Chap 6 - Business Valuation

CHAPTER – 6 BUSINESS VALUATION (252)
BUSINESS VALUATION
NEED FOR VALUATION
 Takeovers / mergers
 Hold or sell decisions
 Shares held by retiring directors
 Tax purposes
 Inheritance
In this chapter we will discuss valuation in following contexts:
 Valuation without any objective of merger or acquisition

 Valuation for the purpose of merger or acquisition
VALUATION – WITHOUT ANY OBJECTIVE OF MERGER OR ACQUISITION
1. VALUATION TECHINIQUES – DEBT
Type of Debt Valuation

Preference shares Value =
Irredeemable debt Value =
Redeemable debt Value = PV (discounted @ r) of following cash
flows:
T1 to Tn Interest payment
Tn Redemption price
Convertible debt Value = Present value (discounted @ r) of
following cash flows:
T1 to Tn Interest payment
Tn Higher of redemption price or
conversion value at maturity
Note:
In case of debt, If Kd is to be used as discount rate then Interest is taken net of tax i.e. “I (1-t)”
2. VALUATION TECHINIQUES – EQUITY

2.1 Asset Based Methods
Sr. # Method Formula
1. Book value method Value of equity = equity as per balance sheet
2. Realizable value Value of equity = equity as per balance sheet adjusted by the
method difference between the book value and realizable value; if any
3. Replacement cost Value of equity = equity as per balance sheet adjusted by the
method difference between the book value and replacement cost; if
any
4. Price to Book value Value of equity = equity as per balance sheet x suitable P/B
ratio [P/B] method ratio
In asset based valuation methods 2 and 3, ignore intangible assets unless their reliable
market values can be determined.
2.2 Earning Based Methods

Important:
Earnings should preferably be “prospective”. However in absence of data, “past”
earnings can be used as estimator of “prospective” earnings. Moreover, abnormal items
of income or expense should be excluded from earnings.
2.2.1 PE ratio method:
Value of equity = PAT x Suitable P/E ratio

OR
Value of share = EPS x Suitable P/E ratio
(PE ratio must be of comparable Quoted Co. in same industry or industry average)
Such PE ratio must be adjusted for (normally downwards e.g. 70%):

 Marketability (i.e. listing on stock exchange)
 Earnings growth
 Risk/Gearing
Quantity of adjustment is not important rather direction is more important.

2.2.2 Earning yield method:
Value of equity = PAT / Suitable EY%

OR
Value of share = EPS / Suitable EY%
(EY% must be of comparable quoted co. in same industry or industry average)

Such EY% must be adjusted for (normally upwards e.g. 130%):

 Earnings growth
 Risk/Gearing
Sometimes, “ke” and “required return” may be used as EY in this formula.
In case Earning grows at a constant rate:

( )
Value of share =
( )
OR
( )
Value of equity =
( )
2.3 Cash Flow Based Methods
2.3.1 Dividend Valuation Model (more relevant for Non-Controlling Interest):

Constant dividend every year
Value of share =
Dividend grows at a constant growth rate every year
( )
Value of share = OR MV =
Dividend grows at multiple growth rates for different periods
Value of share = PV of all future dividends discounted @ K e
Value of equity
= Value of share (as per above formula) x no. of shares
Alternatively, if Total dividend is used instead of dividend per share in the above
formula, we will directly get the ‘value of equity’ instead of ‘value of share’.
If growth rate is not given then following two methods are used to find “g”
Gordon Growth Extrapolation of past dividends

g = r x ROE
g= -1
Here: Here:
r = retention rate n = time between above two dividends
If ‘g’ can be calculated by both formulae in the question, then look carefully for any
hint given in question requiring any specific method. Otherwise use easier method.
2.3.2 Dividend yield method (more relevant for Non Controlling Interest):
Value of equity = Total dividend / Suitable DY%
OR
Value of share = D / Suitable DY%
(DY% must be of comparable quoted co. in same industry or industry average)
Such DY% must be adjusted for (normally upwards e.g. 130%):
 Earnings growth
 Risk/Gearing
2.3.3 Free cash flow model (more relevant for Controlling Interest):
Free cash flows are the cash flows generated every year by operating and investing
activities of business and available for onward utilization by investors of business i.e.
equity investors and debt investors. There are two types of free cash flows namely:
 Free cash flow to firm (FCFF)
PBIT – Tax (PBIT x tax %) + depreciation – capital expenditure – working
capital investment
 Free cash flow to equity
PBT – Tax (PBT x tax %) + depreciation – capital expenditure – working capital
investment – principal repayment of debt
This model gives value of equity or overall business using two different
methods:
Free cash flow to firm (FCFF) Free cash flow to equity (FCFE)
Value of overall business = PV of Value of equity = PV of FCFE
FCFF discounted @ WACC discounted @ Ke
Value of equity = Value of overall

business – Value of debt
Following is an exemplary format for calculation using free cash flow

methods (FCFF or FCFE):
 Free cash flow projections are made for each year up to a certain number of
years (say 5 years)
 For cash flows beyond projected figures, a constant growth rate is used in
perpetuity. A single present value, for this cash flow in perpetuity, is
determined called “terminal value”.
 Now all these cash flows are discounted at relevant discount rate
FCFF method
T1 T2 T3 T4 T5
Sales XXX XXX XXX XXX XXX
Cash expenses (excluding interest) (XXX) (XXX) (XXX) (XXX) (XXX)
Depreciation (XXX) (XXX) (XXX) (XXX) (XXX)
PBIT XXX XXX XXX XXX XXX
Tax (PBIT x TAX%) (XXX) (XXX) (XXX) (XXX) (XXX)
Depreciation XXX XXX XXX XXX XXX
Capital Investment (XXX) (XXX) (XXX) (XXX) (XXX)
WC Investment (XXX) (XXX) (XXX) (XXX) (XXX)
Free cash flow XXX XXX XXX XXX XXX
Terminal Value (Note) XXX
XXX XXX XXX XXX XXX
Discount factor @ WACC XXX XXX XXX XXX XXX
Present value XXX XXX XXX XXX XXX
Terminal value:
( )
Terminal Value = [“g” will be given in question]
( )
Here:
Value of overall business = Total present values
Value of equity = Value of overall business – Value of debt
OR
Value of equity = Value of Business x
FCFE method
T1 T2 T3 T4 T5
Sales XXX XXX XXX XXX XXX
Cash expenses (including interest) (XXX) (XXX) (XXX) (XXX) (XXX)
Depreciation (XXX) (XXX) (XXX) (XXX) (XXX)
PBT XXX XXX XXX XXX XXX
Tax (PBT x TAX%) (XXX) (XXX) (XXX) (XXX) (XXX)
Depreciation XXX XXX XXX XXX XXX
Principal debt repayment (XXX) (XXX) (XXX) (XXX) (XXX)
Capital Investment (XXX) (XXX) (XXX) (XXX) (XXX)
WC Investment (XXX) (XXX) (XXX) (XXX) (XXX)
Free cash flow XXX XXX XXX XXX XXX
Terminal Value (Note) XXX
XXX XXX XXX XXX XXX
Discount factor @ Ke XXX XXX XXX XXX XXX
Present value XXX XXX XXX XXX XXX
Terminal value:
( )
Terminal Value = [“g” will be given in question]
( )
Here: Value of equity = Total present values

VALUATION – WITHOUT ANY OBJECTIVE OF MERGER OR ACQUISITION

1. Types of Mergers/Acquisitions:
 Horizontal – Acquisition in same industry (e.g. competitor)
 Vertical – Acquisition along supply chain
 Conglomerate – Diversification into other industries
2. Merger Motivations – “Synergies”:

 Operating cost reduction
 Power to set price
 Achieving rapid growth
 Increase market growth
 Gain access to unique capability – R&D
 Diversification
 Increase in debt capacity
 Tax benefits
3. MODE OF PAYMENT:
 Cash offer
 Non cash offer (e.g. Share exchange, Issue of bonds)
4. MODE OF PAYMENT – FACTORS TO BE CONSIDERED:

For shareholders of Acquirer For shareholders of Target
 Dilution of control  Tax on capital gain
 Gearing ratio  Potential of increase in value of acquirer’s
 Effect of EPS shares
 Effect on wealth of shareholders  Premium offered
5. VALUATION OF EQUITY OF TARGET

Same valuation methods are used as studied earlier. However, some additional points must be
considered which are as follows:
5.1 Asset based methods:
 Book value method is totally irrelevant for acquisition / merger.
 Realizable value is used as a lower limit for shareholders of target as they will not
accept takeover price for their shares less than this value.
 Replacement value is used as an upper limit for acquirer bidding for a company
which does not have any goodwill.
5.2 Earning based methods:
If past earnings are used then these should be adjusted for:
- Non-recurring items (exclude these items)
- Any post acquisition effect on specific incomes or expenses.
5.3 Cash flow based methods:

 Dividend model is not much relevant for acquisition / merger if K e is given or
calculated using CAPM model. However, it may be used if K e is calculated using
dividend growth model.
 For Free cash flow methods, discount rate (WACC / K e) is used as follows:
Target is in different industry Use Target’s WACC / Ke
OR
Use Acquirer’s acquisition specific WACC / K e
Target is in same industry Use Target’s WACC / Ke
[Acquirer’s WACC can also be used]
6. POST MERGER VALUE OF EQUITY OF ACQUIRER

Valuation methods are again same as studied earlier for individual company. However, some
additional points must be considered which are as follows:
6.1 Earning based methods:
 Combined earnings = Acquirer’s PAT + Target’s PAT + post-merger synergy in PAT
 Post-merger P/E ratio will be given in question. However in absence of information,
Acquirer’ pre-merger P/E will be used.
6.2 Cash flow based methods:
 If dividend valuation method is to be used then combined dividend is discounted at
post-merger Ke. Here:
Combined dividend = Combined PAT x Acquirer’s dividend payout ratio.
 For Free cash flow methods, combined cash flows (FCFF / FCFE) are discounted at
combined WACC / Ke. Combined WACC / Ke can only be calculated using iterative
process performed by a computer program, which is definitely not possible manually
in an exam question. Therefore, for exam purposes assumption must be given for
calculation of combined WACC / Ke. In absence of any assumption, students may use
any reasonable assumption.
Merger may result in certain one-off benefits such as sale of surplus assets. In this case, such
one-off benefits are also added to the value calculated by any of the above methods to arrive
at post-merger value.
Following are some important calculations that may be examined in relation to the post-merger
value of acquirer, which are quite relevant for the decision of merger:
1) Synergy = Combined equity value – Acquirer’s equity value – Target’s equity value
If free cash flow method is used, then synergy is calculated by using values of overall
business i.e. using FCFF method.
2) Maximum takeover premium that can be offered = Synergy

3) Maximum price that can be offered = Combined equity value – Acquirer’s equity value
OR = Target’s equity value + synergy
4) Takeover premium offered:

Cash offer: Non cash offer:
Cash offered – Target’s equity value Effective price offered – Target’s equity value
Here: Effective price offered = Offered instrument current price x exchange ratio
5) Net benefit of acquisition to acquirer = Synergy – Takeover premium offered
7. DEMERGER
A demerger refers to splitting-up of a business into two or more independent entities.
Decision rule:
Demerger is worthwhile if “Total of values of demerged units (using any valuation
method)” is higher than “Existing value of business”.
Market efficiency:
It refers to the type of information which is reflected in market prices.
Market type Share price reflects:

Weak form Past price trends
Semi strong form Public information (e.g. Annual report)
Strong form Public as well as private information
PRACTICE QUESTIONS
QUESTION – 1
The Share Capital and Term Finance Certificates (TFCs) of Faiz Limited (FL) are listed on the Karachi
Stock Exchange. An extract from the company’s latest balance sheet as on December 31, 2007 is as
follows:
Rs. in million
Ordinary share capital of Rs. 10 each 400
Revenue reserves 350
Other reserves 150
Total equity 900
6% TFCs of Rs. 100 each 595
Short term loan – at KIBOR + 3% 80
Total debt and equity 1,575
Six years TFCs were issued at par on January 1, 2007. Interest is payable annually in arrears on every
1st January. The original effective interest rate was 10%. These TFCs were issued to fund a medium
term project. The prevailing commercial rate for similar risk bonds is KIBOR plus 2%. The accounting
policy of the company states that TFCs are carried at the amortized cost.
KIBOR is currently 9% which can be considered as risk free. FL has an equity beta value of 1.6 with
market equity premium of 6.25%. The rate of income tax is 35%.
The dividend paid in the year 2007 was 12.5% and current year’s dividend will be paid shortly. The
dividend is expected to grow at a constant rate of 10%.
Required:
Compute the following as on December 31, 2007:
(a) Market price of Faiz Limited’s Equity Shares and TFCs; and
(b) Weighted Average Cost of Capital. (12)
(ICAP Summer 2008, Q-2)
QUESTION – 2
The Directors of Shaheen Ltd – a private company – have decided that it is likely they will have to
sell the company in near future. They intend adopting a positive approach to this by seeking out
prospective purchasers. Prior to doing this they wish you to put a value on an ordinary share in the
company using the methods which a prospective purchaser might apply.
You are required to make this valuation using the undernoted information, commenting briefly on
each method adopted, and showing clearly how you have arrived at your answers.
Shaheen Ltd.
Summary position as at most recent balance sheet date:
Rs. Rs. Rs. Rs.
Share capital Fixed assets
200,000 Re. 1 ordinary 200,000 Land and building 500,000
shares
Reserves 595,000 Plant and equipment 275,000
795,000 Motor vehicles 55,000
Non-current liabilities 830,000
Loan
(Secured on land & building) 150,000
Current liabilities Current assets
Taxation 135,000 Cash 15,000
Other creditors and accruals Debtors 145,000
45,000 180,000
Stock 133,000 293,000
1,123,000
Preliminary expenses 2,000
1,125,000 1,125,000
Shaheen Ltd – profit/dividend record
The profit record after tax and interest, but before dividends, over the last five years has been as
follows:
Year 1 Rs. 80,000
Year 2 Rs. 75,000
Year 3 Rs. 95,000
Year 4 Rs. 80,000
Year 5 Rs. 85,000
The annual dividend has been Rs. 30,000 (gross) for the last ten years.
The operating budget shows that the estimated after tax profit for the next twelve months will be
Rs.85,000 and thereafter it is estimated that this will increase by 5% per annum over the next four
years.
In light of recent developments in the field of financial reporting the company has had its fixed assets
valued by an independent expert where report discloses:
Land and buildings Rs. 610.000
Plant and equipment Rs. 288,000
Motor vehicles Rs.102,000
A study of three public companies in the same market as Shaheen shows that the average dividend
yield and price/earnings ratio of these over the last three years has been:
COMPANY 1 COMPANY 2 COMPANY 3

Dividend P/E ratio Dividend P/E ratio Dividend P/E ratio
yield (%) yield (%) yield
Year 1 17 8.00 17.0 8.50 16.5 9.00
Year 2 17 8.00 15.0 9.00 17.0 10.00
Year 3 17 9.00 18.0 10.00 17.5 11.50
Average 17 8.33 16.7 9.17 17.0 10.17
One director has indicated that in conversation with colleagues in other larger companies they have
said that for acquisition purposes their after – tax cost of capital is now 17.5%. The estimated net
cash flows of the company after taking into consideration taxation and capital expenditure over the
next five years in order to achieve/and as a result of, the five – year profit plan, are as follows:
Year 1 Rs. 110,000
Year 2 Rs. 120,000
Year 3 Rs. 130,000
Year 4 Rs. 140,000
Year 5 Rs. 150,000
P/V of Re 1 discounted at:

Year 17.5% 15% 12.5%
1 0.85 0.97 0.89
2 0.72 0.76 0.79
3 0.62 0.66 0.70
4 0.52 0.57 0.62
5 0.45 0.50 0.56
(Adapted)
QUESTION – 3
The finance director of Kohat Ltd is concerned about the impact of capital structure on the
company’s value, and wishes to investigate the effect of different capital structures.
He is aware that as gearing increases the required return on equity will also increase, and the
company’s interest cover is likely to decrease. A decrease in interest cover could lead to a change in
the company’s credit rating by the leading rating agencies. He has been informed that the following
changes are likely:
Interest cover Credit rating Cost of long term debt

More than 6.5 AA 8%
4.0 – 6.5 A 9%
1.5 – 4.0 BB 11%
The company is currently rated A. Summarized financial data is as follows:

Rs. in million
Net operating income 110
Depreciation 20
Earnings before interest and tax 90
Interest 22
Taxable income 68
Tax @ 30% 20.4
Net income 47.6
Capital spending 20
Market value of equity is Rs. 458 million, and of debt Rs. 305 million. Kohat’s equity beta is 1.4. The
beta of debt may be assumed to be zero.
The risk free rate is 5.5% and the market return 14%.
The company’s growth rate of cash flow may be assumed to be constant and to be unaffected by
any change in capital structure.
Required:
Determine the likely effect on the company’s cost of capital and corporate value if the company’s
capital structure was:
(i) 80% equity, 20% debt by market values
(ii) 40% equity, 60% debt by market values.
Recommend which capital structure should be selected.
(Any change in capital structure would be achieved by borrowing to repurchase existing equity, or
by issuing additional equity to redeem existing debt as appropriate.)
The current total firm value (market value of equity plus market value of debt) is consistent with the
growth model (CF1/(K – g)) applied on a corporate basis. CF1 is next year’s free cash flow, k is the
weighted average cost of capital (WACC), and g the expected growth rate.
Company free cash flow may be estimated using EBIT(l – t) + depreciation – Capital spending.
(20)
QUESTION – 4
The management of Copper Industries Limited (CIL) intends to raise financing for the company’s
expansion project but is concerned about the impact of proposed additional financing on the
company’s existing capital structure and values.
The management is aware that there is an inverse relationship between interest cover and cost of
long term debt and the following relationship exist between interest cover and cost of debt:
Interest cover (time) >8 6 to 8 4 to 6 2 to 4

Cost of long term debt 8% 9% 11% 13%
The management has found that the following two debt equity ratios are usually prevalent in the
industry and are also acceptable to the company’s banker.
(i) 70% equity, 30% debt by market values
(ii) 50% equity, 50% debt by market values
The latest audited financial statements depict the following position:
Rs. in million
Net profit before tax 272
Depreciation 50
Interest @ 9% 55
Capital expenditure 150
Market value of existing equity and debt is Rs. 825 million and Rs. 550 million respectively. CIL’s
equity beta is 1.25 and its debt beta may be assumed to be zero. The risk-free rate of return and
market return are 7% and 15% respectively. Applicable tax rate is 35%.
Assume that:
 CIL’s cash flow growth rate would remain constant and would not be affected by any change
in capital structure.
 Market value of the company at the existing weighted average cost of capital, after the
proposed expansion, would remain the same.
Required:
(a) Calculate the following under the current as well as each of the above debt equity ratios being
considered by the company:
(i) Weighted average cost of capital
(ii) Value of the company
(b) Compare the three options and give recommendations in respect thereof to the company.
(23)
(ICAP Winter 2010, Q-5)
QUESTION – 5
MNO Chemicals Limited is a fertilizer company. The company is planning to diversify into the food
business and has identified two companies, PQ (Pvt.) Limited and RS Limited (a listed company), as
potential target for acquisition. MNO Chemicals Limited intends to buy one of these companies in a
share exchange arrangement. Extracts from the latest financial statements of the three companies
are given below:
STATEMENT OF FINANCIAL POSITION

MNO PQ (Pvt.) RS Limited
Chemicals Limited
---------------- Rs. in millions-----------------
1,500 800 1,200
Share capital (Rs. 10 each)
Retained earnings 700 300 350
TFCs 1,000 400 500
Current liabilities 300 100 200

3,500 1,600 2,250
Non-current assets 3,000 1,400 1,800

Investment held for trading - - 300
Current assets 500 200 150
3,500 1,600 2,250
STATEMENT OF COMPREHENSIVE INCOME
MNO PQ (Pvt.) RS Limited

Chemicals Limited
------------------- Rs. in millions-----------------
Sales 2,500.00 800.00 1,200.00
Operating profit before interest, 1,250.00 400.00 540.00
depreciation and tax
Interest (100.00) (48.00) (55.00)
Depreciation (450.00) (180.00) (270.00)
Other income 200.00 20.00 45.00
Net profit before tax 900.00 192.00 260.00
Tax @ 35% (315.00) (67.20) (91.00)
Net profit 585.00 124.80 169.00
Dividend payout 292.50 87.36 84.50

