m freeaccastudymaterial.blogspot.com co sp ot ACCA l.b log ria Paper P4 ym ate Advanced Financial Management fre ea cc as tud Essential Text freeaccastudymaterial.blogspot.com sp ot co m freeaccastudymaterial.blogspot.com l.b log British library cataloguinginpublication data Published by: Kaplan Publishing UK Unit 2 The Business Centre Molly Millars Lane Wokingham Berkshire RG41 2QZ ym © Kaplan Financial Limited, 2014 ate ria A catalogue record for this book is available from the British Library. as tud The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. Printed and bound in Great Britain. Acknowledgements cc We are grateful to the Association of Chartered Certified Accountants and the Chartered Institute of Management Accountants for permission to reproduce past examination questions. The answers have been prepared by Kaplan Publishing. fre ea All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Kaplan Publishing. ii KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Contents Page The role and responsibility of the financial manager Chapter Investment appraisal Chapter The financing decision Chapter The dividend decision Chapter International operations and international investment appraisal Chapter International operations the financing decision 101 and the dividend decision Chapter Option pricing Chapter The weighted average cost of capital (WACC) Chapter Risk adjusted WACC and adjusted present value 153 Chapter 10 Corporate failure and reconstruction 171 Chapter 11 An introduction to risk management 205 Chapter 12 Hedging foreign exchange risk 225 Chapter 13 Hedging interest rate risk 257 Chapter 14 Strategic aspects of acquisitions 287 Chapter 15 Business valuation 305 Chapter 16 Topical issues in financial management 333 Chapter 17 Questions & Answers 347 ot Chapter co m freeaccastudymaterial.blogspot.com sp 23 61 71 113 133 fre ea cc as tud ym ate ria l.b log 47 iii KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com fre ea cc as tud ym ate ria l.b log sp ot co m freeaccastudymaterial.blogspot.com iv KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com chapter m Introduction fre ea cc as tud ym ate ria l.b log sp Paper Introduction ot co v freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com How to Use the Materials ot co m Introduction sp These Kaplan Publishing learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your examinations. l.b log The product range contains a number of features to help you in the study process. They include: (1) Detailed study guide and syllabus objectives (2) Description of the examination (3) Study skills and revision guidance (5) Question practice ria (4) Complete text or essential text ate The sections on the study guide, the syllabus objectives, the examination and study skills should all be read before you commence your studies. They are designed to familiarise you with the nature and content of the examination and give you tips on how to best to approach your learning. fre ea cc as tud ym The complete text or essential text comprises the main learning materials and gives guidance as to the importance of topics and where other related resources can be found. Each chapter includes: • The learning objectives contained in each chapter, which have been carefully mapped to the examining body's own syllabus learning objectives or outcomes. You should use these to check you have a clear understanding of all the topics on which you might be assessed in the examination • The chapter diagram provides a visual reference for the content in the chapter, giving an overview of the topics and how they link together • The content for each topic area commences with a brief explanation or definition to put the topic into context before covering the topic in detail. You should follow your studying of the content with a review of the illustration/s. These are worked examples which will help you to understand better how to apply the content for the topic vi KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com m freeaccastudymaterial.blogspot.com Test your understanding sections provide an opportunity to assess your understanding of the key topics by applying what you have learned to short questions Answers can be found at the back of each chapter • Summary diagrams complete each chapter to show the important links between topics and the overall content of the paper These diagrams should be used to check that you have covered and understood the core topics before moving on • Question practice is provided at the back of each text l.b log sp ot co • Quality and accuracy are of the upmost importance to us so if you spot an error in any of our products, please send an email to mykaplanreporting@kaplan.com with full details, or follow the link to the feedback form in MyKaplan Icon Explanations ate ria Our Quality Coordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions ym Definition – Key definitions that you will need to learn from the core content Key Point – Identifies topics that are key to success and are often examined as tud New – Identifies topics that are brand new in papers that build on, and therefore also contain, learning covered in earlier papers cc Expandable Text – Expandable text provides you with additional information about a topic area and may help you gain a better understanding of the core content Essential text users can access this additional content on-line (read it where you need further guidance or skip over when you are happy with the topic) ea Test Your Understanding – Exercises for you to complete to ensure that you have understood the topics just learned fre Illustration – Worked examples help you understand the core content better vii KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com m Introduction co Tricky topic – When reviewing these areas care should be taken and all illustrations and test your understanding exercises should be completed to ensure that the topic is understood. ot Tutorial note – Included to explain some of the technical points in more detail. sp Footsteps – Helpful tutor tips. Syllabus Paper background Objectives of the syllabus Syllabus objectives ate The examination ria Core areas of the syllabus l.b log Online subscribers Examination format Examination tips ym Study skills and revision guidance Preparing to study as tud Effective studying Three ways of taking notes Revision You can find further reading and technical articles under the student section of ACCA's website. Also, you may find it useful to read "Corporate Finance and Valuation" by Bob Ryan (the P4 examiner). Several theories and methods from this book appear in this Kaplan Text with the kind permission of the author. fre ea cc Further reading viii KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com chapter m freeaccastudymaterial.blogspot.com ot co l.b log sp The role and responsibility of the financial manager Chapter learning objectives Study guide section Study guide outcome (b) Recommend strategies for the management of the financial resources of the organisation such that they are utilised in an efficient, effective and transparent way (c) Advise the board of directors or management of the organisation in setting the financial goals of the business and in its financial policy development with particular reference to: (i) Investment selection and capital resource allocation (ii) Minimising the cost of capital (iii) Distribution and retention policy (iv) Communicating financial policy and corporate goals to internal and external stakeholders (v) Financial planning and control (vi) The management of risk fre ea cc as tud ym ate ria A1: The role and (a) Develop strategies for the responsibility of the senior achievement of the organisational financial executive / advisor goals in line with its agreed policy framework. freeaccastudymaterial.blogspot.com l.b log sp ot A3: Conflicting stakeholder (a) Assess the potential sources of the interests conflict within a given corporate governance/ stakeholder framework informed by an understanding of the alternative theories of managerial behaviour. Relevant underpinning theory for this assessment would be: (i) The separation of ownership and control (ii) Transaction cost economics and comparative governance structures (iii) Agency Theory. co The role and responsibility of the financial manager m freeaccastudymaterial.blogspot.com (b) Recommend, within specified problem domains, appropriate strategies for the resolution of stakeholder conflict and advise on alternative approaches that may be adopted fre ea cc as tud ym ate ria (c) Compare the different governance structures and policies (with particular emphasis upon the European stakeholder and the US/UK shareholder model) and with respect to the role of the financial manager KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com m Questions & Answers co Is the issue price of the new shares fair? $000 Tax PAT Interest cover (EBIT/Interest) = sp 360 90 l.b log Earnings before tax ot Profit before interest and tax Interest: 12% Debentures – 3,000 × 0.12 = 9% Overdraft – 1,000 × 0.09 = $000 (450) –––– 550 (165) –––– 385 2.2 ria The interest cover is below the minimum acceptable level of 2.5 times and is therefore cause for concern. E.P.S = PAT/No. of Shares = 385 / 10,000 = 3.85c ate P/E ratio: Issue price/E.P.S 120c/3.85 = 31.17 times ym Assume that the industry average P/E is 16 times. Therefore would investors also be willing to pay 31.17 times the estimated earnings of Last Chance for a share? as tud The answer is no, they would want to be able to buy the shares at a discount given the fact that earnings would be perceived to be less reliable as a result of its recent poor performance. Therefore the current issue price may be unacceptable to investors. A discount of 25% would seem reasonable i.e. 16 times × 0.75 = 12 times. Then a more reasonable issue price would appear to be 3.85c × 12 times = 46.2c. fre ea cc Conclusion: The shares could not be sold for $1.20. Thus the financial viability of the scheme is called into question. (As the 12m cash in from the issue of new shares will not occur.) 