co’s PE ratio
will increase by 15%.
(viii) It is estimated that the combined company’s annual after-tax earnings will increase by $7 million due to the synergy
benefits resulting from combining Vogel Co and Department A.

Required:
(a)Discuss the possible reasons why Vogel Co may have switched its strategy of organic growth to one of growing by acquiring
companies. (4 marks)
(a) Vogel Co may have switched from a strategy of organic growth to one of growth by acquisition, if it was of the opinion that
such a change would result in increasing the value for the shareholders.

Acquiring a company to gain access to new products, markets, technologies and expertise may be quicker and less costly.
Horizontal acquisitions may help Vogel Co eliminate key competitors and enable it to take advantage of economies of scale.
Vertical acquisitions may help Vogel Co to secure the supply chain and maximise returns from its value chain.

Organic growth may take a long time, can be expensive and may result in little competitive advantage being established due to
the time taken. Also organic growth, especially into a new area, would need managers to gain knowledge and expertise of an
area or function, which they not currently familiar with. Furthermore, in a saturated market, there may be little opportunity
for organic growth.

Required:
(b) Discuss the possible actions Vogel Co could take to reduce the risk that the acquisition of Tori Co fails to increase shareholder
value. (7 marks)

Vogel Co can take the following actions to reduce the risk that the acquisition of Tori Co fails to increase shareholder value.

Since Vogel Co has pursued an aggressive policy of acquisitions, it needs to determine whether or not this has been too
aggressive and detailed assessments have been undertaken.

Vogel Co should ensure that the valuation is based on reasonable input figures and that proper due diligence of the perceived
benefits is undertaken prior to the offer being made.

Often it is difficult to get an accurate picture of the target when looking at it from the outside. Vogel Co needs to ensure that it
has sufficient data and information to enable a thorough and sufficient analysis to be undertaken.

The sources of synergy need to be properly assessed to ensure that they are achievable and what actions Vogel Co needs to
undertake to ensure their achievement.

This is especially so for the revenue-based synergies.

An assessment of the impact of the acquisition on the risk of the combined company needs to be undertaken to ensure that the
acquisition is not considered in isolation but as part of the whole company.

The Board of Directors of Vogel Co needs to ensure that there are good reasons to undertake the acquisition, and that the
acquisition should result in an increase in value for the  shareholders.
Research studies into mergers and acquisitions have found that often companies are acquired not for the shareholders’ benefit,
but for the benefit or self-interest of the acquiring company’s management.

The non-executive directors should play a crucial role in ensuring that acquisitions are made to enhance the value for the
shareholders.

A post-completion audit may help to identify the reasons behind why so many of Vogel Co’s acquisitions have failed to create
value. Once these reasons have been identified, strategies need to be put in place to prevent their repetition in future
acquisitions.

Procedures need to be established to ensure that the acquisition is not overpaid. Vogel Co should determine the maximum
premium it is willing to pay and not go beyond that figure.

Research indicates that often too much is paid to acquire a company and the resultant synergy benefits are not sufficient to
cover the premium paid.

Often this is the result of the management of the acquiring company wanting to complete the deal at any cost, because not
completing the deal may be perceived as damaging to both their own, and their company’s, reputation.

The acquiring company’s management may also want to show that the costs related to undertaking due diligence and initial
negotiation have not been wasted.

Vogel Co and its management need to guard against this and maybe formal procedures need to be established which allow
managers to step back without loss of personal reputation.

Vogel Co needs to ensure that it has proper procedures in place to integrate the staff and systems of the target company
effectively, and also to recognise that such integration takes time.

Vogel Co may decide instead to give the target company a large degree of autonomy and thus make integration less necessary;
however, this may result in a reduction in synergy benefits.

Vogel Co should also have strategies which allow it sufficient flexibility when undertaking integration so that it is able to respond
to changing circumstances or respond to inaccurate information prior to the acquisition.

Vogel Co should also be mindful that its own and the acquired company’s staff and management need to integrate and ensure a
good working relationship between them.

Syllabus C: Acquisitions And Mergers

C1. Acquisitions and mergers versus other growth strategies

Required:
(a) Discuss the advantages and disadvantages of the acquisition of Tidded Co from the viewpoint of Louieed Co. (6 marks)

Advantages of the acquisition

Louieed Co and Tidded Co appear to be a good strategic fit for a number of reasons. Louieed Co appears to have limited
potential for further growth.

