ACCA AFM: ADVANCED FINANCIAL MANAGEMENT
28 PCO INC
(a) (i) P/E ratios and market values
PCO Inc OT Inc
Information in case
(shown here for convenience)
EPS – cents 106 92
Share price – cents 967 1,020
No. of shares in issue (millions) 40 24
P/E ratio 9.1 11.1
(SP/EPS)
Market value ($million) 386.8 244.8
(No. of shares × SP)
(ii) Cost of equity using CAPM
PCO Inc OT Inc
E(ri) = Rf + bi(E(rm) − Rf)
Rf rate (given) 0.04 0.04
Market return (given) 0.08 0.08
Beta 0.9 1.2
Cost of equity 7.6% 8.8%
(iii) Share price and market value using DVM
Do(1 + g)
Po
(re – g)
Share price – pence 1,292 n/a
[(32¢ × 1.05)/[(21¢ × 1.09)/
(0.076 – 0.05)] (0.088 – 0.09)]
Market value – $ million 517 n/a
(b) Advice on price and form of funding
(i) Price to be offered
• The market value of OT Inc can be determined most easily by reference
to the current share price.
• The constant growth version of the DVM will not work because
estimated growth is greater than the cost of equity. It would be possible
to use an adjusted version of the model but information on future cash
flows would be necessary.
• Using current market values, PCO Inc is worth $387 million and OT Inc,
$245 million, a total of $632 million before any acquisition gains.
• The financial advisors have estimated that the NPV of the combined
companies is $720 million, a post-acquisition gain of $88 million.
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LECTURER RESOURCE PACK – ANSWERS
• The price to be offered will depend on the negotiating abilities of the
two companies. Clearly, PCO Inc will not be able to retain all, or possibly
even most, of the acquisition gains.
• A key factor may be that it is likely to be a hostile bid. This will inevitably
raise the price to be paid and most research has shown that hostile bids
result in a fall in wealth for the bidder’s shareholders.
• A realistic starting point may be to allocate the gains in the proportion of
the relative current market values of the two companies. This would be
$88 million in the proportions 61% and 39%.
• This would mean PCO Inc would take $54 million of the gain and OT Inc
$34 million.
• The price to be offered would, therefore, be $279 million ($245 million
market value + $34 million share of merger gains) or 1,162 cents per
share.
• PCO Inc would also, presumably, take on OT Inc’s outstanding debt of
approximately $40 million, but the terms of the debt contract would
need to be investigated.
(ii) Form of funding
Cash
• PCO Inc could not offer cash without raising additional debt funding.
• Assuming it was prepared to use all its cash reserves of $105 million
(assuming the balance has not been used recently) this would mean an
additional $174 million debt, or $214 million if OT Inc’s $40 million debt
has to be repaid under the terms of the debt contract and PCO Inc is
required to refinance it.
• PCO Inc’s debt ratio (debt as a proportion of market value) would then
increase substantially – much would depend on how the share price
moved following the acquisition. If the market value of the combined
group is worth $632 million, then the gearing in market value terms
(assuming debt trading at par) would rise from 17% to 29%. This might
be quite acceptable, although the effect on the cost of capital must be
considered.
Shares
• The opening bid would be based on current market prices, i.e. 967 cents
and 1,020 cents.
• Suggests an exchange ratio of 1.05 of a PCO Inc share for every OT Inc
share, which would almost certainly be rejected as inadequate, as OT
Inc’s shareholders would have no incentive to accept the offer.
If all the gains were to be given to OT Inc’s shareholders the share price would
be 1,387 cents for OT Inc ($333 million/24 million). This would suggest a
ratio of 1.43 PCO Inc shares per OT Inc share, and 34.32 million new
shares would need to be issued to OT Inc shareholders.
• If first-year earnings are forecast as $70 million, this would be an EPS of
94.3 cents – a decline on current EPS for PCO Inc, which might not satisfy
shareholders.
• A strong statement from management would be needed.
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ACCA AFM: ADVANCED FINANCIAL MANAGEMENT
• PCO Inc has only 50 million shares authorised and 40 million are issued.
A share offer would require increasing authorised share capital. This
might give a signal to the market that PCO Inc might be considering a bid
for a large company, which would have an effect on the share price.
Whether this is up or down would depend on market perceptions and
sentiment towards PCO Inc at the time. If the share price rose, then this
is to PCO Inc’s advantage in any share exchange. If it fell, then a share
exchange might be considered unwise.
Combination
• A combination offer could be considered; for example, shares plus cash
or shares plus debt.
(iii) Business implications
• It is likely to be a hostile bid, which will involve extensive advisors’ costs
and PCO Inc will probably eventually pay all acquisition gains (and
possibly more) to OT Inc’s shareholders.
• Advantages include the diversification aspects of the acquisition, which
is after all why PCO Inc wants to acquire another company. However,
PCO Inc has no experience of the industry.
• OT Inc operates in an area in which PCO Inc does not have any particular
expertise, so it is difficult to see where any additional value can be
created. Some synergies as a result of vertical integration might be
claimed but these are likely to be small, and accompanied by a reduction
in PCO Inc’s flexibility to change suppliers. It is in the oil business so,
again, it does not really look like a diversification move.
• The required investment is likely to be large by PCO Inc’s standards. The
company would be taking on a substantial amount of debt in the form of
OT Inc’s existing borrowings. A rights issue is possible, perhaps
conditional upon the bid being successful.
A share offer would need to be a bit above one-for-one, given the current
market prices. This would require a prior increase in PCO Inc’s authorised
capital, since only 10 million shares remain unissued, and might give a signal
that an acquisition was being considered. A possibility is a choice between
shares in PCO Inc or cash. Provided no more than half of OT Inc’s shareholders
opted for cash, this would leave a reasonable capital structure but, to be
comfortable, the company would still need to increase authorised share
capital.
• An evaluation of the acquisition should look in more detail at the effect
on business growth, risk of the company, effect on capital structure and
cost of capital and so on.
• An exercise to identify other possible acquisition targets could (should?)
be launched.
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