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for payment of the consideration for acquisition. MBO is the purchase of a business by its
management, who when threatened with the sale of its business to third parties or frustrated by the
slow growth of the company, step-in and acquire the business from the owners, and run the
business for themselves. The majority of buy-outs is management buy-outs and involves the
acquisition by incumbent management of the business where they are employed. Typically, the
purchase price is met by a small amount of their own funds and the rest from a mix of venture
capital and bank debt.
Internationally, the two most common sources of buy-out operations are divestment of parts of
larger groups and family companies facing succession problems. Corporate groups may seek to
sell subsidiaries as part of a planned strategic disposal programme or more forced reorganisation
in the face of parental financing problems. Public companies have, however, increasingly sought to
dispose of subsidiaries through an auction process partly to satisfy shareholder pressure for value
maximisation.
In recessionary periods, buy-outs play a big part in the restructuring of a failed or failing businesses
and in an environment of generally weakened corporate performance often represent the only
viable purchasers when parents wish to dispose of subsidiaries.
Buy-outs are one of the most common forms of privatisation, offering opportunities for enhancing
the performances of parts of the public sector, widening employee ownership and giving managers
and employees incentives to make best use of their expertise in particular sectors.
Question 3
What is take over by reverse bid? (3 Marks) (May 2006), (4 Marks) (November 2011)
Answer
Generally, a big company takes over a small company. When the smaller company gains
control of a larger one then it is called “Take-over by reverse bid”. In case of reverse take-
over, a small company takes over a big company. This concept has been successfully
followed for revival of sick industries.
The acquired company is said to be big if any one of the following conditions is satisfied:
(i) The assets of the transferor company are greater than the transferee company;
(ii) Equity capital to be issued by the transferee company pursuant to the acquisition
exceeds its original issued capital, and
(iii) The change of control in the transferee company will be through the introduction of
minority holder or group of holders.
Reverse takeover takes place in the following cases:
(1) When the acquired company (big company) is a financially weak company
(2) When the acquirer (the small company) already holds a significant proportion of shares of
the acquired company (small company)
(3) When the people holding top management positions in the acquirer company want to be
relived off of their responsibilities.
The concept of take-over by reverse bid, or of reverse merger, is thus not the usual case of
amalgamation of a sick unit which is non-viable with a healthy or prosperous unit but is a case
whereby the entire undertaking of the healthy and prosperous company is to be merged and
vested in the sick company which is non-viable.
Question 4
Write a short note on Financial restructuring.
(5 Marks) (November 2008) (S), (4 Marks) (May 2013)
Answer
Financial restructuring, is carried out internally in the firm with the consent of its various
stakeholders. Financial restructuring is a suitable mode of restructuring of corporate firms that
have incurred accumulated sizable losses for / over a number of years. As a sequel, the share
capital of such firms, in many cases, gets substantially eroded / lost; in fact, in some cases,
accumulated losses over the years may be more than share capital, causing negative net
worth. Given such a dismal state of financial affairs, a vast majority of such firms are likely to
have a dubious potential for liquidation. Can some of these Firms be revived? Financial
restructuring is one such a measure for the revival of only those firms that hold prom-
ise/prospects for better financial performance in the years to come. To achieve the desired
objective, 'such firms warrant / merit a restart with a fresh balance sheet, which does not
contain past accumulated losses and fictitious assets and shows share capital at its real/true
worth.
Question 5
What is reverse merger? (4 Marks) (November 2010) (M)
Answer
A merger is considered to be the fusion of two Companies. The two Companies which have
merged into another Company in the same industry, normally the market share of the
company would increase. In addition to normal merger (where smaller companies merge into
larger Company), vertical merger (where to companies of different industry merge together),
there is one more hand of merger, known as Reverse Merger.
In this, two Companies are normally of the same industry but here bigger company merges
into smaller company that’s why it is called reverse merger. In order to avail benefit of carry
forward of losses which are available as per tax laws, the profit making Company is merged
with companies having accumulates losses. Following three things are very important for
reverse merger.
1. The assets of transfer company are greater than the transferee company.
2. Equity Capital to be issued by the transferee company pursuant to the merger exceeds to
original capital.
3. There is a change in control in the transferee company through the introduction of a
minority group or new group of shareholders.
Question 6
What is an equity curve out? How does it differ from a spin off? (4 Marks) (November 2013)
Answer
Equity Curve out can be defined as partial spin off in which a company creates its own new
subsidiary and subsequently bring out its IPO. It should be however noted that parent
company retains its control and only a part of new shares are issued to public.
On the other hand in Spin off parent company does not receive any cash as shares of
subsidiary company are issued to existing shareholder in the form of dividend. Thus,
shareholders in new company remain the same but not in case of Equity curve out.
Question 7
B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its
expected high growth in earnings and dividends is reflected in its PE ratio of 17. The Board of
Directors of B Ltd. has been advised that if it were to take over firms with a lower PE ratio than
it own, using a share-for-share exchange, then it could increase its reported earnings per
share. C Ltd. has been suggested as a possible target for a takeover, which has a PE ratio of
10 and 1,00,000 shares in issue with a share price of 15. B Ltd. has 5,00,000 shares in
issue with a share price of 12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of C Ltd. by issuing
shares at its market price of 12. Assume the price of B Ltd. shares remains constant.
(8 Marks) (November 2009) (M)
Answer
Total market value of C Ltd is = 1,00,000 x 15 = 15,00,000
PE ratio (given) = 10
Therefore , earnings = 15,00,000 /10
= 1,50,000
Total market value of B Ltd. is = 5,00,000 x 12 = 60,00,000
PE ratio ( given) = 17
Therefore, earnings = 60,00,000/17
= 3,52,941
The number of shares to be issued by B Ltd.
15,00,000 ÷ 12 = 1,25,000
Question 9
ABC Limited is considering acquisition of DEF Ltd., which has 3.10 crore shares issued
and outstanding. The market price per share is 440.00 at present. ABC Ltd.'s average
cost of capital is 12%. The cash inflows of DEF Ltd. for the next three years are as under:
Year in crores
1 460.00
2 600.00
3 740.00
You are required to calculate the range of valuation that ABC Ltd. has to consider.
