Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Details of the number and market value of each company’s shares are as follows:
Gross Klinsmann
No. of shares issued 100 m 20 m
Share price 600p 700p
Required
Analyse this bid to include:
(a) Possible ways in which Gross may hope to recoup the bid premium when operating Klinsmann.
(b) The final and strategic effects on Gross if the bid is accepted by Klinsmann’s shareholders.
3 Dangara plc is contemplating a takeover bid for another quoted company, Tefor plc. Both companies are in
the leisure sector, operating a string of hotels, restaurants and motorway service stations. Tefor’s most recent
Balance Sheet shows the following:
£m £m
Fixed assets (net) 800
Current assets less
Current liabilities 50
Long-term debt
(12% debenture 2002) (200)
650
Issued share capital (25p units) 80
Revenue reserves 420
Revaluation reserve 150
650
Tefor has just reported full-year profits of after tax.
You are provided with the following further information:
(a) Dangara’s shareholders require a return of 14 per cent.
(b) Dangara would have to divest certain of Tefor’s assets, mainly motorway service stations, to satisfy the
competition authorities. These assets have a book value of million, but Dangara thinks they could be
sold on to Lucky Break plc for million.
(c) Tefor’s assets were last revalued in 1992, at the bottom of the property market slump.
(d) Dangara’s P:E ratio is 14:1, Tefor’s is 10:1.
(e) Tefor’s earnings have risen by only 2 per cent p.a. on average over the previous five years, while
Dangara’s have risen by 7 per cent p.a. on average.
(f) Takeover premiums (i.e. amount paid in excess of pre-bid market values) have recently averaged 20 per
cent across all market sectors.
(g) Many ‘experts’ believe that a stock market ‘correction’ is imminent, due to the likelihood of a new gov-
ernment, led by Bony Clair, being elected. The new government would possibly adopt a more stringent
policy on competition issues.
(h) If a bid is made, there is a possibility that the Chairman of Tefor will make a counter-offer to its share-
holders to attempt to take the company off the Stock Exchange.
(i) If the bid succeeds, Tefor’s ex-chairman is expected to offer to repurchase a major part of the hotel portfolio.
(j) Much of Tefor’s hotel asset portfolio is rather shabby and requires refurbishments, estimated to cost some
million p.a. for the next five years.
Required
As strategic planning analyst, you are instructed to prepare a briefing report for the main board, which:
(i) assesses the appropriate value to place on Tefor, using suitable valuation techniques. (State clearly any
assumptions you make.)
(ii) examines the issues to be addressed in deciding whether to bid for Tefor at this juncture.
4 Larkin Conglomerates plc owns a subsidiary company, Hughes Ltd, which sells office equipment. Recently,
Larkin Conglomerates plc has been reconsidering its future strategy and has decided that Hughes Ltd should
be sold off. The proposed divestment of Hughes Ltd has attracted considerable interest from other companies
wishing to acquire this type of business.
£50
£200
£100
£200 m
Chapter 20 Acquisitions and restructuring 585
Continued
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The most recent accounts of Hughes Ltd are as follows:
586 Part V Strategic financial decisions
The subsidiary has shown a stable level of sales and profits over the past three years. An independent
valuer has estimated the current realisable values of the assets of the company as follows:
Balance Sheet as at 31 May 1995
£000 £000 £000
Fixed assets
Freehold premises at cost 240
Less Accumulated depreciation (40) 200
Motor vans at cost 32
Less Accumulated depreciation (21) 11
Fixtures and fittings at cost 10
Less Accumulated depreciation (2) 8
219
Current assets 34
Stock at cost 22
Debtors 20
Cash at bank 76
Creditors: amounts falling due within one year
Trade creditors (52)
Accrued expenses (14) (66) 10
229
Creditors: amounts falling due beyond one year
12% Loan – Cirencester Bank (100)
129
Capital and reserves
ordinary shares 60
General reserve 14
Retained profit 55
129
Profit and Loss Account for the year ended 31 May 1995
£000
Sales turnover 352.0
Profit before interest and taxation 34.8
Interest charges (12.0)
Profit before taxation 22.8
Corporation tax (6.4)
Profit after taxation 16.4
Dividend proposed and paid (4.0)
12.4
Transfer to general reserve (3.0)
Retained profit for the year 9.4
£1
£000
Freehold premises 235
Motor vans 8
Fixtures and fittings 5
Stock 36
For the remaining assets, the Balance Sheet values were considered to reflect their current realisable values.
