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Q. Harmony Limited is intending to acquire the Taikon Limited. In this connection, the
Harmony Limited is seeking your suggestion as to whether acquire or not the Taikon Limited.
The Balance Sheet of the Taikon Limited as on March 31, 2016 is as follows:

Liabilities Amount (Rs. Lakh) Assets Amount (Rs. Lakh)

Equity Share Capital (4 Lakh
400 Plant and Machinery 800
Shares of Rs. 100 each)
Retained Earnings 200 Inventory 150
11% Debentures 300 Receivables 100
Creditors 200 Cash 50
Total 1100 Total 1100

The following additional information is supplied to you:

(i) The shareholders of Taikon Limited will get 1.5 shares in Harmony Limited for
every 2 shares,
(ii) The shares of the Harmony Limited will be issued at current market price of Rs.
200 per share,
(iii) The debenture holders will get 12% debentures of the same amount,
(iv) The creditors are to be settled at Rs. 190 Lakh,
(v) Acquisition expenses of Rs. 20 Lakh are to be met by the Harmony Limited,
(vi) The projected free cash flows from the acquisition are as follows:

Year 1 Rs. 150 Lakh Year 4 Rs. 280 Lakh

Year 2 Rs. 180 Lakh Year 5 Rs. 350 Lakh
Year 3 Rs. 220 Lakh Year 6 Rs. 350 Lakh

(vii) The free cash flow of the Taikon Limited is expected to grow at 3% per annum
after the sixth year,
(viii) There is a contingent liability of Rs. 25 Lakh which will devolve on the Harmony
Limited consequent to acquisition,
(ix) The relevant PV factors are as follows:
Year 1 0.885 Year 2 0.783 Year 3 0.693
Year 4 0.613 Year 5 0.543 Year 6 0.480

Solution:

Calculation of Number and Value of Shares Issued:

1.5 shares for every two shares (1.5/2)X4,00,000 = 3,00,000 shares @ Rs. 200 per share
totaling to shares of Rs. 600 Lakh

Calculation of Cost of Acquisition: Shares 600 Lakh

12% Debentures 300 Lakh
Creditors 190 Lakh
Acquisition Exp. 20 Lakh
Contingent Liability 25 Lakh
1135 Lakh
 2

Calculation of Gross Present Value of Free Cash Flows:

Year FCF FCF X PV Factor PV

Year 1 Rs. 150 Lakh 150 X .885 132.75
Year 2 Rs. 180 Lakh 180 X .783 140.94
Year 3 Rs. 220 Lakh 220 X .693 152.46
Year 4 Rs. 280 Lakh 280 X .613 171.64
Year 5 Rs. 350 Lakh 350 X .543 190.05
Year 6 Rs. 350 Lakh 350 X .480 168.00
Gross Present Value 955.84

Calculation of K =
PV factor for Year 1 as given in the question = .885
As per Discounting Formula PV = 1 / (1+r)
.885 = 1 / (1+r)
.885 X (1+r) = 1
.885 + .885r = 1
.885r = 1 - .885 = .115
r = .115 / .885 = .1299 = .13 = 13%

Calculation of Terminal Value:

FCF of the Year 6 (1+G) 350 (1 +.03 )
Terminal Value = =
K–G .13 - .03

350 X 1.03 360.5

= = = 3605
.10 .10
Present Value of Terminal Value = TermiValue X PV Factor of 6th Year
= 3605 X .480
= 1730.4

Total PV of FCFs = 955.84 + 1730.40 = 2686.24

NPV = Total PV – Cost of Acquisition = 2686.24 – 1135.00 = 1551.24

Since the NPV from the acquisition is positive, therefore the acquisition serves the objective of
wealth maximization. As such, the Harmony Ltd. is advised to acquire the Taikon Ltd.