Take P.V.F. (12%, 3) = 0.893, 0.797, 0.712 (5 Marks) (May 2013)
Answer
Valuation based on Market Price
Market Price per share 440.00
Thus value of total business is (3.10 crore x 440) 1,364.00 Crore
Valuation based on Discounted Cash Flow
Present Value of cash flows
( 460 Crore x 0.893) + ( 600 Crore X 0.797) +
( 740 Crore X 0.712 ) = 1,415.86 Crore
Value of per share ( 1415.86 Crore / 3.10 Crore) 456.73 per share
Range of valuation
Per Share Total ( Crore)
Minimum 440.00 1364.00
Maximum 456.73 1415.86
Question 10
X Ltd. reported a profit of 65 lakhs after 35% tax for the financial year 2007-08. An analysis of the
accounts revealed that the income included extraordinary items 10 lakhs and an extraordinary
loss 3 lakhs. The existing operations, except for the extraordinary items, are expected to continue
in the future; in addition, the results of the launch of a new product are expected to be as follows:
lakhs
Sales 60
Material costs 15
Labour Costs 10
Fixed costs 8
PE ratio 8
Market price per share 13.40
Question 11
Eagle Ltd. reported a profit of 77 lakhs after 30% tax for the financial year 2011-12. An
analysis of the accounts revealed that the income included extraordinary items of 8 lakhs
and an extraordinary loss of 10 lakhs. The existing operations, except for the extraordinary
items, are expected to continue in the future. In addition, the results of the launch of a new
product are expected to be as follows:
In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10
You are required to:
(i) Calculate the value of the business, given that the capitalization rate is 14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share capital being
comprised of 1,00,000 13% preference shares of 100 each and 50,00,000 equity shares
of 10 each and the P/E ratio being 10 times. (8 Marks) (November 2012)
Answer
(i) Computation of Business Value
( Lakhs)
77 110
Profit before tax
1 0.30
Less: Extraordinary income (8)
Add : Extraordinary losses 10
112
Profit from new product ( Lakhs)
Sales 70
Less: Material costs 20
Labour costs 12
Fixed costs 10 (42) 28
140.00
Less: Taxes @30% 42.00
Future Maintainable Profit after taxes 98.00
Relevant Capitalisation Factor 0.14
Value of Business ( 98/0.14) 700
= 16128/1.521 = 10603.55
(In Thousands)
Total for first 4 years (A) 4145.35
Residual value (6225.73/0.14) 44469.50
Present value of Residual value [ 44469.50/(1.14)4] (B) 26329.51
Total Shareholders value (C) = (A) +(B) 30474.86
Pre strategy value (4200/0.14) (D) 30000.00
Value of strategy (C) – (D) 474.86
Conclusion: The strategy is financially viable.
Alternative Solution
If candidates have assumed that if the Equity amount is 16000 instead of 15000.
Projected Balance Sheet
(In Thousands)
Year 1 2 3 4 5
Fixed Assets (25% of sales) 13000.00 16900.00 21970.00 28561.00 28561.00
Current Assets (15% of sales) 7800.00 10140.00 13182.00 17136.60 17136.60
Total Assets 20800.00 27040.00 35152.00 45697.60 45697.60
Current Liability 1300.00 1690.00 2197.00 2856.10 2856.10
Equity and Reserves 19500.00 25350.00 32955.00 42841.50 42841.50
(In Thousands)
Sales (30% yoy) 52000.00 67600.00 87880.00 114244.00 114244.00
PBT 15% 7800.00 10140.00 13182.00 17136.60 17136.60
PAT 70% 5460.00 7098.00 9227.40 11995.62 11995.62
Depreciation 15% 1500.00 1950.00 2535.00 3295.50 4284.15
(In Thousands)
Total for first 4 years (A) 3113.03
Residual value (6225.73/0.14) 44469.50
Present value of Residual value [ 44469.50/(1.14)4] (B) 26329.51
Total Shareholders value (C) = (A) +(B) 29442.54
Pre strategy value (4200/0.14) (D) 30000.00
Value of strategy (C) – (D) -557.46
Conclusion: The strategy is financially not viable.
Question 14
MK Ltd. is considering acquiring NN Ltd. The following information is available:
Company Earning after No. of Equity Shares Market Value
tax( ) Per Share( )
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as above. There is
no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a loss.
(8 Marks) (November 2010) (S)
Answer
(i) Earning per share of company MK Ltd after merger:-
Exchange ratio 160 : 200 = 4 : 5.
that is 4 shares of MK Ltd. for every 5 shares of NN Ltd.
Total number of shares to be issued = 4/5 3,00,000 = 2,40,000 Shares.
Total number of shares of MK Ltd. and NN Ltd.=12,00,000 (MK Ltd.)+2,40,000 (NN Ltd.)
= 14,40,000 Shares
Total profit after tax = 60,00,000 MK Ltd.
= 18,00,000 NN Ltd.
= 78,00,000
EPS. (Earning Per Share) of MK Ltd. after merger
78,00,000/14,40,000 = 5.42 per share
(ii) To find the exchange ratio so that shareholders of NN Ltd. would not be at a Loss:
Present earning per share for company MK Ltd.
= 60,00,000/12,00,000 = 5.00
Present earning per share for company NN Ltd.
= 18,00,000/3,00,000 = 6.00
Exchange ratio should be 6 shares of MK Ltd. for every 5 shares of NN Ltd.
Shares to be issued to NN Ltd. = 3,00,000 6/5 = 3,60,000 shares
Now, total No. of shares of MK Ltd. and NN Ltd. =12,00,000 (MK Ltd.)+3,60,000 (NN Ltd.)
= 15,60,000 shares
EPS after merger = 78,00,000/15,60,000 = 5.00 per share
Total earnings available to shareholders of NN Ltd. after merger = 3,60,000 shares
5.00 = 18,00,000.
This is equal to earnings prior merger for NN Ltd.
Exchange ratio on the basis of earnings per share is recommended.
Question 15
A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one
share of T Ltd.). Following information is provided:
A Ltd. T. Ltd.
Profit after tax 18,00,000 3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS 3 2
PE Ratio 10 times 7 times
Market price per share 30 14
Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
Required:
(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earning per share for ABC
Ltd.? Assume that the merger takes place by exchange of equity shares and the
exchange ratio is based on the current market price.
