Section B – TWO questions ONLY to be attempted
Louieed Co
Louieed Co, a listed company, is a major supplier of educational material, selling its products in many countries. It supplies schools and colleges and also produces learning material for business and professional exams. Louieed Co has exclusive contracts to produce material for some examining bodies. Louieed Co has a well-defined management structure with formal processes for making major decisions.
Although Louieed Co produces online learning material, most of its profits are still derived from sales of traditional textbooks. Louieed Co’s growth in profits over the last few years has been slow and its directors are currently reviewing its long-term strategy. One area in which they feel that Louieed Co must become much more involved is the production of online testing materials for exams and to validate course and textbook learning.
Bid for Tidded Co
Louieed Co has recently made a bid for Tidded Co, a smaller listed company. Tidded Co also supplies a range of educational material, but has been one of the leaders in the development of online testing and has shown strong profit growth over recent years. All of Tidded Co’s initial five founders remain on its board and still hold 45% of its issued share capital between them. From the start, Tidded Co’s directors have been used to making quick decisions in their areas of responsibility. Although listing has imposed some formalities, Tidded Co has remained focused on acting quickly to gain competitive advantage, with the five founders continuing to give strong leadership.
Louieed Co’s initial bid of five shares in Louieed Co for three shares in Tidded Co was rejected by Tidded Co’s board. There has been further discussion between the two boards since the initial offer was rejected and Louieed Co’s board is now considering a proposal to offer Tidded Co’s shareholders two shares in Louieed Co for one share in Tidded Co or a cash alternative of $22·75 per Tidded Co share. It is expected that Tidded Co's shareholders will choose one of the following options:
(i) To accept the two-shares-for-one-share offer for all the Tidded Co shares; or,
(ii) To accept the cash offer for all the Tidded Co shares; or,
(iii) 60% of the shareholders will take up the two-shares-for-one-share offer and the remaining 40% will take the cash offer.
In case of the third option being accepted, it is thought that three of the company's founders, holding 20% of the share capital in total, will take the cash offer and not join the combined company. The remaining two founders will probably continue to be involved in the business and be members of the combined company's board.
Louieed Co’s finance director has estimated that the merger will produce annual post-tax synergies of $20 million. He expects Louieed Co’s current price-earnings (P/E) ratio to remain unchanged after the acquisition.
Extracts from the two companies’ most recent accounts are shown below:
Discuss the advantages and disadvantages of the acquisition of Tidded Co from the viewpoint of Louieed Co.
Advantages of the acquisition
Louieed Co and Tidded Co appear to be a good strategic fit for a number of reasons. Louieed Co appears to have limited potential for further growth. Acquiring Tidded Co, a company with better recent growth, should hopefully give Louieed Co the impetus to grow more quickly.
Acquiring a company which has a specialism in the area of online testing will give Louieed Co capabilities quicker than developing this function in-house. If Louieed Co does not move quickly, it risks losing contracts to its competitors.
Acquiring Tidded Co will give Louieed Co access to the abilities of some of the directors who have led Tidded Co to becoming a successful company. They will provide continuity and hopefully will help integrate Tidded Co’s operations successfully into Louieed Co. They may be able to lead the upgrading of Tidded Co’s existing products or the development of new products which ensures that Louieed Co retains a competitive advantage.
It appears that Tidded Co’s directors now want to either realise their investment or be part of a larger company, possibly because it will have more resources to back further product development. If Louieed Co does not pursue this opportunity, one of Louieed Co’s competitors may purchase Tidded Co and acquire a competitive advantage itself.
There may also be other synergistic benefits, including savings in staff costs and other savings, when the two companies merge.
Disadvantages of the acquisition
It is not known what the costs of developing in-house capabilities will be. Although the process may be slower, the costs may be less and the process less disruptive to Louieed Co than suddenly adding on Tidded Co’s operations.
It is not possible to tell which of Tidded Co’s directors are primarily responsible for its success. Loss of the three directors may well represent a significant loss of its capability. This will be enhanced if the three directors join a competitor of Louieed Co or set up in competition themselves.
There is no guarantee that the directors who remain will fit into Louieed Co’s culture. They are used to working in a less formal environment and may resent having Louieed Co’s way of operating imposed upon them. This could result in departures after the acquisition, jeopardising the value which Tidded Co has brought.
Possibly Tidded Co’s leadership in the online testing market may not last. If competitors do introduce major advances, this could mean that Tidded Co’s current growth is not sustainable.
Calculate the P/E ratios of Tidded Co implied by the terms of Louieed Co’s initial and proposed offers, for all three of the above options
P/E Ratio calculations
Value of Louieed Co’s share = $296m x 14/340m = $12·19
Value of Tidded Co share per original bid = $12·19 x (5/3) = $20·32
Tidded Co earnings per share = $128m/90 = $1·42
Tidded Co P/E ratio implied by original bid = $20·32/$1·42 = 14·3
Tidded Co P/E ratio implied by all Tidded Co’s shareholders taking up the share offer = $12·19 x 2/$1·42 = 17·2
Tidded Co P/E ratio implied by mixed cash and share offer = ($22·75 x 0·4 + $12·19 x 2 x 0·6)/$1·42 = 16·7
Tidded Co P/E ratio implied by all Tidded Co’s shareholders taking up the cash offer = $22·75/$1·42 = 16·0
Calculate, and comment on, the funding required for the acquisition of Tidded Co and the impact on Louieed Co’s earnings per share and gearing, for each of the three options given above.
