Question Tag: Free Cash Flow

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FM – May 2016 – L3 – Q4 – Mergers and Acquisitions

Estimating the additional equity value created by combining two companies and analyzing the impact of premium increases on shareholders.

Question

Eko Product Plc (EP Plc) is a producer of a variety of vegetable oil and other household products in Lagos. The company presently faces significant competition in the market for one of its major raw materials – palm oil. To secure a regular flow of the raw material, the Directors of EP Plc are now considering making an offer for the entire share capital of Benin Oil Plc (BO Plc), a palm oil producing company in Benin.

The following financial information is provided for the two companies:

Parameter	EP Plc	BO Plc
Equity beta	1.2	1.2
Asset beta	0.9	1.2
Number of shares (million)	210	200
Current share price	N29	N12

It is thought that combining the two companies will result in several benefits. It is estimated that combining the two companies will generate free cash flow to the firm (FCFF) of N1,080 million in current value terms, but these will increase by an annual growth rate of 5% for the next four years before reverting to an annual growth rate of 2.25% in perpetuity. In addition to this, combining the companies will result in cash synergy benefits of N100 million per year for the next four years. These synergy benefits are not subject to any inflationary increase, and no synergy benefits will occur after the fourth year.

The debt-to-equity ratio of the combined company will be 40:60 in market value terms and it is expected that the combined company’s cost of debt will be 4.55% before tax.

The income tax rate is 20%, the current risk-free rate of return is 2%, and the market risk premium is 7%. It can be assumed that the combined company’s asset beta is the weighted average of EP Plc’s and BO Plc’s asset betas weighted by their current market values.

EP Plc has offered to acquire BO Plc through a mixed offer of one of its shares for two BO Plc shares, plus a cash payment, such that a 30% premium is paid for the acquisition. Shareholders of BO Plc feel that a 50% premium would be more acceptable. EP Plc has sufficient cash reserves if the premium is 30%, but not if it is 50%.

You are required to:

(a) Estimate the additional equity value created by combining EP Plc and BO Plc based on the free cash flow to firm method. Comment on the results obtained and discuss briefly the assumptions made. (11 Marks)

(b) Estimate the impact on EP Plc’s equity holders if the premium paid is increased to 50% from 30%. (5 Marks)

c. Estimate the additional funds required if a premium of 50% is paid instead of 30% and discuss how this premium could be financed. (4 Marks)

Answer

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Tags: Acquisition, Equity Value, Free Cash Flow, Premium, Shareholder Impact, Synergies
Level: Level 3

Topic: Mergers and acquisitions

FM – May 2019 – L3 – Q1 – Mergers and Acquisitions

Evaluate the synergy expected from a proposed merger between Pako Plc. and RT Plc. using free cash flow analysis, and discuss limitations and alternatives.

Question

Pako Plc. will soon announce a take-over bid for Ronke Tina (RT) Plc., a company in the same industry. The initial bid will be an all-share bid of four Pako shares for every five RT Plc. shares. The most recent annual data relating to the two companies are shown below:

The take-over is expected to result in cost saving in advertising and distribution, reducing the operating costs (including depreciation) of Pako from 76% of sales to 70% of sales. The growth rate of the combined company is expected to be 6% per year for four years and 5% per year thereafter. RT’s debt obligations will be taken over by Pako. The corporate tax rate is expected to remain at 30%.

Sales and costs relevant to the decision may be assumed to be in cash terms.

Required:

a. Estimate how much synergy is expected to be created from the take-over, using free cash flow to the firm analysis for each individual company and the potential combined company. State clearly any assumptions that you make.
Note: The weighted average cost of capital of the combined company is assumed to be 9%. (20 Marks)

b. Discuss any five limitations of the above estimates. (5 Marks)

c. Explain, generally, three advantages and two disadvantages of expansion through merger and acquisition rather than through organic growth. (5 Marks)
(Total: 30 Marks)

Answer

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Tags: Free Cash Flow, Growth Analysis, M&A, Synergy, WACC
Level: Level 3

Topic: Mergers and acquisitions

FM – Nov 2018 – L3 – Q3 – Business Valuation Techniques

Valuation of acquisition target using free cash flow forecast and P/E ratio analysis in the context of an acquisition.

Question

Lagelu Plc. (LP) is a very successful entity. The company has consistently followed a business strategy of aggressive acquisitions, looking to buy companies that it believes were poorly managed and hence undervalued. LP can be described as a modern-day conglomerate with business interests stretching far and wide.

Its board of directors has chosen the takeover targets with care. LP has maintained its price earnings (P/E) ratio on the stock market at 12.2.

LP’s figures show a profit after tax of ₦4,430 million, and it has 375 million shares.