388 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com Is the scheme acceptable to all parties? Unsecured creditors: sp ot In the event of liquidation they would receive 70c in the pound (ignoring liquidation expenses). However under the scheme they should receive a full repayment. The scheme is clearly beneficial to them. co m chapter 17 The Bank: Liquidation Scheme $000s $000s 840 1,000 l.b log Bank overdraft Current position (sunk) $000s 1,200 The reality of the situation is that the scheme will be organised (and the overdraft will be $1m) or the company will be liquidated and the bank will only receive $840,000. The current position of an overdraft of $1.2m as denoted in the balance sheet is a sunk position. ate ria Thus the bank has a simple choice have $840,000 on liquidation or agree to a reduced overdraft of $1,000,000 under the scheme, which will be secured. If the bank agrees to the scheme the capital loss on the overdraft is reduced from $360,000 to $160,000 – a saving of $200,000. Thus the bank will probably agree to the reduced overdraft (thus the reduced overdraft does not give rise to a cash flow). ym However the low interest cover would be of concern to the Bank, and raises doubts about the company’s ability to repay the interest. Therefore the bank may which to scrutinise the company profit forecasts in some details to ensure that they are based on realistic assumptions. as tud Existing Shareholders: Per share Current position Liquidation Scheme – cash repayment Capital 22c – ? Nil 25c cc The current share of 22c does not represent a realistic exit strategy of all the existing shareholders, because if a sizeable proportion of shareholders try to sell, this would drive down the share price. Thus existing shareholders will probably agree to the scheme. fre ea The company may consider offering the existing shareholders a share for share exchange as opposed to offering them a cash repayment as this would reduce the need for financing and allow those existing shareholders who wish to remain the opportunity to do so. 389 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Questions & Answers co Conclusion (have the reconstruction principles been adhered to): m freeaccastudymaterial.blogspot.com ot (1) The shares appear to be overpriced at $1.20. This need to be reviewed immediately and possibly reduced to a more realistic level sp (2) As the shares are overpriced – the $12m cash inflow from their issue is therefore unrealistic. Thus the scheme in its current form will not raise adequate finance (3) The planning horizon needs to be extended beyond one year l.b log (4) I recommend that the company valuation be taken using the present value of the free cash flows approach, if the information is available. Together with some evaluation of the risk inherent in the scheme. Risk analysis methods, which may be considered, are scenario planning, sensitivity analysis and simulation ria Political risk ym ate (a) The consultant’s report should not be used as the only basis for the African investment decision, for the following reasons. (i) The decision should be taken after evaluating the risk/return tradeoff; financial factors (e.g. the expected NPV from the investments); strategic factors; and other issues including political risk. Political risk is only one part of the decision process (although in extremely risky countries it might be the most important one) as tud (ii) The scores for the three countries are, giving double weighting to economic growth and political stability: Country 1 29 Country 2 24 fre ea cc Country 3 28 390 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com co ot Just because previous clients have not invested in countries with scores of less than 30 does not mean that Beela should not. The previous countries may not have been comparable with these in Africa. This decision rule also ignores return. If return is expected to be very high, a relatively low score might be acceptable to Beela. m chapter 17 The factors considered by the consultant might not be the only relevant factors when assessing political risk. Others could include the extent of capital flight from the country, the legal infrastructure, availability of local finance and the existence of special taxes and regulations for multinational companies. (iv) The weightings of the factors might not be relevant to Beela. (v) Scores such as these only focus on the macro risk