(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings to members are
as before the merger takes place? (8 Marks) (May 2004)
Answer
(i) Earnings per share = Earnings after tax /No. of equity shares
ABC Ltd. = 50,00,000/10,00,000 = 5
XYZ Ltd. = 18,00,000 / 6,00,000 = 3
(ii) Number of Shares XYZ limited’s shareholders will get in ABC Ltd. based on market
value per share = 28/ 42 6,00,000 = 4,00,000 shares
Total number of equity shares of ABC Ltd. after merger = 10,00,000 + 4,00,000 =
14,00,000 shares
Earnings per share after merger = 50,00,000 + 18,00,000/14,00,000 = 4.86
(iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd. to earn the same
as was before merger:
Shares to be exchanged based on EPS = ( 3/ 5) 6,00,000 = 3,60,000 shares
EPS after merger = ( 50,00,000 + 18,00,000)/13,60,000 = 5
Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. = 3,60,000 5=
18,00,000.
Thus, to ensure that Earning to members are same as before, the ratio of exchange should be
0.6 share for 1 share.
Question 17
XYZ Ltd. is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at 25.
it has 2,00,000 shares outstanding and its earning after taxes (EAT) amount to 4,00,000.
ABC Ltd. has 1,00,000 shares outstanding; its current market price is 12.50 and its EAT is
1,00,000. The merger will be effected by means of a stock swap (exchange). ABC Ltd. has
agreed to a plan under which XYZ Ltd. will offer the current market value of ABC Ltd.’s shares.
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies?
(ii) If ABC Ltd.’s P/E ratio is 8, what is its current market price? What is the exchange ratio?
What will XYZ Ltd.’s post merger EPS be?
(iii) What must the exchange ratio be for XYZ Ltd.’s pre-merger and post-merger EPS to be
the same? (8 Marks) (May 2005)
Answer
Merger and EPS
Company XYZ ABC
Rs. Rs.
Market price of equity shares 25.00 12.50
No. of equity shares outstanding 2,00,000 1,00,000
Earning after tax 4,00,000 1,00,000
(ii) (a) If ABC Ltd. P/E ratio is 8, its current market price will be 8 only (8 1).
(b) Then the exchange ratio will be 8/25 i.e. 32/100. For every 100 shares of
ABC, 32 shares of XYZ will be issued (1,00,000 32)/100 = 32,000 shares of
XYZ will be issued to all the shareholders of ABC Ltd.
(c) Post merger EPS of XYZ Ltd. = Total earning/Total shares = 5,00,000/2,32,000
equity shares = 2.16.
(iii) Total earnings 5,00,000/EPS 2 = 2,50,000 equity shares i.e. 50,000 shares of
XYZ will have to be issued to the shareholders of ABC i.e. one share of XYZ will be
issued for every two shares held by ABC shareholders.
Then pre-merger and post-merger EPS of XYZ will be same as follows:
Pre-merger EPS of XYZ 2.00
Post-merger EPS of XYZ 5,00,000/2,50,000 equity shares
= 2.00
Question 18
LMN Ltd is considering merger with XYZ Ltd. LMN Ltd's shares are currently traded at
30.00 per share. It has 3,00,000 shares outstanding. Its earnings after taxes (EAT) amount
to 6,00,000. XYZ Ltd has 1,60,000 shares outstanding and its current market price is
15.00 per share and its earnings after taxes (EAT) amount to 1,60,000. The merger is
decided to be effected by means of a stock swap (exchange). XYZ Ltd has agreed to a
proposal by which LMN Ltd will offer the current market value of XYZ Ltd's shares.
Find out:
(i) The pre-merger earnings per share (EPS) and price/earnings (P/E) ratios of both the
companies.
(ii) If XYZ Ltd's P/E Ratio is 9.6, what is its current Market Price? What is the Exchange
Ratio? What will LMN Ltd's post-merger EPS be?
(iii) What should be the exchange ratio, if LMN Ltd's pre-merger and post- merger EPS are to
be the same? (8 Marks) (May 2012)
Answer
(i) Pre-merger EPS and P/E ratios of LMN Ltd. and XYZ Ltd.
Particulars LMN Ltd. XYZ Ltd.
Earnings after taxes 6,00,000 1,60,000
Number of shares outstanding 3,00,000 1,60,000
EPS 2 1
Market Price per share 30 15
P/E Ratio (times) 15 15
(ii) Current Market Price of XYZ Ltd. if P/E ratio is 9.6 = 1 × 9.6 = 9.60
30
Exchange ratio = = 3.125
9.60
Post merger EPS of LMN Ltd.
6,00,000 + 1,60,000
=
3,00,000 + (1,60,000/3.125)
7,60,000
= = 2.16
3,51,200
(iii) Desired Exchange Ratio
Total number of shares in post-merged company
Post - merger earnings 7,60,000
= = = 3,80,000
Pr e - merger EPS of LMN Ltd. 2
Number of shares required to be issued to XYZ Ltd.
= 3,80,000 – 3,00,000 = 80,000
Therefore, the exchange ratio should be
80,000 : 1,60,000
80,000
= = 0.50
1,60,000
Question 19
K. Ltd. is considering acquiring N. Ltd., the following information is available :
Company Profit after Tax Number of Equity shares Market value per share
K. Ltd. 50,00,000 10,00,000 200.00
N. Ltd. 15,00,000 2,50,000 160.00
Exchange of equity shares for acquisition is based on current market value as above. There is
no synergy advantage available :
Find the earning per share for company K. Ltd. after merger.
Find the exchange ratio so that shareholders of N. Ltd. would not be at a loss.
(12 Marks) (November 2008) (S)
Answer
(i) Earning per share for company K. Ltd. after Merger:
Exchange Ratio 160 : 200 = 4: 5
That is 4 shares of K. Ltd. for every 5 shares of N. Ltd.
4
Total number of shares to be issued = × 2,50,000 = 2,00,000 shares
5
Total number of shares of K. Ltd. and N .Ltd. = 10,00,000 K. Ltd.
+ 2,00,000 N. Ltd
12,00,000
Total profit after Tax = 50,00,000 K. Ltd.
15,00,000 N Ltd.
65,00,000
E.P.S. (Earning per share) of K. Ltd. after Merger
65,00,000
= = 5.42 Per Share
12,00,000
(ii) To find the Exchange Ratio so that shareholders of N. Ltd. would not be at a Loss:
Present Earnings per share for company K. Ltd.
50,00,000
= 5.00
10,00,000
Present Earnings Per share for company N. Ltd.