(50%:70%:50%)
Additional information:
(i) All companies maintain a stable dividend payout policy.
(ii) It is estimated that earnings of PQ and RS will grow by 4% and 5% respectively.
(iii) The risk free rate of return is 8% per annum and the market return is 13% per annum. The
market applies a premium of 300 basis points on the required returns of unlisted companies.
The required rate of returns can be used in earnings growth model for equity valuation.
(iv) RS Limited’s equity beta is estimated to be 1.20.
(v) Synergies in administrative functions arising from merger would increase after tax profits by
5% in the case of PQ and 6% in the case of RS.
Required:
Which of the two companies should be acquired by MNO Chemicals Limited? Show necessary
computations to support your answer. (21)
QUESTION – 6
KLR Limited has two operating segments viz. Paints and Chemicals. Break-up of its shareholders’
equity is as follows:
Rs. in million
Share capital (Rs. 10 each) 2,000
Retained earnings 11,765
Latest segment-wise financial information of KLR is summarized below:
Chemicals Paints
Rs. in million
Revenue 3,150 2,500
Gross profit 378 650
Net profit after tax 220 330
Assets
Non-current assets 6,610 5,250
Current asset 7,930 6,300
Liabilities
Non-current liabilities - 12% Debentures (Rs. 100 each) 2,100 1,950
Current liabilities 4,770 3,505
KLR’s current share price is Rs. 13 per share and the market value of its debenture is Rs. 101.50. The
risk free interest rate and market return are 8% and 14% respectively. KLR’s equity beta is 1.15.
Debentures are redeemable at par in ten years.
The company is considering a demerger whereby the two segments would be listed separately on
the stock market. The existing equity would be split between the segments based on the net assets
held by each segment. The following information is relevant for the purpose of demerger:
(i) Transfers to the Paint Segment account for 25% of the revenues of the Chemicals Segment.
The transfers are made at cost. After the demerger, all transactions would be made on an
‘arms length basis’.
(ii) Common expenses amounting to Rs. 100 million are shared by the two segments on the basis
of their revenues. After the demerger, cost of such expenses for Chemicals and the Paints
entities would be Rs. 70 million and Rs. 30 million respectively.
(iii) The average equity betas of the companies associated with the Chemicals and Paints
business is 1.2 and 1.5 respectively and the average debt equity ratios are 60:40 and 70:30
respectively.
(iv) Projected cash flows for Year 1 are as follows:
Chemicals Paints
------Rs. in million------
Pre-tax operating cash flows 280 360
Tax deprecation 70 40
From Year 2, projected cash flows and profit after tax are expected to grow at 5% per annum in
perpetuity.
Tax rate is 35%. Tax is payable in the year in which the relevant cash flows arise.
Required:
(a) Calculate the weighted average cost of capital of both companies after demerger. (10)
(b) Using cash flows, evaluate whether the demerger would be financially advantageous for
KLR’s existing shareholders. (15)
QUESTION – 7
Jazba Ltd will soon announce a takeover bid for Zoom Ltd, a company in the same industry. The initial
bid will be an all share bid of four Jazba shares for every five Zoom shares.
The most recent annual data relating to the two companies are shown below:
--------------Rs.’000’------------
Jazba Zoom
Sales revenue 13,333 9,400
Operating costs (8,683) (5,450)
Tax allowable depreciation (1,450) (1,100)
Earnings before interest and tax 3,200 2,850
Net interest (715) (1,660)
Taxable income 2,485 1,190
Tax (30%) (746) (357)
After tax income 1,739 833
Dividend (870) (458)
Retained earnings 869 375
Other information: Jazba Zoom

Annual replacement capital expenditure (Rs.’000) 1,600 1,240
Expected annual growth rate in sales, operating costs (including 5% 6.5%
depreciation), replacement investment and dividends for the
next four years
Expected annual growth rate in sales, operating costs (including 4% 5%
depreciation), replacement investment and dividends after four
years
Gearing (long term debt/long term debt plus equity by market 30% 55%
value)
Market price per share (Paisas) 298 192
Number of issued shares (million) 7 8
Current market cost of fixed interest debt 6% 7.5%
Equity beta 1.18 1.38
Risk free rate 4%

Market return 11%
The takeover is expected to result in cost savings in advertising and distribution, reducing the operating
costs (including depreciation) of Jazba from 76% of sales to 70% of sales. The growth rate of the
combined company is expected to be 6% per year for four years, and 5% per year thereafter. Zoom’s
debt obligations will be taken over by Jazba. The corporate tax rate is expected to remain at 30%.
Sales and costs relevant to the decision may be assumed to be in cash terms.
Required:
Using free cash flow analysis for each individual company and the potential combined company,
estimate how much synergy is expected to be created from the takeover. State clearly any
assumptions that you make.
Note: The weighted average cost of capital of the combined company may be assumed to be the
market weighted average of the current costs of capital of the individual companies, weighted
by the current market value of debt and equity of the combined company, with the equity of
Zoom adjusted for the effect of the bid price.
(20)
QUESTION – 8
MK Limited is presently considering a proposal to acquire 100 % shareholdings of ZA Limited which
is engaged in the same business. The financial data extracted from the latest audited financial
statements and other records of the two companies is presented below:
------------Rs. in million---------
MK ZA
Operating expenses excluding depreciation (7,695) (4,905)
Depreciation (1,305) (990)
PBIT 3,000 2,565
Interest (644) (1,494)
PBT 2,356 1,071
Tax (35%) (825) (375)
PAT 1,531 696
Other information:
Dividend payout 50% 55%
Capital expenditure during the year (Rs. in million) 700 650
Debt ratio 40% 55%
Market rate of interest on debentures 6.5% 7.5%
Number of shares issued (in million) 100 90
Market price of share (Rs.) 20 12
Equity beta 1.1 1.3
The following further information is available:
(i) Both the companies follow the policy of maintaining stable dividend payouts and debt ratios.
(ii) Annual growth in sales, operating expenses, depreciation and capital expenditures are
estimated as under:
Year 1 – 2 Year 3 onwards

MK 4% 5%
ZA 5.5% 5%
(iii) Accounting depreciation is the same as tax depreciation.
(iv) The prevailing risk-free rate of return is 8% whereas the market return is 13%.
The key aspects of the feasibility study carried out by MK are as follows:
 MK would issue 7 shares in exchange for 9 shares of ZA.
 A rationalization of administrative and operational functions after takeover would reduce
operating expenses including depreciation, from 75% to 70% of total sales.
 The annual growth in sales, operating costs, depreciation and capital expenditures in the
merged company would be as follows:
Year 1 – 2 5%
Year 3 onwards 5.5%
Required:
(a) Based on an analysis of Free Cash Flows, calculate the value of MK Limited, ZA Limited and
the company which would be formed after the merger.
(b) Estimate the synergy effect which is expected to accrue to MK Limited on account of
acquisition of ZA Limited. (25)
QUESTION – 9
Prodco Ltd. is contemplating a bid for the share capital of Nordik Ltd. The following statistics are
available:
Prodco Ltd. Nordik Ltd.
Number of shares 14 million 45 million
Share price Rs. 8.40 Rs. 1.66
Latest equity earnings Rs. 11,850,000 Rs. 9,337,500
Prodco Ltd's plan is to reduce the scale of Nordik Ltd's operations by selling off a division which
accounts for Rs. 1,500,000 of Nordik Ltd's latest earnings, as indicated above. The estimated selling
price for the division is Rs. 10.2 million.
Earnings in Nordik Ltd's remaining operations could be increased by an estimated 20% on a
permanent basis by the introduction of better management and financial controls.
Prodco Ltd does not anticipate any alteration to Nordik Ltd's price / earnings multiple as a result of
these improvements in earnings.
To avoid duplication, some of Prodco Ltd's own property could be disposed of at an estimated price
of Rs.16 million. Redundancy costs are estimated at Rs. 4.5 million.
Required:
(a) Calculate the effect on the current share price of each company, all other things being equal,
of a two for nine share offer by Prodco Ltd. (08)
(b) Assume now that Prodco Ltd, instead of making a two for nine share exchange offer, wishes
to offer an exchange which would give Nordik Ltd shareholders a 10% gain on the existing
value of their shares. Calculate what share exchange would achieve this effect, assuming the
same synergy forecasts as before. (06)
QUESTION – 10
ARA Venture Capital Limited specialises in acquiring loss making companies and converting them into
profitable entities with the objective of disposing them subsequently.
Presently, ARA is planning to acquire 60% shareholdings in PUN Electric Supply Company. Its Financial
Analyst has obtained the following information about PUN’s operations:
(i) During the year ended December 31, 2010, total electricity demand and supply was Mwh 2.0
million, whereas the cumulative generation capacity of all the existing plants was Mwh 2.1
million. The demand for electricity is expected to grow at the rate of 5% per annum.
(ii) Cost of power generation per Kwh is Rs. 7 (excluding depreciation) which is expected to
increase by 8% per annum.
(iii) PUN’s line losses for the year were 30%. Line losses are assumed to be electricity consumption
by fake connections which remain unbilled.
(iv) The Power Tariff Regulatory Authority has allowed PUN to determine the tariff so as to sell
electricity at a margin of 10% above the total cost of generation. PUN is permitted to include
line losses of 20% in the total cost of generation. The price per unit is determined by the
following formula:
(Total Cost + 10%) ÷ {Number of units produced × (1 – Permissible line losses %)}
where, one unit = 1 Kwh and 1 Mwh = 1,000 Kwh
(v) Revenue collection ratio for the year 2010 was 90% of the aggregate billing.
(vi) Other expenses, excluding depreciation and financial charges for 2010 amounted to Rs. 300
million and are expected to increase by 8% per annum.
(vii) Depreciation on all assets is charged on straight line method over the useful life of 20 years.
Depreciation for the year 2010 amounted to Rs. 75 million. It is included in total cost of
generation.
(viii) PUN has running finance facilities of Rs. 3,000 million from various banks at an average mark-
up of 13% per annum. The facilities utilized as of December 31, 2010 amounted to Rs. 2,785
million.
(ix) In order to meet the future requirements of electricity, PUN’s management has already started
work on a new generation plant that will be commissioned into operation by the end of 2012
and will increase the present capacity by 15%. Total cost of the new project will be Rs. 1,500
million and PUN had issued TFCs on January 1, 2011 at 14% per annum, to finance the project.
(x) The issued share capital of PUN as at December 31, 2010 consisted of 500 million shares of Rs.
10 each.
ARA intends to invest in PUN’s infrastructure facilities to reduce line losses. It also plans to broaden
the Recovery Department with the objective of improving the recovery ratio.
The projected figures for the next five years are as follows:
Years ending December 31 2011 2012 2013 2014 2015
Capital expenditures (Rs. In million) 500 600 500 - -
Additional staff cost in recovery deptt. 15 17 18 20 22
(Rs. In million)
Line losses 28% 25% 22% 20% 18%
Recovery ratios 92% 94% 96% 97% 97%
The planned capital expenditures would be incurred at the end of the year. ARA would provide a loan
to PUN to finance the capital expenditures. The loan will be disbursed as required and carry a mark-
up of 10% per annum. It would be repayable on December 31, 2015.
In addition, ARA would provide guarantees to different banks to secure additional running finance
facilities for PUN amounting to Rs. 8,000 million, at a markup of 13% per annum.
ARA requires an IRR of 20% from its investment and expects to exit from this venture by selling its
shareholdings at the P/E multiple of 16.
Required:
Determine the purchase consideration that ARA should be willing to pay for the acquisition of 60%
shares in PUN. (Ignore taxation) (25)
(ICAP Summer 2011, Q-5) [Amended]
QUESTION – 11
Ibn-Seena Limited (ISL) is a reputable unquoted company engaged in the business of manufacturing
and sale of pharmaceutical products. It is presently considering a proposal to acquire Al-Biruni
Pharmaceuticals (Private) Limited (APPL) which is a wholly owned subsidiary of Al-Biruni
International (ABI).
Summarized income statements of ISL and APPL for the latest financial year are given below:
ISL APPL
Rs. In million
Sales 2,500 1,800
Less: cost of sales – Variable (1,350) (630)
– Fixed* (150) (190)
Gross profit 1,000 980
Selling expenses (375) (360)
Administrative expenses (125) (90)
Profit before tax 500 530
Tax 35% (175) (186)
Profit after tax 325 344
* includes depreciation of Rs. 70 million and 100 million respectively
Other Information
(i) APPL’s sales consist of Generic Medicines (40%) and Patented Products (60%). Presently, 20%
of the revenue from Patented Products is contributed by a product Z-11. All patents are owned
by ABI; however, no royalty or technical fee is presently claimed by it.
(ii) The variable costs of Patented Products are 30% of the sales amount. Product Z-11 will
complete its patent period after three years and thereafter its price would have to be reduced.
Consequently, the ratio of variable costs of production to sales would fall in line with that of
Generic Medicines.
(iii) After acquisition the costs and revenues of APPL are projected as follows:
- Total sales and variable costs would grow at 10% per annum except in Year 4 when the
growth rate of sales would decline on account of reduction in price of product Z-11.
- Fixed costs other than depreciation would increase at the rate of 5% per annum. However,
depreciation would remain constant over the next five years.
- Selling expenses and administration expenses would be reduced by 30% and 80%
respectively. However, from Year 2 onwards, selling expenses would increase at 7% per
annum whereas administration expenses would increase by 5% per annum.
- ABI will charge 15% royalty on sale of Patented Products whereas 3% technical fee will be
levied on the sales of all products.
(iv) Free cash flows of APPL are expected to grow at 3% per annum after Year 5.
(v) ISL would discount this project at its existing weighted average cost of capital of 20%.
Required:
Calculate the bid price that ISL may offer for the acquisition of APPL. (17)
(ICAP Winter 2011, Q-3) [Amended]
QUESTION – 12
Fuji Company is a small software design business established four years ago. The company is owned by
three directors who have relied upon external accounting services in the past. The company has grown
quickly and the directors have appointed you as a financial consultant to advise on the value of the
business under their ownership.
The directors have limited liability and the bank loan is secured against the general assets of the
business. The directors have no outstanding guarantees on the company’s debt.
The company’s latest income statement and the extracted balances from the latest statement of financial
position are as follows:
Income Statement Rs.’000’ Financial Position Rs.’000’
Revenue 5,000 Opening non current assets 1,200
Cost of sales (3,000) Additions 66
Gross profit 2,000 Non current assets (gross) 1,266
Other operating costs (1,877) Accumulated depreciation (367)
Operating profit 123 Net book value 899
Interest on loan (74) Net current assets 270
Profit before tax 49 Loan (990)
Income tax (15) Net assets 179
Profit for the period 34
During the current year:

(1) Depreciation is charged at 10% per annum on the year end non-current asset balance before
accumulated depreciation, and is included in other operating costs in the income statement.
(2) The investment in net working capital is expected to increase in line with the growth in gross
profit.
(3) Other operating costs consisted of:
Rs.’000’
Variable component at 15% of sales 750
Fixed costs 1,000
Depreciation on non-current assets 127
(4) Revenue and variable costs are projected to grow at 9% per annum and fixed costs are projected
to grow at 6% per annum.
(5) The company pays interest on its outstanding loan of 7·5% per annum and incurs tax on its
profits at 30%, payable in the following year. The company does not pay dividends.
(6) The net current assets reported in the statement of financial position contain Rs. 50,000 of
cash.
One of your first tasks is to prepare for the directors a forward cash flow projection for three years
and to value the firm on the basis of its expected free cash flow to equity. In discussion with them
you note the following:
 The company will not dispose of any of its non-current assets but will increase its investment in
new non-current assets by 20% per annum. The company’s depreciation policy matches the
currently available tax write off for capital allowances. This straight-line write off policy is not
likely to change.
 The directors will not take a dividend for the next three years but will then review the position
taking into account the company’s sustainable cash flow at that time.
 The level of the loan will be maintained at Rs. 990,000 and, on the basis of the forward yield
curve, interest rates are not expected to change.
 The directors have set a target rate of return on their equity of 10% per annum which
they believe fairly represents the opportunity cost of their invested funds.
Required:
Estimate the value of the business based upon the expected free cash flow to equity and a terminal value
based upon a sustainable growth rate of 3% per annum thereafter. (15)
{Adapted}
QUESTION – 13
Big Co, a listed company which manufactures electronic components, is interested in acquiring Small
Co, an unlisted company involved in the development of sophisticated but high risk electronic
products. The owners of Small Co are a consortium of private equity investors who have been looking
for a suitable buyer for their company for some time. Big Co estimates that a payment of the equity
value plus a 25% premium would be sufficient to secure the purchase of Small Co. Big Co would also pay
off any outstanding debt that Small Co owed. Big Co wishes to acquire Small Co using a combination of
debt finance and its cash reserves of Rs. 20 million, such that the capital structure of the combined
company remains at Big Co’s current capital structure level.

Information on Big Co and Small Co
Big Co
Big Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently Big Co has a
total firm value (market value of debt and equity combined) of Rs. 140 million.
Small Co, Income Statement Extracts
Year Ended 31 May 2011 31 May 2010 31 May 2009 31 May
2008
All amounts are in Rs. ’000
Sales revenue 16,146 15,229 14,491 13,559
Operating profit (after operating
costs and tax allowable depreciation) 5,169 5,074 4,243 4,530
Net interest costs 489 473 462 458
Profit before tax 4,680 4,601 3,781 4,072
Taxation (28%) 1,310 1,288 1,059 1,140
After tax profit 3,370 3,313 2,722 2,932
Dividends 123 115 108 101
Retained earnings 3,247 3,198 2,614 2,831
Small 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, Small Co will require an additional investment in assets of
22 paisas per Re. 1 increase in sales revenue, for the next four years. It is anticipated that Small Co will
pay interest at 9% on its future borrowings.
For the next four years, Small 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 Rs.
51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future. 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 Rs. 513,000 in the first year and
then 18 paisas per Re. 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%.
Required:
Prepare a report to the Board of Directors of Big Co that:
(i) Evaluates whether the acquisition of Small Co would be beneficial to Big Co and its
shareholders. The free cash flow to firm method should be used to estimate the values of
Small Co and the combined company assuming that the combined company’s capital
structure stays the same as that of Big Co’s current capital structure. Include all relevant
calculations; (16)
(ii) Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire
Small Co and concludes whether Big Co’s current capital structure can be maintained; (03)
{Adapted}
QUESTION – 14
Green Co is a publicly listed company involved in the production of highly technical and
sophisticated electronic components for complex machinery. It has a number of diverse and
popular products, an active research and development department, significant cash reserves and a
highly talented management who are very good in getting products to market quickly.
A new industry that Green Co is looking to venture into is biotechnology, which has been expanding
rapidly and there are strong indications that this recent growth is set to continue. However, Green
Co has limited experience in this industry. Therefore it believes that the best and quickest way to
expand would be through acquiring a company already operating in this industry sector.
Yellow Co is a private company operating in the biotechnology industry and is owned by a consortium
of business angels and company managers. The owner-managers are highly skilled scientists who have
developed a number of technically complex products, but have found it difficult to commercialize
them. They have also been increasingly constrained by the lack of funds to develop their innovative
products further.
Discussions have taken place about the possibility of Yellow Co being acquired by Green Co. Yellow Co’s
managers have indicated that the consortium of owners is happy for the negotiations to proceed. If
Yellow Co is acquired, it is expected that its managers would continue to run the Yellow Co part of the
larger combined company.
Yellow Co is of the opinion that most of its value is in its intangible assets, comprising intellectual capital.
Therefore, the premium payable on acquisition should be based on the present value to infinity of the
after tax excess earnings the company has generated in the past three years, over the average return
on capital employed of the biotechnological industry. However, Green Co is of the opinion that the
premium should be assessed on synergy benefits created by the acquisition and the changes in value, due
to the changes in the price-to-earnings (PE) ratio before and after the acquisition.
Given below are extracts of financial information for Green Co for 2013 and Yellow Co for 2011, 2012
and 2013:
Green Co -------------Yellow Co. -----------
Year ended 30 April 2013 2013 2012 2011
Rs. million Rs. million Rs. million Rs. million
Earnings before tax 1,980 397 370 352
Non-current assets 3,965 882 838 801
Current assets 968 210 208 198
Share capital (25 paisas/share) 600 300 300 300
Reserves 2,479 183 166 159
Non-current liabilities 1,500 400 400 400