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Another company in the same line of business, which is listed on the Stock Exchange, has a gross dividend
yield of 5 per cent and a price:earnings ratio of 12.
Assume a standard rate of income tax of 25 per cent.
Required
(a) Calculate the value of an ordinary share in Hughes Ltd using the following methods:
(i) net assets (liquidation) basis
(ii) dividend yield
(iii) price:earnings ratio
(b) Briefly evaluate each of the share valuation methods used above.
(c) Identify and discuss four reasons why a company may undertake divestment of part of its business.
(d) Briefly state what other information, besides that provided above, would be useful to prospective buyers
in deciding on a suitable value to place on the shares of Hughes Ltd.
5 The directors of Fama Industries plc are currently considering the acquisition of Beaver plc as part of its
expansion programme. Fama Industries plc has interests in machine tools and light engineering while Beaver
plc is involved in magazine publishing. The following financial data concerning each company is available:
Chapter 20 Acquisitions and restructuring 587
Profit and Loss Accounts for the year ended 30 November 1995
Fama Industries £m Beaver
£m
Sales turnover 465 289
Profit before interest and taxation 114 43
Interest payable (5) (9)
Profit before taxation 109 34
Taxation (26) 9
Net profit after taxation 83 25
Dividends (8) (12)
Retained profit for the year 75 13
Balance Sheets as at 30 November 1995
Fixed assets 105 84
Net current assets 86 38
191 122
Fama Industries
£m
Beaver
£m
Less creditors due beyond one year (38) (58)
153 64
Capital and reserves
Ordinary shares 50 30
Retained profit 103 34
153 64
Price:earnings ratio prior to bid 16 12
The ordinary share capital of Fama Industries plc consists of 50p shares and the share capital of Beaver plc
consists of shares. The directors of Fama Industries plc have made an offer of four shares for every five
shares held in Beaver plc.
The directors of Fama Industries plc believe that combining the two businesses will lead to after-tax sav-
ings in overheads of million per year.
Required
(a) Calculate:
(i) the total value of the proposed bid
(ii) the earnings per share for Fama Industries plc following the successful takeover of Beaver plc
(iii) the share price of Fama Industries plc following the takeover, assuming that the price:earning ratio is
maintained and the savings are achieved.
£4
£1
Continued
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(b) Comment on the value of the bid from the viewpoint of shareholders of both Fama Industries plc and
Beaver plc.
(c) Identify, and briefly discuss, two reasons why the managers of a company may wish to take over
another company. The reasons identified should not be related to the objective of maximising share-
holder wealth.
6 Europium plc is a large conglomerate which is seeking to acquire other companies. The Business Development
division of Europium plc has recently identified an engineering company – Promithium plc – as a possible
acquisition target.
Financial information relating to each company is given below:
588 Part V Strategic financial decisions
Profit and Loss Account for the year ended 30 November 1997
Europium plc Promithium plc
Turnover 820 260
Profit on ordinary activities before tax 87 33
Taxation on profit on ordinary activities (27) (9)
Profit on ordinary activities after tax 60 24
Dividends (15) (5)
Retained profit for the year 45 19
Price:earnings ratio 16 10
Capital and reserves
ordinary shares 80 30
Retained profits 195 124
275 154
£1
The Business Development division of Europium plc believes that shares of Promithium plc can be
acquired by offering its shareholders a premium of 25 per cent above the existing share price. The purchase
consideration will be in the form of shares in Europium plc.
Required
(a) Calculate the rate of exchange for the shares and the number of shares of Europium plc which must be
issued at the anticipated price in order to acquire all the shares of Promithium plc.
(b) Suggest reasons why Europium plc may be prepared to pay a premium above the current market value
to acquire the shares of Promithium plc.
(c) Calculate the market value per share of Europium plc following the successful takeover and assuming the
P:E ratio of Europium plc stays at the pre-takeover level. Would you expect the P:E ratio of Europium plc
to stay the same?
(d) State what investigations Europium plc should undertake before considering a takeover of Promithium
plc.
7 As a defence against a possible takeover bid the managing director proposes that Woppit make a bid for
Grapper plc, in order to increase Woppit’s size and, hence, make a bid for Woppit more difficult. The compa-
nies are in the same industry.
Woppit’s equity Beta is 1.2 and Grapper’s is 1.05. The risk-free rate and market return are estimated to be
10 and 16 per cent p.a. respectively. The growth rate of after-tax earnings of Woppit in recent years has been
15 per cent p.a. and of Grapper 12 per cent p.a. Both companies maintain an approximately constant dividend
payout ratio.