of the country. The micro risk, the risk for the actual company investing in a country, is the vital factor. This differs between companies and between industries. A relatively hitech electronics company might be less susceptible to political actions than, for example, companies in extractive industries where the diminishing bargain concept may apply. (vi) There is no evidence of how the scores have been devised and how valid they are. ate ria l.b log sp (iii) as tud ym (b) Prior to investing Beela might negotiate an agreement with the local government covering areas of possible contention such as dividend remittance, transfer pricing, taxation, the use of local labour and capital, and exchange controls. The problem with such negotiations is that governments might change, and a new government might not honour the agreement The logistics of the investment may also influence political risk: cc (i) If a key element of the process is left outside the country it may not be viable for the government to take actions against a company as it could not produce a complete product. This particularly applies when intellectual property or knowhow is kept back fre ea (ii) Financing locally might deter political action, as effectively the action will hurt the local providers of finance (iii) Local sourcing of components and raw materials might reduce risk (iv) It is sometimes argued that participating in joint ventures with a local partner reduces political risk, although evidence of this is not conclusive 391 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Questions & Answers co (v) Control of patents and processes by the multinational might reduce risk, although patents are not recognised in all countries m freeaccastudymaterial.blogspot.com ot Governments or commercial agencies in multinationals’ home countries often offer insurance against political risk. sp Murwald (Interest rate hedging) l.b log (a) The treasury team believe that interest rates are more likely to increase than to decrease, and any hedging strategy will be based upon this assumption. There is also a requirement that interest payments do not increase by more than £10,000 from current interest rates Current expectations ria The current expectation is a £12m deficit in three months’ time for a sixmonth period. At current rates, the company could borrow at 6% + 1.5% = 7.5%. Interest costs at current borrowing rates would therefore be: £12m × 7.5% × 6/12 = £450,000. ate Alternative 1: Futures hedges ym Use June contracts to hedge a deficit of £12 million. To hedge against the risk of a rise in interest rates, the company should sell futures. as tud Tutorial note: We sell futures because if interest rates do rise, the market price of the futures will fall. The company can then close its position by buying futures, and making a gain on the futures trading to offset the ‘loss’ from higher interest rates in the loans market. (i) If interest rates rise by 2% and the futures price moves by 1.80% The tick value is £500,000 × 0.0001 × 3/12 = £12.50 fre ea cc As a six months hedge is required and each future is for a three month interest period, the number of contracts will be £12m / £500k × 6/3 = 48 contracts 392 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com co as tud ym ate ria l.b log sp ot £ Cost of borrowing at current rate 450,000 Cost if rates rise 2% (£12m × 9.5% × 6/12) 570,000 ––––––– "Loss" from extra borrowing cost (120,000) Futures Sell 48 contracts at 93.10 Buy 48 contracts at (93.10 – 1.80) 91.30 ––––– Gain per contract 1.80 ––––– Value of gain 180 × 48 × £12.50 108,000 ––––––– Net additional cost with hedging (12,000) ––––––– (ii) If interest rates fall by 1% and the futures price moves by 0.9% £ Cost of borrowing at current rate 450,000 Cost if rates fall 1% (£12m × 6.5% × 6/12) 390,000 ––––––– "Gain" from fall in borrowing cost 60,000 Futures Sell 48 contracts at 93.10 Buy 48 contracts at (93.10 + 0.90) 94.00 ––––– Loss per contract 0.90 ––––– Value of loss 90 × 48 × £12.50 (54,000) ––––––– Net gain with hedging 6,000 ––––––– Based on these futures prices, hedging in the futures market does not allow the company to guarantee that interest costs in the case of a deficit do not increase by more than £10,000. m chapter 17 The expectation is for interest rates to rise, therefore put options on futures will be purchased. This will allow the company to sell futures contracts at the exercise price for the options. The company should buy 48 options, since this is the number of futures contracts that might be required. (If interest rates rise the value of the put options will also increase.) fre ea cc Alternative 2: Options hedges 393 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com m Questions & Answers co For example using the 9400 exercise price: (i) If interest rates rise by 2% and the futures price