Note: Up to 10 marks are available for the calculations.
Funding of bid
No extra finance will be required if all Tidded Co’s shareholders take up the share offer.
All Tidded Co’s shareholders take up cash offer
Cash required = 90 million x $22·75 = $2,048m
Extra debt finance required = $2,048m – $220m – $64m = $1,764m
60% share-for-share offer, 40% cash offer
Cash required = 40% x 90m x $22·75 = $819m
Extra debt finance required = $819m – $220m – $64m = $535m
Impact of bid on EPS
Louieed Co’s EPS prior to acquisition = $296m/340 = $0·87
All Tidded Co’s shareholders take up share offer
Number of shares after acquisition = 340m + (90m x 2) = 520m
EPS after acquisition = ($296m + $128m + $20m)/520m = $0·85
All Tidded Co’s shareholders take up cash offer
Number of shares after acquisition = 340m
EPS after acquisition = ($296m + $128m + $20m – $11·36m – $105·84m)/340m = $0·96
$105·84m is the post-tax finance cost on the additional loan finding required of $1,764m. Therefore $1,764m x 7·5% x 80% = $105·84m.
$11·36m is the post-tax opportunity cost of interest foregone on the cash and cash equivalents surpluses of the two companies of $220m + $64m = $284m. Therefore $284m x 5% x 80% = $11·36m
60% share-for-share offer, 40% cash offer
Number of shares after acquisition 340m + (90m x 2 x 0·6) = 448m
EPS after acquisition = ($296m + $128m + $20m – $11·36m – $32·1m)/448m = $0·89
$32·1m is the post-tax finance cost on the additional loan funding required of $535m. Therefore $535m x 7·5% x 80% = $32·1m
Impact of bid on gearing (using market values)
Louieed Co’s gearing (debt/(debt + equity)) prior to bid = 540/(540 + (340 x 12·19)) = 11·5%
All Tidded Co’s shareholders take up share offer
Debt/(Debt + equity) after bid = (540 + 193)/(540 + 193 + (520 x $0·85 x 14)) = 10·6%
All Tidded Co’s shareholders take up cash offer
Debt/(Debt + equity) after anticipated bid = (540 + 193 + 1,764)/(540 + 193 + 1,764 + (340 x $0·96 x 14)) = 35·3%
60% share-for-share offer, 40% cash offer
Debt/(Debt + equity) after bid = (540 + 193 + 535)/(540 + 193 + 535 + (448 x $0·89 x 14)) = 18·5%
Comments
The calculations suggest that if Tidded Co’s shares are acquired on a share-for-share exchange on the terms required by its shareholders, Louieed Co’s shareholders will suffer a fall in earnings per share attributable to them from $0·87 to $0·85. This is because Tidded Co is being bought on a higher price-earnings ratio than Louieed Co and the synergies arising from the acquisition are insufficient to compensate for this.
Use of loan finance to back a cash offer will attract tax relief on interest. The cost of debt will be lower than the cost of equity.
Issuing extra shares will lead to a dilution of the power of Louieed Co’s existing shareholders. If all of Tidded Co’s shareholders take up the share-for-share offer, they will hold around a third of the shares of the combined company (180m/520m) and this may be unacceptable to Louieed Co’s shareholders.
The benefits which Tidded Co’s shareholders will gain will be fixed if they take up a cash offer and do not acquire shares in the combined company. If there are significant gains after the acquisition, these will mostly accrue to Louieed Co’s existing shareholders if a significant proportion of Tidded Co’s shareholders have taken a cash offer.
If the forecast for take up of the offer is correct, even by combining the cash flows of the two companies, the new company will have insufficient funds to be able to pay all the shareholders who are expected to take up the cash offer. Further finance will be required.
The alternative to loan finance is financing the bid by issuing shares. Depending on the method used, this may also result in dilution of existing shareholders’ ownership and also there is no guarantee that the issue will be successful.
There is also no guarantee that the forecast of 40% of the shareholders taking up the cash offer is correct. If all five of the major shareholders decide to realise their investment rather than just two, this will increase the cash required by $512 million (25% x $22·75 x 90m), for example.
Gearing will increase if loan finance is needed to finance the cash offer. If the mixed share and cash offer is taken up in the proportions stated, the gearing level of the combined company will increase from 11·5% to 18·5%. Current shareholders may not be particularly concerned about this. However, if all or most of the share capital is bought for cash, the gearing level of the combined company will be significantly greater, at maximum 35·3%, than Louieed Co’s current gearing. This may be unacceptable to current shareholders and could mean an increase in the cost of equity, because of the increased risk, and also possibly an increase in the cost of debt, assuming in any case that debt finance at the maximum level required will be available. To guard against this risk, Louieed Co’s board may want to limit the cash offer to a certain percentage of share value.