Woppit’s directors require information about how much premium above the current market price to offer
for Grapper’s shares. Two suggestions are:
(i) The price should be based upon the Balance Sheet net worth of the company, adjusted for the current
value of land and buildings, plus estimated after tax profits for the next five years.
(ii) The price should be based upon a valuation using the Dividend Valuation Model, using existing growth
rate estimates.
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Summarised financial data for the two companies are shown below:
Chapter 20 Acquisitions and restructuring 589
Most recent Balance Sheets (£m)
Woppit Grapper
Land and buildings (net)
a
560 150
Plant and machinery (net) 720 280
Stock 340 240
Debtors 300 210
Bank 20 660 40 490
Less: Trade creditors (200) (110)
Overdraft (30) (10)
Tax payable (120) (40)
Dividends payable (50) (400) (40) (200)
Total assets less current liabilities 1,540 720
Financed by:
Ordinary shares
b
200 100
Share premium 420 220
Other reserves 400 300
1,020 620
Loans due after one year 520 100
1,540 720
a
Woppit’s land and buildings have been recently revalued. Grapper’s have not been revalued for four
years, during which time the average value of industrial land and buildings has increased by
25 per cent p.a.
b
Woppit 10p par value, Grapper 25p par value
Most recent Profit and Loss Accounts (£m)
Woppit Grapper
Turnover 3,500 1,540
Operating profit 700 255
Net interest (120) (22)
Taxable profit 580 233
Taxation (203) (82)
Profit attributable to shareholders 377 151
Dividends (113) (76)
Retained profit 264 75
The current share price of Woppit is 310 pence and of Grapper 470 pence.
Required
(a) Calculate the premium per share above Grapper’s current share price that would result from the two sug-
gested valuation methods. Discuss which, if either, of these values should be the bid price. State clearly
any assumptions that you make.
(b) Assess the managing director’s strategy of seeking growth by acquisition in order to make a bid for
Woppit more difficult.
(c) Illustrate how Woppit might achieve benefits through improvements in operational efficiency if it
acquires Grapper.
(ACCA)
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590 Part V Strategic financial decisions
Select one of the merger/takeover situations that has been given prominence recently in the media. Analyse your
selected case under the following headings (indicative guidelines are provided).
11
Strategy
– How does the ‘victim’ appear to fit into the acquiror’s long-term strategy?
22
Valuation and bid tactics
– Has the acquirer bid or paid ‘over the odds’? What were the pros and cons of the
financing package?
33
Defence tactics
– Were the tactics employed sensible ones? Were the managers of the target company gen-
uinely resisting or simply seeking to squeeze out a higher offer?
44
Impact
– Will the acquired company be difficult to integrate? Are any sell-offs likely?
Practical assignment
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This section contains two chapters that deal with issues of international financial management
(IFM). IFM adopts essentially the same perspective as domestic financial management, i.e. it looks at
how decisions in the areas of investment appraisal, financing and dividend policy can be used to
create wealth for the owners of the firm. However, there is a major difference – cash flows expected
from foreign trading and investment activities are subject to exchange risk, the risk that the
domestic currency value may be undermined by adverse exchange rate changes.
Chapter 21 explores the various types of exposure and explains how exporters and importers can, if
they so choose, take precautionary measures against such exposures.
Chapter 22 examines how to evaluate foreign investment decisions (FIDs), using principles
developed in earlier chapters, but focusing on the strategic motives for undertaking FIDs, and the
particular problems, such as exchange exposure and multiple tax regimes, facing firms when
evaluating FIDs. In particular, the issue of managing long-term strategic or operating exposure is
examined in a strategic context.
Chapter 21 Managing currency risk 593
Chapter 22 Foreign investment decisions 630
INTERNATIONAL FINANCE
Part
VI
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Managing currency risk
21
Learning objectives
This chapter explains the nature of the special risks incurred by companies that engage in interna-
tional operations:
■ It explains the economic theory underlying the operation of international financial markets.
■ It offers an understanding of the three forms of currency risk: translation risk, transaction risk and
economic risk.
■ It explains how firms can manage these risks by adopting hedging techniques internal to the
firm’s operations.
■ It explains how firms can use the financial markets to hedge these risks externally.
Similar problem, different result
Two multinational firms reported results in early
2004, both bewailing the impact of the falling US
dollar on their profits.