15,00,000
= 6.00
2,50,000
Exchange Ratio should be 6 shares of K. Ltd. for every 5 shares of N Ltd.
Shares to be issued to N. Ltd.
2,50,000 6
= = 3,00,000 Shares
5
Total No. of Shares of K.Ltd. and N. Ltd.
= 10,00,000 K. Ltd.
+ 3,00,000 N. Ltd
13,00,000
65,00,000
E.P.S. After Merger = 5.00 Per Share
13,00,000
Total Earnings Available to Shareholders of N. Ltd. after Merger
= 3,00,000 × 5.00 = 15,00,000
This is equal to Earnings prior Merger for N. Ltd.
Exchange Ratio on the Basis of Earnings per Share is recommended.
Question 20
M Co. Ltd., is studying the possible acquisition of N Co. Ltd., by way of merger. The following
data are available in respect of the companies:
Particulars M Co. Ltd. N Co. Ltd.
Earnings after tax ( ) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share ( ) 200 160
(i) If the merger goes through by exchange of equity and the exchange ratio is based on the
current market price, what is the new earning per share for M Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders will not be
diminished by the merger. What should be the exchange ratio in that case?
(8 Marks) (November 2003)
Answer
(i) Calculation of new EPS of M Co. Ltd.
No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 shares × 160/ 200 = 3,20,000 shares
Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd.
Since the Company has limited liability the value of equity cannot be negative therefore the value
of equity under slow growth will be taken as zero because of insolvency risk and the value of debt
is taken at 410 lacs. The expected value of debt and equity can then be calculated as:
Simple Ltd.
in Lacs
High Growth Medium Growth Slow Growth Expected Value
Prob. Value Prob. Value Prob. Value
Debt 0.20 460 0.60 460 0.20 410 450
Equity 0.20 360 0.60 90 0.20 0 126
820 550 410 576
Dimple Ltd.
in Lacs
High Growth Medium Growth Slow Growth Expected Value
Prob. Value Prob. Value Prob. Value
Equity 0.20 985 0.60 760 0.20 525 758
Debt 0.20 65 0.60 65 0.20 65 65
1050 825 590 823
Expected Values
in Lacs
Equity Debt
Simple Ltd. 126 Simple Ltd. 450
Dimple Ltd. 758 Dimple Ltd. 65
884 515
Question 23
Longitude Limited is in the process of acquiring Latitude Limited on a share exchange basis.
Following relevant data are available:
Longitude Limited Latitude Limited
Profit after Tax (PAT) in Lakhs 140 60
Number of Shares Lakhs 15 16
Earning per Share (EPS) 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)
Answer
(i) Pre Merger Market Value of Per Share
P/E Ratio X EPS
Longitude Ltd. 8 X 15 = 120.00
Latitude Ltd. 5 X 10 = 50.00
(ii) (1) Maximum exchange ratio without dilution of EPS
Pre Merger PAT of Longitude Ltd. 140 Lakhs
Pre Merger PAT of Latitude Ltd. 60 Lakhs
Combined PAT 200 Lakhs
Longitude Ltd. ’s EPS 8
Maximum number of shares of Longitude after merger ( 25 Lakhs
200 lakhs/ 8)
Existing number of shares 15 Lakhs
Maximum number of shares to be exchanged 10 Lakhs
Maximum share exchange ratio 10:16 or 5:8
(2) Maximum exchange ratio without dilution of Market Price Per Share
Pre Merger Market Capitalization of Longitude Ltd. 1800 Lakhs
( 120 × 15 Lakhs)
Pre Merger Market Capitalization of Latitude Ltd. 800 Lakhs
( 50 × 16 Lakhs)
Combined Market Capitalization 2600 Lakhs
Current Market Price of share of Longitude Ltd. 120
Maximum number of shares to be exchanged of Longitude 21.67 Lakhs
(surviving company )( 2600 Lakhs/ 120)
Current Number of Shares of Longitude Ltd. 15.00 Lakhs
Maximum number of shares to be exchanged (Lakhs) 6.67 Lakhs
Maximum share exchange ratio 6.67:16 or 0.4169:1
Note: Since in the question figures given of PAT of both companies are not
matching with figures of EPS X Number of Shares. Hence, if students computed
PAT by using this formula then alternative answer shall be as follows:
(1) Maximum exchange ratio without dilution of EPS
Pre Merger PAT of Longitude Ltd. 120 Lakhs
Pre Merger PAT of Latitude Ltd. 80 Lakhs
Combined PAT 200 Lakhs
Answer
(i) SWAP ratio based on current market prices:
EPS before acquisition:
Mani Ltd. : 2,000 lakhs / 200 lakhs: 10
Ratnam Ltd.: 4,000 lakhs / 1,000 lakhs: 4
Market price before acquisition:
Mani Ltd.: 10 × 10 100
Ratnam Ltd.: 4 × 5 20
SWAP ratio: 20/100 or 1/5 i.e. 0.20
(ii) EPS after acquisition:
(2, 000 4, 000) Lakhs
= 15.00
(200 200) Lakhs
(iii) Market Price after acquisition:
EPS after acquisition : 15.00
P/E ratio after acquisition 10 × 0.9 9
Market price of share ( 15 X 9) 135.00
(iv) Market value of the merged Co.:
135 × 400 lakhs shares 540.00 Crores
or 54,000 Lakhs
(v) Gain/loss per share:
Crore
Mani Ltd. Ratnam Ltd.
Total value before Acquisition 200 200
Value after acquisition 270 270
Gain (Total) 70 70
No. of shares (pre-merger) (lakhs) 200 1,000
Gain per share ( ) 35 7
Question 25
P Ltd. is considering take-over of R Ltd. by the exchange of four new shares in P Ltd. for every
five shares in R Ltd. The relevant financial details of the two companies prior to merger
announcement are as follows:
P Ltd R Ltd
Profit before Tax ( Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9
Corporate Tax Rate 30%
Company’s forecast turnover for the year to 31st March, 2005 is 2,000 lacs which is mainly
dependent on the ability of the Company to obtain the new contract, the chance for which is
60%, turnover for the following year is dependent to some extent on the outcome of the year
to 31st March, 2005. Following are the estimated turnovers and probabilities:
Year - 2005 Year - 2006
Turnover Prob. Turnover Prob.
