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Hi John,
The answer for a(i) includes a small sentence “However, once Fodder Co’s debt obligations and the equity shareholders have been paid, the benefit to Pursuit Co’s shareholders reduces to approximately $52,000 (see appendix), which is minimal.”
However, the answer does NOT deal with the debt repayment as the latest has nothing to do with synergies. Therefore, the notice “once Fodder Co’s debt obligations have been paid” is irrelevant (and confusing a little bit). Am I correct?
In addition, for the part (iv), the answer states:
(iv) If Pursuit Co aims to acquire Fodder Co using debt finance and cash reserves, then the capital structure of the combined company will change. It will also change if they adopt the Chief Financial Officer’s recommendation and acquire Fodder Co
using only debt finance. Both these options will cause the cost of capital of the combined company to change. This in turn will cause the value of the company to change. This will cause the proportion of market value of equity to market value of debt to change, and thus
change the cost of capital. Therefore the changes in the market value of the company and the cost of capital are interrelated. To resolve this problem, an iterative procedure needs to be adopted where the beta and the cost of capital are recalculated to
take account of the changes in the capital structure, and then the company is re-valued. This procedure is repeated until the assumed capital structure is closely aligned to the capital structure that has been re-calculated. This process is normally done
using a spreadsheet package such as Excel. This method is used when both the business risk and the financial risk of the acquiring company change as a result of an acquisition (referred to as a type III acquisition).”He makes a conclusion that it’s the type three acquisition without direct provement that the business risk has been changed. Thus, he starts with description of change of financial risk (which relates to type 2 acquisition) and then just mentions that it’s type 3 without any provement.
Please clarify whether this is inconsistent (or, alternatively, I lack some understanding).
Thank you in advance.
For you first point, I agree that it would be been better to have left out the little bit about debt obligations. Otherwise what he has written is fine.
On your second point, although the question does not specifically say that the business risk will change, the very first sentence of the question does imply it. So I think that what he was written here is valid.
Sir,
regarding this requirement:
(iv) Explain the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved;
“Explain the implications of a change in the capital structure of the combined company, to the valuation method used in part (i)”
Seems to me vague requirement and unfair is not it?
Do I understand correctly that it means – describe how change in gearing (increase in gearing or decrease in gearing also not stated in the requirement) affects value of the combined company and DCF valuation model determinants – i.e., beta, wacc, weght debt finance and eqity finance, value of the combined company, etc.?
“and how the issue can be resolved”
I can not understand this part of the requirement overall and what do we mean by “issue” and why there is an “issue”?
Should I interpret this requirement as e.g. – advise how to recalculate the value of the company in an efficient manner? And then examiners explains that how it can be done using excel spread sheets…Please advice how to interpret this requirement properly)) very unclear to me…
The question is certainly not unfair.
Part (a) assumes that the current gearing remains constant and that therefore the WACC will stay constant and that therefore it is valid to discount at the WACC.
If the gearing is going to change then it will affect the WACC which in turn affect the NPV of the project, which will in turn affect the MV of the equity (because the NPV is the gain to the shareholders), which will further affect the gearing. That is why we would need to keep recalculating and therefore it would really need to be done on something like a spreadsheet.
This is all explained in the lecture notes.
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