Section A – This question is compulsory and MUST be attempted
Chikepe Co is a large listed company operating in the pharmaceutical industry with a current market value of equity of $12,600 million and a debt to equity ratio of 30:70, in market value terms. Institutional investors hold most of its equity shares. The company develops and manufactures antibiotics and anti-viral medicines. Both the company and its products have an established positive reputation among the medical profession, and its products are used widely. However, its rate of innovation has slowed considerably in the last few years and it has fewer new medical products coming into the market.
At a recent meeting of the board of directors (BoD), it was decided that the company needed to change its current strategy of growing organically to one of acquiring companies, in order to maintain the growth in its share price in the future. The members of the BoD had different opinions on the type of acquisition strategy to pursue.
Director A was of the opinion that Chikepe Co should follow a strategy of acquiring companies in different business sectors. She suggested that focusing on just the pharmaceutical sector was too risky and acquiring companies in different business sectors will reduce this risk.
Director B was of the opinion that Director A’s suggestion would not result in a reduction in risk for shareholders. In fact, he suggested that this would result in agency related issues with Chikepe Co’s shareholders reacting negatively and as a result, the company’s share price would fall. Instead, Director B suggested that Chikepe Co should focus on its current business and acquire other established pharmaceutical companies. In this way, the company will gain synergy benefits and thereby increase value for its shareholders.
Director C agreed with Director B, but suggested that Chikepe Co should consider relatively new pharmaceutical companies, as well as established businesses. In her opinion, newer companies might be involved in research and development of innovative products, which could have high potential in the future. She suggested that using real options methodology with traditional investment appraisal methods such as net present value could help establish a more accurate estimate of the potential value of such companies.
The company has asked its finance team to prepare a report on the value of a potential target company, Foshoro Co, before making a final decision.
Foshoro Co
Foshoro Co is a non-listed pharmaceutical company established about 10 years ago. Initially Foshoro Co grew rapidly, but this rate of growth slowed considerably three years ago, after a venture capital equity backer exited the company by selling its stake back to the founding directors. The directors had to raise substantial debt capital to buy back the equity stake. The company’s current debt to equity ratio is 60:40. This high level of gearing means that the company will find it difficult to obtain funds to develop its innovative products in the future.
The following financial information relates to Foshoro Co:
Extract from the most recent statement of profit or loss
In arriving at the profit before interest and tax, Foshoro Co deducted tax allowable depreciation and other non-cash expenses totalling $112·0 million. It requires a cash investment of $98·2 million in non-current assets and working capital to continue its operations at the current level.
Three years ago, Foshoro Co’s profit after tax was $83·3 million and this has been growing steadily to their current level. Foshoro Co’s profit before interest and tax and its cash flows grew at the same growth rate as well. It is likely that this growth rate will continue for the foreseeable future if Foshoro Co is not acquired by Chikepe Co. Foshoro Co’s cost of capital has been estimated at 10%.
Combined company: Chikepe Co and Foshoro Co
Once Chikepe Co acquires Foshoro Co, it is predicted that the combined company’s sales revenue will be $4,200 million in the first year, and its operating profit margin on sales revenue will be 20% for the foreseeable future.
After the first year, the sales revenue is expected to grow at 7% per year for the following three years. It is anticipated that after the first four years, the growth rate of the combined company’s free cash flows will be 5·6% per year.
The combined company’s tax allowable depreciation is expected to be equivalent to the amount of investment needed to maintain the current level of operations. However, as the company’s sales revenue increases over the four-year period, the combined company will require an additional investment in assets of $200 million in the first year and then $0·64 per $1 increase in sales revenue for the next three years.
It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ value of equity. It can also be assumed that the capital structure of the combined company remains at Chikepe Co’s current capital structure level, a debt to equity ratio of 30:70. Chikepe Co pays interest on borrowings at a rate of 5·3% per annum.
Chikepe Co estimates that it will be able to acquire Foshoro Co by paying a premium of 30% above its estimated equity value to Foshoro Co’s shareholders.
Other financial information
Compare and contrast the reasons for the opinions held by Director A and by Director B, and discuss the types of synergy benefits which may arise from the acquisition strategy suggested by Director B.
Director A’s focus is on reducing the risk in the business through diversification and thereby increasing its value. A strategy of risk diversification resulting in greater value can work in situations where the equity holders are exposed to both unsystematic and systematic risks, for example, when their investment is concentrated in one company. In such situations, the shareholders would be subject to unsystematic risk and diversification would reduce this risk.