Current liabilities 354 209 180 140
The current average PE ratio of the biotechnology industry is 16·4 times and it has been estimated that
Yellow Co’s PE ratio is 10% higher than this. However, it is thought that the PE ratio of the combined
company would fall to 14·5 times after the acquisition. The annual after tax earnings will increase by
Rs. 140 million due to synergy benefits resulting from combining the two companies.
Both companies pay tax at 20% per annum and Yellow Co’s annual cost of capital is estimated at 7%.
Green Co’s current share price is Rs. 9·24 per share. The biotechnology industry’s pre-tax return on
capital employed is currently estimated to be 20% per annum.
Green Co has proposed to pay for the acquisition using one of the following three methods:
(i) A cash offer of Rs. 5·72 for each Yellow Co share; or
(ii) A cash offer of Rs. 1·33 for each Yellow Co share plus one Green Co share for every two Yellow
Co shares; or
(iii) A cash offer of Rs. 1·25 for each Yellow Co share plus one Rs. 100 3% convertible bond for every
Rs. 5 nominal value of Yellow Co shares. In six years, the bond can be converted into 12 Green
Co shares or redeemed at par.
Required:
(a) Based on the two different opinions expressed by Green Co and Yellow Co, calculate the maximum
acquisition premium payable in each case. (06)
(b) Calculate the percentage premium per share that Yellow Co’s shareholders will receive
under each acquisition payment method and justify, with explanations, which payment
method would be most acceptable to them. (10)
{Adapted}
QUESTION – 15
(a) GHP Limited is a fast growing business which operates a chain of petrol pumps across the
country. The company is committed to an aggressive strategy of expansion through
acquisition. It is considering to acquire 100 percent shareholding in IJQ Limited that operates
a chain of CNG stations on the highways. GHP is contemplating to offer 1 share for every 3
shares held in IJQ.
Latest financial data of GHP and IJQ are summarised below:
Statement of Financial Position
GHP IJQ
Rs. in million
Non-current assets 5,220 2,340
Current assets minus current liabilities 1,640 900
6,860 3,240
Less: Non-current liabilities 1,240 120
5,620 3,120
Ordinary share capital (Rs. 10 each) 3,000 2,000
Retained earnings 2,620 1,120
5,620 3,120
Statement of Comprehensive Income

GHP IJQ
Rs. in million
Revenue 11,280 4,840
Net profit after taxation 6,580 3,760
Dividend 1,316 1,880
Average share price for each company in recent years has been as follows:
2009 2010 2011 2012
--------------------Rupees---------------------
CHP 70 96 138 186
IJQ 48 64 68 58
GHP’s board of directors feel that there is a strong synergy between the two businesses
which will lead to an increase of Rs. 300 million per year in combined after tax profit,
following the acquisition. Both GHP and IJQ are listed companies and their cost of equity is
13% and 18% respectively.
Required:
(i) Calculate the share price of GHP following the takeover, assuming price earnings
ratio of the company is maintained and the synergy is achieved as expected. (05)
(ii) Calculate the cost of equity of the merged entity. You may use any reasonable
assumption wherever necessary. (05)
(b) Mr. Danish, a shareholder of IJQ, has expressed concern over the bid. He claims that,
following the acquisition, the annual dividends are likely to be lower as GHP normally pays
small dividends. As he relies on dividend income to cover his living expenses, he is concerned
that he will be worse off following the acquisition. He also believes that price offered for the
shares of IJQ is too low.
Required:
Discuss the bid from the point of view of shareholders of IJQ including the concerns raised
by Mr. Danish. (08)
QUESTION – 16
The Board of Directors of Taxila Power Limited (TPL) is considering to acquire the entire shareholding
of Digari Power Limited (DPL) in a share exchange arrangement. TPL’s Board is of the opinion that
the proposed acquisition would enable TPL to:
(i) immediately increase the combined profits of the two companies by Rs. 12 million;
(ii) sell DPL’s surplus fixed assets. These assets can be sold for Rs. 20 million; and
(iii) reduce TPL’s risk factor as perceived by its shareholders which would result in decline in their
annual return expectations by 2%.
DPL has maintained a steady level of profitability and dividend performance in the preceding years
and its existing shareholders expect that this trend would continue in the future. Current market
value of DPL’s ordinary shares is Rs. 25.60 per share.
Following information has been extracted from the financial statements of both the companies for
the year ended 31 May 2013:
TPL DPL
Rs. in million
Non-current assets 600 100
Current assets, less current liabilities 200 20
Share capital (Rs. 10 each) 100 50
Reserves 700 70
Net profit for the year 80 16
Dividend for the year (paid on 31 May 2013) 40 16
The current market value of TPL’s ordinary shares is Rs. 56 per share. At present, the expected growth
rate in net profits is 12% per annum which is expected to be maintained after acquisition. The Board
intends to continue to maintain the same dividend payout ratio.
Required:
(a) Calculate the maximum price that TPL may pay for the acquisition of DPL. (08)
(b) The financial consultant of TPL is of the opinion that DPL’s shareholders may be persuaded
to sell the entire shareholding at a premium of 20% over the current market price. Based on
this assumption:
(i) Calculate the number of shares which TPL would be required to issue to the
shareholders of DPL as price consideration. (04)
(ii) What benefits, if any, would accrue to the existing shareholders of TPL and DPL
through the proposed acquisition? (03)
(iii) Discuss other relevant factors that the directors/shareholders of both companies
may consider in assessing the proposed acquisition. Ignore taxation. (10)
QUESTION – 17
Strong Inc is a listed telecommunications company. The company is considering the purchase of
Potential Co, an unlisted company that has developed, patented and marketed a secure, medium-
range, wireless link to broadband. The wireless link is expected to increase Potential’s turnover by
25% per year for three years, and by 10% per year thereafter.
Potential is currently owned 35% by its senior managers, 30% by a venture capital company, 25%
by a single shareholder on the board of directors, and 10% by about 100 other private investors.
Summarised accounts for Potential for the last two years are shown below:
Income statements for the years ended 31 March ------------ Rs. ‘000’ -----------
20 x 6 20 x 5
Operating profit before exceptional items 1,302 820
Exceptional items (2,005) -
Interest paid (net) (280) (228)
Profit before taxation (983) 592
Taxation (210) (178)
Profit after taxation (1,193) 414
Note: Dividend 200 100
Statements of financial position (Balance sheets) as at 31 March
Non-current assets (net)
Tangible assets 5,430 5,048
Goodwill 170 200
Current assets
Inventory 3,400 2,780
Receivables falling due within one year 2,658 2,462
Receivables falling due after one year 100 50
Cash at bank and in hand 48 48
Total assets 11,806 10,588
Equity and liabilities
Called-up share capital (25 cents par) 2,000 1,000
Retained profits 3,037 4,430
Other reserves 1,249 335
Total equity 6,286 5,765
Current liabilities - payables 5,520 4,823
11,806 10,558
Other information relating to Potential:
(i) Non-cash expenses, including depreciation, were Rs. 820,000 in 20X5-6.
(ii) Corporate taxation is at the rate of 30% per year.
(iii) Capital investment was Rs. 1 million in 20X5-6, and is expected to grow at the same rate as
turnover.
(iv) Working capital, interest payments and non-cash expenses are expected to increase at the
same tate as turnover.
(v) The estimated value of the patent if sold now is Rs. 10 million. This has not been included in
non-current assets.
(vi) Operating profit is expected to be approximately 8% of turnover in 20X6-7, and to remain at

the same percentage in future years.
(vii) Dividends are expected to grow at the same rate as turnover.
(viii) The realizable value of existing inventory is expected to be 70% of its book value.
(ix) The estimated cost of equity of Potential is 14%.
Information regarding the industry sector of Potential:

(i) The average PE ratio of listed companies of similar size to Potential is 30:1.
(ii) Average earnings growth in the industry is 6% per year.
Required:
Estimate the value of Potential Co using:

(i) Asset based valuation
(ii) PE ratios
(iii) Dividend based valuation
(iv) The present value of expected future cash flows
Discuss the potential accuracy of each of the methods used and recommend, with reasons, a value,
or range of values that Strong might bid for Potential.
State clear any assumptions that you make (27)

{Adapted}
QUESTION – 18
As part of a strategic plan, the Federal Government has decided to privatize National Airline Limited
(NAL) and is offering management control for a 40% stake in the company.
Summarized income statement of NAL for the year ended 30 June 2015 is as follows:
Income Statement
Rs. in million
Operating revenue 144,342

Cost of services (147,119)
Gross loss (2,777)
Operating expenses (10,217)
Financial charges (9,793)
Other income 1,501
Net loss (21,286)
The following additional information is available from the annual report of the company:
(i) 4.3 million passengers travelled during 2014-15.
(ii) The planes used by NAL have average capacity of 300 passengers. However, due to flights
operating on unprofitable routes, the existing utilisation is 180 passengers per flight.
(iii) Discounted tickets are provided to the government departments. Approximately 20

passengers from government departments travel on each flight and the average discount rate
is 50%.
(iv) Cost of services includes cost of fuel amounting to Rs. 69,284 million.
(v) 20% of operating expenses comprise of depreciation.
A local group is interested in bidding for NAL. Initial planning of the group is as follows:
(i) Capital expenditure of Rs. 15,000 million and Rs. 25,000 million would be made in 2016 and
2017 respectively.
(ii) NAL’s operations would be restructured which are expected to have the following impact:
Year 2016 2017 2018 2019 2020

Increase in number of flights due
to new routes and new aircrafts 4% 4% 5% 5% 5%
Increase in average number of
passengers per flight due to new
routes and discontinuance of
unprofitable routes 6% 6% 6% - -
Increase in average revenue and

fuel cost due to inflation 2% 2% 2% 2% 2%
Discount to be offered to
Government departments 35% 25% 25% 25% 25%
(iii) The ratio of Government passengers to other passengers would remain the same during the
next 5 years.
(iv) Cost of services (excluding fuel) and operating expenses (excluding depreciation) are
expected to grow at 8% per annum.
(v) Other income mainly comprises of income from courier and freight services and is expected
to grow in line with the operating revenue.
(vi) Increase in working capital is forecasted as follows:

Year 2016 2017 2018 2019 2020

Working capital (Rs. in million) 5,350 3,450 2,500 1,500 1,500
(vii) Due to carried forward tax losses and future capital expenditures, NPL is not expected to pay
any tax for the next 5 years.
(viii) Free cash flows are expected to grow by 5% after year 2020.
(ix) The cost of capital of the local group is 16%.
Required:
Based on an analysis of Free Cash Flows, calculate the bid price that the local group may offer for the
acquisition of 40% stake in NAL. (All cash flows are assumed to arise at the end of the year) (21)
QUESTION – 19
Violet Telecom Ltd. (VTL) and Blue Telecom Ltd. (BTL) are competitors in the telecom industry which
has been witnessing fierce competition in the domestic market.
Following information has been extracted from the latest annual reports of the two companies:
VTL BTL
Customers (in million) 20 10
Average revenue per customer per month (Rs.) 250 180
Number of shares issued (in million) 1,500 1,250
Earnings per share (Rs.) 5.5 (0.5)
Book value per share (Rs.) 33 24
VTL is considering to acquire BTL. It is estimated that after this acquisition:

(i) the combined infrastructure of the two companies will create enough space to accommodate
expected growth in customer base without incurring any additional capital expenditure.
(ii) due to growth in customer base, overall revenues of the merged entity would increase by 10%
per annum whereas the total costs would increase by 3% only.
(iii) VTL will be able to utilize BTL’s tax assessed carried forward losses of Rs. 3,300 million.
(iv) the price earnings ratio of the merged entity would be 8.
VTL intends to offer its own shares to shareholders of BTL as bid price for the transaction. It is
expected that VTL’s shareholders would accept a share exchange ratio which would not dilute their
existing earnings per share whereas BTL’s shareholders would accept any offer which is at least
equivalent to the existing book value of BTL’s shares.
Applicable tax rate is 30% of profit before tax or 1% of revenues whichever is higher.
Required:
(a) Determine the ratio of share exchange which must be offered to shareholders of BTL to gain
their acceptance and assess whether this ratio would be acceptable to shareholders of VTL
also. (12)
(b) Discuss five other relevant factors that the directors/shareholders of both companies may
consider in evaluating the proposed merger. (05)
QUESTION – 20
Mangal Limited (ML) is a manufacturer and retailers of garments. ML is considering to takeover
Somvar Limited (SL) which is engaged in a similar business.
Extracts from the latest statements of financial position and income statements of both companies
are as follows:
Summarized Statements of Financial Position
ML SL
Rs. in million
Land and building (net) 483.0 42.3
Other non-current assets (net) 150.0 17.0
Current assets 384.0 63.0
1,017.0 122.3
Long term loan – 10% Bank loan 74.0 17.5
– 2% Term finance certificates (Rs. 100 each) 200.0 -
Current liabilities 391.0 50.1
Share capital (Rs. 10 each) 300.0 40.0
Reserves 52.0 14.7
1,017.0 122.3
Summarised Income Statements
ML SL
Rs. in million
Sales 1,130.0 181.0
Profit after tax 50.0 8.0
Dividends paid by ML and SL during the latest year amounted to Rs. 24 million and Rs.5 million
respectively. The latest market prices of their shares and debt instruments are as follows:
ML SL
Ordinary shares (ex-dividend) (Rs.) 20.5 26.5
Term finance certificates (cum interest) (Rs.) 109.0 -
ML estimates that after acquisition it would be able to achieve savings of Rs. 2.7 million per annum
(net of tax) for at least 5 years by eliminating certain administrative functions. Further, sale of excess
non-current assets would yield Rs. 6.8 million (net of tax on disposal). However, ML would have to
make ‘one time’ redundancy payment of Rs. 9 million (net of tax).
ML plans to offer four ordinary shares for every three ordinary shares of SL. A public announcement
of the proposal has not been made.
ML’s cost of equity and weighted average cost of capital are estimated at 16% and 14% respectively
whereas SL’s cost of equity is estimated at 15%.
Required:
(a) Discuss whether the announcement of proposed acquisition would be beneficial for the
existing shareholders of ML and SL if:
- the market is semi strong form efficient; (07)
- the market is strong form efficient. (03)
(Show working of all relevant calculations)
(b) Discuss the other factors which may influence the interests of the shareholders.
(10)
(ICAP Winter 2016, Q-5) [Amended]
QUESTION – 21
Mars Petroleum (Private) Limited (MPL) is engaged in the marketing of petroleum and related
products through fuel stations operated under its brand name. Recently, Government of Pakistan
has issued license to MPL to establish and operate 200 fuel stations on the CPEC route. MPL estimates
that it requires an amount of Rs. 2,500 million for this project.
The board of directors has decided to finance this expansion through IPO and directed the
management to initiate the process.
The existing capital structure of MPL is as follows:
Rs. in million
Share capital (Rs. 10 each) 2,000
Reserves 980
2,980
(i) The profit before tax and depreciation, in the year prior to the commencement of the
project was Rs. 1,025 million.
(ii) As a result of the above project, the profit before tax and depreciation is expected to grow
at the rate of 20% per annum for next five years after which profit would stabilize.
(iii) Accounting and tax depreciation on fixed assets including the new capital expenditure in
the first year would be Rs. 350 million which would be reduced by 10% in each of the next
five years and would remain the same thereafter.
(iv) Average equity beta and debt to equity ratio of similar listed companies is 1.9 and 40:60
respectively.
(v) Annualized return on KSE 100 index is 14% and 6-months KIBOR is 8%.
(vi) The cost of initial public offerings would be 5%.
(vii) The tax rate applicable on the company is 30%.
Required:
(a) Advise MPL about the IPO price and suggest the number of shares to be offered in the IPO
assuming that entire amount would be spent in year 0. (14)
(b) Write a brief memorandum to the board of directors discussing the advantages of leverage,
for the shareholders of the company. (03)
QUESTION – 22
Tulip Textile Limited (TTL) is engaged in the business of export to customers in USA and Europe. In a
recent meeting, the board of directors (BOD) has approved an expansion plan which envisages
introducing local sales by acquiring retails shops with the brand name ‘Wirsa’. In this regard, a
company named Blossom Textile (Private) Limited (BTL) has been identified for acquisition. BTL has
two divisions, i.e. textile manufacturing division and retail business division. The plan is to acquire
BTL, dispose of its manufacturing division and use the retail business division for the sale of TTL’s
products.
After several meetings, BTL’s shareholders have finally showed their inclination to sell BTL if TTL
offers them five ordinary shares of TTL for every seven shares of BTL. Subsequently, a due diligence
exercise has been carried out. TTL’s CFO has summarised the key information as follows:
(i) Extracts from the latest financial statements of TTL and BTL:
TTL BTL
----- Rs. in million -----
Sales 35,000 6,000
Profit after taxation 2,900 500
Share capital (Rs. 10 each) 7,500 2,500
Reserves 5,520 520
10% bank loan (repayable after five years) 17,500 1,500
(ii) 30% of the net assets of BTL pertain to the retail business division.
(iii) BTL’s textile manufacturing division can be disposed of immediately at around 1.5 times of
its net assets value.
(iv) BTL has assessed carried forward tax losses of Rs. 1,500 million.
(i) TTL’s board has planned to maintain the proportion of debt to equity in terms of market
value at the same level as it was before the acquisition.
(ii) Annual savings of Rs. 70 million are expected to be achieved as a result of synergies due to
acquisition and are expected to continue till perpetuity. However, TTL would have to make
one-time payment of Rs. 35 million immediately to the redundant staff.
(iii) The sales of ‘Wirsa’ in the first year is estimated at Rs. 1,000 million which is estimated to
grow by 10% per annum in second and third years. Thereafter, the sales growth would
normalize at 5% per annum till perpetuity. The profit before tax is expected at 20% of the
retail business sales.
(iv) Depreciation relating to retail business division would stay constant at Rs. 25 million per
annum.
(v) Currently, TTL and BTL have equity beta of 1.1 and 0.91 respectively. The risk free rate of
return is 7% and the market premium is 6%.
(vi) The asset beta of the combined entity may be taken as the individual companies’ asset betas,
weighted in proportion of market values of their equity.
(vii) Applicable income tax rate is 30%.
(viii) The shares of textile companies are being traded at price earnings ratio of 12.
(ix) Based on the financial projections, it is estimated that there would be enough profits in the
books of TTL to absorb all brought forward losses of BTL in the first year.
Required:
Evaluate whether the proposed acquisition would be beneficial for the existing shareholders of TTL
and BTL. (25)
QUESTION – 23
Sun Public Limited (SPL) is a listed company and has two divisions i.e. supermarket division (SD) and
hotel division (HD). The board of directors is presently considering to demerge both divisions. In the
opinion of the board, the demerger would increase operational efficiency and enhance value for
shareholders. The proposed scheme of demerger is as follows:
(i) Both divisions would be listed separately on the stock market.
(ii) For every 100 shares in SPL, a shareholder would receive 60 shares in SD and 40 shares in
HD. Similarly, a person holding 100 Term Finance Certificates (TFCs), would be given 60 TFCs
in SD and 40 TFCs in HD.
(iii) SD and HD would incur one-time cost (net of tax) of Rs. 12 million and Rs. 8 million
respectively at the time of demerger.
Annual free cash flows after demerger are projected as follows:
SD HD
Rs. in million
Years 1 to 5 33.2 25.6
Year 6 onwards 39.8 32.0
Information relating to SPL

(i) Details of SPL’s equity and TFCs as per latest financial statements:
Rs. in million
Share capital (Rs. 10 each) 50
Reserves 130
10% Term finance certificates (Rs. 100 each)
(repayable after 10 years at par) 115
(ii) Current market prices of SPL’s shares and TFCs are Rs. 30 and Rs. 110 respectively.
(iii) The cost of capital and equity beta of SPL are 10% and 1.15 respectively.
Other relevant information:
(i) The market values of the new companies are to be estimated at the price-earnings
ratios of the relevant industries.
(ii) Information regarding supermarket industry and hotel industry:
Supermarket industry Hotel industry
Average equity beta 1.25 0.9
Average debt equity ratio 30:70 20:80
Price earnings ratio 8 10
(iii) The risk free rate of return is 9% per annum and the market return is 15% per annum.
(iv) Applicable income tax rate is 30%.
Required:
(a) Evaluate the financial viability of the demerger scheme for the shareholders of SPL
using 10 years’ time horizon. (Assume all cash flows arise at the end of each year
except where otherwise specified) (19)
(b) List any four additional information that would assist the directors in evaluating the
decision of demerger. (04)
QUESTION – 24
Yellow Limited (YL) is a manufacturer and supplier of electronic appliances. YL is considering to
acquire entire shareholdings of White Limited (WL) which is also engaged in the same business.
Following information has been extracted from the latest management accounts of the two
companies:
YL WL
Share capital (Rs. 10 each) 4,500 3,000
12% convertible term finance certificates (Rs. 100 each) 2,350 -
14% irredeemable debentures (Rs. 50 each) - 1,800
Annual free cash flows 860 390
YL estimates that the takeover would increase the combined annual free cash flows to Rs. 1,340
million after considering all the synergy effects of the takeover.
YL plans to offer its own shares to WL’s shareholders as bid price for the transaction. It is expected
that WL's shareholders would accept a share exchange ratio which provides them at least 5% more
than current market value of their shares.
Following additional information is also available:
(i) The shares of YL and WL are currently traded at Rs. 15 and Rs. 9 respectively.
(ii) The market value of YL’s TFC is Rs. 120 each whereas market value of WL’s debenture is Rs.
47 each.
(iii) Each TFC is convertible into 10 ordinary shares of YL at maturity i.e. at the end of the year 4.
(iv) The risk free rate of return and current market return are 11% and 16% respectively.
(v) The average equity beta and average debt equity ratio of the industry are 1.4 and 45:55
respectively. Debt beta is assumed to be zero.
(vi) Applicable tax rate is 35%.
Required:
(a) Determine the share exchange ratio which must be offered to WL’s shareholders to gain their
acceptance. Also assess whether this ratio would be acceptable to YL’s shareholders.
(18)
(b) Identify and discuss other relevant factors that directors and shareholders of both
companies may consider while evaluating the proposed takeover. (06)
QUESTION – 25
Karakorum Limited (KL) is considering to expand its business by acquiring 100% shareholdings in
Shalimar Limited (SL) which is operating in the same industry.
Following information has been extracted from the latest audited financial statements of both
entities:
Statement of profit or loss
KL SL
Revenue 564 177
Cost of sales (384) (110)
Operating expenses (84) (30)
Profit before interest and tax 96 37
Interest expense (18) (16)
Profit before tax 78 21
Taxation @ 30% (23) (6)
Net profit 55 15
Statement of financial position
KL SL
Share capital (Rs. 10 each) 205 127
Retained earnings 289 75
Long term loans (KL: 11%, SL: 12%) 165 148
659 350
Non-current assets 384 286

