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Exercise 7.2: A "Promising" Takeover Valuation

Riding on the back of domestic economic growth, the Mantra Company is an Indian cash-rich conglomerate that wishes to expand its global operations with European facilities.

Through inept management, the highly regarded Rock Company based in the north of England with mining operations throughout the Europe has recently suffered a reversal of fortune. Share price has plummeted, so much so, that Mantra regards their takeover as a perfect fit for its existing activities.

The Balance Sheet for Rock reveals the following: (£million)

Share Capital: £1.00 ordinary shares 1,200

Reserves 6,432

CAPITAL EMPLOYED 7,632

REPESENTED BY

Mining property 4,200

Equipment 1,200

Distribution Facilities 900

Vehicles 120

6,420

Investments 1,050

As a basis for acquisition, Mantra believes that Rock's post-takeover turnover and profits should be in the region of £33,000 million and £1,500 million, respectively. The company has also prepared the following data relating to the acquisition.

- A 15 per cent incremental return on any new asset investment.

- A five year assimilation of goodwill, equivalent to a 20 per cent return on superprofits.

Rationalization policies £million

Sale of equipment 1,263

Sale of investments at market value 1,122

Annual cost savings from sale of equipment 207

New construction costs 630

Required:

1. Prepare a series of bid prices per share, using any assumptions you care to make, based on the information available and the following valuation techniques.

- Tangible assets

- Goodwill

- Profitability

2. Provide a risk assessment of your valuations.

3. Summarize your bid strategy

An Indicative Outline Solution

1. A Range of Bid Prices per Share

(i) Minimum Valuation (net asset revaluation)

£million

Assumptions

Mining Property

4,200

Current Valuation

Distribution Facilities

900

Current Valuation

Sale of Equipment

1,263

Realizable Value

Vehicles

120

Current Valuation

Investments

1,122

Current Valuation

Net Current Assets

162

Current Valuation

Total Asset Value

7,767

With 1,200 million shares in issue and a net tangible asset revaluation of £7,767 million we can derive a

price of:

£7,767m / 1,200m

£ 6.50 per share (say)

(ii) Goodwill Valuation (using the capitalisation of superprofits)

Goodwill computation: (P - r. A) / m

£million

Assumptions

Forecast profit per annum

1,500

Given

Less normal profit (15% return on £7,767m)

1,165

Incremental return

Super profit per annum

335

Capitalised at 20% (5 years purchase)

1,675

i.e. m > r

Going concern valuation: V = A + (P - r. A ) / m

V = £7,767m + (£1,500m - £1,165m) / 0.2 = £9,442 million

With 1,200 million shares in issue we can derive the following bid price:

£9,442m / 1,200m £7.90 per share (say)

(iii) Profitability Valuation: (capitalisation of future earnings)

£million Assumptions

Forecast profit per annum 1,500 Given

Cost saving per annum 207 Given

Forecast profit per annum 1,707

Capitalised at 15% 11,380 Incremental return

Add: Sale of equipment 1,263 Given

Sale of investments 1,122 Given

Less: New build (630) Given

Total Profitability Valuation 13,135

So, dividing by the 1,200 million shares in issue, we can derive the following bid price: £13,135m / 1,200m £10.95 per share (say)

2. Risk Assessment

Although we have no precise information on the current market price for Rock, its mediocre stock market performance explains Mantra's predatory interest. Our range of bid prices per share also reveals an ideal "domino" effect.

The profitability valuation exceeds the going concern valuation (incorporating any remaining goodwill), which is higher than the current market valuation of assets. The latter also exceeds the total Balance Sheet value of assets

However, if profits do not materialize, or the residue of goodwill evaporates post-acquisition, then Mantra may have a problem. Their return on investment will be no more than the realization of Rock's assets.

To assess the risk of a worst-case scenario using the information available, we can compare the purchase value of net tangible assets in relation to a profitability valuation. What is termed asset backing can be measured in one of two ways, using either market capitalisation (total value) or bid price per share.

Cover = Net asset valuation /Profitability valuation

Valuation ratio = Profitability valuation / Net Asset valuation

Remember from your previous Exercise that the valuation ratio is the simply the reciprocal of the cover. So, we can define (with rounding) the two equations, either in aggregate, or on a per share basis, as follows.

- Market Capitalisation

Cover: Net Asset Valuation/Profitability Valuation = £7,767m / 13,135m = 60%

Valuation Ratio: Profitability Valuation/Net Asset Valuation = £13,135m / £7,767m = 1.7

- Bid Price

Cover: Net Asset Valuation/Profitability Valuation = £6.50 / £10.95 = 60%

Valuation Ratio: Profitability Valuation/Net Asset Valuation = 1 / Cover = 1.7

The purchase value of Rock's net tangible assets (asset backing) only supports sixty per cent of Mantra's profitability valuation. But to access a new market that complements existing activities premised on global growth is a rational strategic maneuver, particularly if the target company's shares are a bargain buy.

3. A Bid Strategy

Mantra could make an initial bid of £6.50 but a fairer price might be £8.00, if only to flush out other predators. In the event of a "bidding war", price might go higher still. Mantra can bide its time, and progressively up its offer to £11.00. Beyond this, much depends on the strength of its objective, strategic pre-planning, attitude toward risk and how the market values Rock's shares

 
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