Selorne Co
Selorne Co is one of the biggest removal companies in Pauland, offering home and business removals. It has a number of long-term contracts with large businesses, although it has not won any new major contracts in the last two years. Selorne Co is listed on Pauland’s stock market for smaller companies. Selorne Co is financed by a mixture of equity and short and long-term debt, but its gearing level is below the average for its sector.
Selorne Co has four executive directors, who each own 20% of the company’s share capital, with the other 20% owned by external shareholders. Selorne Co has paid a constant dividend since it has been listed and its share price has risen slightly over the last three years.
Selorne Co is based in a number of the large cities and towns in Pauland and owns the majority of the sites where it is located. Many of its employees have worked for the company for a long time. Drivers of the lorries used by Selorne Co are required to have a special, heavy vehicles licence. Salary levels at Selorne Co are relatively high compared with other companies in the sector.
Chawon Co
Selorne Co is currently considering making a bid for Chawon Co, an unlisted company specialising in distribution and delivery services. Chawon Co is owned 100% by its founder, Chris Chawon. Chawon Co has built up a portfolio of small contracts over time. It has made unsuccessful bids for two larger contracts over the last 12 months, the bids being rejected primarily because Chawon Co was not felt to be big enough to be able to guarantee the level of service required.
Chawon Co is based in many of the same cities and towns where Selorne Co is located, although Chawon’s premises are all rented. The drivers of Chawon’s vehicles do not require a heavy vehicles licence. Chawon Co has a few long-serving employees who are mostly centre managers. Most of its drivers and staff, however, stay at Chawon Co for only a short time. Salary levels are low, although Chawon Co pays high levels of overtime and high bonuses if target profit levels are achieved. Chawon Co is highly geared, leading to recent media speculation about its financial viability.
Terms of bid for Chawon Co
In initial discussions about the acquisition, Chris Chawon indicated that he would prefer the consideration to be a share-for-share exchange, the terms being one Chawon Co share for five Selorne Co shares.
Chawon Co has 2 million $1 shares in issue, and Selorne Co has 50 million $0·50 shares in issue. Each Selorne Co share is currently trading at $6·50, which is a multiple of 8 of its free cash flow to equity. The multiple of 8 can be assumed to remain unchanged if the acquisition takes place. Chawon Co’s free cash flow to equity is currently estimated at $7 million, with an expected annual growth rate of 3%, and it is expected to generate a return on equity of 15%.
Chris Chawon expects that the total free cash flows to equity of the combined company will increase by $5 million due to synergy benefits. He believes that Selorne Co will be able to win more contracts because it is larger and because it will be diversifying the services which it offers. He also believes that significant operational synergies can be achieved, pointing out the time Selorne Co drivers spend idle during the winter months when removal activity is traditionally lower. Chris Chawon believes that he can achieve the synergies if he is given management responsibility for the operational reorganisation, including dealing with the staff employment and retention issues. Chris Chawon thinks that synergies could also be achieved in central administration and in premises costs.
The chief executive and the finance director of Selorne Co are in favour of bidding for Chawon Co. However, one of the other executive directors is opposed to the bid. He is sceptical about the level of synergies which can be achieved and does not want Chris Chawon to be brought into the management of Selorne Co. He suggests that if the bid is to go ahead, it should be a cash offer rather than a share exchange. Selorne Co’s chief executive has responded that Chris Chawon is likely to ask for a higher equivalent price if the purchase is for cash.
Financing the bid for Chawon Co
Selorne Co’s finance director has pointed out that Selorne Co will need additional funding if Chawon Co is purchased for cash. He has suggested that there may be a number of possible sources of finance:
–A rights issue
– A fixed rate, long-term, bank loan
– A three-year, unsecured, mezzanine loan facility
– Convertible debt, with conversion rights being exercisable in five years’ time
Required:
(i) Estimate the equity value of the combined company and the expected additional value arising from the combination of Selorne Co and Chawon Co.
(ii) Estimate the share of the gain from the combination created for Chris Chawon and the share of the gain created for Selorne Co’s shareholders and comment on your results.
(i) Selorne Co current equity value = 50m shares x $6·50 = $325m
Chawon Co current equity value = $7 million x 1·03/(0·15 – 0·03) = $60·1m
Selorne Co free cash flow to equity = $325m/8 = $40·6m
Combined company valuation = ($40·6m + $7m + $5m) x 8 = $420·8m
Additional value created = $420·8m – $325m – $60·1m = $35·7m
(ii) Chris Chawon will hold 2m x 5 = 10m shares in combined company
Value per share in combined company = $420·8m/(50m + 10m) = $7·01
Value of Chris Chawon’s shareholding = 10m x $7·01 = $70·1m
Gain created for Chris Chawon = $70·1m – $60·1m = $10m
Gain created for Selorne Co shareholders = $35·7m – $10m = $25·7m
Chris Chawon will have a 16·7% (10m/(50m + 10m)) shareholding in the combined company but 28·0% ($10m/$35·7m) of the gain on the combination will be attributable to him. Shareholders who are doubtful about the merger may question whether this is excessive, as possibly Chawon Co’s desire to sell is being prompted by the company struggling to remain solvent.
Evaluate how reliable the estimates of the synergies for the combined company are likely to be and discuss the factors which may prevent the forecast synergies from being achieved.
