Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Bara Ltd. is contemplating a bid for the share capital of Pwani Ltd. with an intention of buying the whole company. The following data for the two companies have been provided.

After acquisition, Bara Ltd. intends to sell a division of Pwani Ltd. which accounts for Sh.20 million annually in equity earnings. The division does not form part of the core business of the intended group. The division has a current market price of Sh. 50 million.

Bara Ltd.‟s management believes that introducing better management, earnings of Pwani Ltd. could be permanently increased 25% although the price/earnings multiple will remain the same. To avoid duplication, some of Bara Ltd.‟s own property could be disposed of at an estimated price of Sh. 130 million.
Rationalisation costs are estimated at Sh. 100 million, these comprise retrenchment and legal costs among others.

Required:
(a) Highlight the advantages of growth acquisition.
(b) Calculate the effect on the current share price of each company, all other things being equal, of a two for ten share offer Bara Ltd., assuming that Bara Ltd.‟s estimates are in line with those of the market.
(c) Assume that Bara Ltd. is proposing to offer Pwani Ltd.‟s shareholders the choice of a two for ten share exchange or a cash alternative. Giving reasons, advise Bara Ltd. whether the cash alternative should be more or less that the current value of the share exchange.
ANSWER
(a) Advantages of growth acquisition

Diversification of risk especially where the returns of acquired firm are uncorrelated to those acquiring firms Operating and financial synergies resulting from economies of scale
Asset backing thus generation of higher returns due to efficient asset utilization New business opportunities e.g accessing foreign markets, intellectual capital etc Larger market share and competitive advantage
Tax advantage when the target has accumulated loses

(b) Determine the maintainable profit of Pwani Ltd equity


(c) The cash offer has the following implications

It has a certain value compared to value of a share. Due to certainity , it will be lower than the value attached to share for share exchange

Shareholders of Pwani can dispose off their shares without incurring any transaction cost

Any capital gains realized may be subjected to tax where possible

Pwani shareholders will use cash to buy Treasury bills and bonds thus reduce the risk of their portfolios

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