Question

QUESTION 1 (25 Marks)

1.1 Discuss in detail any SEVEN (7) advantages that big corporate companies aim to take advantage of when considering an acquisition. (14 marks)

1.2 Explain in detail, what is a hostile take-over. (4 marks) 1.3 Explain each of the following types of mergers in detail:

1.3.1 Horizontal Merger (3 marks)

1.3.2 Vertical Merger (2 marks)

1.3.3 Conglomerate Merger (2 marks)

QUESTION 2 (25 Marks)

The directors of Dell Limited have appointed you as their financial consultant. They are considering new investment projects and need you to calculate the cost of capital for the company.

The present capital structure is as follows:

 Two million ordinary shares with a par value of 75 cents per share. These shares are currently trading at R4.50 per share and the latest dividend paid is 30 cents. An average dividend growth of 13% is maintained.

 One and a half million 14% R3.00 preference shares, with a market value of R5.00 per share.

 R2 000 000 non-distributable reserves  R800 000 8% debentures due in 6 years’ time and the current yield-to-maturity is 6%, and  R900 000 13% bank loan. Additional information:

 The company has a beta of 1.7, a risk-free rate of 5% and enjoys a premium of 8%

 The company's tax rate is 30%.

Question 2 Questions:

2.1 Calculate the weighted average cost of capital, using the Gordon Growth Model to calculate the cost of equity. (20 marks)

2.2 Calculate the adjusted weighted average cost of capital, using the Capital Asset Pricing Model as the Cost of equity. (5 marks)

QUESTION 3 (25 Marks)

P.L.U.S City urgently needs to upgrade its utility capacity. They require a new generator costing R120 000. The generator can be leased or owned and the terms are as follows:

Cost of leasing:

The lease would require annual end-of-year payments of R39 200 over the four years.

Service and insurance costs of R10 000 per annum will be borne by the lessee.

The P.L.U.S City will purchase the asset for R15 000 at the termination of the lease in four years.

Cost of owning:

The cost could be financed with XYZ Financers Limited. It would require a four-year 16% loan, with annual year-end payments of R42 890.

P.L.U.S City will pay maintenance cost of R9 000 per annum. Depreciation charges are based on the straight-line method. At the end of the period the generator will be sold at its residual value of R20 000. Interest payments included in the year-end payments are R19 200; R15 410; R10 020; and R5 920 respectively.

Additional Information:

 the company is in the 30% tax bracket

 the after-tax cost of the debt is 11% Required:

Question 3 Questions:

3.1 Calculate the after-tax cash outflows and the net present value of the cash outflows under each alternative. (22 marks)

3.2 Which alternative would you recommend? Why? (3 marks)

QUESTION 4 (25 Marks)

Shafi Limited is an American based manufacturer of heavy duty equipment. The company is currently investigating two projects for expansion. It can only undertake one of them and has asked your advice in deciding which one to proceed with.

Project A:

Production at the existing factory could be expanded. The cost of the new plant for this option would be an initial outlay of $49 million. This would result in an additional $650 000 profit being earned in each of the 10 years that the project would last. The new plant to be fully depreciated over the 10 years, on a straight-line basis, in accordance with the company's accounting policy. The financial team has also determined that the new plant must bear its share of the existing overheads and that amounted to $200 000 per annum. These expenses were also included in the profit calculation. Consultant fees cost R500 000.

Project B:

Production could be increased by purchasing a new manufacturing facility in South Africa. The cost of the facility would be an initial outlay of Three Hundred million Rands. Annual sales for the 10-year period is expected to be Eighty million Rands annually, and fixed and variable cost of R23 million and R4 million respectively. The fixed cost includes depreciation of R20 million per annum. Consultants fees is expected to be R1.1 million.

Additional information:

 The South African inflation is expected to exceed the American inflation by 2% throughout the life of the project.

 Shafi Limited cost of capital is currently 12%.

 The current spot exchange rate is R15.23/$.

Question 4 Questions:

4.1 Make all the necessary calculations for the two options. (22 marks)

4.2 Advise Shafi Limited if it is worth investing in neither, in one or in both of these projects (3 marks)

Appendix 1:

Appendix 2:

Answer 1

QUESTION 1

1.1

Seven advantages that big corporate companies aim to take when considering an acquisition are:

• Access to large pool of resources of the other firms
• A broader target audience in the industry.
• Access to knowledge possessed by other company’s employees
• Dominance over the industry
• Arrival of fresh ideas and better perspectives
• Motivated workforce – as the combined employees of both firms work hard to make a place for themselves.
• Benefit of economies of scale with the help of expanded production capacity.

*All these points are general and easily understandable. You can elaborate them according to the marks weightage.

1.2

A hostile takeover is the acquisition of one company (called the target company) by another (called the acquirer) that is accomplished by going directly to the company's shareholders or fighting to replace management to get the acquisition approved.