Reliability of synergy estimates
The reliability of the estimates may vary depending on the synergies involved. The synergies relating to size and services offered will depend on the ability to gain large contracts and neither company has had recent success in doing this. However, the contracts recently bid for by Chawon Co might have been won if the larger combined company had bid. The synergies relating to operations and working practices may be difficult to obtain if it is difficult to change the employment conditions of Selorne Co drivers. Claims that improved driver utilisation may reduce spare capacity may be true, but there is likely to be less spare capacity anyway if more contracts are won.
Other synergies may be easier to obtain. Duplication of premises in some locations should be eliminated easily, providing Chawon Co does not have onerous rental contracts and there is space on Selorne Co’s sites. Combining central administrative functions should reduce some staffing costs, although these are likely to be smaller synergies than the potential operational synergies.
Problems with achieving synergies
A significant problem may be lack of unity at the top of the company. Selorne Co’s directors are not all keen on the acquisition and this may spill over into being unable to agree on a clear post-acquisition plan. If lack of unity at board level becomes apparent to staff, it may be difficult to achieve unity at employee level.
Chris Chawon’s role in the combined company may also make synergies difficult to achieve. He will have a significant shareholding and a place on the board, so it will be difficult for him not to be involved. Possibly he has the abilities and desire to achieve changes in operational practices which other board members lack. However, if Chris is given the leading role he requires, there may be a change in management style which may upset long-serving Selorne Co staff. Some may leave, jeopardising the continuity which seems to have been an important part of Selorne Co’s success.
Another reason for possible problems with staff is the differing remuneration arrangements. Selorne Co’s staff may have stayed with the company because both their job prospects and their remuneration have been safe. Attempts to change their employment conditions may lead to resistance and employee departures. Ex-Chawon Co employees who have been with the company for a while may expect salaries to be increased to be more in line with Selorne Co’s employees, particularly if bonus arrangements become less generous.
The success of the acquisition may also depend on how well the staff of the two businesses integrate. Integration may be difficult to achieve. Many of Chawon Co’s staff will not have the necessary licence to drive the Selorne Co lorries and may not wish to go through the process of obtaining this licence. Selorne Co drivers may be reluctant to drive the smaller vehicles. Staff sticking to what they have been used to driving is likely to prolong a ‘them and us’ culture.
Discuss the factors which Selorne Co’s board will consider when determining which source or sources of finance are chosen to finance a possible cash bid for the share capital of Chawon Co.
Availability
Although the finance director has identified possible sources of finance, there is no guarantee that they will necessarily be available. The success of a rights issue may well depend on the willingness and ability of the director-shareholders to subscribe. It may be difficult to find others willing to take up the directors’ rights if they do not subscribe, as the directors’ unwillingness may be seen as indicating a lack of confidence in the business. A rights issue may also take longer to arrange than other methods, which may be significant if Selorne Co needs the finance quickly to complete the acquisition.
Obtaining a bank loan or mezzanine finance may be difficult if Selorne Co takes on Chawon Co’s debt and is viewed as too highly geared as a result. The success of a convertible debt issue may depend on the terms, also how possible subscribers view the future prospects of Selorne Co and the marketability of the shares.
Cost
Cost will be another significant factor. The cost of equity will normally be viewed as higher anyway than the cost of debt. Issue costs of equity are likely to be higher than those of debt. As Selorne Co’s share price is stable, its current external shareholders appear content with the dividends paid, so there does not appear to be pressure to increase them. In any case, the board is not required to pay dividends every year.
Fixed interest cost on the bank loan may become a burden if interest rates fall, but the cost can be forecast with certainty. Because the mezzanine finance is unsecured, it is likely to have a higher interest cost than the bank loan. The rights of conversion to shares attaching to the convertible debt will mean a lower rate can be set for this, but the cost will depend on how appealing the possibility of conversion is. Again, the finance cost of debt will depend on the finance providers’ attitude towards the increased debt burden resulting from the acquisition of Chawon Co.
Director preferences
The choice will also be determined by Selorne Co’s board’s attitude to gearing as well as how the possible finance providers view the company’s gearing level. The board may feel that Selorne Co has reached, or exceeded, the gearing level which it would regard as desirable by taking on Chawon Co’s debt. If this is the case, the board would have to use equity finance. The board may also be influenced by how gearing is likely to change over time. Over the next few years gearing may fall as Selorne Co makes profits and (hopefully) its share price increases. Chawon Co’s debt may be repaid and not replaced. The convertible debt and mezzanine finance will also not be long-term sources of debt finance.
Control of Selorne Co
Selorne Co’s board decision may also be determined by the implications of the different sources of finance for control of the company. The directors’ control of the company will not be diminished if a rights issue is used and they take up their rights. An issue of shares arising from the convertible debt would change the balance of shareholdings, so the directors would have to decide how significant this would be. Mezzanine finance may also offer conversion rights, but possibly these could only be exercised if Selorne Co defaulted, which the board may view as unlikely.
Using a bank loan will have no impact on share capital, but the bank may impose restrictions which the directors are unwilling to bear, particularly if high gearing is an issue. These conditions could include restrictions on the sale of assets, limitations of dividends, or requiring accounting figures, for example, liquidity or solvency ratios, not to go beyond certain levels.
Mix of finance
Ultimately the board may also consider the possibility of a mix of finance. The offer could be backed by a core of equity finance from a rights issue, but if Selorne Co has to pay a higher price than expected, the difference could be made up by mezzanine finance.
Note: Credit will be given for alternative, relevant answers.