Lam Technical (LT) is a well-established owner-managed business. It has had its ups and downs in financial terms, corresponding directly with the state of the global economy. Since 2001, its profits have fallen each year, with the 2017 results as stated below:

With economists predicting an upturn in the global economy, LT’s management team feels that revenue will increase by 6% per annum up to and including year 2021. The company’s operating profit margin is not expected to change in the foreseeable future.

Operating profits are shown after deducting non-cash expenses (including tax-allowable depreciation) of ₦650m. This is expected to increase in line with sales. However, the company has recently spent ₦1,050m on the purchase of non-current assets, and LT’s management believes this will need to increase by 10% per annum until year 2021 to enable the company to remain competitive.

LT is currently financed by debt and equity. It has maintained a constant debt-to-total-asset ratio of 40% and has no intention to change this financing mix in the near future.

The company has a cost of equity of 17% and a weighted average cost of capital of 12%.

Assume a tax rate of 25% in all cases.

Some of LT’s major shareholders are not so confident about the future and would like to sell the business as a going concern. The minimum price they would consider would be the fair value of the shares plus a 10% premium. LT’s Chief Financial Officer believes the best way to find the fair value of the shares is to discount the forecast Free Cash Flows to the firm, assuming that beyond the year 2021, these will grow at a rate of 3% per annum indefinitely.

Required:

a. Prepare a schedule of forecast Free Cash Flows to the firm for each of the years from December 31, 2018, to 2021. (5 Marks)

b. Estimate the fair value of LT’s equity on a per-share basis. (6 Marks)

c. LP intends to make an offer to LT based on a share-for-share swap. LP will exchange one of its shares for every two LT shares. Assuming that LP can maintain its price earnings (P/E) ratio of 12.2, calculate the percentage gain in equity value that will be earned by both groups of shareholders. (6 Marks)

d. What factors should the LT shareholders consider before deciding whether to accept or reject the offer made by LP? (3 Marks)

Answer

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Tags: Acquisition, Discounting Techniques, Free Cash Flow, P/E Ratio, Share Swap, Shareholders’ Equity, Takeover Decision
Level: Level 3

Topic: Business Valuation Techniques

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

Question

Raymond Plc. is a successful IT services company incorporated 10 years ago. It was listed on the Stock Exchange 3 years ago. The company has a broad customer base mainly consisting of small and medium-sized companies. Raymond Plc. has achieved rapid growth in recent years by obtaining regular business from satisfied customers and also by acquiring other IT services companies.

The Directors of Raymond Plc. have identified Harold Limited, an unlisted company, as a possible acquisition target. Harold Limited has a number of large multinational clients, and, in general, its clients tend to be larger than those of Raymond Plc. If successful, the acquisition would go ahead on January 1, 2018.

Forecast financial data for Raymond Plc. and Harold Limited as of December 31, 2017, are summarized below:

Financial Item	Raymond Plc.	Harold Limited
Share capital (Ordinary ₦1 shares)	₦150m	₦40m
Market share price	₦4.90	N/A

N/A: Not applicable (not listed).

Additional information:

If Harold Limited were to remain an independent company, its Directors estimate that reported Profit After Tax would be ₦15 million for 2018 and then grow by 2% yearly in perpetuity;
If the acquisition were to go ahead, Raymond Plc.’s Directors estimate that Harold Limited’s profit after tax would be 5% higher for 2018 than if the company remains an independent company, and that profit after tax would then grow by 3% yearly in perpetuity;
The average ungeared Cost of Equity for the industry is 8%;
Both Raymond Plc. and Harold Limited are wholly equity financed; and
Profit after tax can be assumed to be a good approximation of free cash flow attributable to investors.

The Directors of Raymond Plc. are considering offering to purchase Harold Limited at a price of ₦7.00 per share. It is estimated that transaction costs of ₦8 million would be payable on the acquisition and that ₦2 million would be required in the first year to cover the costs of integrating the two companies.

Required:

(a) Calculate:
- i. The value of Raymond Plc. as at December 31, 2017.
- ii. The value of Harold Limited as at December 31, 2017 before taking the possible acquisition of the company by Raymond Plc. into account.
- iii. The overall increase in value created by the acquisition of Harold Limited by Raymond Plc. (8 Marks)
(b)
- i. Explain how value might be created by the proposed acquisition. (2 Marks)
- ii. Comment on the difficulties which Raymond Plc. is likely to face in realizing the potential added-value, after the acquisition. (2 Marks)
(c) Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the point of view of:
- i. Harold Limited’s shareholders.
- ii. Raymond Plc.’s shareholders. (8 Marks)

(Total 20 Marks)

Answer

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Tags: Acquisition, Cost of Equity, Free Cash Flow, Integration Costs, IT Services, Shareholder Analysis, Stock Exchange, Synergies, Valuation
Level: Level 3

Topic: Mergers and acquisitions
Series: NOV 2017

AFM – Nov 2018 – L3 – Q3b -Valuation and use of free cash flows

Estimate the value of the firm and its equity using the FCFF and FCFE valuation approaches and calculate the value per share.

