Financial Management 2

Question 1:
The economically justifiable rationales for mergers are synergy and
tax consequences. Synergy occurs when the value of the combined
firm exceeds the sum of the values of the firms taken separately.(if
synergy exists, then the whole is greater than the sum of the parts,
and hence synergy is also called the 2 + 2 = 5 effect.)
A synergistic merger creates value that must be apportioned
between the stockholders of the companies involved.Synergy can
arise from four sources:
(1) Operating economies of scale in management, production,
marketing, or distribution;
(2) Financial economies, which could include higher debt
capacity, lower transactions costs, or better coverage by
securities analysts that can lead to higher demand and,
hence, higher prices;
(3) Differential management efficiency, which implies that new
management can increase the value of a firms assets; and
(4) Increased market power due to reduced competition.
Operating and financial economies are socially desirable, as are
mergers that increase managerial efficiency. However, mergers that
reduce competition are both undesirable and at times, illegal.
Another valid rationale behind mergers is tax considerations.For
example, a firm that is highly profitable and consequently in the
highest corporate tax bracket could acquire a company with large
accumulated tax losses, and immediately use those losses to shelter
its current and future income.
The motives that are generally less supportable on economic
grounds are risk reduction, purchase of assets at below replacement
cost, control, and globalization.Managers often state that
diversification helps to stabilize a firms earnings stream and thus
reduces total risk, and hence benefits shareholders.Stabilization of
earnings is certainly beneficial to a firms employees, suppliers,
customers, and managers.However, if a stock investor is concerned
about earnings variability, he or she can diversify more easily than
can the firm. Why should Firm A and Firm B merge to stabilize
earnings when stockholders can merely purchase both stocks and
accomplish the same thing? Further, we know that well-diversified
shareholders are more concerned with a stocks market risk than its
stand-alone risk, and higher earnings instability does not necessarily
translate into higher market risk.

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Sometimes a firm will be touted as a possible acquisition candidate
because the replacement value of its assets is considerably higher
than its market value.For example, in the early 1980s, oil companies
could acquire reserves more cheaply by buying out other oil
companies than by exploratory drilling.However, the value of an
asset stems from its expected cash flows, not from its cost.Thus,
paying $1 million for a slide rule plant that would cost $2 million to
build from scratch is not a good deal if no one uses slide rules.

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Question 2:
In a friendly merger, there is an agreement between the
management of the acquiring firm and the management of the
target firm. In most cases, the acquiring firm initiates the action,
and the rest of the time, the target initiatesit.The managements of
both firms get together and work out terms that they believe to be
beneficial to both sets of shareholders.At times, the management
may also encourage shareholders to tender their shares at the
agreed price. Then they issue statements to their stockholders
recommending that they agree to the merger.Of course, the
shareholders of the target firm normally must vote on the merger,
but managements support generally assures that the votes will be
favorable.
If a target firms management resists the merger, or there is
disagreement between the acquiring firm and the target firm, then
the acquiring firms advances are said to be hostile rather than
friendly.In this case, the acquirer, if it chooses to, must make a
direct appeal to the target firms shareholders.This takes the form of
a tender offer, whereby the target firms shareholders are asked to
tender their shares to the acquiring firm in exchange for cash,
stock, bonds, or some combination of the three.If 51 percent or
more of the target firms shareholders tender their shares, then the
merger will be completed over managements objection. A key point
to note is that the management of the target company discourages
the tendering of stockholders shares.
Hostile takeovers generally end up in the acquiring company
offering (and sometimes winning) a premium price for the price of a
share. This is to win over the stockholders of the target firms who
may be skeptical regarding the fair value of the price and / or to
tempt them with monetary incentive. Additionally, a premium
generally detracts other prospective, competing, acquiring firms.

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Question 3:
Net Sales
Variable Operating Costs
Depreciation
Fixed Operating Costs
Interest Expense
Earnings Before taxes
Taxes
Net Income
Plus Depreciation
Cash Flow
Required
Addition
to
Equity
Available Cash Flow
Expected Terminal Value
Free Cash Flow

1996
$20,000,000
1,70,00,000
2,50,000
7,50,000
2,50,000
17,50,000
7,00,000
10,50,000
2,50,000
13,00,000
5,00,000

1997
$25,000,000
2,12,50,000
3,00,000
9,00,000
3,00,000
22,50,000
9,00,000
13,50,000
3,00,000
16,50,000
6,00,000

1998
$31,250,000
2,65,62,500
3,60,000
10,80,000
3,60,000
28,87,500
11,55,000
17,32,500
3,60,000
20,92,500
7,20,000

8,00,000

10,50,000

13,72,500

8,00,000

10,50,000

13,72,500

Interest Expenses are usually deducted in the merger cash flow statements to de
cash flow available to the company. However, for capital budgeting cash flow
required by the investors furnishing the capital is accounted cost of capital disc
including again interest expenses in financing flows for capital budgeting wo
counting."

