Strategic Financial Management

Hints to the Case Study

1. The factors in favor of the acquisition of Indus Aluminium Company by New Aluminium Company are: a. With the government giving a push to the power sector, demand for aluminium may pick up. b. Possibility of increase in demand in the European market, which may lead to higher profits. c. Improvement in the position of he automobile industry in India, which can increase the demand for aluminum. d. Increased use of aluminium foils for packaging of food products, etc. e. Indus Aluminium Company has captive mines, which protect it from fluctuations in raw material prices. Therefore it is an attractive target. f. The economies of scale are high in this industry. The factors against acquisition are: a. Demand outlook being low due to weak demand from Japan. b. The increased production of some of the existing players not being absorbed by the market coupled with dumping by other countries. c. The economy is experiencing a slowdown. As a result the demand from the other sectors may not show an uptrend in immediate future. d. Threat from substitute materials such as steel, plastics, HDPE and copper may depress the demand for aluminium. ER1 = S1 (E 1 + E 2 )PE 12 + S2 P1S 2 Pr ice EPS

2.

PE ratio of New India Aluminium Company = EPS = PE = PAT 6123.7 = = 82.23 No. of shares 74.47

711.78 = 8.66 82.23 PE ratio after acquisition = 8.66 1.20 = 10.39 (6123.7 + 839.4) 10.39 74.47 ER1 = + = 71.11 (711.78 71.11)

1.0473 + 1.4294 = 0.3821 or say 0.4

The ratio of 0.4 indicates that a maximum of one share of New Aluminium Company can to be offered to the shareholders of Indus Aluminium Company for every 2.5 shares of Indus Aluminium Company held by them. 3. The cashflows of Indus Aluminium Company at the end of the period for which data is available are as follows: EBDIT Depreciation EBIT Less: Tax on EBIT @ 30% NOPLAT Add: Depreciation Gross cashflow Gross Investment (see below) Free cash flow 03/00 2024.5 564.6 1459.9 438.0 1021.9 564.6 1586.5 951.0 635.5

Calculation of gross investment : Increase in fixed asses Increase in capital works in progress Net increase in fixed assets (A) Increase in investments (B) Inventories Sundry debtors Cash and bank balace Loans and advances Increase in miscellaneous expenses Net increase in current assets (C) Increase in sundry creditors/acceptances Increase in other liabilities Increase in provisions Total increase in current liabilities (D) Net increase in current assets (E = CD) Gross Investment (A+B+E) For cost of capital of New Aluminium Company, Cost of equity = ke = D1 +g P0
1/ 3

1339.5 501.5 838.0 146.9 140.5 143.8 38.5 124.9 16.4 387.1 35.3 256.7 164.8 127.2 259.9 951.0

690.7 Compounded annual growth rate in dividend, g = 368.6 Dividend as on march 2000 = The cost of equity (ke) The cost of debt (kd ) = = 690.7 = 9.275 74.47

1 = 0.2328 i.e. 0.233

9.275 1.233 + 0.233 = 0.249 711.78 836.4 726.1 493.3 1 596.6 + + + = 0.102 5753 . 7 6870 . 1 7798.9 5513 4 = = 5513.1 + 7798.9 + 6870.1 + 5753.7 34052.8 + 40166.0 + 55244.9 + 58086.8

The proportion of debt in the capital structure (wd)

25935.8 = 0.138 14% 187550.5 and the proportion of equity in the capital structure (we) = 1 0.14 = 0.86 Hence, the cost of capital = 0.249 x we + (1 0.30) x 0.102 x 0.14 = 0.224 635.5 1.14 Value of Indus Aluminium Company = = 8624.64 0.224 0.14 Value of equity = Value of the firm Value of debt = 8624.64 4095.10 = 4529.54 The price that can be paid towards acquiring equity of Indus Aluminium Company is Rs.4529.54 million. 4. Stock price = Value of assets = 13445.2 Exercise price = Value of total debt = 4095.1 + 1630.1 = 5725.2 Value of equity = Value of call option: E C = S0 N(d1) N(d2) e rt (S 0 2 ln E + r + 2 t d1 = t

d2

d1 t 0.60 2 13445.2 ln 0.08 + + 2 5725.2 0.60 1 0.854 + 0.26 = 1.857 0.60 1.857 0.6 1 = 1.257 = 0.9678 = 0.8944 13345.2 0.9678 5725.2 1.0

d1

= =

d2 = N(d1) N(d2) C =

5.