(in lacs) (in lacs)
2,000 0.6 2,500 0.7
3,000 0.3
1,500 0.3 2,000 0.5
1,800 0.5
1,200 0.1 1,500 0.6
1,200 0.4
Operating costs inclusive of depreciation are expected to be 40% and 35% of turnover
respectively for the years 31st March, 2005 and 2006. Tax is to be paid at 30%. It is assumed
that profits after interest and taxes are free cash flows. Growth in earnings is expected to be
405 for the years 2007, 2008 and 2009 which will fall to 105 each year after that. Industry
average cost of equity (net of tax) is 15%. (10 Marks) (November 2007)
Answer
Estimation of earnings for the years ended 31st March, 2005 & 2006
( In lacs)
Prob. Turnover Expected Prob. Turnover Expected
Turnover Turnover
0.6 2000 1200 0.6 0.7 2500 1050
0.6 x 0.3 3000 540
0.3 1500 450 0.3 0.5 2000 300
0.3 0.5 1800 270
0.1 1200 120 0.1 0.6 1500 90
0.1 0.4 1200 48
1770 2298
Operating Costs (40%) (708) (35%) (804)
Interest 100 1 (10) (10)
Profit after Interest 1052 1484
Tax 316 445
Earnings/Cash flows 736 1039
Earnings would have witnessed 5% constant growth rate without merger and 6% with merger
on account of economies of operations after 5 years in each case. The cost of capital is 15%.
The number of shares outstanding in both the companies before the merger is the same and
the companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
Answer
Alternative 1 (when number of shares are 2.4 and 1.7 lakhs respectively)
Evaluation:-
Background calculations:-
(Figures in lakhs)
AB Ltd. CD Ltd. Total
PBT 125 110 235
PAT 87.5 77 164.5
Pre bid EPS 36.46 45.29
P/E ratio 11 7
Pre-bid Price Per Share 401.06 317.03
Market value of the company 962.54 538.95 1,501.49
No. of New Shares Post bid 2.4 1.36 3.76
% combined company owned by 63.83% 36.17%
Value to the original Shareholders 958.40 543.09 1,501.49
Post bid Price per share to original shareholders i.e., 399.33 319.46
2.40 lakhs and 1.70 lakhs shareholders respectively.
(Note: The Post bid Price per share to new shareholders as per terms of acquisition works
out to 399.33 for both the companies)
These figures suggest post bid acquisition share price of 399.33 for AB Ltd., and 319.46 for
CD Ltd.’s. Original shareholders. The price of CD Ltd share is likely to be influenced by the
value of cash alternative.
The post bid share price of the new firm can be estimated by applying the P/E ratio to the
combined earnings of the two old companies.
In that case,
Market Value would be = 164.5 11 = 1809.50
1,809.50
Price per share of the combined company would be = 481.25
3.76
Therefore share of AB Ltd., shareholders would raise by 481.25 – 401.06= 80.19 i.e.,
20%.
Share value of CD Ltd., shareholder expected to rise by
4
481.25 317.03 67.97i.e.21.44%
5
360 317.03
With the cash offer the premium is 13.55% only
317.03
Hence shareholders of CD Ltd are gaining more from the merger in a share exchange and cash
alternative is unlikely to be accepted.
Using constant growth model the value of both the individual companies would be:
36.46(1.04)
AB Ltd., share price = 473.98
0.12 0.04
45.29 1.04
CD Ltd., share price = 785.03
0.10 0.04
On this basis market slightly undervalues AB Ltd share but share of CD Ltd., are highly
undervalued possibly because of previous disappointments. However, if AB Ltd. forecast is
believed that the AB Ltd., is getting CD Ltd. shares, it will be a cheap proposal for AB Ltd. to
acquire the CD Ltd. on share exchange basis and especially if any of the shareholder of CD
Ltd. Accept the cash offer.
The shareholders of CD Ltd. would also be benefited post merger based on share exchange
ratio since the value of their share would be going up from 317.03 to 399.33. However,
their share price would still be undervalued as compared with the share price calculated by
using constant growth model.
Alternative 2 (when number of shares are 24 and 17 lakhs respectively)
If we take into consideration the number of shares being 24 lakhs and 17 lakhs the Pre-bid
share price works out to 40.15 and 31.71 respectively, which seems to be illogical against a
cash offer @ 360/- per share. However, since many students may have solved this question
based on the figures of 24 lakhs and 17 lakhs number of shares, an alternative solution is
provided below.
Evaluation: Figures in lakhs
Background calculations: AB Ltd. CD Ltd. Total
PBT 125 110 235
PAT 87.5 77 164.5
Pre bid EPS 3.65 4.53
P/E Ratio 11 7
Pre-bid Price per share 40.15 31.71
Market value of the company 963.60 539.07 1502.67
No. of new shares Post-bid 24 13.6 37.6
% of combined company owned by 63.83 36.17
Value to the original shareholders 959.15 543.52 1502.67
Post-bid Price to original shareholders i.e,, 24 39.96 31.97
lakhs and 17 lakhs shareholders respectively
(Note: The Post bid price per share works out to 39.96 for both the companies)
These figures suggest Post acquisition share price of 39.96 for AB Ltd and 31.97 for CD
Ltd’s original shareholders. The Price of CD Ltd. Share is likely to be influenced by the value
of cash alternative.
The Post bid share price of the new firm can be estimated by applying the P/E ratio to the
combined earnings of the two old companies.
In that case,
Market-value would be = 164.5 11 = 1809.50
Price per share of the combined company
1809.50
Would be = 48.13
37.6
Shares of AB Ltd. shareholders would raise by 48.13 – 40.15 = 7.98 i.e., 19.87% or 20%.
4
Share value of CD Ltd., shareholders expected to raise by 48.13 31.71
5
= 7.40 or 23.34%.
360 31.71
However, with the cash offer the premium is 1035.29%
31.71
Hence, the shareholders of CD Ltd., are substantially benefited by cash offer and they are
unlikely to accept the share swap ratio.
Using constant growth model the value of shares of both the individual companies would be
3.65(1.04) 3.80
AB Ltd. Share Price = =
0.12- 0.04 0.08
= 47.5
4.53 (1.04) 4.71
CD Ltd. Share Price =
0.10 0.04 0.06
= 78.5
On this basis market slightly undervalues AB Ltd. Share but share of CD Ltd., is highly
undervalued possibly because of previous disappointments. However, if AB Ltd. forecast is
believed that the AB Ltd. is getting CD Ltd. share it will be a cheap proposal for AB Ltd., to
acquire CD Ltd., on share exchange basis.