Retained earnings are also deduced to as that money is accounted for reinves
business & it should not be included in the free cash flow of the company.

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Question 4:
Beta Unlevering:
Beta of Nero
Debt
Equity
D/E
Tax
Unlevered Beta

Values
1.2
40%
60%
0.667
30%
0.82

Beta Relevering
Unlevered Beta
Debt
Equity
Tax
D/E
Relevered Beta

Values
0.82
50%
50%
40%
1
1.31

Column1
Cost of Capital (WACC)
Constant Growth rate
Rf
Market Risk Premium
Cost of Debt
Cost of Equity Re= (Rf+(RmRf))
Equity
Debt
WACC

Values
5%
7%
6%
10%
14.85%
50%
50%
10.43%

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Question 5:

Terminal Value = Final year CF * (1 + Long term growth rate)/(Discount rate - Long te
= $2,35,32,574

If there is another firm that is evaluating Nero, they would get a different WACC unle
keep the same capital structure and they have the same operating risk

Question 6:

(a) Nero's management may consider to employee Poison pills and Golden parach
defensive moves.

(b)Bringing in many firms to bid for Nero would drive up the value of the stock du
between the firms

(c) The management must negotiate in order to get a higher price. In case, they a
they must bring in more companies in order to bid for them

(d)There is sufficient evidence to show that there may arise a potential agency p
Nero's acquisition. The management may be worried about the job security an
golden parachutes. In such a case, it may not favour the shareholders.

Question 7:
NPV
Max offer per share
Max value per
share
Offer rate

$1,87,11,198.24
$3.74
2.621119824
$2.62

$2.62

Question 8:

It is determined on the amount of shares that the owners of the takeover company
case, the owners have an equity share of 30% only. In case they have a higher eq
need to pay them an extra premium. On average, an equal distribution of value b
and the acquired firm would create a perfect synergy

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
Question 9:
The variable cost in the case is given as 85% of the sales. Now if it
goes above 85% the net income will decrease and in turn the cash
flow will be reduced. On the other hand if the variable cost is below
85%, the cash flow for the years increases.
The managers will be interested in the sensitivity analysis to
determine the effect that variable costs have on the price of the
share. In this case, if the share price has to be $3/share, the NPV of
Nero should be (3*5000000)=$15000000.The variable costs will be
more than 85% of the sales.

Question 10:
Beta before merger = 1.2
According to Hamada's EquationBeta levered = beta unlevered * (1+(1-T)*D/S)
Beta before Merger- 1.2 = Beta* (1+(.7*2/3))
Beta After merger = 1.2* (1+ (.6*1))/1.47 = 1.3
Return on Equity = 7+ 1.3*6 = 14.8%
WACC= .5*14.8+.5*10*(1-.4)= 10.4%
Return on equity projected in the analysis is 42% for the year 1996.
Return on equity projected in the analysis is 45% for the year 1997.
Return on equity projected in the analysis is 48.13% for the year
1998.
Return on equity projected in the analysis is 51.38% for the year
1999.
The return on equity is increasing by 3% every year. More
conservative estimates on the various costs can lead to different
values.

Question 11:
30% of the stocks is held by the management of Nero. But an
acquisition requires minimum of 51% of the stocks of the target
company which implies that the bidder should turn to the
stockholders of the company.
ICI pays a premium as we have already discussed above.
Offering the ICIs stocks instead of Neros.
In both the options shareholders accept only if crosses or reaches
their perceived value. Otherwise, the stockholder could accept to a
cash offer if there is an open offer to offer a premium price over the
current market price of the stock. If the offer made is in stock, then

Neros Pasta Inc. Case Study

Analysis

Financial Management 2
the risk is transferred to Neros Pasta, hence they will get a higher
part of the synergy.

Question 12:
ICI should make an offer as below:
It should be a friendly deal with stock price at $2.00 if the
Neros reject the offer then increase the premium to 40% of
$1.5 which is about $2.1
Neros present management should be included to mitigate
the operational risks. An advisory board can be set up from ICI
to work hand in hand with the present management of Neros
Pasta; so that both the parties can make the maximum benefit
of the synergies.
However, if they try to reject the offers, ICI can have a hostile
takeover.

Neros Pasta Inc. Case Study

Analysis