VW, Europe’s largest car-maker, was also experienc-
ing substantial capital outlays on new models, and
restructuring in Brazil. Because it exports the vast
majority of the cars it sells in the US from Europe, a
strong euro affects VW’s ability to price competitive-
ly, and therefore, its volumes. It also affects the trans-
lation of dollar revenues into euros. Rather late in the
day, VW decided to increase the proportion of foreign
sales that were hedged against currency risk from
only 30% in early 2002, up to 50% during 2003, and
a planned 70% in 2004.
VW’s Chief Financial Officer claimed that the rise
in the euro had cost VW in pre-tax earn-
ings, down by 48% to With a negative
net cash flow of in its core automotive
business, VW then cut its dividend for the first time
in 10 years from in 2002 to for 2003.
However, the shares rose slightly as an analyst at
Commerzbank said that the dividend cut was
‘well-flagged’.
Hanson, the British building materials firm that has
been investing strongly in the USA – in
2003 – admitted a hit with worse threat-
ened for 2004. Operating profits overall fell from
to as the Finance Director esti-
mated that every one cent fall in the dollar generated
a profit reduction. Hanson translated US
earnings, accounting for half of group profits, at the
rate of $1.63 to the pound, considerably below pre-
vailing rates during 2004.
Yet, Hanson raised dividend by 10% to 16.95p per
share for the year:
Can you explain the different dividend responses by
these two firms?
Source: Based on articles in the Financial Times, May 2003–March 2004.
£1 million
£394 million,£433
£20 million
£150 million
;1.05;1.30
;2.2 billion
;2.5 billion.
;1.6 billion
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With the huge growth in world trade over the last few decades, companies increasing-
ly deal, as buyer, seller or investor, in foreign currency, making it a key factor in finan-
cial management. For competitive reasons, exporters are commonly obliged to invoice
in the customer’s currency – in 2001, the Customs and Excise (www.hmce.gov.uk)
reported that 50 per cent of UK exports were invoiced in foreign currencies (and, sur-
prisingly, 60 per cent of imports).
Foreign currency can change in value relative to the home currency to significant
degrees over a short time.
Table 21.1 and Figure 21.1 illustrate changes of the exchange rate of sterling against
other currencies. The data in Table 21.1 are the average of daily Telegraphic Transfer
rates in London. The charts on Figure 21.1 are based on a log scale.
Such changes can seriously undermine the often wafer-thin profit margin of a trad-
er awaiting payment in foreign currency. If sterling appreciates, the sterling value of
the deal can evaporate before its eyes, while the likelihood of repeat business dimin-
ishes unless it lowers price, i.e. takes a smaller profit margin in sterling terms. It is easy
to understand the concern of a major exporter like VW, a great proportion of whose
export trade is priced in dollars.
In this chapter, we explain the theory of foreign exchange markets and how they
work in practice, and how exporters and importers can protect themselves against the
risks of foreign exchange rate variations. There are two key issues for the treasurer of
a company with significant foreign trading links to address:
1 Whether to seek protection against these variations, i.e. to ‘hedge’, or to ride the risks,
on the basis that in the long-term they will even out. Most companies do seek
hedges, being risk-averters. Yet some actively seek out foreign exchange risk, and
use dealing opportunities as a source of profit by deliberately taking ‘positions’ in
particular currencies. BP plc (www.bp.com) for example, exploits its position as a
multinational with a substantial two-way flow in several currencies to operate its
currency dealing activity as a separate profit centre. Such companies are called
‘speculators’.
2 The second issue concerns the extent to which the firm wants to hedge – whether to
totally avoid exposure to exchange rate risk or to control the degree of exposure.
The policy of the Anglo-Dutch steel group Corus plc (www.corusgroup.com) is
clear. It states in its 2004 Annual Report, ‘It is the group’s policy that substantial-
ly all of the net currency transaction exposure arising from contracted sales and
594 Part VI International finance
21.1 INTRODUCTION
hedge
A hedge is an arrangement
effected by a person or firm
attempting to eliminate or
reduce exposure to risk –
hence to hedge and hedger
Table 21.1
Average rates against
sterling
Year Euro US$ Swiss Franc Yen
1999 1.519 1.618 2.430 184
2000 1.642 1.516 2.558 163
2001 1.609 1.440 2.430 175
2002 1.591 1.503 2.334 188
2003 1.446 1.635 2.197 189
2004 1.474 1.832 2.276 198
Range 0.196 0.392 0.361 35
% of 2004 13.3% 21.4% 15.9% 17.7%
Source: Economic Trends, February 2005.
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