Current assets 463 198
847 484
Current liabilities (188) (134)
659 350
Other information:
(i) The proposed acquisition would enable KL to save operating expenses by Rs. 31 million per
annum. However, KL would have to pay Rs. 20 million immediately to the outgoing staff.
(ii) Following projections have been worked out in respect of merged entity:
 In first three years
- Growth in revenue and cost of sales (other than depreciation) would be 6% per
annum.
- Operating expenses (other than depreciation) would grow by 5% per annum.
 From fourth year and onwards
Free cash flows are expected to grow at a constant rate of 3% per annum.
 Current assets and current liabilities would grow in line with revenue.
(iii) Depreciation represents 25% of cost of sales and 10% of operating expenses in both entities.
It is expected that there will be no material change in depreciation over the years. Assume
that tax depreciation is equal to accounting depreciation.
(iv) Current market price of KL and SL are Rs. 38 and Rs. 20 per share respectively.
(v) The weighted average cost of capital will be 18% following the acquisition of SL.
Required:
(a) Using the free cash flow method, determine the maximum price that KL may pay to the
shareholders of SL. (13)
(b) Assume that the offer of Rs. 450 million is accepted by SL’s shareholders. Discuss the impact
of this acquisition on control, gearing and earnings per share of KL if it is funded:
(i) with new debt at 10%; or (ii) by issuance of shares. (10)
QUESTION – 26
SuperSky International Airlines Ltd. (SIL) is a listed, international airline carrier based in Karachi with
routes to neighbouring countries, some Russian states and European countries.
SIL currently does not operate a domestic schedule in Pakistan so the board of directors have
expressed an interest in acquiring Wings Ltd. (WL), a low-cost regional private airline company which
schedules domestic flights between Karachi, Lahore and Islamabad.
Information on WL
WL is an unlisted company with 500,000 issued shares. WL’s recent results for the year ended 30
November 2020 are as follows:
In order to assist with the valuation, the directors of WL have provided the following information and
assumptions:
(i) Annual growth for the years 30 November 2021 to 2024 is expected as follows:
Revenue 2.5%
Expenditure except finance charges 2.0%
Finance charges 0.0%
(ii) There is no revenue or cost inflation from 2025 and onwards.
(iii) Annual capital expenditure on aircraft is expected to be as follows:
(iv) From 2021 to 2024, capital allowances on aircraft are expected to be 10% per annum on a
reducing balance basis. The tax written down value on WL's present fixed assets at 1
December 2020 is Rs. 9,000 million.
(v) For 2025, and each year thereafter, annual capital expenditure on aircraft is equal to the
cash inflow from tax saved on capital allowances in that year.
(vi) Annual corporate tax is expected to remain at 29%.
(vii) For the years 2021 to 2024, additional working capital equivalent to 10% of the increase in
revenue for that year, will be required. Working capital cash flows occur at the end of the
year in which the increase in revenue arises.
(viii) For 2025 and onwards, the annual increase in working capital requirements is Rs. 10 million
per annum.
(ix) WL has Rs. 1,000 million long-term debt at 4.8% interest per annum.
Information on SIL
The current paid-up capital of SIL is two million shares. Each share is currently trading at Rs. 4,300
per share.
SIL currently has Rs. 2,000 million of corporate bonds. The average maturity of SIL’s corporate bonds
is 18 years. SIL currently has 'AA' credit rating.
Market information
Quoted credit spread for corporates in the airline sector are as follows:
The current yield on Pakistan government bonds is 3.75% for all bond maturities. The current market
return on the Pakistan equity market portfolio is 6.85% and the Pakistan corporate tax rate is
expected to be 29% for the foreseeable future.
The average airline industry equity beta is 2.45 at 50% gearing (measured as debt/equity).
Share offer
The directors of SIL are considering making a two for one share offer which will replace each existing
WL’s shares with two new SIL’s shares.
Required:
(a) Determine a valuation for WL’s equity shares by using SIL's risk adjusted weighted average cost
of capital. (20)
As a result of the merger, the directors of SIL expect to make cost efficiencies in the new merged
group with a present value of at least Rs. 3,000 million.
Required:
(b) Compare the value of SIL and WL shareholdings before and after the merger to determine if
their shareholders are likely to accept the terms of the share for share exchange offer proposed
by SIL’s directors. (05)
QUESTION – 27
Alpha Foods Limited (Alpha) is a listed, food processing company based in Karachi which
manufactures canned and boxed vegetable and crop based products.
Alpha is currently in the final stages of negotiation to purchase a listed frozen food production
company, Fresh & Frozen Limited (FF), which supplies supermarkets throughout Pakistan with frozen
fruits and vegetables and other frozen, processed foods. The directors of Alpha are confident that
the proposed acquisition is a good strategic fit and are expecting to negotiate a price close to FF's
current traded share price.
Should the acquisition of FF reach agreement and proceed, the two companies will be merged into
a new listed entity, Alpha Fresh & Frozen Limited (AFFL), which is expected to commence trading
with an uplift of 7.5% on the current combined equity values of Alpha and FF.
Current market information:
Alpha Foods Limited Fresh & Frozen Limited

Number of shares 100 million 30 million
Long term bank loans at 5.5% Rs. 11,500 million Rs. 4,500 million
annual interest
Quoted equity beta 1.454 2.585
Share price Rs. 435.75 Rs. 722.40
The current yield on Pakistan government bonds is 3.85%. The current market return on the Pakistan
equity market portfolio is 6.65% and Pakistan's corporate tax rate is expected to be 29% for the
foreseeable future.
Information about the new corporate debenture
Alpha is expected to raise a new six-year 6.5% coupon corporate debenture for Rs. 22,500 million on
the day of acquisition to finance the purchase of FF. The new debenture is expected to be issued at
95.8% of its par value (where par equals 100) and will redeem in six years' time at a 5% premium
above its par value.
Investors’ concerns
Certain significant institutional investors have expressed concern that the proposed acquisition of FF
will be funded by further debt finance which may exceed 30% gearing, measured as debt/(debt plus
equity), which is considered to be the highest comfortable level of gearing by investors for companies
operating in the food processing industry.
A major institutional shareholder is also concerned about the impact on the weighted average cost
of capital (WACC) as a result of the acquisition.
Required:
(a) Calculate the current gearing of Alpha and the expected gearing level of the new combined
entity, AFFL, immediately following the proposed acquisition and evaluate the result. (04)
(b) Forecast the expected after-tax WACC of AFFL immediately following acquisition. (09)
To manage the debt position, the directors of Alpha are considering divesting a currently
profitable trading division which manufactures rice based processed food products. This sale
is expected to raise a minimum of Rs. 8,500 million which will be solely used to reduce the
value of the remaining bank loans. The directors are confident this strategy will be favourably
received by institutional investors and expect AFFL's post-acquisition share price to remain
unaltered, following the sale.
(c) Determine the expected impact on gearing and WACC immediately following the proposed
sale of the division and recommend after critically evaluating the directors’ view, if Alpha
should proceed with the sale.
(07)

SOLUTIONS
Answer to Q-1
Market Price of Share
Ke = Rf + (Equity Premium x Equity Beta)
= 9% + (6.25% x 1.6)
= 19%
Rs.
Current dividend expected (Rs.1.25 x (1+10%) 1.375
Present value of all future dividends:
( ) . ( %)
= = 16.608
% %
Market price per share 18.181
Market price of TFCs

Calculation of TFCs Market Price (cum interest)
Factor Amount PV
(Rs.) (Rs.)
PV of 1st coupon today 1.000 6.00 6.00
PV of 5 coupons today @ 11% 3.696 6.00 22.18
PV of Redemption today @ 11% 0.593 130.98 77.67
(W-1)
Market Price today (cum interest) 105.84
*KIBOR + 2% i.e. prevailing commercial rate
(W-1) Calculation of Redemption Price

Rs.
Issue Price 100.00
Less: Present value of coupons at 10% (4.355[Factor] x Rs.6) 26.13
Hence PV of Redemption Price must be 73.87
Price on redemption @ 10% (Rs.73.87 / 0.564 [Factor]) 130.98
(b)
Weighted Average Cost of Capital
Price No. of Value Cost %
Rs. shares Rs.
Million
Equity (Ex-Dividend) 16.806 40,000,000 672 19.00%
TFCs (Ex-interest) *99.84 **5,410,000 540 11.00%
Bank Loan (equals to book value) 80 12.00%
1,292
*Rs. 105.84 - 6 = 99.84
**Rs. 595/1.1 = 541m / Rs. 100 = 5.41 million shares
WACC = WeKe + Wdkd (1 - T) + Wdkd (1 - T)
= x 19% + x 11% x 65% + x 12% x 65% = 13.35%

, , ,
Answer to Q-2
(i) P/E Ratio Method
As the P/E ratio reflects what the market believes will be the company’s future earnings, it
would appear sensible the ratio to the average of future profits over the next five years,
calculates as follows.
Rs.
Year 1 85,000
Year 2 (1.05 x year 1) 89,250
Year 3 (1.05 x year 2) 93,713
Year 4 (1.05 x year 3) 98,399
Year 5 (1.05 x year 4) 103,319
469,681
Average (469,681/5) 93,936
.
Earnings per share = = Rs. 0.469
,
Value of ordinary share = P/E ratio x EPS

*
= 7 x Rs. 0.469
= 3.283
* It is a subjective figure. Apparent average of all companies in industry is 9, which is again
adjusted subjectively downwards to 7.
(ii) Dividend Yield Method

Assuming the level of dividend paid in the past will continue into the future, the future
dividend per share will be:
. ,
= Rs. 0.15
,
*
The value of an ordinary share is then Rs.0.15 / 20% = Rs. 0.75
* It is a subjective figure. Apparent average of all companies in industry is 17%, which is again
adjusted subjectively upwards to 20%.
(iii) Book Value Method

Rs.
Share capital 200,000
Reserves 595,000
795,000
. ,
Value per ordinary share = = 3.975
,
(iv) Realizable Value Method

A disadvantage of this valuation basis, is that it ignores the company’s future earnings
prospects.
Rs. Rs.
Fixed assets at valuation
Land and buildings 610,000
Plant and equipment 288,000
Motor vehicles 102,000
1,000,000
Current assets – as per balance sheet 293,000
Less: Current liabilities 180,000
Loan 150,000
(330,000)
963,000
. ,
Value per share =
,
= 4.815
(v) Present Value of Future Cash Flows:
Year Cash flow Discount PV

(Rs.) Factor at (Rs.)
17.5%
1 110,000 0.85 93,500
2 120,000 0.72 86,400
3 130,000 0.62 80,600
4 140,000 0.52 72,800
5 150,000 0.45 67,500
Present value of company 400,800
No information is given about cash flows after year 5. Therefore, assumptions may be used.
Here it has been assumed that cash flow of year 5 will continue in perpetuity afterwards.
PV of perpetuity end of year 5 = 150,000 x

.
= Rs. 857,143
PV of perpetuity at beginning of year 1 = 857,143 x 0.45

= Rs. 385,714
Total PV of Company = 400,800 + 385,714
= Rs. 786,514
Value of equity = 786,514 – 150,000 = Rs. 636,514
Value per Share = Rs. 636,514/200,000
= Rs 3.18
Answer to Q-3
Existing capital structure 40:60*
WACC = x Ke + x Kd(1 - 30%)
= x 17.4%(W-1) + x 9%(1 – 30%) = 12.96%
Corporate value = Rs. 763 million

*Existing D:E Ratio
Existing gearing = = 40% hence existing debt equity is 40:60.
(i) Debt Equity 20:80
WACC = Ke x We + Kd x Wd
= 15.02%(W-1) x 80% + 8% (W-2) (1 – 30%) x 20% = 13.14%
[ . % (𝑾 𝟒)]
Corporate value= = 743 million
. % . %
(ii) Debt Equity 60:40
= 22.08% (W-1) x 40% + 11%(W-2) (1 – 30%) x 60% = 13.45%
[ . % (𝑾 𝟒)]
Corporate value= = 718 million
. % . %
(W-1) Existing
Ke = 5.5% + 1.4(14% - 5%) = 17.4%
Debt equity 20:80
Ke = 5.5% + 1.12(W-3)(14% - 5.5%) = 15.02%
Debt equity 60:40
Ke = 5.5% + 1.95(W-3)(14% - 5.5%) = 22.08%
(W-2) Cost of debt

 At 80% equity 20% debt
It is assumed that with decrease in debt, credit rating will improve to AA as
shown below:
Debt = Rs. 305 million x 20/40 = Rs. 152.5 million
Cost of debt = (8% x 152.5) = Rs. 12.2 million
Interest cover = 90 / 12.2 = 7.38
∴ pre tax Kd = 8%
It is assumed that with increase in debt, credit rating will fall to BB as shown
below:
Debt = Rs. 305 million x 60/40 = Rs. 457.5 million
Cost of debt = (11% x 457.5) = Rs. 50.325 million
Interest cover = 90 / 50.325 = 1.78
∴ pre tax Kd = 11%
(W-3) βa = 1.4 x = 0.954

( %)
Debt equity 20:80

βe = 0.954 /( ) = 1.12
( %)
Debt equity 60:40

βe = 0.954 /( ) = 1.95
( %)
(W-4) Company’ free cash flows = 90(1 – 30%) + 20 – 20 = 63

So;
( )
763 =
. %
g = 4.3%
Answer to Q-4
(a) (i) Weighted average cost of capital
 Existing WACC = (Equity % (W-1) x Ke (W-2)) + (Debt % (W-1) x Kd (1-t))
= (60% x 17% (W-2) ) + (40% x 9% x 65%) = 12.54%
 70% equity 30% debt

WACC = (70% x 15.9% (W-2)) + (30% x 8% (W-3) x 65%) = 12.70%
 50% equity 50% debt
WACC = (50% x 18.5% (W-2)) + (50% x 11% (W-3) x 65%) = 12.83%
(ii) Value of the company
 Current value of the company (825+550) = Rs. 1.375 million

 Value of the company at 70% equity 30% debt
WACC (Computed above) = 12.70%
Valuation =
. .
Valuation = = 1350 million
. . ( )
 Value of the company at 50% equity 50% debt

WACC (Computed above) = 12.83%
. .
Valuation = = 1330 million
. . ( )
W-1 Existing debt equity ratio
Equity = = 60%
Debt = = 40%
W-2 Cost of equity

 Existing
Ke = rf + (rm + rf ) β
Ke = 7% + (15% - 7%) x 1.25 = 17%
 At 70% equity 30% debt

Ke = 7% + (15% - 7%) x 1.115 = 15.9%
( ) % % %
Βe = βa = * 0.872 = 1.115
%
 At 50% equity 50% debt

Ke = 7% + (15% - 7%) x 1.439 = 18.5%
( ) % % %
Βe = βa = * 0.872 = 1.439
%
( )
βa = Β e +𝛽
( ) ( )
= 1.25 + 0 = 0.872
%
W-3 Cost of debt
Since interest cover has an inverse relationship, we assume decline in debt
moves the CIL to lower category of interest rate:
30% debt in existing market value of the company (30% x 1375) = 412.5
Cost of debt = (8% x 412.5) = 33
Interest cover = (327* ÷ 33) = 9.91
∴ Kd = 8%
* Profit before interest and tax
Since interest cover has an inverse relationship, we assume increase in debt
moves the CIL to upper category of interest rate:
50% debt in existing market value of the company (50% x 1375) = 687.5
Cost of debt is = (11% x 687.5) = 75.63
Interest cover = (327 ÷ 75.63) = 4.32
Kd = 11%
Rs. in million
W-4 Current Free cash flow (FCFo)
Profit before tax 272.00
Add: Interest 55.00
Profit before tax and interest 327.00
Less: Income tax @ 35% 114.45
Profit after tax 212.55
Add: Depreciation 50.00
Less: Capital expenditures (150.00)
Free cash flow 112.55
W-5 Computation of growth factor
Current valuation = 1,375 =

( )
. ( )
1,375 = ⇒ 1,375 = ⇒ 𝑔 = 4.03%
( ) .
(b) Evaluation of the above options

(i) The existing debt equity structure gives the lowest WACC i.e. 12.54%.
(ii) If debt equity ratio is decreased, some of the benefits of tax shield on debt are lost.
(iii) If debt equity ratio is increased, the financial risks cause an increase in the cost of debt.
Since the existing debt equity ratio gives the lowest WACC and resultantly the highest valuation to
the company, the capital structure of the company should not be changed.
Answer to Q-5
Merger with Merger with
PQ RS
Rupees in million
Net profit after tax 124.80 169.00
Synergy impact (W-3) 35.49 45.24
160.29 214.24
Investment required to be made (W-1) 998.00 1,972.00
Return on investment 16.06% 10.86%
Conclusion:
By acquiring PQ (Pvt.) Ltd., the shareholders of MNO Chemicals will earn a higher return on
investment as compared to the acquisition of RS. Hence, acquisition of PQ is financially feasible for
the shareholders of MNO Chemicals.
(W–1) Value of equity i.e. investment required to be made by MNO

( ) . ( %)
Value of PQ = = = 998 million
% (𝐖 𝟐) – %
( ) ( %)
Value of RS = = = 1,972 million
% (𝐖 𝟐) – %
(W-2) Cost of equity (ke)

ke = Rf + β(Rm – Rf)
Cost of equity of RS Ltd. = 8% + 1.2(13% – 8%) = 14%
Cost of equity of PQ (Pvt.) Ltd. = Re of RS Ltd. + Illiquidity premium = 14% + 3% = 17%

(W-3) Synergy Impact

PQ RS
Rupees in
million
Net profit after tax of MNO 585.00 585.00
Net profit after tax of PQ 124.8 -
Net profit after tax of RS - 169.00
709.8 754.00
Synergies impact on profitability 5% 6%
Synergy impact 35.49 45.24
Answer to Q-6
(a) Calculation of WACC
( ) ( )
WACC = ke (W -1) + 𝑘𝑑(𝑊 − 3)(1 − 𝑇)
, 2,131.50
WACC (Chemicals) = 15.2% + 7.76% = 10.76%
, , . 1,443 2,131.50
, 1,979.50
WACC (Paints) = 15.55% + 7.76% = 10.63%
, , . 1,157 1,979.50
W-1: Cost of equity

Ke = rf + [rm – ef] 𝛽
(Chemicals) = 8% +[14% – 8%]1.2 = 15.2%
(Paints) = 8% +[14% – 8%]1.259 (W-2) = 15.55%
Debt equity ratio of Chemicals is same as industry (W-4). Therefore, we use the
market beta for determination of cost of equity.
W-2: Determination of 𝜷 of Paints
Since the debt equity ratio of Paints i.e. 63:37 (W-4) differ from the industry gearing
level, we must un-gear the industry beta and must re-gear the asset beta to take into
account the differing capital structure. Here it is assumed that debt is risk free.
30
𝛽𝑎= 𝛽𝑒 =150 x = 0.596
(1-T) ( . )
Re-gearing
(1-T) 1,157 1,979.50(1-0.35)
𝛽𝑒 = 𝛽a =0.596 x = 1.259
.
W-3: Cost of debt