The shareholders of CD Ltd., would however be more benefited by cash offer.
Question 29
The following information is provided relating to the acquiring company Efficient Ltd. and the
target Company Healthy Ltd.
Promoter’s holding = 4.75 lakh shares + (5 2.5 = 12.5 lakh shares) = 17.25 lakh i.e.
Promoter’s holding % is (17.25 lakh/28.75 lakh) 100 = 60%.
Calculation of EPS, Market price, Market capitalization and free float market
capitalization.
(ii) The Book Value, Earning Per Share and Expected Market Price of Swabhiman Ltd.,
(assuming P/E Ratio of Abhiman ratio remains the same and all assets and liabilities of
Swabhiman Ltd. are taken over at book value.) (8 Marks) (May 2011)
Answer
SWAP RATIO
Abhiman Ltd. Swabhiman Ltd.
( ) ( )
Share capital 200 lacs 100 lacs
Free reserves & surplus 900 lacs 600 lacs
Total 1100 lacs 700 lacs
No. of shares 2 lacs 10 lacs
Book value for share 550 70
Promoters Holding 50% 60%
Non promoters holding 50% 40%
Free float market capitalization (Public) 500 lacs 156 lacs
Total Market Cap 1000 lacs 390 lacs
No. of shares 2 lacs 10 lacs
Market Price 500 39
P/E ratio 10 4
EPS 50.00 9.75
Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the
swap ratio weights are assigned to different parameters by the Board of Directors as follows:
Book Value 25%
EPS (Earning per share) 50%
Market Price 25%
(a) What is the swap ratio based on above weights?
(b) What is the Book Value, EPS and expected Market price of Abhiman Ltd. after
acquisition of Abhishek Ltd. (assuming P.E. ratio of Abhiman Ltd. remains unchanged
and all assets and liabilities of Abhishek Ltd. are taken over at book value).
(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.), if
after acquisition of Abhishek Ltd., Abhiman Ltd. decided to :
(a) Issue Bonus shares in the ratio of 1 : 2; and
(b) Split the stock (share) as 5 each fully paid. (20 Marks) (June 2009) (S)
Answer
(a) Swap Ratio
Abhiman Ltd. Abhishek Ltd.
Share Capital 200 Lakh 100 Lakh
Free Reserves 800 Lakh 500 Lakh
Total 1000 Lakh 600 Lakh
No. of Shares 2 Lakh 10 Lakh
Book Value per share 500 60
Promoter’s holding 50% 60%
Non promoter’s holding 50% 40%
Free Float Market Cap. i.e. 400 Lakh 128 Lakh
relating to Public’s holding
Hence Total market Cap. 800 Lakh 320 Lakh
No. of Shares 2 Lakh 10 Lakh
Market Price 400 32
P/E Ratio 10 4
EPS 40 8
Profits ( 2 X 40) 80 -
( 8 X 10) - 80
Required:
(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama Ltd. and Krishna
Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to remain the same.
(iv) Ascertain the profits accruing to shareholders of both the companies.
(10 Marks) (November 2009) (S)
Answer
(i) Exchange Ratio 1:1
New Shares to be issued 2,00,000
Total shares of Rama Ltd. (4,00,000+2,00,000) 6,00,000
Total earnings ( 10,00,000 + 7,00,000) 17,00,000
New EPS ( 17,00,000/6,00,000) 2.83
(ii) Existing EPS of Rama Ltd. 2.50
Increase in EPS of Rama Ltd ( 2.83 – 2.50) 0.33
Existing EPS of Krishna Ltd. 3.50
Decrease in EPS of Krishna Ltd. ( 3.50 – 2.83) 0.67
(iii) P/E ratio of new firm (expected to remain same) 14 times
New market price (14 × 2.83) 39.62
Total No. of Shares 6,00,000
Total market Capitalization (6,00,000 × 39.62) 2,37,72,000
Existing market capitalization ( 70,00,000 + 1,40,00,000) 2,10,00,000
Total gain 27,72,000
(iv)
Rama Ltd. Krishna Ltd Total
No. of shares after merger 4,00,000 2,00,000 6,00,000
Market price 39.62 39.62 39.62
Total Mkt. Values 1,58,48,000 79,24,000 2,37,72,000
Existing Mkt. values 1,40,00,000 70,00,000 2,10,00,000
Gain to share holders 18,48,000 9,24,000 27,72,000
or 27,72,000 3= 9,24,000 to Krishna Ltd. and 18,48,000 to Rama Ltd. (in 2: 1
ratio)
Question 33
T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of the
latter. Important information about the two companies as per their latest financial statements is
given below:
T Ltd. E Ltd.
10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures ( Lakhs) 580 --
12.5% Institutional Loan ( Lakhs) -- 240
Earning before interest, depreciation and tax (EBIDAT) ( Lakhs) 400.86 115.71
Market Price/share ( ) 220.00 110.00
T Ltd. plans to offer a price for E Ltd., business as a whole which will be 7 times EBIDAT
reduced by outstanding debt, to be discharged by own shares at market price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based on the market
price. Tax rate for the two companies may be assumed as 30%.
Calculate and show the following under both alternatives - T Ltd.'s offer and E Ltd.'s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.
(iv) Expected market price per share of T Ltd. after acquisition.
(v) State briefly the advantages to T Ltd. from the acquisition.
Calculations (except EPS) may be rounded off to 2 decimals in lakhs.