moves by 1.8% Value of gain 86 × 48 × £12.50 ria Net additional cost with hedging ot (1.84) 94.00 (91.30) ––––– 0.86 ––––– l.b log Gain per contract sp Cost of borrowing at current rate Cost if rates rise 2% (£12m × 9.5% × 6/12) "Loss" from extra borrowing cost Options Buy 48 puts at Exercise – sell futures at (exercise price) Buy 48 futures contracts at (93.10 – 1.80) £ 450,000 570,000 ––––––– (120,000) 51,600 ––––––– (68,400) ––––––– ym ate In reality the options are likely to be sold rather than exercised. This is because they are June contracts, so they will still have time value that will be reflected in the option price. The gain from the options sale is therefore likely to be higher than the gain from exercising the options and selling futures. However, no data is provided on option prices on 1 June. cc as tud (ii) If interest rates fall by 1% and the futures price moves by 0.9% £ Cost of borrowing at current rate 450,000 Cost if rates fall 1% (£12m × 6.5% × 6/12) 390,000 ––––––– "Gain" from fall in borrowing cost 60,000 Options Buy 48 puts at 1.84. Cost = 184 × 48 × (110,400) £12.50 ––––––– Net additional cost with hedging (50,400) ––––––– Different outcomes will exist for using options if different put option exercise prices are selected. The best exercise price to select if the put options are exercised will be the 9350 option. fre ea 394 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com ot 93.50 – 91.30 – 1.25 = 0.95 or 95 ticks co If interest rates rise by 2% and the futures price falls by 180 to 91.30, this will give a gain from the options of: m chapter 17 95 × 48 × £12.50 = £57,000 sp If interest rates fall by 1% and the futures price rises to the futures price moves to 94.00, the option will not be exercised. The loss from hedging with options will be the premium paid off: l.b log 125 × 48 × £12.5 = £75,000 Outcomes with options at 9350 2% increase: £(120,000) + £57,000 = £(63,000) 1% decrease: £60,000 – £75,000 = £(15,000). ria Neither futures nor options hedges can satisfy, with certainty, the requirement that the interest payment should not increase by more than £10,000. ate Collar ym However, one way to achieve this would be to use a collar option, whereby downside risk is protected, but potential gains are also limited. A collar effectively fixes a maximum and minimum interest rate. as tud If a company expects to be borrowing and is worried about interest rate increases, a suitable collar can be achieved by buying put options and selling call options, to reduce the cost of protection. For example a collar could be achieved by buying forty eight 9400 put options at 1.84 and selling 9400 call options at 1.74, a net premium cost of 0.10 (other alternatives are possible). cc Murwald doesn't want interest to move adversely by more than £10,000 for a six month period on a £12 million loan. fre ea In annual terms this is a £10k/£12m × 2 = 0.167% A put option at the current interest rate (6%) and a total premium cost of less than 0.167% will satisfy the company's requirement. In the above example the total premium cost is 0.10%, and no matter what happens to interest rates Murwald can fix its borrowing cost at 7.6% (= 100 – 94.00 + 0.10 net option premium, plus the 1.5% premium over base rate for borrowing). 395 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Questions & Answers co This satisfies the requirement. (Interest payments would be £12m × 7.6% × 0.5 = £456,000 which is £6,000 worse than current interest rates.) m freeaccastudymaterial.blogspot.com sp (i) Alternative interest rate hedges include: (i) Forward rate agreements (FRAs). ot The use of a collar is the recommended hedging strategy, but the company should consider the implications of the collar if a cash surplus were to occur rather than a cash deficit. (iii) Interest rate swaps. l.b log (ii) OTC interest rate options – including interest rate guarantees. ate ria (i) A forward rate agreement (FRA) is a contract to agree to pay a fixed interest rate that is effective at a future date. As such Murwald could fix now a rate of interest of 6.1% (for example) to be effective in three months time for a period of six months. If interest rates were to rise above 6.1% the counterparty, usually a bank, would compensate Murwald for the difference between the actual rates and 6.1%. If interest rates were to fall below 6.1% Murwald would compensate the counterparty for the difference between 6.1% and the actual rate ym (ii) OTC options. Instead of market traded interest rate options such as those that are available on LIFFE, Murwald might use OTC options through a major bank. This would allow options to be tailored to the company's exact size and maturity requirements. An OTC collar would be possible, and the cost of this should be compared with the cost of using LIFFE options. Interest rate options for