Acquiring Tidded Co, a company with better recent growth, should hopefully give Louieed Co the impetus to grow more quickly.

Acquiring a company which has a specialism in the area of online testing will give Louieed Co capabilities quicker than developing
this function in-house. If Louieed Co does not move quickly, it risks losing contracts to its competitors.

Acquiring Tidded Co will give Louieed Co access to the abilities of some of the directors who have led Tidded Co to becoming a
successful company.

They will provide continuity and hopefully will help integrate Tidded Co’s operations successfully into Louieed Co.

They may be able to lead the upgrading of Tidded Co’s existing products or the development of new products which ensures that
Louieed Co retains a competitive advantage.
It appears that Tidded Co’s directors now want to either realise their investment or be part of a larger company, possibly
because it will have more resources to back further product development.

If Louieed Co does not pursue this opportunity, one of Louieed Co’s competitors may purchase Tidded Co and acquire a
competitive advantage itself.

There may also be other synergistic benefits, including savings in staff costs and other savings, when the two companies merge.

Disadvantages of the acquisition

It is not known what the costs of developing in-house capabilities will be. Although the process may be slower, the costs may be
less and the process less disruptive to Louieed Co than suddenly adding on Tidded Co’s operations.

It is not possible to tell which of Tidded Co’s directors are primarily responsible for its success. Loss of the three directors may
well represent a significant loss of its capability.

This will be enhanced if the three directors join a competitor of Louieed Co or set up in competition themselves.

There is no guarantee that the directors who remain will fit into Louieed Co’s culture. They are used to working in a less formal
environment and may resent having Louieed Co’s way of operating imposed upon them.

This could result in departures after the acquisition, jeopardising the value which Tidded Co has brought.

Possibly Tidded Co’s leadership in the online testing market may not last. If competitors do introduce major advances, this could
mean that Tidded Co’s current growth is not sustainable.

Q4a - December 2013

Nubo Co has divisions operating in two diverse sectors: production of aircraft parts and supermarkets. Whereas the aircraft parts
production division has been growing rapidly, the supermarkets division’s growth has been slower. The company is considering
selling the supermarkets division and focusing solely on the aircraft parts production division.

Extracts from the Nubo Co’s most recent financial statements are as follows:

Year ended 30 November 2013

$m
Profit after tax 166
Non-current assets 550
Current assets 122
Non-current liabilities 387
Current liabilities 95
About 70% of Nubo Co’s non-current assets and current assets are attributable to the supermarkets division and the remainder
to the aircraft parts production division. Each of the two divisions generates roughly half of the total profit after tax.

The market value of the two divisions is thought to be equivalent to the price-to-earnings (PE) ratios of the two divisions’
industries. The supermarket industry’s PE ratio is 7 and the aircraft parts production industry’s PE ratio is 12.

Nubo Co can either sell the supermarkets division as a going concern or sell the assets of the supermarkets division separately. If
the assets are sold separately, Nubo Co believes that it can sell the non-current assets for 115% of the book value and the
current assets for 80% of the book value. The funds raised from the sale of the supermarkets division will be used to pay for all
the company’s current and non-current liabilities.

Following the sale of the supermarkets division and paying off the liabilities, Nubo Co will raise additional finance for new
projects in the form of debt. It will be able to borrow up to a maximum of 100% of the total asset value of the new downsized
company.

One of the new projects which Nubo Co is considering is a joint venture with Pilvi Co to produce an innovative type of machinery
which will be used in the production of light aircraft and private jets. Both companies will provide the expertise and funding
required for the project equally.
Representatives from both companies will make up the senior management team and decisions will be made jointly. Legal
contracts will be drawn up once profit-sharing and other areas have been discussed by the companies and agreed on.

Pilvi Co has approached Ulap Bank for the finance it requires for the venture, based on Islamic finance principles. Ulap Bank has
agreed to consider the request from Pilvi Co, but because the financing requirement will be for a long period of time and
because of uncertainties surrounding the project, Ulap Bank wants to provide the finance based on the principles of a
Musharaka contract, with Ulap Bank requiring representation on the venture’s senior management team.

