Section A – BOTH questions are compulsory and MUST be attempted Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products. The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed. Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level. Information on Pursuit Co and Fodder Co Pursuit Co Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million. Fodder Co, Income Statement Extracts Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1·53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels. However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings. For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future. Information about the combined company Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable futue. After the first year the growth rate in sales revenue will be 5·8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6·4% on future borrowings. The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate. 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’ market value. Other information The current annual government base rate is 4·5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%. SGF Co’s interest in Pursuit Co There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company. The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid. The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form. of a special dividend. Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co. Required: Prepare a report to the Board of Directors of Pursuit Co that (i) Evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Fodder Co and the combined company assuming that the combined company’s capital structure stays the same as that of Pursuit Co’s current capital structure. Include all relevant calculations; (16 marks) (ii) Discusses the limitations of the estimated valuations in part (i) above; (4 marks) (iii) Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co and concludes whether Pursuit Co’s current capital structure can be maintained; (3 marks) (iv) Explains the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved; (4 marks) (v) Assesses whether the Chief Financial Officer’s recommendation would provide a suitable defence against a bid from SGF Co and would be a viable option for Pursuit Co. (5 marks) Professional marks will be awarded in question 1 for the format, structure and presentation of the report. (4 marks)