periods of less than one year are sometimes known as interest rate guarantees fre ea cc as tud (iii) Interest rate swaps. Murwald expects to borrow at a floating rate of interest. It might be possible for Murwald to swap its floating rate interest stream for a fixed rate stream, pegging interest rates to approximately current levels (the terms of the swap would have to be negotiated). Interest rate swaps are normally for longer periods than six months 396 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com Rayswood Inc Assumptions: ot (1) Share price is the present value of future cash flows i.e. the economic model co m chapter 17 sp (2) The stock market is weak and semi strong efficient most of the time, therefore once new information is communicated to the market it is rapidly reflected in the share price l.b log (3) In an efficient market shares are fairly priced i.e. a zero NPV transaction. They give investors the exact return to compensate them for the perceived level of systematic risk of the shares (4) If shares are zero NPV transactions, takeovers/mergers could only be successful due to value created as a result of the merger i.e. the synergies ria (5) Therefore it is absolutely essential that one undertakes an exhaustive review to identify all the synergies. In this question no synergies have been identified, therefore before any final advice would be given to the client one would request an immediate review of all synergies as tud ym ate (6) The question will therefore have to be answered on the basis of the unrealistic assumption that there are no synergies. Post acquisition share price: The Add Company Approach: Market values: $m Rayswood – 40 × 3.2 = 128.0 Pondhill – 150 × 0.45 = 67.5 Value of combined company 195.5 ––––– No of shares: 65m Share price of the combined company 3.01 fre ea cc Rayswood buys Pondhill in a 1 for 6 shares for share exchange. Rayswood already has 40m shares and buys Pondhill for (150 × 1/6) = 25m shares, thus 65m shares in total. 397 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com m Questions & Answers co Tutorial note: ot In fact the takeover has been a wealth decreasing decision in relation to the shareholders of Rayswood. The new share price of $3.01 is lower than current market price of $3.20. Which reflects the fact that premium payment to Pondhill’s shareholders has reduced the wealth of Rayswood’s shareholders. sp Calculation of the acquisition premium – Value per one share of Pondhill: (1 × 3.01)/6 = $0.50 (0.50 – 0.45)/0.45 = 11.11% l.b log Pondhill shareholders get 1 share in Rayswood ($3.01) for every 6 shares of Pondhill. ate Director’s comments: ria Therefore before an acquisition premium is paid consideration should be given to ensure that it does not exceed the synergistic effects of the acquisition. ‘As a result of this takeover we will diversify our operations and our earnings per share will rise by 13%, bringing great benefits to our shareholders.’ ym Risk diversification: as tud One of the primary reasons put forward for all mergers is that the income of the combined entity will be less volatile (less risky) as its cash flows come from a wide variety of products and markets. However this is a reduction in total risk, but has little or no affect on the systematic risk. Will this benefit the shareholders? fre ea cc Basic answer: No. Shareholders should diversify for themselves, because a shareholder can more easily and cheaply eliminate unsystematic risk by purchasing an international unit trust. As the majority of investors in quoted companies have well diversified portfolios they are only exposed to systematic risk. Thus the reduction of total risk by the more expensive company diversification option is generally not recommended. The Director’s comment is incorrect. 398 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com m chapter 17 co Earnings per share will rise by 13%: ot Calculation of EPS: Rayswood Pondhill Enlarged Rayswood 7.8m ––––– 19.5c 6.5m ––––– 4.33c 14.3 ––––– 22c sp Profit available to ordinary shareholders ––––––––––––––––– EPS l.b log % increase in the Earnings per share: (22 19.5) / 19.5 × 100 = 13% An increasing EPS does not automatically result in an increase share price, as the P/E ratio may fall to reflect the lower growth potential of the enlarged company. The P/E ratios: ate Share price ––––– EPS Pondhill 45 ––––– 4.33 10.39 Enlarged Rayswood 301 ––––– 22 13.68 ria Rayswood 320 ––––– 19.5 16.41 ym In the absence of synergy from the acquisition, purchasing Pondhill, with relatively low growth expectations, will depress the growth of the enlarged Rayswood’s post acquisition and thus the post acquisition P/E ratio falls. as tud The Director’s comment is incorrect, the increasing earnings per shares does not bring great benefits to the shareholders, in fact it masks a potential decrease