Normally Ulap Bank provides funds based on the principles of a Mudaraba contract, which the bank provides for short-term, low-
risk projects, where the responsibility for running a project rests solely with the borrower.

Required:

Advise Nubo Co whether it should sell the supermarkets division as a going concern or sell the assets separately and estimate
the additional cash and debt funds which could be available to the new, downsized company. Show all relevant calculations.
(7 marks)

Current and non-current liabilities = $387m + $95m = $482m

Sale of assets of supermarkets division

Proportion of assets to supermarkets division
Non-current assets = 70% x $550m = $385m; Current assets = 70% x $122m = $85•4m
Sale of assets = $385m x 1•15 + $85•4m x 0•80 = $511•07m

Sale of supermarkets division as a going concern

Profit after tax attributable to the supermarkets division: $166m/2 = $83m

Estimate of value of supermarkets division based on the PE ratio of supermarket industry: $83 x 7 = $581m

Although both options generate sufficient funds to pay for the liabilities, the sale of the supermarkets division as a going concern
would generate higher cash flows and the spare cash of $99m [$581m – $482m] can be used by Nubo Co for future investments.
This is based on the assumption that the value based on the industries’ PE ratios is accurate.

Proportion of assets remaining within Nubo Co

30% x ($550m + $122m) = $201•6m

Add extra cash generated from the sale of $99m

Maximum debt capacity = $300•6m

Total additional funds available to Nubo Co for new investments = $300•6m + $99m = $399•6m

Required:

Discuss whether a demerger of the supermarkets division may be more appropriate than a sale. (6 marks)

A demerger would involve splitting Nubo Co into two separate companies which would then operate independently of each
other. The equity holders in Nubo Co would continue to have an equity stake in both companies.

Normally demergers are undertaken to ensure that each company’s equity values are fair. For example, the value of the aircraft
parts production division based on the PE ratio gives a value of $996m (12 x $83m) and the value of the supermarkets division as
$581m.

If the current company’s value is less than the combined values of $1,577m, then a demerger may be beneficial. However, the
management and shareholders of the new supermarkets company may not be keen to take over all the debt.

Nubo Co’s equity holders may view the demerger more favourably than the sale of the supermarkets division. At present their
equity investment is diversified between the aircraft parts production and supermarkets.
If the supermarkets division is sold, then the level of their diversification may be affected. With the demerger, since the equity
holders will retain an equity stake in both companies, the benefit of diversification is retained.

However, the extra $99m cash generated from the sale will be lost in the case of a demerger. Furthermore, if the new aircraft
parts production company can only borrow 100% of its asset value, then its borrowing capacity and additional funds available to
it for new investments will be limited to $201•6m instead of $399•6m.

Q1v - June 2011

Required:
Assesses whether the Chief Financial Officer’s recommendation would provide a suitable defence against a bid from SGF Co
and would be a viable option for Pursuit Co. (5 marks)

The Chief Financial Officer’s suggestion appears to be a disposal of ‘crown jewels’. Without the cash reserves, Pursuit Co may
become less valuable to SGF Co. Also, the reason for the depressed share price may be because Pursuit Co’s shareholders do not
agree with the policy to retain large cash reserves.

Therefore returning the cash reserves to the shareholders may lead to an increase in the share price and make a bid from SGF Co
more unlikely. This would not initially contravene the regulatory framework as no formal bid has been made.

However, Pursuit Co must investigate further whether the reason for a possible bid from SGF Co might be to gain access to the
large amount of cash or it might have other reasons. Pursuit Co should also try to establish whether remitting the cash to the
shareholders would be viewed positively by them.

Whether this is a viable option for Pursuit Co depends on the bid for Fodder Co. In part (iii) it was established that more than the
expected debt finance would be needed even if the cash reserves are used to pay for some of the acquisition cost.

If the cash is remitted, a further $20,000,000 would be needed, and if this was all raised by debt finance then a significant
proportion of the value of the combined company would be debt financed.

The increased gearing may have significant implications on Pursuit Co’s future investment plans and may result in increased
restrictive covenants. Ultimately gearing might have to increase to such a level that this method of financing might not be
possible.

Pursuit Co should investigate the full implications further and assess whether the acquisition is worthwhile given the marginal
value it provides for the shareholders.