Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

(a) The Development Company of Kenya Ltd. has operated very successfully over the past few years despite the adverse economic situation. As a result, the company has a good liquidity position and a relatively advantageous stock exchange valuation. The chairman of the company has suggested that because of this, it should look for growth through a vigorous acquisition policy.

Required:
Prepare a memorandum outlining the points which should be included in an acquisition strategy paper to be presented for discussion in the next board meeting.

(b) Two relatively small companies, Elgon Company Ltd. And Kilima Company Ltd., have decided in principle to merge so that they can complete more effectively with larger companies. The boards of directors of the two companies have decided that a scheme of amalgamation should be drawn the end of September 2003 based on the following agreed figures:
Required:

Comment on the values which have been placed on the ordinary shares for the purpose of merging the two companies.
ANSWER
(a) The question of an acquisition strategy should cover the following:

(i) Need to define the objectives of the acquisition. The ultimate purpose must be to achieve a target rate of return but this may require to be sub-divided under other headings, for example:

– growth of annual sales
– a specified return on investment

Included in the objectives will be non-financial matters which also should be incorporated in the strategy for example, improving management personnel, quit entry into new markets, economies of large scale production, etc. Although the objectives cannot be specifically quantified there should be an attempt, … subjective to rank these in some order of priority.

(ii) The acquisitions strategy should also cover the general factors that will be looked at in all possible acquisitions, e.g.

1. Ownership of the company
What is the share structure, do shares carry votes, who are the main shareholders, how important is the shareholding of directors and officers.

2. Top management
Attempt should be made to assess the past performance of existing management and while this will be done in relation to profitability both absolute and relative, other factors should be looked at
e.g. name, position, age, company service, service contracts, salaries, bonuses, and shareholding.

3. Finance
The main purpose of the strategy is to try to elicit information which will enable management to determine two separate but closely related pieces of information.

Firstly to ascertain the value based on the performance of the company to date which will likely have to be put on that company in order to achieve control and secondly the increased profitability which would arise for the parent company in the event of an acquisition being successful. The starting off point will of course be an analysis of the financial records of the company to be acquired, for example, to isolate operating profit from holding profit from extra-ordinary profit (or losses).

4. Completion
Assessment of the market situation which the company will find itself in if the acquisition is successful. For example, how will it affect the existing situation, customers, etc? what new situations will present themselves?

(b) The value of shares for amalgamation is based on forecasted equity earnings. It is assumed that P/E is applied in forecasting earnings rather than historic earnings.


Despite the higher earnings per share of Kilima Company Ltd. based on the forecast earnings, a higher value has been placed on each share of Elgon Company Ltd. on each share of Kilima Company Ltd. because of its lower gearing and therefore better borrowing potential and/or because of its better earnings potential or record in terms of both growth and consistency and the certainty of forecasts earnings for Elgon Company Ltd. compared to Kilima Company ltd. in light of the past performance.

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