Question

DoGood Ltd is evaluating Phinex Ltd using the Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) valuation approaches.

DoGood Ltd has gathered the following information (in current Ghana Cedis terms):

Phinex Ltd has net income of GH¢250 million, depreciation of GH¢90 million, capital expenditures of GH¢170 million, and an increase in working capital of GH¢40 million.
Phinex Ltd will finance 40% of the increase in net fixed assets (capital expenditures less depreciation) and 40% of the increase in working capital with debt financing.
Interest expenses are GH¢150 million. The current market value of Phinex’s outstanding debt is GH¢1,800 million.
FCFF is expected to grow at 6.0% indefinitely, and FCFE is expected to grow at 7.0%.
The tax rate is 30%.
Phinex Ltd is financed with 40% debt and 60% equity. The before-tax cost of debt is 9% and the before-tax cost of equity is 13%.
Phinex Ltd has 10 million outstanding shares.

Required:
i) Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the value per share.
(6 marks)

ii) Using the FCFE valuation approach, estimate the total market value of equity and the value per share.
(6 marks)

Answer

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Tags: Cost of Capital, FCFE, FCFF, Free Cash Flow, Valuation, Value per Share
Level: Level 3

Topic: Valuation and use of free cash flows
Series: NOV 2018

FM – May 2016 – L3 – Q4 – Mergers and Acquisitions

Estimating the additional equity value created by combining two companies and analyzing the impact of premium increases on shareholders.

Question

The following financial information is provided for the two companies:

Parameter	EP Plc	BO Plc
Equity beta	1.2	1.2
Asset beta	0.9	1.2
Number of shares (million)	210	200
Current share price	N29	N12

The debt-to-equity ratio of the combined company will be 40:60 in market value terms and it is expected that the combined company’s cost of debt will be 4.55% before tax.

You are required to:

(b) Estimate the impact on EP Plc’s equity holders if the premium paid is increased to 50% from 30%. (5 Marks)

c. Estimate the additional funds required if a premium of 50% is paid instead of 30% and discuss how this premium could be financed. (4 Marks)

Answer

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Tags: Acquisition, Equity Value, Free Cash Flow, Premium, Shareholder Impact, Synergies
Level: Level 3

Topic: Mergers and acquisitions

FM – May 2019 – L3 – Q1 – Mergers and Acquisitions

Evaluate the synergy expected from a proposed merger between Pako Plc. and RT Plc. using free cash flow analysis, and discuss limitations and alternatives.

Question

Sales and costs relevant to the decision may be assumed to be in cash terms.

Required:

b. Discuss any five limitations of the above estimates. (5 Marks)

c. Explain, generally, three advantages and two disadvantages of expansion through merger and acquisition rather than through organic growth. (5 Marks)
(Total: 30 Marks)

Answer

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Tags: Free Cash Flow, Growth Analysis, M&A, Synergy, WACC
Level: Level 3

Topic: Mergers and acquisitions

FM – Nov 2018 – L3 – Q3 – Business Valuation Techniques

Valuation of acquisition target using free cash flow forecast and P/E ratio analysis in the context of an acquisition.

Question

Its board of directors has chosen the takeover targets with care. LP has maintained its price earnings (P/E) ratio on the stock market at 12.2.

LP’s figures show a profit after tax of ₦4,430 million, and it has 375 million shares.

LT is currently financed by debt and equity. It has maintained a constant debt-to-total-asset ratio of 40% and has no intention to change this financing mix in the near future.

The company has a cost of equity of 17% and a weighted average cost of capital of 12%.

Assume a tax rate of 25% in all cases.

Required:

a. Prepare a schedule of forecast Free Cash Flows to the firm for each of the years from December 31, 2018, to 2021. (5 Marks)

b. Estimate the fair value of LT’s equity on a per-share basis. (6 Marks)

d. What factors should the LT shareholders consider before deciding whether to accept or reject the offer made by LP? (3 Marks)

Answer

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Tags: Acquisition, Discounting Techniques, Free Cash Flow, P/E Ratio, Share Swap, Shareholders’ Equity, Takeover Decision
Level: Level 3

Topic: Business Valuation Techniques

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

Question

Forecast financial data for Raymond Plc. and Harold Limited as of December 31, 2017, are summarized below:

Financial Item	Raymond Plc.	Harold Limited
Share capital (Ordinary ₦1 shares)	₦150m	₦40m
Market share price	₦4.90	N/A

N/A: Not applicable (not listed).

