Part 2 Short answer questions

Question 1:

The primary motivation for M&As is an attempt to realize synergy by combining the acquiring and target firms. However, the estimation of synergy is challenging. The acquirer often overestimates potential synergy in an M&A deal and results in overpaying the target. Why is potential synergy often overestimated?

Question 2

Xon Enterprises is attempting to take over Rayon Group. Rayon’s shareholders have the right to buy additional shares at a below-market price if Xon (considered by Rayon’s board to be a hostile bidder) buys more than 15% of Rayon’s outstanding shares. Identify the takeover defense strategy employed by Rayon Group. Explain why it is used and how does it discourage unwanted bidder.

Question 3

When using the variable growth model, do small changes in the assumptions on the estimation of the terminal value significantly influence the total value of the target firm? If so, why? 

Question 4

CSMAR is a leading financial data provider and aims to acquire its direct competitor, Wind Data. The CSMAR estimate Wind Data has sales of $40 million and after-tax income of $4 million this year. Wind Data has the debt to equity ratio is 20%, and the after-tax income is expected to grow at 15% per annual for the next 3 years and 5% per annual thereafter. Capital expenditures are expected to grow in line with depreciation and working capital requirements are minimal. The average beta of publicly traded companies in the financial data provider industry is 2 and the average debt/equity ratio is 50%. The Wind Data is managed very conservatively and does not intend to issue new debt and change its D/E ratio through the foreseeable future. It has no preferred stock as well. The current risk free rate is 5% and the tax rate is 30%. The market return is believed to be 11% on average for the next three years.  Reflecting the slower growth rate in the fourth year and beyond, the firm’s discount rate is expected to decline to the industry average cost of equity of 10.4%. Estimate the value of Wind Data’s equity. Show all your workings. 

Question 5

Do you agree with the following statement? When using the relative valuation method, the recent comparable transactions valuation method is considered less accurate than the comparable companies valuation method. Explain your answer.

Question 6

In October 2018, IBM announced to acquire software maker Red Hat Inc. in a $33.4 billion deal. The share price of Red Hat increased more than 45%, while IBM share price decreased by more than 5% on the announcement date. For most M&A cases, the acquiring firm shareholders seem to benefit little or even lose from takeovers.

Why is this finding a puzzle? Explain any three reasons offered for it.

Question 7

Japanese electrical engineering firm Kandenko Co. plans to acquire a 40% ownership stake in a Philippine peer, PHOC Co., as part of its global expansion. The current Japanese Treasury bond rate is 5% and the expected inflation is 3% in Japan per annual. The expected inflation rate in the Philippines is 6% annually. To compensate for the uncommon political and economic risks, investors would require an additional 2% return for any investment in the Philippines. Based on the target’s interest coverage ratio, its credit rating is estimated to be AA. The current interest rate on AA-rated Japanese corporate bond is 6.25%. Kandenko Co. has the marginal tax rate of 23% and its pre-tax cost of debt is 6%. Kandenko’s total capitalization consists of common equity and debt only. Kandenko Co. has projected debt to total capital ratio is 0.3.

PHOC’s beta and the Philippine country beta are estimated to be 1.3 and 0.7, respectively. The equity premium is estimated to be 6% based on the spread between the prospective return on the country’s equity index and the estimated risk free rate of return. Given the PHOC’s current market capitalization, the firm size premium (FSP) is estimated at 1%.

What is the appropriate weighted average cost of capital Kandenko Co. should use to discount the target’s projected annual cash flows, expressed in its own local currency?

Question 8

BigCo’s Chief Financial Officer is trying to determine a fair value for PrivCo, a non-publicly traded firm that BigCo’s is considering acquiring. Several of PrivCo’s competitors, Ion International, and Zenon are publicly traded. Ion and Zenon have price-to-earnings ratios of 20 and 15, respectively. The Ion’s and Zenon’s earnings per share are projected to grow by 10% and 15% per annual, respectively. BigCo estimates that next year, PrivCo will achieve earnings per share of $4 per share and its earnings per share is expected to grow at 20%. To gain a controlling interest in the firm, BigCo expects to pay at least a 40% premium to the firm’s estimated market value. What should BigCo expect to pay for PrivCo per share?

Question 9

Acquiring Company is considering the acquisition of Target Company in a stock for stock transaction in which Target Company would receive $60.00 for each share of its common stock. The Acquiring Company does not expect any change in earnings in both firms after the merger, but it expects that this merger will increase its P/E ratio by 20%. 

Using the information provided above on these two firms and calculate the Acquiring Compay post-merger share price. Showing all your work. 

Question 10

Do you agree with the following statement? Explain the reasons.

 “A business with high growth potential may not be a good candidate for an LBO.”

Question 11

a)      What factors influence a parent firm’s decision to undertake an equity carve-out rather than a spin-off? Explain the reasons.

b)      What is the major drawback of equity carve-out? Why? Explain the reasons.