- 20 Marks
AFM – Nov 2015 – L3 – Q5 – Valuation of acquisitions and mergers
Evaluate the acquisition of Anas-Expo Clothing Ltd by Two-Pack Fashion Ltd, analyzing its effect on EPS, shareholders' wealth, and sources of conflict.
Question
You are the Finance Manager of a growing clothing company, Two-Pack Fashion Ltd (Two-Pack). Two-Pack has enjoyed significant growth in recent years using an internal growth strategy. Two-Pack is now seeking to acquire other companies to speed up its growth drive. It has identified Anas-Expo Clothing Ltd (Anas-Expo) as a suitable candidate for takeover. Both companies have the same level of risk.
Anas-Expo produces high-quality handmade clothes, with which it has earned several awards. The company has recorded considerable profits in the past, but its output has dwindled over the past two years due to increasing labour costs. Labour unions have pressured policymakers into amending labour regulations, particularly those relating to pensions and minimum wages, to provide more benefits and protection for workers. Directors of Two-Pack believe that production and profitability of Anas-Expo will be enhanced if its production process is mechanized.
Below are summarized financial data for the two companies immediately before acquisition:
| Two-Pack (GHS’m) | Anas-Expo (GHS’m) |
|---|---|
| Sales revenue | 285.8 |
| Net operating income | 85.8 |
| Interest charges | 14.2 |
| Net income before tax | 71.6 |
| Corporate tax | 15.8 |
| Net income after tax | 55.8 |
| Dividends | 22.3 |
| Addition to retained earnings | 33.5 |
Two-Pack has 40 million shares and a P/E ratio of 18, while Anas-Expo has 25 million shares and a P/E ratio of 12. Directors of Two-Pack have decided that Two-Pack takes up all the equity shares in Anas-Expo by offering to its shareholders one new share for every share they hold. They have also decided that Two-Pack mechanizes Anas-Expo’s production process immediately at the cost of GHS18 million, replacing work currently done by hand. It is estimated that operational efficiency arising from the acquisition and integration of the two companies would yield after-tax benefits of GHS25 million per year to perpetuity. The cost of capital of Two-Pack is 25%.
Required:
(a) Evaluate the acquisition proposal, and recommend whether the acquisition should go ahead.
(b) Analyze the effect of the acquisition on the earnings per share (EPS) of Two-Pack following the successful acquisition of Anas-Expo.
(c) Analyze the effect of the acquisition on the wealth of the shareholders of each company.
(d) Advise the directors of Two-Pack on three likely sources of conflict in relation to the acquisition of Anas-Expo and the mechanization of its production process, and suggest ways through which the conflict could be avoided or resolved.
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