0.8944 = 8188.56 million. e 0.081 The adjusted book value approach to valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern. It is a pointer to the liquidation value of the firm. A. Valuation of Tangible Assets I. Fixed Assets: i. Land is valued at its current market price. ii. Buildings are normally valued at replacement cost. However appropriate allowances are to be made for depreciation and deterioration in its conditions. iii. Plant & machinery, capital equipments, furniture, fixtures, etc. are to be valued at fixed costs net of depreciation and allowances for deterioration in condition. II. Current assets: i. The inventory is valued depending upon its nature; the raw materials are to be valued at the rates of the latest orders; the finished goods at the current realizable sale value after deducting provisions for packing, transportation, selling costs etc. The work-in-process can be valued either based on the cost i.e. cost of materials plus processing costs incurred or based on the sales price. ii. Debtors are generally valued at their book value. However, allowances should be made for any doubtful debts. iii. Valuation of cash (including balances with bank) does not need any great expertise. iv. Miscellaneous current assets like income accrued but not due, prepaid expenses, deposits made etc, are to be taken at their book value. B. Valuation of Intangible Assets The valuation of intangible assets like brands, goodwill, patents, trademarks & copyrights, distribution channel, etc, is a controversial area of valuation. The two popular methods of valuing intangibles are given below: I. Earnings Valuation Method: This method of valuation is widely accepted in most markets around the world. The value of an intangible asset like any other asset is equal to the present value of the future earnings attributable to it. This is a two-staged process involving i. determining the future earnings attributable to the intangible asset; ii. applying an appropriate multiplier to determine its present value. The main drawback of this approach is that the future projections of the earnings may be optimistic. II. Cost Method: This method involves stating the value of the intangible asset at is cost to the company. This is relatively easy when the intangible asset is acquired. The money paid to buy the brands can be directly stated. (For e.g. Coca Cola aid Rs.170 cr to acquire the soft drinks brands of Parle). C. Valuation of Liabilities It must be noted that share capital, reserves and surpluses are not included in the valuation. Only liabilities owed to outsiders are to be considered. i. All long-term debt like loans, bonds, etc are to be valued at their present value using the standard bond valuation model. This involves computing the present value of the debt servicing.

D.

Current liabilities include amount due to creditors, short-term borrowings, provision for taxes accrued expenses, advance payment received. Valuation of the Firm The ownership value of a firm is the difference between the value of the assets (both tangible and intangible) and the value of the liabilities. Normally no premium is added for control as assets and liabilities are taken at their economic values. On the other hand, a discount may be necessary to factor in the marketability element. The market for some of the assets may be illiquid or may fetch a slightly lesser price if the buyer does not perceive as much value of the asset to his business. Hence a discount factor may be applied.

ii.

6.

Some of the anti-takeover defenses used by Indus Aluminium Company are as under: i. Share Repurchases: This involves the firm buying back its own shares from the public. This is a sound strategy and has a two-fold impact. Firstly, the amount of floating stock which is available for a raider is reduced. Secondly, the management is able to increase its stake in the company without investing any additional funds. ii. White Knights: White Knight strategy involves selecting of a "lesser evil". White knight defence is effected when a firm is a target of a hostile tender offer. The target firm may invite another firm, called as the white knight, to make a counter offer for its share. The white knight may bid for the shares of the target at a price equal to or greater than the hostile tender offer. iii. Poison Pills: Poison Pills as a defence tool was invented by the famous M&A attorney Marty Lipton (nicknamed as the Dean of takeover defence) to defend El Paso Electric from General American Oil in 1982 and Lenox from Brown Foreman in 1983. The poison pill strategy involved issuing new securities which would be convertible into equity at a low price in the event of an hostile takeover of the firm. Such conversion would severely dilute the equity capital of the firm. iv. Corporate Charter Amendments: The Corporate Charter (the equivalent of Memorandum & Articles of Association in India) is amended by including provisions which impede hostile takeovers. Such amendments to the Charter generally require approval of the shareholders. The common types of charter amendments are super majority provisions, fair price provisions and staggered boards. v. Golden Parachutes: Golden Parachutes are agreements that provide for payment of huge severance packages to the senior management executives in case of takeover of the firm. The word `Golden' signifies the lucrative nature of the compensation payment. vi. Greenmail: Greenmail is a form of targeted share repurchase. It refers to the repurchase of a block of shares from specific shareholder(s), at a substantial premium, to prevent a hostile tender offer on the company. Greenmail brings in significant profits to those, who play their cards well. vii. Standstill Agreements: A standstill agreement refers to the agreement between a target firm and a potential acquirer wherein the potential acquirer agrees not to increase his/her stake in the company, for a fee. Normally standstill agreements are executed when the potential acquirer has bought a significant stakes in the company. viii. Poison Puts: The Poison Put strategy involves issuance of debt with put options exercisable only in the event of an hostile acquisition. The put option allows the debt provider/bond holder to exit from the exposure by making the firm to redeem the loan/ bond. The target firm hopes that the possibility of a liquidity crisis, in the event of exercise of the put option, would make the firm unattractive to the acquirer. ix. White Squire: This strategy entails the target company issuing a large block of shares or convertible preference shares to a friendly party. This is done to dilute the stake of the hostile acquirer in the company by increasing the number of shares.