A hostile takeover can be accomplished by three common methods:

• Hostile Bid - Company A wants to achieve a hostile takeover of Company B. Company A goes directly to the shareholders of Company B with an offer to buy their stock at a premium price - substantially above the current market price. This is known as making a tender offer, and if successful, Company A takes majority ownership of Company B, even if the board of Company A objects.
• Open Market - Company A buys a majority of the available shares in Company B on the open market, thus taking control of Company B. This may not always be possible as the majority of shares may be in the hands of private investors and not in holdings of financial institutions, available for purchase.
• Proxy Fight - Shareholders in a company have a right to vote on things, like replacing management or selling the company. They can either vote on their own behalf or assign their voting rights to someone else through a form called the proxy. A proxy fight is when an acquiring company convinces shareholders of a target company to assign them their voting rights through the proxy. The acquiring company then uses the proxy votes to boot out the management who opposed the takeover, taking control.

The key characteristic of a hostile takeover is that the target company's management does not want the deal to go through. Sometimes a company's management will defend against unwanted hostile takeovers by using several controversial strategies, such as:

• Poison Pill - This type of defense is designed to make the target company less attractive or desirable to the acquiring company. An example would be a clause in the shareholder agreement that says if there is a takeover, existing shareholders (except the acquirer) can buy additional shares at a discounted price, which would dilute the acquirer's shares and make them less valuable.
• People Pill - This is a stipulation that in the event of a takeover, certain key personnel of the target company have to resign, denying the acquiring company valuable leadership.
• Pac-Man Defense - The target company turns around and buys a large amount of stock in the acquiring company - if you're going to eat me, I'm going to eat you too.
• Crown Jewel Defense - In the event of a takeover bid, the target company sells off its most valuable assets, making it less attractive.

Most acquisitions and mergers occur in the business world by mutual agreement -- both sides agree that all of the shareholders' interests are served best by the transaction. In those instances, both sides have a chance to evaluate the costs and benefits, assets and liabilities, and proceed with full knowledge of the risks and returns.
However, in a hostile takeover, because the management and board of the target company resist the acquisition, they usually do not share any information that is not already publicly available. As a result, the acquiring firm takes a risk and may unwittingly acquire debts or serious technical problems.
In addition, the loss of key managers and leadership within the company may cause a shakeup within the target company that may disrupt its operations and threaten its viability.

1.3

1. Horizontal Merger: These types of mergers are similar to types of diversification.

Horizontal merger is a combination of firms engaged in the same industry. It is a merger with a direct competitor. The principal objective behind this type of merger is to achieve economies of scale in the production process by shedding duplication of installations and functions, widening the line of products, decrease in working capital and fixed assets investment, getting rid of competition and soon. For example, formation of Brooke Bond Lipton India Ltd. through the merger of Lipton India and Brooke Bond.

2. Vertical Merger: It is a merger of two organizations that are operating in the same industry but at different stages of production or distribution system. This often leads to increased synergies with the merging firms. If an organization takes over its supplier/producers of raw material, then it leads to backward integration.

On the other hand, forward integration happens when an organization decides to takeover its buyer organizations or distribution channels. Vertical merger results in many operating and financial economies. Vertical mergers help to create an advantageous position by restricting the supply of inputs to other players, or by providing the inputs at a higher cost.

3. Conglomerate Merger: Conglomerate mergers are the combination of organizations that are unrelated to each other. There are no linkages with respect to customer groups, customer functions and technologies being used. There are no important common factors between the organizations in production, marketing, research and development and technology. In practice, however, there is some degree of overlap in one or more of these factors.

QUESTION 2

2.1

PARTICULAR	k (Cost of Capital)	WEIGHTAGE	PRODUCT
EQUITY	20.53	15.46	3.173938
PREFERENCE SH.	14	46.4	6.496
RETAINED EARNINGS	20.53	20.61	4.231233
DEBENTURES	8	8.24	0.6592
BANK LOAN	13	9.27	1.2051
		TOTAL WACC	15.765471

Cost of Equity (GG Model) = [0.30(1.13)*100 / 4.50] + 13% = 20.53%

2.2

PARTICULAR	k (Cost of Capital)	WEIGHTAGE	PRODUCT
EQUITY	18.6	15.46	2.87556
PREFERENCE SH.	14	46.4	6.496
RETAINED EARNINGS	18.6	20.61	3.83346
DEBENTURES	8	8.24	0.6592
BANK LOAN	13	9.27	1.2051
		TOTAL WACC	15.06932

Cost of Equity = 5% + 1.7(8)% = 18.6%

(*I don't have the exact knowledge of the rest of the 2 questions. I am sorry to bother you with this, but still wanted to help you with these 2 questions.)