in the share price. Nonexecutive comments: “The share price of Rayswood will rapidly increase to $3.61 following the announcement of the bid.” cc Bootstrapping: ea A company is able to increase its EPS by merging with a company on a lower P/E ratio than its own. The bootstrapping argument states that the fre Share price of the enlarged Rayswood = Post acq EPS × Pre acq P/E ratio of Rayswood. $3.61 = 22c × 16.41 times 399 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Questions & Answers ot co It contends that the market may believe that when that merger is completed that the management team of Rayswood can increase growth potential of Pondhill earnings to the same level as Rayswood earnings. It may then assign the Rayswood’s higher P/E ratio to the combined earnings of both companies (i.e. the post acquisition EPS). m freeaccastudymaterial.blogspot.com sp There has been some well documented cases of bootstrapping occurring in the 50s and 60s in America however as the stock markets have become more and more efficient it much less likely to occur today. The investors would request a detail analysis of the synergies so they could calculate the present value of future cash flows. l.b log If there are no synergies identified the higher post acquisition EPS simply results in a lower post acquisition P/E multiple as we have seen. Therefore the nonexecutive is also incorrect in his views. Predator ria Predator Inc ate The approaches to use for valuation are: (1) Net asset valuation (2) Dividend valuation model ym (3) P/E ratio valuation. (1) Net asset valuation as tud Target is being purchased as a going concern, so realisable values are irrelevant. Valuation –––––– Say $1.4m fre ea cc Net assets per accounts (1,892 – 768) Adjustment to freehold property (800 – 460) Adjustment to inventory $000 1,124 340 (50) –––––– 1,414 400 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com (2) Dividend Valuation Model ot The average rate of growth in Target’s dividends over the last 4 years is 7.4% on a compound basis. co m chapter 17 The estimated value of Target using the dividend valuation model is therefore: $113,100 × 1.074/(0.15 – 0.074) = $1,598,281 Say $1.6m l.b log (3) P/E ratio Valuation sp Valuation A suitable P/E ratio for Target will be based on the P/E ratio of Predator as both companies are in the same industry. P/E of Predator (70m × $4.30)/$20.04m or 430/28.63 = 15.02 ria The adjustments: – Downwards by 20% or 0.20 i.e. multiply by 0.80. (1) Target is a private company and its shares may be less liquid ate (2) Target is a private company and it may have a less detailed compliance environment and therefore maybe more risky A suitable P/E ratio is therefore 15.02 × 0.80 = 12.02 (Multiplying by 0.80 results in the 20% reduction). ym Target’s PAT + Synergy after tax: $183,000 + ($40,000 × 67%) = $209,800. as tud After adjusting for the savings in the director’s remuneration. The estimated value is therefore $209,800 × 12.02 = $2,521,796 Say $2.5m Advice to the board cc On the basis of its tangible assets the value of Target is $1.4m, which excludes any value for intangibles. fre ea The dividend valuation gives a value of around $1.6m. The earnings based valuation indicates a value of around $2.5m, which is based on the assumption, that not only will the current earnings be maintained, but that they will increase by the savings in the director’s remuneration. 401 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com Questions & Answers co On the basis of these valuations an offer of around $2m would appear to be most suitable, however a review of all potential synergies is recommended. The directors should, however, be prepared to increase the offer to maximum price. m freeaccastudymaterial.blogspot.com ot Maximum price comment sp It is worth noting that the maximum price Predator should be prepared to offer is: l.b log The maximum price Predator should pay for target is: PVTarget Company + PVSynergy fre ea cc as tud ym ate ria The comment on the maximum price is particularly appropriate in this question, as this an example of horizontal acquisition where considerable synergies normally exist. 402 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com ... In addition to general rules of ethics and governance, members of the ACCA have additional guidance to support their decision making. ACCA Code of Ethics fre ea cc • • • 16 KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com... fre ea cc as tud ym ate ria l.b log sp ot co m freeaccastudymaterial.blogspot.com iv KAPLAN PUBLISHING freeaccastudymaterial.blogspot.com freeaccastudymaterial.blogspot.com chapter m Introduction... papers cc Expandable Text – Expandable text provides you with additional information about a topic area and may help you gain a better understanding of the core content Essential text users can access