In the case of Chikepe Co, this is unlikely to be the case as a large proportion of shares are owned by institutional shareholders and it is likely that their investment portfolios are already well-diversified and therefore they are not exposed to unsystematic risk. Further diversification will be of no value to them. In fact, it may be construed that managers are only taking this action for their own benefit, as they may be closely tied to the company and therefore be exposed to total risk (both unsystematic and systematic risks). This may then become a source of agency related conflict between the management and the shareholders.
However, diversification overseas into markets which have some barriers to entry might reduce both systematic and unsystematic risks as well.
Director B, on the other hand, seems to be suggesting that Chikepe Co should focus on its core business and increase value through identifying areas of synergy benefits. It may be the case that Chikepe Co’s management and directors are well placed to identify areas where the company can gain value by acquiring companies with potential synergy benefits.
The types of synergy benefits, which may arise in established pharmaceutical companies, can include:
Identifying undervalued companies, where the management is not effective in unlocking the true value of company. By replacing the existing management, Chikepe Co may be able to unlock the value of the company.
Acquiring companies which have strategic assets or product pipelines. Chikepe Co may be well placed to identify companies which have a number of product pipelines, which those companies are not exploiting fully. By acquiring such companies, Chikepe Co may be able to exploit the product pipelines.
Through acquisitions, Chikepe Co may be able to exploit economies of scope by eliminating process duplication or economies of scale where its size may enable it to negotiate favourable terms.
Foshoro Co may benefit if Chikepe Co acquires it because it is struggling to raise funding for its innovative products. Chikepe Co is an established company but has few new product innovations coming in the future. Therefore, it may have spare cash resources which Foshoro Co may be able to utilise.
(Note: Credit will be given for alternative valid discussion)
Discuss how using real options methodology in conjunction with net present value could help establish a more accurate estimate of the potential value of companies, as suggested by Director C.
Traditional investment appraisal methods such as net present value assume that an investment needs to be taken on a now or never basis, and once undertaken, it cannot be reversed. Real options take into account the fact that in reality, most investments have within them certain amounts of flexibility, such as whether or not to undertake the investment immediately or to delay the decision; to pursue follow-on opportunities; and to cancel an investment opportunity after it has been undertaken. Where there is increasing uncertainty and risk, and where a decision can be changed or delayed, this flexibility has value, known as the time value of an option.
Net present value captures just the intrinsic value of an investment opportunity, whereas real options capture both the intrinsic value and the time value, to give an overall value for an opportunity. When a company still has time available to it before a decision needs to be made, it may have opportunities to increase the intrinsic value of the investment through the strategic decisions it makes.
Investing in new companies with numerous potential innovative product pipelines may provide opportunities for flexibility where decisions can be delayed and the intrinsic value can be increased through strategic decisions and actions taken by the company. Real options try to capture the value of this flexibility within companies with innovative product pipelines, whereas net present value does not.
Prepare a report for the board of directors of Chikepe Co which:
(i) Estimates the current equity value of Foshoro Co; (6 marks)
(ii) Estimates the equity value arising from combining Foshoro Co with Chikepe Co; (11 marks)
(iii) Evaluates whether the acquisition of Foshoro Co would be beneficial to Chikepe Co’s shareholders and discusses the limitations of the valuation method used in (c)(i) and (c)(ii) above. (7 marks)
Professional marks will be awarded in part (c) for the format, structure and presentation of the report. (4 marks)
Report to the board of directors (BoD), Chikepe Co
Introduction
This report evaluates whether the acquisition of Foshoro Co would be beneficial to Chikepe Co’s shareholders by estimating the additional equity value created from the synergies resulting when the two companies are combined. The market values of equity of the two companies as separate entities are considered initially and then compared with the equity value of the two companies together. The free cash flow to firm valuation method is used to estimate the values of the companies and the limitations of this method are discussed.
The market value of equity of Chikepe Co is given as $12,600 million.
Based on the free cash flow to firm valuation method:
The current market value of equity of Foshoro Co is estimated at $986 million (appendix 1), and
The market value of equity of the combined company is estimated at $14,993 million (appendix 2).
Therefore, the additional market value of equity arising from synergy benefits when the two companies are combined is estimated at $1,407 million (appendix 3), which is then split between Foshoro Co’s shareholders receiving $296 million (a 30% premium) and Chikepe Co’s shareholders receiving the balance of $1,111 million, which is approximately 8·8% excess over the original equity value (appendix 3).