(16 Marks) (May 2010) (S)
Answer
As per T Ltd.’s Offer
in lakhs
(i) Net Consideration Payable
7 times EBIDAT, i.e. 7 x 115.71 lakh 809.97
Less: Debt 240.00
569.97
(ii) No. of shares to be issued by T Ltd
569.97 lakh/ 220 (rounded off) (Nos.) 2,59,000
(iii) EPS of T Ltd after acquisition
Total EBIDT ( 400.86 lakh + 115.71 lakh) 516.57
Less: Interest ( 58 lakh + 30 lakh) 88.00
428.57
Less: 30% Tax 128.57
Total earnings (NPAT) 300.00
Total no. of shares outstanding (12 lakh + 2.59 lakh) 14.59 lakh
EPS ( 300 lakh/ 14.59 lakh) 20.56
(iv) Expected Market Price:
in lakhs
Pre-acquisition P/E multiple:
EBIDAT 400.86
10
Less: Interest ( 580 X ) 58.00
100
342.86
Less: 30% Tax 102.86
240.00
No. of shares (lakhs) 12.00
EPS 20.00
220
Hence, PE multiple 11
20
Expected market price after acquisition ( 20.56 x 11) 226.16
As per E Ltd’s Plan
in lakhs
(i) Net consideration payable
6 lakhs shares x 110 660
(ii) No. of shares to be issued by T Ltd
660 lakhs ÷ 220 3 lakh
(iii) EPS of T Ltd after Acquisition
NPAT (as per earlier calculations ) 300.00
Total no. of shares outstanding (12 lakhs + 3 lakhs) 15 lakh
Earning Per Share (EPS) 300 lakh/15 lakh 20.00
(iv) Expected Market Price ( 20 x 11) 220.00
(v) Advantages of Acquisition to T Ltd
Since the two companies are in the same industry, the following advantages could
accrue:
- Synergy, cost reduction and operating efficiency.
- Better market share.
- Avoidance of competition.
Question 34
The following information is relating to Fortune India Ltd. having two division, viz. Pharma
Division and Fast Moving Consumer Goods Division (FMCG Division). Paid up share capital of
Fortune India Ltd. is consisting of 3,000 Lakhs equity shares of Re. 1 each. Fortune India Ltd.
decided to de-merge Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details of
Fortune India Ltd. as on 31.3.2009 and of Fortune Pharma Ltd. as on 1.4.2009 are given
below:
Particulars Fortune Pharma Ltd. Fortune India Ltd.
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh
Board of Directors of the Company have decided to issue necessary equity shares of Fortune
Pharma Ltd. of Re. 1 each, without any consideration to the shareholders of Fortune India Ltd.
For that purpose following points are to be considered:
1. Transfer of Liabilities & Assets at Book value.
2. Estimated Profit for the year 2009-10 is 11,400 Lakh for Fortune India Ltd. & 1,470
lakhs for Fortune Pharma Ltd.
3. Estimated Market Price of Fortune Pharma Ltd. is 24.50 per share.
4. Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to be expected
for both the companies.
Calculate:
1. The Ratio in which shares of Fortune Pharma are to be issued to the shareholders of
Fortune India Ltd.
2. Expected Market price of Fortune India Ltd.
3. Book Value per share of both the Companies immediately after Demerger.
(8 Marks) (November 2005)
Answer
Share holders’ funds ( Lakhs)
Particulars Fortune India Ltd. Fortune Pharma Ltd. Fortune India (FMCG) Ltd.
Assets 70,000 25,100 44,900
Outside liabilities 25,000 4,100 20,900
Net worth 45,000 21,000 24,000
Hence, Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune India Ltd.
2. Expected market price of Fortune India Ltd.
Fortune India (FMCG) Ltd.
Estimated Profit ( in lakhs) 11,400
No. of equity shares ( in lakhs) 3,000
Estimated EPS ( ) 3.8
Estimated P/E 42
Estimated market price ( ) 159.60
3. Book value per share
Fortune Pharma Ltd. Fortune India (FMCG) Ltd.
Net worth ( in lakhs) 21,000 24,000
No. of shares ( in lakhs) 1,500 3,000
Book value of shares 14 8
Question 35
H Ltd. agrees to buy over the business of B Ltd. effective 1 st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:
Answer
(i) Market value of Companies before Merger
Particulars RIL SIL
EPS 2 Re.1
P/E Ratio 10 5
Market Price Per Share 20 5
Equity Shares 10,00,000 10,00,000
Total Market Value 2,00,00,000 50,00,000
(ii) Post Merger Effects on RIL
Answer
Price/share of AB Ltd. for determination of number of shares to be issued:
( 570 + 430)/2 500
Value of XY Ltd based on future cash flow capitalization
(105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) lakhs 592.40
Value of XY Ltd based on net assets lakhs 250.00
Average value (592.40+250)/2 421.20
No. of shares in AB Ltd to be issued 4,21,20,000/500 Nos. 84240
Basis of allocation of shares
Fully paid equivalent shares in XY Ltd. (20+5) lakhs 2500000
Distribution to fully paid shareholders 84240x20/25 67392
Distribution to partly paid shareholders 84240-67392 16848
Question 39
BA Ltd. and DA Ltd. both the companies operate in the same industry. The Financial
statements of both the companies for the current financial year are as follows:
Balance Sheet
Particulars BA Ltd. DA Ltd.
( ) ( )
Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total ( ) 24,00,000 15,00,000
Equity capital ( 10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 --
14% long-term debt 5,00,000 3,00,00
Current liabilities 7,00,000 4,00,000
Total ( ) 24,00,000 15,00,000
Income Statement
BA Ltd. DA Ltd.
( ) ( )
Net Sales 34,50,000 17,00,000
Cost of Goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
BVPS (EF/N) 12 10
ROE (EAT/EF) × 100 17.50% 12.37%
(ii) Estimation of growth rates in EPS for BA Ltd. and DA Ltd.
Retention Ratio (1-D/P ratio) 0.6 0.4
Growth Rate (ROE × Retention Ratio) 10.50% 4.95%
(iii) Justifiable equity shares exchange ratio
(a) Intrinsic value based = 20 / 40 = 0.5:1 (upper limit)
(b) Market price based = MPSDA/MPSBA = 15 / 40 = 0.375:1 (lower limit)
Since, BA Ltd. has a higher EPS, ROE, P/E ratio and even higher EPS growth
expectations, the negotiable terms would be expected to be closer to the lower limit,
based on the existing share prices.
(iv) Calculation of post merger EPS and its effects
Particulars BA Ltd. DA Ltd. Combined
EAT ( ) (i) 2,10,000 99,000 3,09,000
Share outstanding (ii) 100000 80000 132000*
EPS ( ) (i) / (ii) 2.1 1.2375 2.341
EPS Accretion (Dilution) (Re.) 0.241 (0.301***)
(v) Estimation of Post merger Market price and other effects
Particulars BA Ltd. DA Ltd. Combined
EPS ( ) (i) 2.1 1.2375 2.341
P/E Ratio (ii) 19.05 12.12 19.05
MPS ( ) (i) / (ii) 40 15 44.6
MPS Accretion ( ) 4.6 2.84***
* Shares outstanding (combined) = 100000 shares + (.40 × 80000)= 132000 shares
** EPS claim per old share = 2.34 × 0.4 0.936
EPS dilution = 1.2375 – 0.936 0.3015
***S claim per old share ( 44.60 × 0.4) 17.84
Less: MPS per old share 15.00
2.84
Question 40
A valuation done of an established company by a well-known analyst has estimated a value of
500 lakhs, based on the expected free cash flow for next year of 20 lakhs and an
expected growth rate of 5%.