Cash Discount Discount
Year PV Pv
flows factor factor
Rs. 6% Rs. 10% Rs.
Market value 0 (101.50) 1.000 (101.50) 1.000 (101.50)
Interest 1-10 7.80 7.360 57.41 6.145 47.93
Capital repayment 10 100.00 0.558 55.80 0.386 38.60
11.71 (14.97)
11.71
𝐾 (1 - t) = a + ( ) (b - a) = 6% + × (10% − 6%) = 7.76%
11.71-(-14.9)
W-4: Net assets of each company

Chemicals Paints
-----------Rs. in million----------
Non-current assets 6,610.00 5,250.00
+ Current assets 7,930.00 6,300.00
- Long term debt (2,100.00) (1,950.00)
- Current liabilities (4,770.00) (3,505.00)
Net assets 7,670.00 6,095.00
Shares to be split (7670 : 6095) A (Shares in million) 111 89

Market price per share B Rs. 13 13
Market value of equity A× B Rs. In million 1,443 1,157
Market value of the debt
Chemicals : 2,100 × 101.5 ÷ 100 Rs. In million 2,131.50
Paints : 1,950 × 101.5 ÷ 100 Rs. In million 1,979.25
Debt equity ratio 60 : 40 63 : 37
(b)
Chemicals Paints segment
segment
Year 1 Year 1
--------Rs. in million--------
Net operating cash flows (W-1) 415.77 224.23
Less: Tax depreciation (70.00) (40.00)
345.77 184.23
Tax @ 35% (121.02) (64.48)
224.75 119.75
Add: Tax depreciation 70.00 40.00
294.75 159.75
Discount factor [Chemicals @10.76%(part (a));
Paints @10.63%(part (a)] *17.3611 *17.7620
PV cash flows (Value of the company) 5,117.19 2,837.47
*11 ÷ (10.76% - 5%)
*1 ÷ (10.63% - 5%)
Conclusion:
Rs. in million
Total value of two companies (Rs. 5,117.19 + Rs. 2,837.47) 7,954.66
Less: Value of debt (Rs. 2,131.50 + Rs. 1,979.25) (4,111.75)
Value of equity after demerger 3,842.91
Less: Value of equity before demerger (Rs. 13 × 200) (2,600.00)
Gain to existing shareholders due to demerger (1,249.16)
As the existing shareholders would have a gain due to demerger, it would be financially
advantageous for the KLR to separately float the company.
Chemicals Paints
Rs. in million
W-1: Net operating cash flows
Net operating cash flow (as given) 280.00 360.00
Adjustments:
Impact of common expenses
Common expenses shared (3150 : 2500) 55.75 44.25
Actual common expenses (70.00) (30.00)
(14.25) 14.25
Gross profit (net of tax) on sale of raw materials to Paints 150.02 (150.02)
(W-2)
415.77 224.23
W-2: Gross profit on sale of raw material to Paints
Total Sales to Other
revenues Paints revenue
Segment
--------Rs. in million--------
Revenue 3,150.00 787.50 2,362.50
Less: Cost of sales (2,772) (787.50) (1,984.50)
Gross profit 378.00
GP markup % (378.00 ÷ 1,984.50) 19.05%
Gross profit to be earned on sales to Paints Segment (787.50×19.05%) 150.02
Answer to Q-7
Jazba
Free cash flow:
Cost of equity using CAPM:
Ke = 4% + (11% - 4%) 1.18 = 12.26%
Weighted average cost of capital:
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑘𝑒 + 𝑘𝑑(1 − 𝑡) = 12.26%(0.7) + 6%(1 − 0.3)(0.3) = 9.84%
𝐸+𝐷 𝐸+𝐷
(N.B. rounded discount rates for example 10% are also acceptable in the solution)
Jazba Rs. ‘000’

1 2 3 4
Sales revenue 14,000 14,700 15,435 16,206
Operating Costs (10,640) (11,172) (11,730) (12,317)
EBIT 3,360 3,528 3,705 3,889
Tax (30%) (1,008) (1,058) (1,112) (1,167)
Add back depreciation 1,523 1,599 1,679 1,762
Replacement investment (1,680) (1,764) (1,852) (1,945)
Free cash flow 2,195 2,305 2,420 2,539
Discount factors (9.84%) 0.910 0.829 0.755 0.687
Present values 1,997 1,911 1,827 1,744
2,539(1.04 )
𝑉𝑎𝑙𝑢𝑒 𝑏𝑒𝑦𝑜𝑛𝑑 𝑦𝑒𝑎𝑟 𝑓𝑜𝑢𝑟 𝑖𝑠 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜 𝑏𝑒: 𝑥0.687 = 31,063
0.0984 − 0.04
The estimated value of Jazba is Rs.38,542,000
Zoom
Cost of equity using CAPM:
ke =4%+ (11% -4%) 1.38 = 13.66%
Weighted average cost of capital:
WACC = 13.66% (0.45)+7.5% (1-03)(0.55) = 9.03%
Zoom Rs. ‘000’
1 2 3 4
Sales revenue 10,011 10,662 11,355 12,093
Operating costs (6,976) (7,429) (7,912) (8,426)
EBIT 3,035 3,233 3,443 3,667
Tax (30%) (911) (970) (1,033) (1,100)
Free cash flow 1,975 2,105 2,241 2,387
Present values 1,811 1,770 1,730 1,690
2,387(1.05 )
𝑉𝑎𝑙𝑢𝑒 𝑏𝑒𝑦𝑜𝑛𝑑 𝑦𝑒𝑎𝑟 𝑓𝑜𝑢𝑟 𝑖𝑠 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜 𝑏𝑒: 𝑥 0.708 = 44,032
0.0903 − 0.05
The estimated value of Zoom is Rs. 51,034,000
Combined Company
Market value of equity Rs. in million
Jazba (7 million x 298 paisas) 20.86
Zoom [8 million x (4 x 298)/5] 19.07 (Reflecting the bid value)
Market value of debt
Jazba (20.86/07 x 0.3) 8.94
Zoom [(8 million x 192 paisas)/0.45 x 0.55] 18.77
67.64
Weighted average of capital:

20.86 19.07 8.94 18.77
𝑊𝐴𝐶𝐶 = 12.26% + 13.66% + 6%(1 − 0.3) + 7.5%(1 − 0.3)
67.64 67.64 67.64 67.64
WACC = 9.64%
Combined Company Rs. ‘000’
1 2 3 4
Sales revenue 24,097 25,543 27,075 28,700
Operating costs 70% (16,868) (17,880) (18,953) (20,090)
EBIT 7,229 7,663 8,122 8,610
Tax (30%) (2,169 (2,299) (2,437) (2,583)
Free cash flow 4,753 5,038 5,340 5,661
Present values 4,335 4,192 4,053 3,917
5,661(1.05)
𝑉𝑎𝑙𝑢𝑒 𝑏𝑒𝑦𝑜𝑛𝑑 𝑦𝑒𝑎𝑟 𝑓𝑜𝑢𝑟 𝑖𝑠 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜 𝑏𝑒: 𝑥 0.692 = 88,648
0.0964 − 0.05
The estimated value of the combined company is: Rs. 105,145,000
The sum of the individual companies is: Rs. 38,542,000 + Rs. 51,034,000 = Rs. 89,576,000
The expected synergy is Rs. 15,569,000 [105,145,000 – 89,576,000].
Answer to Q-8
(a) VALUE OF MK LIMITED
Years
1 2
Rupees in million
Sales 4% 12,480 12,979
Operating costs including depreciation 75% (9,360) (9734)
Profit before interest and tax 3,120 3,245
Taxation 35% (1092) (1136)
Add back depreciation 4% 1,357 1,411
Annual capital expenditure 4% (728) (757)
Free cash flow 2,657 2,763
Discount factor (W-1) 9.8% 0.911 0.830
Present value 2,421 2,293
Present value 1-2 years (2,421 + 2,293) 4,714
, ( . )
Free cash flow after year 2 = x 0.83 = Rs. 50,166 million
. .
Total free cash flows = (4,713 + 50,166) = Rs. 54,879 million

(W-1)
D/E Ratio Rate WACC
ke - (8% + (13% - 8%) x 1.1) 60% 13.50% 8.1%
kd - (6.5% x 0.65) 40% 4.23% 1.7%
WACC 9.8%
VALUE OF ZA LIMITED
Years
1 2
Rupees in million
Sales 5.5% 8,925 9,416
Operating costs including depreciation 5.5% (6,219) (6,561)
Taxation 35% (947) (999)
Add back depreciation 5.5% 1,044 1,101
Annual capital expenditure 5.5% (686) (724)
Present value 1,939 1,873
2,233(1.05)
0.092-0.05
(W-2)
Rate D/E Ratio WACC
ke - (8% + (13% -8%) X 1.3 14.5% 45.00% 6.5%
kd - (7.5% x 65%) 4.88% 55.00% 2.7%
WACC 9.2%
VALUE OF PROPOSED MERGED COMPANY

Year 1 Year 2
Rupees in million
Combined Sales 5% 21,483 22,557
Operating costs including depreciation 70% (15,038) (15,790)
Taxation 35% (2,256) (2,368)
Add back depreciation 5% 2,410 2,531
Annual capital expenditure 5% (1,418) (1,489)
Present value (Free cash flows x discount factor) 4,720 4,516
, ( . )
. .
(W-3)
Equity - MK (100 x 20) 2,000 13.50% 270.00
Equity - ZA (90 x 7/9 x 20) 1,400 14.5% 203.00
Debt - MK (2,000 x 40% / 60%) 1,333 4.23% 56.39
Debt - ZA (90 x 12 x 55% / 45%) 1,320 4.88% 64.42
Total equity + debt of merged company 6,053 593.80
WACC (593.80/6,053) 9.8%
(b) SYNERGY EFFECT OF ACQUISITION

Total free cash flow of Merged Co.
Rs. million
120,036
Total free cash flow of MK Limited 54,879
Total free cash flow of ZA Limited 50,649
105,528
Synergy effect of acquisition 14,508
Answer to Q-9
(a)
Value of Prodco Ltd. (After considering the effect of merger) Rupees
Existing value of Prodco [14,000,000 x 8.4] 117,600,000
Value addition:
Nordik value [(9,337,500 – 1,500,000) x 1.2 x 8 (W-1) 75,240,000
Sale of division 10,200,000
Sale of property 16,000,000
Redundancy cost (4,500,000)
[A] 214,540,000
No. of shares [B] 24,000,000
Price per share – Prodco [A / B] 8.94
Price per share – Nordik 1.99
(using exchange ratio)
i.e. Rs. 8.94 x 2 shares = Rs. X x 9 shares
W-1
P/E ratio [45m x 1.66 / 9.3375m] 8.00
(b)
Existing – Prodco shares 14,000,000
Existing – Nordik shares 45,000,000
Target share price for Nordik [1.66 x 1.1] 1.826
Exchange ratio can be found by solving following equation

214,540,000
x exchange ratio=1.826
14,000,000+45,000,000 x exchange ratio
Solving:
Exchange ratio = 0.2 OR 1 for 5 shares
Answer to Q-10
2011 2012 2013 2014 2015
---------------------- Rs. million ---------------------
Loan (Rs. in million) (500) (600) (500)
Interest on loan 10% - 50 110 160 160
Loan repayment 1,600
Exit price [Year 5 PAT(W-1) x 16 x 60%] 4,848
(500) (550) (390) 160 6,608
D.F. 20% 0.833 0.694 0.579 .482 0.402
(417) (382) (226) 77 2,656
Price 1,708
(W – 1) Profit after tax ---------------------- Rs. million ---------------------

Sales (W-2) 15,791 17,785 22,116 25,552 28,265
Power Generation cost (15,951) (17,246) (20,621) (23,229) (25,069)
Other expenses (324) (350) (378) (408) (441)
Additional staff (15) (17) (18) (20) (22)
Bad debts (1,263) (1,067) (885) (767) (848)
PBIT (1,762) (895) 214 1,128 1,885
Interest (W-3) (819) (1,085) (1,239) (1,280) (1,380)
(2,581) (1,980) (1,025) (152) 505
(W – 2) Sales ------------------------ million KWH -------------------------
Demand [LY x 1.05] 2,100 2,205 2,315 2,431 2,553
Capacity 2,100 2,100 2,415 2,415 2,415
Production [A] 2,100 2,100 2,315 2,415 2,415
Line losses [B] 28% 25% 22% 20% 18%
Billed [C = A x (1 – B)] 1,512 1,575 1,806 1,932 1,980
Generation cost (Rs./Kwh) [D] 7.56 8.16 8.82 9.52 10.29

[LY x 1.08]
Total cost: --------------------------- Rs. million -------------------------

Generation cost [C x D] 15,876 17,146 20,416 22,999 24,839
Depreciation – existing 75 75 75 75 75
Depreciation – new plant - - 75 75 75
Depreciation – infrastructure - 25 55 80 80
15,951 17,246 20,621 23,229 25,069
Sales (using given formula) 15,791 17,785 22,116 25,552 28,265

(W – 3) Interest
Markup on TFC 210 210 210 210 210
Interest on ARA loan 50 110 160 160
Interest on OD (W-4) 609 825 919 910 1,010
819 1,085 1,239 1,280 1,380
(W – 4) Interest on OD --------------------- Rs. million ---------------------

b/d (2,785) (5,290) (7,170) (7,990) (7,912)
PBIT + depreciation (1,687) (795) 419 1,358 2,116
Markup on TFC (210) (210) (210) (210) (210)
Loan repaid (1,600)
Interest on ARA loan - (50) (110) (160) (160)
(4,682) (6,346) (7,071) (7,002) (7,767)
Interest @ 13% (609) (825) (919) (910) (1,010)
(5,290) (7,170) (7,990) (7,912) (8,776)
Answer to Q-11
Growth Y-0 Y-1 Y-2 Y-3 Y-4 Y-5
Sales % ……………….Rs. in million………………..
Generic 10% 720 792.00 871.20 958.32 1,054.15 1,159.57
Patented other than Z-11 10% 864 950.40 1,045.44 1,149.98 1,264.98 1,391.48
Z-11(Note 1) 10% 216 237.60 261.36 287.50 223.24 245.56
Less: Variable costs of production
Generic 10% (336.60) (370.26) (407.29) (448.01) (492.82)
Patented other than Z-11 10% (285.12) (313.63) (344.99) (379.49) (417.44)
Z-11 10% (71.28) (78.41) (86.25) (94.88) (104.36)
Less: Fixed costs other than depreciation 5% 90 (94.50) (99.23) (104.19) (109.40) (114.87)
Less: Depreciation (100.00) (100.00) (100.00) (100.00) (100.00)
Less: Selling expenses 7% 360 (252.00) (269.64) (288.51) (308.71) (330.32)
Less: Admin. Expenses 5% 90 (18.00) (18.90) (19.85) (20.84) (21.88)
Less: Royalty on patented items (Note 2) (178.20) (196.02) (215.62) (189.75) (208.72)
Less: Technical fee (Total sales x 3%) (59.40) (65.34) (71.87) (76.27) (83.90)
Adjusted profit before tax 584.90 666.57 757.23 815.02 922.30
Taxation (35%) (204.72) (233.30) (265.03) (285.26) (322.81)
Profit after tax 380.18 433.27 492.20 529.76 599.49
Add: Depreciation 100.00 100.00 100.00 100.00 100.00
480.18 533.27 592.20 629.76 699.49
Terminal value (Note 3) 4,238.09
Total cash flows 480.18 533.27 592.20 629.76 4,937.58
Discount factor at WACC of 20% 0.833 0.694 0.578 0.482 0.402
Discounted cash flows 400 370 342 304 1,985
Maximum bid price 3,401
Notes
1. Sales of Z-11 in Year 4 = 94.88 ÷ 42.5% [W-1]
2. Up to Year 3, 15% royalty would be charged on all patented products, from year 4 onward,
royalty would be charged on patented products other than Z-11.
. ( %)
3. Terminal value = = 4,238.09
% %
(W-1) Determination of variable costs to sales %

Sale
Patented Generic Total
Sales in Year 0 Rs. 1,080 Rs. 720 Rs. 1,800
Variable cost of production Rs. 324 Rs. 306 Rs. 630
Variable costs to sales % 30.00% 42.50% 35.00%
Answer to Q-12
----------------------------- Rs. 000 ------------------------------------
Year 1 Year 2 Year 3
Revenue (9% growth) 5,450 5,941 6,475
Cost of sales (9% growth) (3,270) (3,564) (3,885)
Operating costs (W-1) (2,012) (2,159) (2,317)
Interest (74) (74) (74)
Profit before tax 94 144 199
Taxation (15) (28) (43)
Depreciation (W-2) 134 144 155
Working capital investment (W-3) (20) (21) (24)
Capex (79) (95) (114)
Free cash flow to equity 114 144 173
Terminal value [173 x 1.03 / (10% - 3%) 2,546
114 144 2,719
Discount factor 0.909 0.826 0.751
Present value 104 119 2,043
Value of equity 2,266
W-1 Operating cost

Variable cost (9% growth) 818 891 971
Fixed cost (6% growth) 1,060 1,124 1,191
Depreciation (W-2) 134 144 155
2,012 2,159 2,317
W-2 Capex and depreciation

Opening cost 1,266 1,345 1,440
Addition (20% growth) 79 95 114
Closing cost 1,345 1,440 1,554
Depreciation 10% 134 144 155
W-3 Working capital investment

Working capital balance (9% growth) 240 261 285
Change 20 21 24
* Initial WC = 270 – 50 = 220
Answer to Q-13
(i) The calculations and estimations for part (i) are given in the appendix. To assess whether or
not the acquisition would be beneficial to Big’s shareholders, the additional synergy benefits
after the acquisition has been paid for need to be ascertained.
The estimated synergy benefit from the acquisition is approximately Rs. 9,074,000 (see
appendix), which is the post-acquisition value of the combined company less the values of the
individual companies. However, once Small Co’s debt obligations and the equity shareholders
have been paid, the benefit to Big Co’s shareholders reduces to approximately Rs. 52,000
(see appendix), which is minimal. Even a small change in the variables and assumptions could
negate it. It is therefore doubtful that the shareholders would view the acquisition as beneficial
to themselves or the company.
(ii) The current value of Big Co is Rs. 140,000,000, of which the market value of equity and debt
are Rs. 70,000,000 each. The value of the combined company before paying Small Co
shareholders is approximately Rs. 189,169,000, and if the capital structure is maintained, the
market values of debt and equity will be approximately Rs. 94,584,500 each. This is an increase
of approximately Rs. 24,584,500 in the debt capacity.
The amount payable for Small Co’s debt obligations and to the shareholders including the
premium is approximately Rs. 49,116,500 [4,009 + 36,086 x 1·25]. If Rs. 24,584,500 is paid
using the extra debt capacity and Rs. 20,000,000 using cash reserves, an additional amount
of approximately Rs. 4,532,000 will need to be raised. Hence, if only debt finance and cash
reserves are used, the capital structure cannot be maintained.
APPENDIX
Part (i)
Interest is ignored as its impact is included in the companies’ discount rates
Small cost of capital
Ke = 4·5% + 1·53 x 6% = 13·68%
Cost of capital = 13·68% x 0·9 + 9% x (1 - 0·28) x 0·1 = 12·96% assume 13%
Small
Sales revenue growth rate = (16,146/13,559)1/3 - 1 x 100% = 5·99% assume 6%
Operating profit margin = approx. 32% of sales revenue
Small Co cash flow and value computation (Rs. 000)

Year 1 2 3 4
Sales revenue 17,115 18,142 19,231 20,385
Operating profit 5,477 5,805 6,154 6,523
Tax (1,534) (1,625) (1,723) (1,826)
Additional investment [22% x change in sales] (213) (226) (240) (254)