Additional information:

If Harold Limited were to remain an independent company, its Directors estimate that reported Profit After Tax would be ₦15 million for 2018 and then grow by 2% yearly in perpetuity;
If the acquisition were to go ahead, Raymond Plc.’s Directors estimate that Harold Limited’s profit after tax would be 5% higher for 2018 than if the company remains an independent company, and that profit after tax would then grow by 3% yearly in perpetuity;
The average ungeared Cost of Equity for the industry is 8%;
Both Raymond Plc. and Harold Limited are wholly equity financed; and
Profit after tax can be assumed to be a good approximation of free cash flow attributable to investors.

Required:

(a) Calculate:
- i. The value of Raymond Plc. as at December 31, 2017.
- ii. The value of Harold Limited as at December 31, 2017 before taking the possible acquisition of the company by Raymond Plc. into account.
- iii. The overall increase in value created by the acquisition of Harold Limited by Raymond Plc. (8 Marks)
(b)
- i. Explain how value might be created by the proposed acquisition. (2 Marks)
- ii. Comment on the difficulties which Raymond Plc. is likely to face in realizing the potential added-value, after the acquisition. (2 Marks)
(c) Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the point of view of:
- i. Harold Limited’s shareholders.
- ii. Raymond Plc.’s shareholders. (8 Marks)

(Total 20 Marks)

Answer

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Tags: Acquisition, Cost of Equity, Free Cash Flow, Integration Costs, IT Services, Shareholder Analysis, Stock Exchange, Synergies, Valuation
Level: Level 3

Topic: Mergers and acquisitions
Series: NOV 2017

AFM – Nov 2018 – L3 – Q3b -Valuation and use of free cash flows

Estimate the value of the firm and its equity using the FCFF and FCFE valuation approaches and calculate the value per share.

Question

DoGood Ltd is evaluating Phinex Ltd using the Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) valuation approaches.

DoGood Ltd has gathered the following information (in current Ghana Cedis terms):

Phinex Ltd has net income of GH¢250 million, depreciation of GH¢90 million, capital expenditures of GH¢170 million, and an increase in working capital of GH¢40 million.
Phinex Ltd will finance 40% of the increase in net fixed assets (capital expenditures less depreciation) and 40% of the increase in working capital with debt financing.
Interest expenses are GH¢150 million. The current market value of Phinex’s outstanding debt is GH¢1,800 million.
FCFF is expected to grow at 6.0% indefinitely, and FCFE is expected to grow at 7.0%.
The tax rate is 30%.
Phinex Ltd is financed with 40% debt and 60% equity. The before-tax cost of debt is 9% and the before-tax cost of equity is 13%.
Phinex Ltd has 10 million outstanding shares.

Required:
i) Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the value per share.
(6 marks)

ii) Using the FCFE valuation approach, estimate the total market value of equity and the value per share.
(6 marks)

Answer

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Tags: Cost of Capital, FCFE, FCFF, Free Cash Flow, Valuation, Value per Share
Level: Level 3

Topic: Valuation and use of free cash flows
Series: NOV 2018

Question Tag: Free Cash Flow

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FM – May 2016 – L3 – Q4 – Mergers and Acquisitions

Estimating the additional equity value created by combining two companies and analyzing the impact of premium increases on shareholders.

FM – May 2019 – L3 – Q1 – Mergers and Acquisitions

Evaluate the synergy expected from a proposed merger between Pako Plc. and RT Plc. using free cash flow analysis, and discuss limitations and alternatives.

FM – Nov 2018 – L3 – Q3 – Business Valuation Techniques

Valuation of acquisition target using free cash flow forecast and P/E ratio analysis in the context of an acquisition.

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

AFM – Nov 2018 – L3 – Q3b -Valuation and use of free cash flows

Estimate the value of the firm and its equity using the FCFF and FCFE valuation approaches and calculate the value per share.

FM – May 2016 – L3 – Q4 – Mergers and Acquisitions

Estimating the additional equity value created by combining two companies and analyzing the impact of premium increases on shareholders.

FM – May 2019 – L3 – Q1 – Mergers and Acquisitions

Evaluate the synergy expected from a proposed merger between Pako Plc. and RT Plc. using free cash flow analysis, and discuss limitations and alternatives.

FM – Nov 2018 – L3 – Q3 – Business Valuation Techniques

Valuation of acquisition target using free cash flow forecast and P/E ratio analysis in the context of an acquisition.

FM – Nov 2017 – L3 – Q2 – Mergers and Acquisitions

Calculate Raymond Plc.'s valuation, analyze Harold Limited's acquisition value, and assess the offer price from shareholders' perspectives.

AFM – Nov 2018 – L3 – Q3b -Valuation and use of free cash flows

Estimate the value of the firm and its equity using the FCFF and FCFE valuation approaches and calculate the value per share.

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