However, the valuation method used has a number of limitations, as follows:
– The values of both Foshoro Co and the combined company are based on estimations and assumptions, for example,
– Foshoro Co’s future growth rate of free cash flows is based on past growth rates and it is assumed that this will not change in the future;
– It is not explained how Foshoro Co’s cost of capital is estimated/calculated. Such an estimate may be more difficult to make for private companies;
– The assumption of perpetuity is made when estimating the values of Foshoro Co and the combined company, and this may not be valid.
– The basis for the synergy benefits such as higher growth rates of sales revenue and profit margins needs to be explained and justified. It is not clear how these estimates have been made.
– Whereas it may be possible to estimate the asset beta of a listed company such as Chikepe Co, it may be more difficult to provide a reasonable estimate for the asset beta of Foshoro Co. Therefore, the estimate of the cost of capital of the combined company may not be accurate.
– The costs related to the acquisition process would need to be factored in.
Therefore, whereas the free cash flow method of estimating corporate values is theoretically sound, using it in practice to estimate values is open to errors and judgements.
Conclusion
The valuations indicate that Chikepe Co’s shareholders would benefit from the acquisition of Foshoro Co and the value of their shares should increase by 8·8%. However, the method used to estimate the value created makes a number of estimates and assumptions. It is therefore recommended that a range of valuations is made under different assumptions and estimates, through a process of sensitivity analysis, before a final decision is made. As well as this, the limitations of the valuation method used should be well understood and taken into account.
Report compiled by
Date
APPENDICES:
Appendix 1 (Part (c) (i)): Foshoro Co, estimate of current value
Cost of capital = 10%
Growth rate of profits and free cash flows = ($91·0m/$83·3m)1/3 – 1 = 0·03 = 3%
Free cash flow to firm (FCFF) = PBIT + non-cash expenses – additional cash investment – tax
FCFF = $192·3m + $112·0m – $98·2m – (20% x $192·3m) = $167·6m
Foshoro Co, estimated value = ($167·6m x 1·03)/(0·10 – 0·03) = $2,466·1m
Current estimated market value of equity of Foshoro Co = $2,466·1m x 40% = $986·4m, say $986m approximately.
Appendix 2 (Part (c) (ii)): Estimate of value created from combining Chikepe Co and Foshoro Co
Asset beta of combined company = (0·800 x $12,600m + 0·950 x $986·4m)/($12,600m + $986·4m) = 0·811
Equity beta of combined company = 0·811 x (0·70 + 0·30 x 0·80)/0·70 = 1·089
Cost of equity, combined company = 2% + 1·089 x 7% = 9·6% approx.
Cost of capital, combined company = 9·6% x 0·7 + 5·3% x 0·3 x 0·8 = 8% approx.
Combined company, free cash flows and value computation ($ millions)
Sales growth rate, years 2 to 4 = 7% per annum; operating profit margin = 20%
Discuss how the mandatory bid rule and the principle of equal treatment protects shareholders in the event of their company facing a takeover bid, and discuss the effectiveness of poison pills and disposal of crown jewels as defensive tactics against hostile takeover bids.
Both the mandatory bid rule and the principle of equal treatment are designed to protect minority shareholders, where an acquirer has obtained a controlling interest of the target company. The mandatory bid rule provides minority shareholders with the opportunity to sell their shares and exit the target company at a specified fair share price. This price should not be lower than the highest price paid for shares, which have already been acquired within a specified period. The principle of equal treatment requires the acquiring company to offer the same terms to minority shareholders as were offered to the earlier shareholders from whom the controlling interest was acquired. Both these regulatory devices are designed to ensure that the minority shareholders are protected financially and are not exploited by the acquirer.
The purpose of both poison pills and disposal of crown jewels is to make the target company unattractive to the acquirer. Poison pills give existing shareholders in the target company the right to buy additional shares in their company at a discount once the acquiring company has bought a certain number of shares in the target company. The aim is to make the target company more expensive to purchase, as the acquirer needs to buy more shares. Disposal of crown jewels involves selling the target company’s most valuable assets, and therefore making the target company less attractive to the acquirer. The effectiveness of either defence tactic can be limited, as the company’s management would need its shareholders to authorise such moves (although there are ways in which poison pills can be incorporated without gaining prior authorisation from shareholders). Shareholders may not be willing to do this as they normally get premiums on their shares during takeover battles. Additionally, disposing of key strategic assets could substantially weaken a company’s competitive advantage and therefore its future potential. Such action may be detrimental to the company and therefore shareholders would probably not approve that course of action.