Free cash flows 3,730 3,954 4,191 4,443
Present value at 13% 3,301 3,097 2,905 2,725
Rs. (000)
PV (first 4 years) 12,028
PV (after 4 years) [4,443 x 1·03/(0·13 - 0·03)] x 1·13-4 28,067
Firm value 40,095
Combined Company: Cost of capital calculation
Asset beta (Big Co) = 1·18 x 0·5/(0·5 + 0·5 x 0·72) = 0·686
Asset beta (Small Co) = 1·53 x 0·9/(0·9 + 0·1 x 0·72) = 1·417
Asset beta of combined co. = (0·686 x 140,000 + 1·417 x 40,095)/(140,000 + 40,095) = 0·849
Equity beta of combined company = 0·849 x (0·5 + 0·5 x 0·72)/0·5 = 1·46
Ke = 4·5% + 1·46 x 6% = 13·26%
Cost of capital = 13·26% x 0·5 + 6·4% x 0·5 x 0·72 = 8·93%, assume 9%
Combined Co cash flow and value computation (Rs. 000)
Sales revenue growth rate = 5·8%, operating profit margin = 30% of sales revenue
Year 1 2 3 4
Sales revenue 51,952 54,965 58,153 61,526
Operating profit 15,586 16,490 17,446 18,458
Tax (4,364) (4,617) (4,885) (5,168)
Additional investment [18% x change in sales] (513) (542) (574) (607)
Free cash flows 10,709 11,331 11,987 12,683
Present value at 9% 9,825 9,537 9,256 8,985
Rs. (000)
PV (first 4 years) 37,603
PV (after 4 years) [12,683 x 1·029/(0·09 - 0·029)] x 1·09-4 151,566
Firm value 189,169
Synergy benefits = 189,169,000 - (140,000,000 + 40,095,000) = Rs. 9,074,000
Estimated premium required to acquire Small Co = 0·25 x 36,086,000 = Rs. 9,022,000
Net benefit to Big Co shareholders = Rs. 52,000
Answer to Q-14
(a) Maximum premium based on excess earnings method
Average pre-tax earnings: (397 + 370 + 352)/3 = Rs. 373·0m
Average capital employed: [(882 + 210 - 209) + (838 + 208 - 180) + (801 + 198 - 140)]/3
= Rs. 869·3m Excess annual value/annual premium
= 373m - (20% x Rs. 869·3m) = Rs. 199·1m
After-tax annual premium = Rs. 199·1m x 0·8 = Rs. 159·3m
PV of annual premium (assume perpetuity) = Rs. 159·3m/0·07 = Rs. 2,275·7m

According to this method, the maximum premium payable is Rs. 2,275·7m in total.
Maximum premium based on price-to-earnings (PE) ratio method
Yellow Co estimated PE ratio = 16·4 x 1·10 = 18·0
Yellow Co profit after tax: Rs. 397m x 0·8 = Rs. 317·6m
Green Co profit after tax = Rs. 1,980m x 0·8 =Rs. 1,584·0m
Green Co, current value = Rs. 9·24 x 2,400 shares = Rs. 22,176·0m
Yellow Co, current value = Rs. 317·6m x 18·0 = Rs. 5,716·8m
Combined company value = (Rs. 1,584m + Rs. 317·6m + Rs. 140·0m) x 14·5 = Rs. 29,603·2m
Maximum premium = Rs. 29,603·2m - (Rs. 22,176·0m + Rs. 5,716·8) = Rs. 1,710·4m
(b) Yellow Co, current value per share = Rs. 5,716·8m/1,200m shares = Rs. 4·76 per share
Maximum premium % (PE ratio) = Rs. 1,710·4m/Rs. 5,716·8m x 100% = 29·9%
Maximum premium % (excess earnings) = Rs. 2,275·7m/Rs. 5,716·8m x 100% = 39·8%
Cash offer: premium (%)
(Rs. 5·72 - Rs. 4·76)/Rs. 4·76 x 100% = 20·2%
Cash and share offer: premium (%)
1 Green Co share for 2 Yellow Co shares
Green Co share price = Rs. 9·24
Per Yellow Co share = Rs. 4·62
Cash payment per share= Rs. 1·33
Total return = Rs. 1·33 + Rs. 4·62 = Rs. 5·95
Premium percentage = (Rs. 5·95 - Rs. 4·76)/Rs. 4·76 x 100% = 25·0%
Cash and bond offer: premium (%)
Each share has a nominal value of Rs. 0·25, therefore Rs. 5 is Rs. 5/Rs. 0·25 = 20
shares Bond value = Rs. 100/20 shares = Rs. 5 per share
Cash payment = Rs. 1·25 per share
Total = Rs. 6·25 per share
Premium percentage = (Rs. 6·25 - Rs. 4·76)/Rs. 4·76 = 31·3%
On the basis of the calculations, the cash together with bond offer yields the highest return; in
addition to the value calculated above, the bonds can be converted to 12 Green Co shares,
giving them a price per share of Rs. 8·33 (Rs. 100/12). This price is below Green Co’s current
share price of Rs. 9·24, and therefore the conversion option is already in-the-money. It is
probable that the share price will increase in the 10-year period and therefore the value of the
convertible bond should increase. A bond also earns a small coupon interest of Rs. 3 per Rs. 100
a year. The 31·3% return is the closest to the maximum premium based on the excess earnings
method and more than the maximum premium based on the PE ratio method. It would seem
that this payment option transfers more value to the owners of Yellow Co than the value created
based on the PE ratio method.
However, with this option Yellow Co shareholders only receive an initial cash payment of Rs. 1·25
per share compared to Rs. 1·33 per share and Rs. 5·72 per share for the other methods. This may
make it the more attractive option for the Green Co shareholders as well, and although their
shareholding will be diluted most under this option, it will not happen for some time.
The cash and share offer gives a return in between the pure cash and the cash and bonds offers.
Although the return is lower, Yellow Co’s shareholders become owners of Green Co and have the
option to sell their equity immediately. However, the share price may fall between now and
when the payment for the acquisition is made. If this happens, then the return to Yellow Co’s
shareholders will be lower.
The pure cash offer gives an immediate and definite return to Yellow Co’s shareholders, but is
also the lowest offer and may also put a significant burden on Green Co having to fund so much
cash, possibly through increased debt.
It is likely that Yellow Co’s shareholder/managers, who will continue to work within Green Co,
will accept the mixed cash and bond offer. They, therefore, get to maximise their current return
and also potentially gain when the bonds are converted into shares. Different impacts on
shareholders’ personal taxation situations due to the different payment methods might also
influence the choice of method.
Answer to Q-15
(a) (i) Share price of GHP after the takeover
EPS of GHP before the takeover (Rs. 6,580 ÷ 300) 21.93
P/E ratio of GHP before the takeover (Rs. 186 ÷ 21.93) 8.48
EPS after takeover (W-1) 29.02
Share price of GHP after the takeover (8.48 x Rs. 29.02) 246.09
W-1: EPS after takeover

Profit after tax - GHP 6,580
Profit after tax - IJQ 3,760
Increase due to synergy 300
Combined earnings after takeover 10,640
No. of GHP's share in issue (300) 300.00

Shares to be issued to IJQ's shareholders (200 ÷ 3) 66.67
366.67
EPS after the takeover (10,640 ÷ 366.67) 29.02
(ii) The cost of equity of the two companies prior to acquisition reflects the different
risk/uncertainty associated with the forecasted cash flows of the two companies.
Assuming that these margins of errors are perfectly correlated (i.e. there are no
favourable ‘portfolio effect’), the cost of equity capital after merger would be
somewhere between the two.
The precise weighting is a moot point, but in any case, GHP is the bigger business.
One of the following basis may be used for the determining the cost of equity of the
merged entity:
On the basis of pre-bid market capitalization
Rs. in million Cost of capital
allocation
Pre bid market capitalization of GHP 55,800 10.76%
(Rs. 186 × 300) (55,800 ÷ 67,400 × 13%)

Pre bid market capitalization of IJQ 11,600 3.10%
(Rs. 58 × 200) (11,600 ÷ 67,400 × 18%)
Total 67,400 13.86%
On the basis of price paid for IJP
Cost of capital
Rs. in million
allocation
Market capitalization of GHP 55,800 10.64%
(Rs. 186 × 300) (55,800 ÷ 68,200 × 13%)
Capitalization of IJQ based on bid pric 12,400 3.27%
e
(Rs. 62 × 200) (12,400 ÷ 68,200 × 18%)
Total 68,200 13.91%
(b) IJQ's shareholders are being offered shares in GHP, currently valued at Rs. 186, in
exchange of every 3 shares they hold in IJQ, currently valued at Rs. 174 (3 × 58). The
offer price represents a premium of Rs. 12 per share to the current market price
which is about 6%. This bid premium seems very low. A fall in share price of about
6% would mean that IJQ's shareholders would suffer loss by agreeing to the takeover
offer.
On the other hand, IJQ’s shareholders might take the view that GHP’s shares are
likely to rise further in value after the takeover because of the effect of synergy.
Accepting the offer from GHP would therefore enable them to make a further capital
gain after the takeover has occurred.
The current share price of GHP is Rs. 186 having risen from Rs. 138 last year. The
increase in price may be on account of market knowledge about the merger or
market speculation about the company’s profit. The possibility that share price will
remain at this level or rise further may be questioned.
Existing EPS and P/E ratio of the two companies are as follows:
EPS P/E ratio
GHP (See req. (a)) Rs. 21.93 (See req. (a)) 8.48
IJQ (3,760 ÷ 200) Rs. 18.80 (58 ÷ 18.8) 3.09
Moreover, there is a small difference in the profitability of the companies and a very
large difference between the P/E ratios at which the two companies are being
valued, adding weight to the concern that either GHP's shares are currently over
valued or IJQ’s shares are undervalued by the market.
IJQ shareholders who want high dividends have the option to sell their shares and
invest in a different company after the merger has taken place and synergy effect
has been absorbed in the share price of the merged entity. Moreover, concerns
about dividend policy may not be relevant for many IJQ shareholders.
Answer to Q-16
Part (a) Taxila Power Limited Rs. (million)
Value of TPL - Existing [A] 560.00
Value of TPL - After Acquisition [B] (W-3) 1,028.00
Value addition [B - A] 468.00
Max price to be paid for DPL 468.00
Workings:
W-1 cost of equity:
Ke = D0 (1+g) / MV + g
Dividend 4.00
MV 56.00
g 12%
Existing Ke 20%
Decrease in Ke 2%
Revised Ke (Reduced by 2%) 18%
W-2 Revised earnings of the new company:

TPL PAT 80.00
DPL PAT 16.00
Increase in combined profits 12.00
Revised earning of the companies 108.00
Revised dividend 54.00
W-3 Revised value
As per DVM:
MV = D0 (1+g)/(Ke - g) 1,008.00
Sale of surplus assets 20.00
Value after acquisition 1,028.00
Part (b) (i)

Existing price 25.60
Take-over premium 20%
Take-over price [A] 30.72
Exchange ratio can be found by solving following equation

1,028m
x exchange ratio = 30.72
10m + 5m x exchange ratio
Solving:
Exchange ratio = 0.3513
Shares to be issued = 5m x 0.3513 = 1.76 million
Part (b)(ii)
Benefit to shareholders of DPL Rs. (in million)
Price offered 153.60
Current value (128.00)
25.60
Benefit to shareholders of TPL
Post-merger value of TPL 1,028.00
Pre-merger value of TPL (560.00)
Price offered for DPL (153.60)
314.40
Part (b)(iii) Other factors to be considered are as follows:
The directors and shareholders of TPL
1. They should consider:
 whether there are any other companies that they might take over instead of DPL:
 whether they could acquire a collection of assets similar to DPL on a cheaper,
piecemeal basis: or
 the assessment of performance forecasts that have been made about the enlarged
companies, especially in relation to the relatively high synergy profits that are
expected to be generated and the reduction in operating risk.
2. The earning of TPL appears to be growing at a rapid annual rate and it seems somewhat
doubtful that this same growth rate could be achieved after acquisition of DPL which, as an
independent company, shows no sign of such dynamism.
3. The issuance of shares to DPL may have an effect on the company's existing share voting
power.
4. Serious consideration should be given to the likely degree of compatibility of the combined
workforces and managements - incompatibility in such aspect has caused many takeovers to
founder in past.
5. They should consider the possible monopoly aspects of the proposed acquisition
The directors and shareholders of DPL

1. They should consider whether:
 the price offered by TPL is equivalent to the value of the company's assets.
 there are any other potential bidders for their company's share capital.
 a higher price should be sought from TPL, so that DPL's shareholders may get some
more synergy benefits which presently go mostly to the shareholders of T PL.
2. The directors should also examine the future prospects for DPL acting an independent unit
and consider how compatible would be the two sets of workforces and managements.
3. Finally, of directors should to the shareholders of DPL, is that they will suffer a substantial
cut in, at least their current dividend prospects if the takeover goes ahead.
To balance against this reduction are the future dividend growth prospects which they would
gain as a result of the takeover.
Answer to Q-17
The valuation of private companies involves considerable subjectivity. Many alternative solutions to
the one presented below are possible and equally valid.
As Strong is considering the purchase of Potential, this will involve gaining ownership through the
purchase of Strong's shares, hence an equity valuation is required.
Before undertaking any valuations it is advisable to recalculate the earnings for 20X6 without the
exceptional item. It is-assumed to be a one-off expense, which was not fully tax allowable.
The revised Income Statement is:
20X6
Rs. 000
Sales revenue 22,840
Operating profit before exceptional Items 1,302
Interest paid (net) 280
Profit before taxation 1,022
Taxation (30%) 307
Profit after tax 715
Dividend 200
Change in equity 515
Asset-based valuation
An asset valuation might be regarded as the absolute minimum value of the company. Asset-based
valuations are most useful when the company is being liquidated and the assets disposed of. In an
acquisition, where the company is a going concern, asset- based values do not fully value future cash
flows, or items such as the value of human capital; market position, etc.
Asset values may be estimated using book values, which are of little use, replacement cost values, or
disposal values. The information provided does not permit a full disposal value, although some
adjustments to book value are possible. In this case an asset valuation might be:
Rs. 000
Net assets 6,286
Patent 10,000
Goodwill (170)
Inventory adjustment (1,020)
15,096 or Rs. 15,096,000
This value is not likely to be accurate as it assumes the economic value of non-current assets is the
same as the book value, which is very unlikely. The same argument may also be related to current
assets and liabilities other than inventory.
P/E ratios
P/E ratios of competitors are sometimes used in order to value unlisted companies.
This is problematic as the characteristics of all companies differ, and a P/E ratio valid for one company
might not be relevant to another.
There is also a question of whether or not the P/E ratio should be adjusted downwards for an unlisted
company, and how different expected growth rates should be allowed for.
Expected earnings growth for Potential is much higher than the average for the industry, especially
during this next three years. In view of this it might be reasonable to apply a P/E ratio at least the
industry average when attempting to value Potential.
The after-tax earnings of Potential, based upon the revised income statement, are:
1,022 - 307 = 715
Using a P/E ratio of30:1, this gives an estimated value of, 715 x 30 = Rs. 21,450,000.
This is a very subjective estimate, and it might be wise to use a range of P/E ratio values, for example
from 25: 1 to 35: 1, which would result in a range of values from Rs. 17,875,000 to Rs. 25,025,000.
It could also be argued that the value should be based upon the anticipated next earnings rather
than the past earnings several months ago.
This is estimated to be:
20X7
Rs. 000
Sales revenue 28,100
Operating profit before exceptional items 2,248
Interest paid (net) 350
Profit before taxation 1,898
Taxation 569
1,329
1,329 x 30 gives a much higher estimate of Rs. 39,870,000
P/E-based valuation might also be criticized as it is based upon profits rather than cash flows.
Dividend-based valuation
Dividend-based valuation assumes that the value of the company may be estimated from the present
value of future dividends paid. In this case the expected dividend growth rates are different during
the next three years and the subsequent period.
The estimated dividend valuation is:
Year 1 2 3 After Year 3
( . )
Expected dividend 250 313 391
. .
Discount factors (14%) 0.877 0.769 0.675 0.675

Present values 219 241 264 7,258
The estimated value is Rs. 7,982,000.
This is a rather low estimated value and might be the result of Potential having a relatively low
dividend payout ratio, and no value being available for a final liquidating dividend.
The present value of expected future cash flows
The present value of future cash flows will be estimated using the expected free cash flow to equity.
In theory, this is probably the best valuation method, but in reality it is impossible for an acquiring
company to make accurate estimates of these cash flows. The data below relies upon many
assumptions about future growth rates and relationships between variables.
20X7 20X8 20X9 After 20X9
Sales revenue 28,100 35,125 43,906
Operating profit 2,248 2,810 3,512
Interest paid (net) 350 438 547
Profit before taxation 1,898 2,372 2,965
Taxation 569 712 890
1,329 1,660 2,075

Add back non-cash expenses 1,025 1,281 1,602
Less increase in working capital (172) (214) (268)
Less capital investment (1,250) (1,562) (1,953)
Free cash flow to equity 932 1,165 1,456 40,040

Discount factors (14%) 0.877 0.769 0.675 0.675
Present values 817 896 983 27,027
The estimated present value of free cash flows to equity is Rs. 29,723,000
Note:
, (1.1)
Free cash flow after 20X9 is estimated by = 40,040
. .
This valuation also ignores any real options that arise as a result of the acquisition.
Recommended valuation
It is impossible to produce an accurate valuation. The valuation using the dividend growth model is
out of line with all others and will be ignored.
On the basis of this data, the minimum value should be the adjusted asset value, a little over Rs.
15,000,000, and the maximum approximately Rs. 30,000,000.
All of the above valuations may be criticized as they are based upon the value of Potential as a
separate entity, not the valuation as part of Strong Inc. There might be synergies, such as economies
of scale, savings in duplicated facilities, processes, etc, as a result of the purchase, which would
increase the above estimates.
Answer to Q-18
Notes:
- It is assumed that finance cost will remain at the same level for foreseeable future
- 16% is the appropriate discount rate for discounting free cash flows to equity
1 2 3 4 5
---------------------------- Rs. million ---------------------------
Revenue [W-1] 165,726 187,268 212,843 227,955 244,140
Fuel cost [W-1] (73,490) (77,958) (83,493) (89,421) (95,770)
Other services [LY x 1.08] (84,062) (90,787) (98,050) (105,894) (114,365)
Operating exp. [LY x 1.08] (8,827) (9,534) (10,296) (11,120) (12,010)
Finance cost (9,793) (9,793) (9,793) (9,793) (9,793)
Other income 1,723 1,947 2,213 2,370 2,539
[LY x (1+% change in revenue)]
Capex (15,000) (25,000)
WC Inv (5,350) (3,450) (2,500) (1,500)
(1,500)
(29,073) (27,307) 10,924 12,597
13,240
Terminal value 126,385
(29,073) (27,307) 10,924 12,597 139,625
Factor 16% 0.862 0.743 0.641 0.552 0.476
(25,063) (20,293) 6,999 6,957 66,477
Total value 35,077
40% stake 14,031
W-1
No. of passengers per flight
2015 2016 2017 2018 2019 2020
Growth % [A] 6% 6% 6% 0% 0%
Discount % [B] 50% 35% 25% 25% 25% 25%
Govt. officials [C] 20 21 22 23 23 23
No. of passengers 180 191 202 214 214 214

Free officials [C x B] (10) (7) (6) (6) (6) (6)
Fully paid passengers [X] 170 184 196 208 208 208
Revenue per passenger 2016 2017 2018 2019 2020

2015 revenue = Rs. 144,342 million [D]
2015 passengers = 4.3 million
Fully paid passengers [4.3 x 170/180] = 4.061 million [E]
Average revenue 2015 [D/E] Rs. 35,542
Average revenue (LY x 1.02) [Y] 36,253 36,978 37,717 38,472 39,241
No. of flights 2016 2017 2018 2019 2020

Growth in no. of flights 4% 4% 5% 5% 5%
2015 passengers = 4.3 million
Passengers per flight = 180
No. of flights [Z] = 4.3m / 180 = 23,889
No. of flights [Z] 24,845 25,838 27,130 28,487 29,911
[LY x (1 + growth)]
Total revenue [X x Y x Z] 165,726 187,268 212,843 227,955 244,140
Fuel per flight 2016 2017 2018 2019 2020

Fuel cost [Rs. 69,284 million]
2015 Fuel cost per flight [Rs. 69,284 / Z] = Rs. 2.90
Fuel cost per flight 2.96 3.02 3.08 3.14 3.20
[M = LY x 1.02]
Total fuel cost [M x Z] 73,490 77,958 83,493 89,421 95,770
Answer to Q-19
(a) Share exchange ratio to be offered to BTL's shareholders

Target price per share to be offered Rs. 24
Post merger value of VTL Rs. 98,598 million
No. of shares of VTL 1,500 million
No. of shares of BTL 1,250 million
Share exchange ratio = Y
98,598
x Y = 24
1,500+1,250 x Y
Solving above equation:

Share exchange ratio = 0.525 shares of VTL for each share of BTL
Assessment of VTL's shareholders' acceptability

Shares to be issued to BTL = 1,250 x 0.525 = 656 million shares
Earnings per share of merged entity [12,201(W-1) ÷ (1,500+656)] = Rs. 5.66
If share exchange ratio of 0.525 for every one share is offered to BTL's shareholders, it will
be acceptable to VTL's shareholders as it would increase their earnings per share by Rs. 0.16
per share.
W-1: Value of merged entity
VTL BTL Increase Merged

entity
----------------- Rs. in million -----------------
Revenue 60,000 21,600 8,160 89,760
[20 x 250 x 12] [10 x 180 x 12] [(VTL + BTL) x 10%]
Costs (48,214) (22,009) 2,107 (72,330)