While going through the valuation procedure, you found that the analyst has made the mistake
of using the book values of debt and equity in his calculation. While you do not know the book
value weights he used, you have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while the market
value of debt is equal to the book value of debt.
You are required to estimate the correct value of the company. (8 Marks) (November 2010) (S)
Answer
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-
FCFF1
Value of Firm = V0 =
K c gn
Where –
FCFF1 = Expected FCFF in the year 1
Kc = Cost of capital
gn = Growth rate forever
Thus, 500 lakhs = 20 lakhs /(Kc-g)
Since g = 5%, then Kc = 9%
Now, let X be the weight of debt and given cost of equity = 12% and cost of debt = 6%,
then 12% (1 – X) + 6% X = 9%
Hence, X = 0.50, so book value weight for debt was 50%
Correct weight should be 75% of equity and 25% of debt.
Cost of capital = Kc = 12% (0.75) + 6% (0.25) = 10.50%
and correct firm’s value = 20 lakhs/(0.105 – 0.05) = 363.64 lakhs.
Question 41
Following informations are available in respect of XYZ Ltd. which is expected to grow at a
higher rate for 4 years after which growth rate will stabilize at a lower level:
Base year information:
Revenue - 2,000 crores
EBIT - 300 crores
Capital expenditure - 280 crores
Depreciation - 200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are
depreciation offset by depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3
For all time, working capital is 25% of revenue and corporate tax rate is 30%.
What is the value of the firm? (10 Marks) (May 2010) (M)
Answer
High growth phase :
ke = 0.10 + 1.15 x 0.06 = 0.169 or 16.9%.
kd = 0.13 x (1-0.3) = 0.091 or 9.1%.
Cost of capital = 0.5 x 0.169 + 0.5 x 0.091 = 0.13 or 13%.
Stable growth phase :
ke = 0.09 + 1.0 x 0.05 = 0.14 or 14%.
kd = 0.1286 x (1 - 0.3) = 0.09 or 9%.
Cost of capital = 0.6 x 0.14 + 0.4 x 0.09 = 0.12 or 12%.
Determination of forecasted Free Cash Flow of the Firm (FCFF)
( in crores)
Yr. 1 Yr. 2 Yr 3 Yr. 4 Terminal Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Capital Expenditure 96 115.20 138.24 165.89 -
Less Depreciation
Working Capital 100.00 120.00 144.00 172.80 103.68
Free Cash Flow (FCF) 56.00 67.20 80.64 96.77 375.32
(i) Profit after tax for KLM for the financial year which has just ended is estimated to be 10
crore.
(ii) KLM's after tax profit has an increasing trend of 7% each year and the same is expected
to continue.
(iii) Estimated post tax market return is 10% and risk free rate is 4%. These rates are
expected to continue.
(iv) Corporate tax rate is 30%.
XYZ ABC Proxy entity for KLM in
the same line of business
No. of shares 100 lakhs 80 lakhs --
Current share price 287 375 --
Dividend pay out 40% 50% 50%
Debt : Equity at market values 1:2 1:3 1:4
P/E ratio 10 13 12
Equity beta 1 1. 1 1.1
Assume gearing level of KLM to be the same as for ABC and a debt beta of zero.
You are required to calculate:
(a) Appropriate cost of equity for KLM based on the data available for the proxy entity.
(b) A range of values for KLM both before and after any potential synergistic benefits to XYZ
of the acquisition. (8 Marks) (May 2010) (M)
Answer
a. ungreared for the proxy company = 1.1 X 4 / [ 4 + (1 – 0.3) ] = 0.9362
0.9362 = equity greared X 3/ [ 3 + (1 - 0.3)]
equity geared = 1.1546
Cost of equity = 0.04 + 1.1546 X (0.1 – 0.04) = 10.93%
b. P/E valuation
(Based on earning of 10 Crore)
Using proxy Using XYZ’s
Entity’s P/E P/E
Pre synergistic value 12 X 10 Crore 10 X 10 Crore
= 120 Crore = 100 Crore
Post synergistic value 12 X 10 Crore X 1.1 10 X 10 Crore X 1.1
= 132 Crore = 110 Crore
Question 43
Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry
Ltd. whose stock is currently trading at a total market price of €4 million. For Cranberry Ltd,
the accounting data set forth three business segments: consumer wholesale, retail and
general centers. Data for the firm’s three segments are as follows:
Business Segment Segment Segment Segment Operating
Sales Assets Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:
Business Capitalization/Sales Capitalization/Assets Capitalization/Operating
Segment Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4
Answer
Impact of Financial Restructuring
(i) Benefits to Grape Fruit Ltd.
(a) Reduction of liabilities payable
in lakhs
Reduction in equity share capital (6 lakh shares x 75 per share) 450
Reduction in preference share capital (2 lakh shares x 50 per share) 100
Waiver of outstanding debenture Interest 26
Waiver from trade creditors ( 340 lakhs x 0.25) 85
661
(b) Revaluation of Assets
Appreciation of Land and Building ( 450 lakhs - 200 lakhs) 250
Total (A) 911
(ii) Amount of 911 lakhs utilized to write off losses, fictious assets and over- valued assets.
Writing off profit and loss account 525
Cost of issue of debentures 5
Preliminary expenses 10
Provision for bad and doubtful debts 15
Revaluation of Plant and Machinery 120
( 300 lakhs – 104 lakhs)
Total (B) 675
Capital Reserve (A) – (B) 236
(ii) Balance sheet of Grape Fruit Ltd as at 31st March 2011 (after re-construction)
( in lakhs)
Liabilities Amoun Assets Amoun
t t
12 lakhs equity shares of 25/- 300 Land & Building 450
each
10% Preference shares of 50/- 100 Plant & Machinery 180
each
Capital Reserve 236 Furnitures & Fixtures 50
9% debentures 200 Inventory 150
Answer
Calculation of Purchase Consideration