[60,000 – 11,786] [21,600 + 409] [(VTL + BTL) x 3%]
Profit before tax (balancing figure) 11,786 (409) - 17,430

Tax 30% (3,536) 216 - (5,229)
[8,250 x 30/70] [21,600 x 1%] [17,430 x 30%]
Net profit 8,250 (625) - 12,201

[1,500 x 5.5] [1,250 x –0.5]
Value of combined entity [12,201 x 8] 97,608

Add: One-time benefit of carried forward losses (3,300 × 30%) 990
Value of combined entity 98,598
(b) Other factors to be considered
(i) Synergies estimated from this merger might not realise and key assumptions might
not hold true.
(ii) Cost reduction opportunities may include staff downsizing which may require a
heavy voluntary separation package and may also create unrest.
(iii) The major shareholders of VTL may raise the concern that after issuance of shares
to BTL, their shareholding percentage would be diluted and they may not be able to
exercise significant influence in the company.
(iv) BTL might not be able to blend into the culture of VTL and management conflict may
arise due to different organizational culture.
(v) BTL might not be able to provide the quality of products and services that VTL
expects which might cause customer dissatisfaction
(vi) VTL should consider the possible monopoly aspects of the proposed merged.
Answer No. 20
(a) If the market is semi strong form efficient:

In the semi strong form efficient market, the effect of the expected gains from the takeover
is unlikely to have been reflected in the shares prices of either company. Once the takeover
information is made public, the effect on share prices would be as follows:
Value of combined business
Rs. in million
Value of companies before takeover:
ML (30 × 20.5) 615.00
SL (4 × 26.5) 106.00
721.00
Effect of synergy (W-1) 7.06
Estimated value after takeover 728.06
Value of ML
ML will issue 4 ÷ 3 × 4 million shares = 5.33 million new shares to the shareholders of SL. The
total number of shares in ML will rise to 35.33 million shares.
The expected share price for ML after the announcement will be Rs. 20.6 (728.06 ÷ 35.33).
There is only Re. 0.1 gain to ML's shareholders, who will have allowed all the advantage of
synergy to accrue to SL.
Value of SL
SL price will be expected to reflect the announcement by rising to Rs. 27.47 (20.6 × 4 ÷ 3)
giving them a gain of Re. 0.97 per share.
W-1: Effect of synergy
Rs. in million
Warehouse sale 6.80
Redundancy (9.00)
Wage savings (2.7 × 3.4331) 9.26
7.06
- If the market is strong form efficient

In the strong form efficient market, the shareholders had already guessed that the takeover
would take place and share price had already increased to reflect expected gains.
Therefore, the value of combined entity in the case of strong form efficient market would be
approximated to combined market value of both companies i.e. Rs. 721 million.
(b) Other factors

(i) Gearing
ML is very highly geared. Even if only long term debt is considered, gearing in terms
of book value is 78% (274 ÷ 352) and in terms of market value is 47% (288 ÷ 615).
By comparison, SL's gearing is only 32% (17.5 ÷ 54.77) in book value terms and 17%
(17.5 ÷ 106) in market value terms. In addition, ML has high current liabilities which
indicate that the difference between the gearing would be even more.
The shareholders of ML will favor the share issue terms for the takeover of SL which
should reduce their gearing substantially, whereas SL's shareholders are unlikely to
see this as an advantage.
(ii) Dividend policy
Both companies have different yields and covers, which may influence the views of
some shareholders:
ML SL
Dividend yields 3.90% 4.70%
Dividend cover 2.1 1.6
The expectation regarding dividend policy which ML would follow after merger
would be of interest to the shareholders.
(iii) Management plans
ML’s future plans will be fundamental to the success of the business. A growth
oriented plan would satisfy the concerns of shareholders of both companies.
Further, the shareholders would be interested to know whether brand used by SL
for selling its product would discontinue after takeover. From the available
information, SL seems to have been performing better than ML recently.
Discontinuance of SL’s brand may affect the future sale of merged entity.
Further, shareholders of both companies may be interested in the composition of
the board of directors. SL seems to have been performing better than ML recently
and may be able to argue for more than proportional representation on the board.
(iv) Valuation techniques
The above valuation is determined by adding the synergy effect in the market price
of the shares. Shareholders of both companies may be interested to know the value
of SL and merged entity if other techniques such as discounted cash flow method,
asset valuation method, etc. would be employed.
(v) Proportional ownership

The existing shareholders of ML and SL would be observing the major dilution from
their existing ownership to reduce the ownership in combined entity:
Existing ownership Ownership in merged entity
ML 100% 84.91%
SL 100% 15.09%
(vi) Different cultures
Although SL is operating in similar industry but different organizational culture of
ML may not be accepted by the employees of SL.
Answer No. 21
(a) Determination of IPO price and number of shares to be offered
Let ‘𝑥’ be the no. of shares to be issued and ‘𝑦’ be IPO price
xy = 2,632 → 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1
(200 + 𝑥)y = 7,326 (𝑾 − 𝟏) → 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2
𝐵𝑦 𝑠𝑖𝑚𝑝𝑙𝑖𝑓𝑦𝑖𝑛𝑔 𝑡ℎ𝑒 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛
200𝑦 + xy = 7,326
200y + 2,632 = 7,326
200𝑦 = 4,694
y = Rs. 23 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠𝑠𝑢𝑒 𝑝𝑟𝑖𝑐𝑒
𝑆𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑦 𝑖𝑛 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1 𝑡𝑜 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑖𝑠𝑠𝑢𝑒𝑑
23 x = 2,632
x= 114 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
W-1: Value of company after Years

IPO 0 1 2 3 4 5
--------------------------------- Rs. in million ---------------------------------
Profit before tax (1,025 × 1.20) - 1,230 1,476 1,771 2,125 2,550
Tax depreciation - (350) (315) (284) (256) (230)
Profit before tax - 880 1,161 1,487 1,869 2,320
Tax @ 30% - (264) (348) (446) (561) ( 696)
Net profit after tax - 616 813 1,041 1,308 1,624
Add back tax depreciation - 350 315 284 256 230
Initial investment (2,500) - - - - -
* Cost of IPO (2,500÷95%×5%) (132) - - - - -
Tax savings (132×30%) - 40 - - - -
Terminal value (1,624 +230) ÷ 15.8% - - - - - 11,734
Cash inflows / (outflows) (2,632) 1,006 1,128 1,325 1,564 13,588
Discount factor 15.8% (W-2) 1.0000 0.8636 0.7457 0.6440 0.5561 0.4802
PV (2,632) 869 841 853 870 6,533
DF value of the company (Sum of all present values) 7,326
* It is assumed that cost of IPO was also paid before the start of project.
W-2: Computation of discount factor

Ungeared the equity beta of industry
β𝑎 = [β𝑒 × (𝐸 ÷ 𝐸 + 𝐷(1 − 𝑇)]
= [(1.90 × 0.6 ÷ {0.6. + 0.4 (1-0.3)}] + Nil ⇒ 1.30
Since the company is 100% equity financed, its asset beta is equal to its equity beta
Cost of equity by using CAPM
𝐾𝑒 = 𝑅𝑓 + β𝑒(𝑅𝑚 − 𝑅𝑓)
= [8% + 1.30 × (14% - 8%)] ⇒ 15.8%
(b) Date: 6 June 2017
To: Board of Directors
From: Financial Consultant
Subject: Effect of leverage on the valuation of the company
Dear Sirs
Congratulations on being awarded such a large project which will open new avenues of
growth for your company.
I was given the assignment to determine the price for initial public offering in line with the
Board’s directive. According to the working attached as Appendix, the price has been worked
out at Rs. 23 per share. This is based on the Board’s directive whereby the project would be
100% equity financed. However, before taking final decision in respect of the IPO, I suggest
that the management should also consider some of the advantages of leveraged financing
which are enumerated below:
 Introducing leverage helps the company to get tax benefit on debt servicing cost
which ultimately reduces the overall cost of capital for the company.
 Weighted average cost of capital is used to discount the cash flows of the company
for valuation and a lower cost of capital means higher valuation.
Yours truly
Financial Consultant
Answer No. 22
TTL / BTL
Rs. in million
Value of TTL before take over (MV of equity) (W-1) 34,800.00
Add: Expected cash flows generated from retail outlet division (W-2) 2,766.02
Add: Expected cash flows generated from disposal of BTL textile
manufacturing division (W-4) 2,886.20
Add: Synergy benefits (W-5) 810.68
Estimated value of take over 41,262.90
New number of shares – TTL ( in million) 750 + 250 × 5 ÷ 7 928.57

Expected market value of share of TTL after acquisition 41,262.9 ÷ 928.57 44.44
Synergy loss to TTL shareholders (Rs. per share)

[{(750×44.44)–34,800(W-1)}÷750] OR [44.44 – 46.40 (W-1)] (1.96)
Acquisition gain to BTL's shareholders (Rs. per share)
[{(44.44×250×5÷7)–6,000}÷250] OR [44.44×5÷7=31.74-24 (W-3.5)] 7.74
Conclusion: Sale of BTL would be beneficial for its shareholder but it would reduce the wealth of TTL's
shareholders, therefore they would not favour this merger decision.
W-1: Determination of MV of TTL before acquisition Rs. in million

MV of share of BTL (Rs.) 12 × 2,900 ÷ 750 46.40
Market value of equity (Rs. in million) 750 × 46.40 OR 2,900 × 12 34,800.00
W-2: Value from retail outlet division: Year 1 Year 2 Year 3

------------------- Rs. in million --------------------
Sales revenue (1,000 × 1.10) 1,000.00 1,100.00 1,210.00
Profit before tax (Sales revenue × 20%) 200.00 220.00 242.00
Less: Tax @ 30% 60.00 66.00 72.60
Profit after tax 140.00 154.00 169.40
Add: Depreciation 25.00 25.00 25.00
Cash inflows 165.00 179.00 194.40
Discount factor @ 11.34% (W-3) 0.8981 0.8066 0.7245
Present value of free cash flows from year 1 to 3 148.19 144.38 140.84
Rs. in million
Total present value of cash flows from year 1 to 3 433.41
Terminal value [{194.40×(1+5%)÷(11.34%–5%)}]×(1+11.34%)–3 2,332.61
Total free cash flows from retail division 2,766.02
W-3: TTL - Weighted average cost of capital after acquisition

WACC - Post acquisition
E D
K × + K (1 − T) ×
E+D E+D
67%(𝐖 − 𝟑. 𝟑) 33%(𝐖 − 𝟑. 𝟑)
13.48%(𝐖 − 𝟑. 𝟏) ×
67% + 33%(𝐖 − 𝟑. 𝟑)
+ [10% (1 − 30%) ×
67%(𝐖 − 𝟑. 𝟑) + 33%
= 𝟏𝟏. 𝟑𝟒%
(Debt to equity ratio (MV) would be maintained at same level)
W-3.1: Cost of equity - Post acquisition

𝐾 = 𝑅 + 𝐵 (𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚) ⇒ 7% + 1.08 (W-3.2) x 6% = 13.48%
W-3.2: Equity beta after acquisition

𝐵 = 𝐵 ÷ 𝑉 ÷ 𝑉 + 𝑉 (1 − 𝑡)
0.80(𝐖 − 𝟑. 𝟒)
67%(𝐖 − 𝟑. 𝟑) ⇒ 1.08
67% + 33%(𝐖 − 𝟑. 𝟑)(1 − 30%)
W-3.3: TTL - Debt to equity ratio prior to acquisition

Debt (Rs. in million) Given 17,500
Equity (Rs. in million) (W.1) 34,800
Debt to equity ratio prior to acquisition 17,500 ÷ (17,500 + 34,800) 33.00%
Equity component 34,800 ÷ (17,500 + 34,800) 67.00%
W-3.4: TTL - Asset beta after acquisition (Combined asset beta due to different business risk)
V V
B = ×B + ×B
V V
34,800(𝐖 − 𝟏) 6,000
34,800 + 6,000(𝐖. 𝟑. 𝟓)
× 0.81(𝐖. 𝟑. 𝟕) +
34,800(𝐖 − 𝟏) + 6,000
× 0.77(𝐖. 𝟑. 𝟔) ⇒ 0.80
𝑊ℎ𝑒𝑟𝑒 𝑉 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑇𝑇𝐿 𝑉 = 𝑇𝑜𝑡𝑎𝑙 𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑏𝑜𝑡ℎ 𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠

𝐵 = 𝐴𝑠𝑠𝑒𝑡 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑇𝑇𝐿 𝐵 = 𝐴𝑠𝑠𝑒𝑡 𝐵𝑒𝑡𝑎 𝑜𝑓 𝐵𝑇𝐿
𝑉 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐵𝑇𝐿
W-3.5: Determination of MV of BTL before acquisition

MV of share of BTL (Rs.) 500÷250×12 24.00
Market value of equity (Rs. in million) (500×12) OR (250×24) 6,000
W-3.6: Asset beta of BTL

V
B =B ×
V + V (1 − t)
6,000(𝐖 − 𝟑. 𝟓)
B = 0.91 (𝑮𝒊𝒗𝒆𝒏) × ⇒ 0.77
6,000(𝐖 − 𝟑. 𝟓) + 1,500 (𝑮𝒊𝒗𝒆𝒏) (1 − 30%)
W-3.7: Asset beta of TTL

V
B =B ×
V + V (1 − t)
34,800(𝐖 − 𝟏)
B = 1.1 (𝑮𝒊𝒗𝒆𝒏) × ⇒ 0.81
34,800(𝐖 − 𝟏) + 17,500 (𝑮𝒊𝒗𝒆𝒏) (1 − 30%)
W-4: Value from the disposal of the BTL textile manufacturing division
Rs. in million
Net assets of BTL (2,500 + 520) 3,020.00
Net assets related to BTL textile manufacturing division 3,020 × 70% 2,114.00
Value from disposal 2,114 × 1.5 3,171.00
Value from disposal (net of tax) 3,171 – {(3,171 – 2,114)×30%x(1.1134)–1} 2,886.20
W-5: Synergy benefits
Rs. in million
Annual administration cost savings (Post tax) (Rs. 70 m × 70%)/11.34% (W-3) 432.09
One-time redundancy payment (Post tax) 35 – (35×30%) × (1.1134)–1 (25.57)

One-time benefit of carried forward tax losses (1,500 × 30%) × (1.1134)–1 404.16
810.68
Answer No. 23
(a) Sun Public Limited
Evaluation of demerger scheme Rs. in million

New values of divisions after demerger (185.10 + 153.49) (W-1) 338.59
Less: Value of debt (115÷100×110) (W-2) (126.50)
Value of equity of both companies after demerger 212.09
Less: Market value of equity before demerger (50 ÷ 10 × 30) (150.00)
Gain to existing shareholders due to demerger 62.09
Opinion: Demerger scheme is financially viable.
W-1: Present value to 10 years SD HD

Rs. in million
Present value of 1 - 5 years [*13.5632×33.2], (*23.6535×25.60) 118.30 93.53
Present value of 6 years to 10 years
{39.8 × (*35.5431 – *13.5632)} , {32 × (*45.7773–*23.6535)} 78.80 67.96
Less: PV of one-off cost (12.00) (8.00)
Total 185.10 153.49
*1 *2
AF @ 12.47% 5 years AF @ 11.46% 5 years
*3 *4
AF @ 12.47% 10 years AF @ 11.46% 10 years
W-2: Gearing level of two divisions SD HD

Rs. in million
Market value of debt (115÷100×110×60%), (115÷100×110×40%) A 75.90 50.60
Market value of equity (50÷10×30×60%), (50÷10×30×40%) B 90.00 60.00
165.90 110.60
Gearing ratio (Debt to equity) A ÷ (A +B) × 100 45.75 : 54.25 45.75 : 54.25
Since market value of equity subsequent to demerger cannot be computed based on the
available information, existing market value of SPL has been considered for gearing ratio.
Both division's gearing ratio is different from industry's gearing ratios so ungear the
industry beta and regear the asset beta to take into account the different capital structure.
W-3: Calculation of SD’s WACC:

Step 1: Ungearing SD’s industry beta
V 70%
B =B × = 1.25 × ⇒ 0.96
V + V (1 − t) 70% + 30%(1 − 30%)
Step 2: Regearing SD’s beta

0.96
=
𝐵 = 𝐵 ÷ 𝑉 ÷ 𝑉 + 𝑉 (1 − 𝑡) 54.25% ⇒ 1.53
54.25% + 45.75%(𝐖 − 𝟐)(1 − 30%)
Step 3: Cost of equity – SD

K = R + B (R − R ) = 9% + 1.53(15% − 9%) ⇒ 18.18%
Step 4: WACC – SD
E D 90(𝐖 − 𝟐) 75.90
K × + K (1 − T) × = 18.18% ×
90 + 75.90(𝐖 − 𝟐)
+ 5.70%(𝐖 − 𝟒) ×
90 + 75.90
⇒ 12.47%
E+D E+D
W-4: For cost of TFCs, calculation of IRR:

Cash flows Discount PV @ 5% Discount PV
Year
(Rs. in million) factor 5% (Rs. in million) factor @ 7% (Rs. in million)
0 (110.00) 1.0000 (110.00) 1.0000 (110.00)
1-10
(100×10%×70%) 7.00 7.7217 54.05 7.0236 49.17
10 100.00 0.6139 61.39 0.5083 50.83
5.44 (10.00)
Internal rate of return 5% + [ (7% –5%) × {5.44 ÷ (5.44 + 10.00)}] 5.70%
W-5: Calculation of HD’s WACC:
Step 1: Ungearing HD’s industry beta

V 80%
B =B × = 0.9 × ⇒ 0.77
V + V (1 − t) 80% + 20%(1 − 30%)
Step 2: Regearing HD’s beta

0.77
=
𝐵 = 𝐵 ÷ 𝑉 ÷ 𝑉 + 𝑉 (1 − 𝑡) 54.25% ⇒ 1.22
54.25% + 45.75%(𝐖 − 𝟐)(1 − 30%)
Step 3: Cost of equity – HD

K = R + B (R − R ) = 9% + 1.22(15% − 9%) ⇒ 16.32%
Step 4: WACC – HD
E D 60(𝐖 − 𝟐) 50.60
K × + K (1 − T) × = 16.32% ×
60 + 50.60(𝐖 − 𝟐)
+ 5.70%(𝐖 − 𝟒) ×
60 + 50.60
⇒ 11.46%
E+D E+D
(b) The following additional information that would assist the directors in evaluating the
decision:
(i) The assumptions and basis behind the high projected cash flows of supermarket
division and comparatively low projected cash flows of hotel division need to be
analyzed.
(ii) The free cash flow forecasts as they stand, appear to take no account of uncertainty.
It would have been helpful to see best-worst estimates, simulations or other
techniques that incorporate uncertainty.
(iii) The only information about risk is industry details. The risk profiles of the either or
both the divisions might differ significantly
(iv) Future debt finance requirement is very important as initial gearing arrangements
might not be sufficient if demerged entities to achieve the predicted level of free cash
flows.
(v) Individual divisions might be more vulnerable to takeovers because of their smaller
size after demerger.
(vi) Views of the shareholders and other stakeholders i.e. employees, creditors etc. need
to be considered on the demerger plan e.g. how will creditors view their security.
Answer No. 24
(a)
Assumptions:
- Free cash flows given in question are free cash flows to firm
- In absence of expected growth in share price of YL, current share price is used for K d
calculation of TFCs
Rs. million
Combined firm value [1,340 / 0.1505(W-1)] 8,903.65
Value of TFCs [2,350 x 120/100] (2,820.00)
Value of Debentures [1,800 x 47/50] (1,692.00)
Combined equity value 4,391.65
Determination of target share exchange ratio

Rs.
Target offer share price [Rs. 9 x 1.05] 9.45
If "E" is the target exchange ratio then:
Rs. 4,391.65 million

x E = 9.45
450 + 300 x E
hence solving above equation for "E" will give:
Exchange ratio to be offered = 2.73

Hence 2.73 shares of YL would be offered against 1 share of WL
Effect on shareholders of YL
Rs.
YL share price after acquisition [4,391.65 / (450 + 300 x 2.73)] 3.46
YL share price before acquisition 15.00
Since the share exchange ratio as desired by WL's shareholders will result in significant
fall in share price of YL, therefore, this ratio will not be acceptable to YL's shareholders
ALTERNATIVE – 1
Assumptions:
- Free cash flows given in question are free cash flows to firm.
- If values of YL and WL are calculated using free cash flow method, then these value are
are very low as compared to current market prices. Hence it seems that market prices are
overvalued and will return to equilibrium soon. Moreover, value of combined company
has to be calculated using free cash flow method, therefore, it will be fair to use values
using free cash flow method instead of current market values for solving question.
However, discount rates will have to be calculated using current market prices.
Rs. million
Combined firm value [1,340 / 0.1505(W-1)] 8,903.65
Value of TFCs [2,350 x 120/100] (2,820.00)
Value of Debentures [1,800 x 47/50] (1,692.00)
Combined equity value 4,391.65
Determination of target share exchange ratio

Rs. million
Current firm value of WL [390 / 0.1443 (W-1)] 2,702.70
Value of Debentures (1,692.00)
Current equity value of WL 1,010.70
Rs.
Current value per share [1,010.7 / 300] 3.37
Target offer share price [3.37 x 1.05] 3.54

x E = 3.54
450 + 300 x E

Hence 0.48 shares of YL would be offered against 1 share of WL
Effect on shareholders of YL
Rs. million
Current firm value of WL [860 / 0.1533 (W-1)] 5,609.92
Value of TFCs (2,820.00)
Current equity value of WL 2,789.92
Rs.
Current value per share [2,789.92 / 450] 6.20
YL share price after acquisition [4,391.65 / (450 + 300 x 0.48)] 7.39

Since the share exchange ratio as desired by WL's shareholders will result in increase
in share price of YL, therefore, this ratio will be acceptable to YL's shareholders
W-1: Determination of combined WACC

K = R + B (R − R )
 YL: 11% + [1.16(𝐖 − 𝟐)(16%– 11%)] ⇒ 16.80%
 WL: 11% + [1.28(𝐖 − 𝟐)(16%– 11%)] ⇒ 17.40%
K
 YL: (W-3) ⇒ 11.80%
 WL: 14% × 1,800 × 0.65 ÷ (1,800 ÷ 50 × 47) ⇒ 9.68%
WACC: K × + K (1 − T) ×
6,750 2,820
 YL: 16.80 × + 11.80 × ⇒ 15.33%
6,750 + 2,820 6,750 + 2,820
2,700 1,692
 WL: 17.40 × + 9.68 × ⇒ 14.43%
2,700 + 1,692 2,700 + 1,692
Combined WACC
= [15.33% × (6,750 + 2,820) + 14.43% × (2,700 + 1,692) ÷ (6,750 + 2,820 + 2,700 + 1,692) ⇒ 15.05%
W-2: Determination of individual equity beta

Ungeared industry beta = B × V ÷ (V + V (1 − t))
= 1.4 × 0.55 ÷ [0.55 + 0.45(1 − 0.35)] ⇒ 0.91
Individual company’s geared beta B = B ÷ [V ÷ (V + V (1 − t)]
YL WL
V (450 × 15), (300 × 9) 6,750.00 2,700.00
V (23.5 × 120), (1800 ÷ 50 × 47) 2,820.00 1,692.00
V (1– t) (2820 × 0.65), (1692 × 0.65) 1,833.00 1,099.80
Geared beta of YL: 0.91 ÷ [6,750 ÷ (6,750 + 1,833)] ⇒ 1.16
Geared beta of WL: 0.91 ÷ [2,700 ÷ (2,700 + 1099.8)] ⇒ 1.28
W-3: Calculation of IRR of convertible TFCs
Cash flows Discount PV Discount factor PV
Year
(Rs. in million) Factor @ 10% (Rs. in million) @ 13% (Rs. in million)
0 (120.0) 1.0000 (120.00) 1.0000 (120.00)
1-4 7.8 3.1699 24.73 2.9745 23.20
4 150.0 0.6830 102.45 0.6133 92.00
7.18 (4.80)
Internal rate of return: 10% + [ (13% – 10%) × {7.18 ÷ (4.8 + 7.18)}] 11.80%
Other factors to be considered are as follows:

The directors and shareholders of YL
(i) They should consider:
 whether there are any other companies that they might take over instead of WL;
 whether they could acquire a collection of assets similar to WL on a cheaper, piecemeal
basis; or
 the assessment of performance forecasts that have been made about the enlarged
companies, especially in relation to the relatively high synergy profits that are expected to
be generated and the reduction in operating risk.
(ii) The issuance of shares to WL may have an effect on the company’s existing share voting power.
(iii) Serious consideration should be given to the likely degree of compatibility of the combined
workforces and managements – incompatibility in such aspect has caused many takeovers to
founder in past.
(iv) They should consider the possible monopoly aspects of the proposed acquisition.
The directors and shareholders of WL
(i) They should consider whether:
 the price offered by YL is equivalent to the value of the company’s assets.
 there are any other potential bidders for their company’s share capital.
 a higher price should be sought from YL, so that WL’s shareholders may get some more
synergy benefits which presently go mostly to the shareholders of YL.
(ii) The directors should also examine the future prospects for WL acting an independent unit.
(iii) They should also consider how the dividend payout would be affected due to this merger.
Answer No. 25
(a)
0 1 2 3
--------------------- Rs. in million ----------------------
Sales [LY combined sales x 1.06] 785.46 832.59 882.54
Cost of sales [LY combined COS x 75% x 1.06] (392.73) (416.29) (441.27)
Operating expenses (75.18) (78.94) (82.89)
Yr-1 [{(84 + 30) x 90% - 31} x 1.05] Yr-2 onwards [LY x 1.05]
Depreciation [(384 + 110) x 25% + (84 + 30) x 10%] (134.90) (134.90) (134.90)
Redundancy payments (20.00)
PBIT (20.00) 182.65 202.45 223.49
Tax (48.80) (60.74) (67.05)
Yr-1 [(182.65 - 20) x 30%] Yr-2 onwards [PBT x 30%]
Depreciation 134.90 134.90 134.90
Working capital investment (W-1) (20.34) (21.56) (22.85)
(20.00) 248.42 255.06 268.49
Terminal value [268.49 x 1.03/(0.18 - 0.03)] 1,843.60
(20.00) 248.42 255.06 2,112.09
Factor @ 18% 1.000 0.847 0.718 0.609
(20.00) 210.41 183.13 1,286.26
Total value of merged entity 1,659.80

Debt [165 + 148] (313.00)

Value of equity in merged entity 1,346.80
Premerger value of KL [20.5 x 38] (779.00)
Maximum price for SL 567.80
W-1 Working capital investment (Rs. million)

WC balance Change
[LY x 1.06]
0 339.00
1 359.34 20.34
2 380.90 21.56
3 403.75 22.85
(b) Earnings per share:

EPS would increase under both financing methods but under debt finance, estimate of EPS i.e. Rs.
2.79 (W-1) is slightly lower as compared to EPS of Rs. 2.88 (W-1) under share issuance because of
high finance cost under debt option.
Although the difference is insignificant but due to increase in EPS, the share option is more attractive
because increase in EPS would eventually result in higher share prices.
Control and gearing:

In view of control, an acquisition through debt finance is preferred as existing KL’s shareholders
would retain 100% control. However, in case of acquisition through shares, existing KL’s shareholders
would lose control of 33.42%(W-2). Further, under debt finance option, existing shareholders may
consider the financial risk of increased gearing to 36.16% (W-3) from existing gearing of 17.48% (W-
3). Due to increase in financial risk, higher interest rate may be charged. On the other hand,
acquisition through shares would slightly increase the gearing from 17.48% to 18.86%.
In case of funding through debt, the impact on working capital cash flow may be a greater problem
as borrowing of Rs. 450 million at 10% would mean an additional Rs. 45 million of interest (pre tax)
must be paid annually and this may be difficult to service and would also affect the profitability.
W-1 EPS of Yr-1

Premerger ------- Merged entity -----
KL debt option equity option
----------------- Rs. in million --------------
PBIT 182.65 182.65

Redundancy payments (20.00) (20.00)
Interest on existing loans [165 x 11% + 148 x 12%] (35.91) (35.91)
Interest on new debt [450 x 10%] (45.00) -
81.74 126.74
Tax 30% (24.52) (38.02)
PAT 55.00 57.22 88.72
No. of shares (million) 20.50 20.50 30.79
EPS (Rs. per share) 2.68 2.79 2.88
W-2 Number of shares after merger

Offered share price [450 / 12.7] Rs. 35.43

x E = 35.43
20.50m + 12.70m x E
Hence 0.8099 shares of KL would be offered against 1 share of SL
million shares
No. of shares to be issued [12.7 x 0.8099] 10.29
Already issued shares 20.50
30.79
% loss in shareholding by KL's shareholders [10.29/30.79] 33.42%
W-3 Debt equity ratio

Premerger ------- Merged entity -----
KL debt option equity option
------------------- Rs. in million --------------
Value of equity 779.00 1,346.80 1,346.80

Debt 165.00 763.00 313.00
[313 + 450] [165 + 148]
Total 944.00 2,109.80 1,659.80
Debt equity ratio [debt / total] 17.48% 36.16% 18.86%
Answer No. 26
(a)
Valuation of WL shares
1 2 3 4
------------------- Rs. million --------------------
Revenue [LY x 1.025] 3,045.07 3,121.20 3,199.23 3,279.21
Exp. (excl. depreciation) [LY x 1.02] (2,448.00) (2,496.96) (2,546.90) (2,597.84)
Depreciation (W-1) (950.00) (895.00) (835.50) (771.95)
(352.93) (270.76) (183.17) (90.58)
Tax - - - -
Depreciation 950.00 895.00 835.50 771.95
597.07 624.24 652.33 681.37
Capex (500.00) (400.00) (300.00) (200.00)
WC Inv [Increase in revenue x 10%] (7.43) (7.61) (7.80) (8.00)
Free cashflow to firm 89.64 216.62 344.52 473.37
Terminal value [473.77(W-2) ÷ 0.0786(W-3)] - - - 6,027.64
89.64 216.62 344.52 6,501.02
Discount factor at 7.86% (W-3) 0.927 0.859 0.796 0.738
83.10 186.08 274.24 4,797.75
Value of firm [i.e. total of PVs] 5,341.17

Value of debt (1,000.00)
Value of equity 4,341.17
WORKINGS
W-1 Depreciation 1 2 3 4
--------------------- PKR million ---------------------
b/d 9,000.00 8,550.00 8,055.00 7,519.50
Capex 500.00 400.00 300.00 200.00
9,500.00 8,950.00 8,355.00 7,719.50
Depreciation 10% (950.00) (895.00) (835.50) (771.95)
Contribution 8,550.00 8,055.00 7,519.50 6,947.55
W-2
Net cashflow 681.37
Tax (197.60)
WC Inv. (10.00)
473.77
W-3 Risk adjusted WACC

W-3.1 Asset beta of industry
βa = βe x E / (E + D(1 - t)]
βa = 2.45 x 50% /(50% + 50% x 71%)
= 1.43
W-3.2 Geared beta for valuation

βa = βe x E / (E + D(1 - t)] here:
1.43 = βe x 8,600 / (8,600 + 2,000(1 - 29%)] E = 2m x 4,300 = Rs. 8,600m
= 1.67 D = Rs. 2,000m
W-3.3 Risk adjusted Ke

Ke = Rf + βe (Rm - Rf)
Ke = 3.75% + 1.67 (6.85% - 3.75%)
= 8.93%
W-3.4 cost of debt

Risk free rate 3.75%
Credit spread* [75 + (103 - 75) x 8/20] 0.86%
4.61%
After tax cost of debt [4.61% x 71%] 3.27%
* Credit spread for 18 years maturity is calculated by averaging 10 years and 30 years spreads given.
W-2.5 Risk adjusted WACC

WACC = 8.93% x 8,600/10,600 + 3.27% x
2,000/10,600
= 7.86%
(b)
Rs.
Post merger value: million
Combined equity [8,600 + 4,341.17] 12,941.17
Synergies 3,000.00
15,941.17
million
Revised no. of shares of SIL [2m + 0.5m x 2/1] shares 3.00
SIL Rs.
Revised share price [15,941.17 / 3] 5,313.72
Existing share price 4,300.00
WL
Bid adjusted share price [5,313.72 x 2/1] 10,627.45
Existing share price [4,341.17* / 0.5] 8,682.34
Conclusion:
Shareholders of both companies will gain due to merger. Therefore, it is likely the terms of merger will
be accepted.
* No information is given regarding current share price of WL which must definitely be lower than value
calculated in part(a). However, in absence of current share price, we are using value of equity as per
part (a) as current equity value of WL.
Answer No. 27
Alpha Foods Limited
(a) Alpha FF AFFL

Quoted equity beta 1.454 2.585
--------------- Rs. in million ---------------
Equity values before acquisition
(435.75×100);(722.4×30) 43,575 21,672 65,247
Uplift of 7.5% in combined equity value 4,894
Total equity value post acquisition 70,141
Existing loans 11,500 4,500 16,000
Issue of new corporate debenture for
purpose for acquisition 22,500 22,500
Total debt value post acquisition 38,500
Current Alpha gearing
[11,500÷(11,500+43,575)] 20.88%
Expected new group gearing
[38,500÷(38,500+70,141)] 35.44%
The current gearing level of Alpha Foods Limited is 20.88% which is significantly below the
investor’s maximum threshold of 30%.
Investors have cause to be concerned, as the issue of new debenture of Rs. 22,500 million to
fund FF’s acquisition is expected to raise the gearing to 35.44%, which is higher than the
acceptable 30% threshold.
The directors will need to explain to its investors why the benefit of this acquisition warrants
operating at a higher gearing level. Otherwise there is a risk that key institutional investors may
refuse to support the acquisition.
(b) Calculate WACC for AFFL
Ungear equity betas: Alpha FF

ßu = ßg × [1 + (1 – t) Vd/Ve] (A) 1.225 2.253
1.454÷[1+(11,500×71%)÷43,575] 2.585÷[1+(4,500×71%)÷21,672]
Find the weighted average asset beta based on current equity values:
Alpha FF
Proportion based on equity values (B) 66.8% 33.2%
(43,575÷65,247) (21,672÷65,247)
Weighted average asset beta C=A×B 0.818 0.748
1.566
Regear the asset beta to AFFL level of gearing to reflect the actual level of financial risk
accepted by both groups of shareholders:
ßg = 1.566 [1+(1–0.29)38,500÷70,141] OR 1.566÷[70,141÷(70,141+38,500×71%)] = 2.176
Calculate the cost of equity (Ke) using CAPM:

Ke = Rf + ßg (Rm – Rf)
Ke = 3.85% + 2.176 × (6.65% - 3.85%) = 9.94%
Calculate the after-tax cost of the new corporate bond (IRR):

Cash flows Present Present
DF @ 10% DF @ 5%
value value
Year 0: Current debenture value (95.8) 1 (95.8) 1 (95.8)
Years 1 to 6: Annual interest =
6.5×(1–0.29) 4.615 4.355 20.10 5.076 23.42
Year 6: Capital repayment at 5%
premium 105 0.564 59.22 0.746 78.33
Total (16.48) 5.95
Calculate the cost of debt using an IRR calculation:

NPV
𝑎% + × (𝑏 − 𝑎)
NPV − NPV
IRR = 5 + (105)×{5.95/(5.95+16.48)} = 6.33%
Calculate the after-tax cost of existing loans:

The after-tax rate is 5.5% × (10.29) = 3.91%
Determine the WACC of the new combined group:

Vequity % = 70,141/108,641 64.6%
Vd debenture % = 22,500/108,641 20.7%
Vd loan % = 16,000/108,641 14.7%
Ke = 9.94%
Kd debenture = 6.33%
Kd loan = 3.91%
WACC = Vequity % × Ke + Vd debenture % × Kd debenture +Vd loan % × Kd loan

WACC = 64.6% × 9.94% + 20.7% × 6.33% + 14.7% × 3.91% = 8.31%
(c) Impact on gearing

Current values On sale of division
Vequity 70,141 70,141
Vd debenture 22,500 22,500
Vd loan 16,000 7,500
(16,000–8,500)
Revised gearing (D/D+E) 29.96%
The directors of Alpha propose that the sale of the division will reduce AFFL’s debt by Rs. 8,500
million. This is forecast to reduce the gearing level to 29.96%, based on existing values. This is
within the upper level that institutional investors are believed to find acceptable.
However, this is very close to upper limit, and it assumes there is no change in share price
following the sale of the division, which is unlikely. The share price could rise or fall depending on
how positively the market react to the proposed sale.
If the share price falls then gearing may rise higher than 30% gearing threshold, and this may
result in additional share price volatility if key investors decide to sell their shareholdings due to
a perception of unacceptable levels of financial risk.
Impact on WACC
Regear the asset beta to reflect the revised level of gearing:
ßg = 1.566 [1+(1–0.29)30,000/70,141] OR 1.566÷[70,141÷(70,141+30,000×71%)] = 2.042
Calculate the cost of equity using CAPM:
Ke = Rf + ßg (Rm – Rf)
Ke = 3.85 + 2.042 × (6.65-3.85) = 9.57%
Determine the revised WACC following sale:

Vequity % = 70,141 / 100,141 70.0%
Vd debenture % = 22,500 / 100,141 22.5%
Vd loan % = 7,500 / 100,141 7.5%
Ke = 9.57%
Kd debenture = 6.33%
Kd loan = 3.91%
WACC = Vequity % × Ke + Vd debenture % × Kd debenture +Vd loan % × Kd loan

WACC = 70.0%% × 9.57% + 22.5% × 6.33% + 7.5% × 3.91% = 8.42%
Following the sale of the division and the repayment of the loan, the overall WACC is forecast to
increase from 8.31% to 8.42% which is not significant.
This suggests the overall risk to investors remains unchanged, meaning investors are likely to
support the sale of the division if risk and return levels are maintained, whilst operating within
the acceptable gearing threshold of 30%.
On the basis that there is no change in the value of the equity shares, and the Alpha is unable to
add further value to the rice food product division, and its sales have no impact on the capacity
of the remaining business, then the sale is recommended on the basis that group gearing will be
acceptable to its major shareholders.

Chap 6 - Business Valuation

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CHAPTER – 6 BUSINESS VALUATION (252)

In this chapter we will discuss valuation in following contexts:

 Valuation without any objective of merger or acquisition

VALUATION – WITHOUT ANY OBJECTIVE OF MERGER OR ACQUISITION

1. VALUATION TECHINIQUES – DEBT

Type of Debt Valuation

2. VALUATION TECHINIQUES – EQUITY

2.2 Earning Based Methods

2.2.1 PE ratio method:

Value of equity = PAT x Suitable P/E ratio

Such PE ratio must be adjusted for (normally downwards e.g. 70%):

Quantity of adjustment is not important rather direction is more important.

Value of equity = PAT / Suitable EY%

(EY% must be of comparable quoted co. in same industry or industry average)

Such EY% must be adjusted for (normally upwards e.g. 130%):

In case Earning grows at a constant rate:

2.3 Cash Flow Based Methods

2.3.1 Dividend Valuation Model (more relevant for Non-Controlling Interest):

Gordon Growth Extrapolation of past dividends

Value of equity = Value of overall

Following is an exemplary format for calculation using free cash flow

Here: Value of equity = Total present values

VALUATION – WITHOUT ANY OBJECTIVE OF MERGER OR ACQUISITION

2. Merger Motivations – “Synergies”:

4. MODE OF PAYMENT – FACTORS TO BE CONSIDERED:

5. VALUATION OF EQUITY OF TARGET

5.3 Cash flow based methods:

6. POST MERGER VALUE OF EQUITY OF ACQUIRER

2) Maximum takeover premium that can be offered = Synergy

OR = Target’s equity value + synergy

4) Takeover premium offered:

5) Net benefit of acquisition to acquirer = Synergy – Takeover premium offered

Market type Share price reflects:

COMPANY 1 COMPANY 2 COMPANY 3

P/V of Re 1 discounted at:

Interest cover Credit rating Cost of long term debt

The company is currently rated A. Summarized financial data is as follows:

Interest cover (time) >8 6 to 8 4 to 6 2 to 4

STATEMENT OF FINANCIAL POSITION

TFCs 1,000 400 500

Current liabilities 300 100 200

Non-current assets 3,000 1,400 1,800

STATEMENT OF COMPREHENSIVE INCOME

MNO PQ (Pvt.) RS Limited

Dividend payout 292.50 87.36 84.50

Other information: Jazba Zoom

Risk free rate 4%

Year 1 – 2 Year 3 onwards

During the current year:

company remains at Big Co’s current capital structure level.

Non-current liabilities 1,500 400 400 400

Statement of Comprehensive Income

Net profit after taxation 6,580 3,760

Dividend 1,316 1,880

(vi) Operating profit is expected to be approximately 8% of turnover in 20X6-7, and to remain at

Information regarding the industry sector of Potential:

Estimate the value of Potential Co using:

State clear any assumptions that you make (27)

Operating revenue 144,342