MAKERERE UNIVERSITY

MAKERERE UNIVERSITY BUSINESS SCHOOL

MSc in Banking and Investment

MBI 7107: CORPORATE FINANCE
MUTENYO SOLOMON SYDNEY
HAMDI OMAR
CALVIN DAVID BATEME

Question Four
a) By means of a thorough discussion of working capital components, explain the term working capital
management and reasons why you think working capital is of great importance to you as a corporate
finance manager
Working Capital Management.

Definitions:

1. Working Capital.

It refers to that part of the company’s capital, which is required for financing short-term or current
assets such a cash marketable securities, debtors and inventories.

Working capital is a measure of the company’s efficiency and short-term financial health.

It is a company’s surplus of current assets over current liabilities, which measures the extent to which it
can finance any increase in turnover from other fund sources.

Working Capital is also known as a revolving or circulating capital or short-term capital.

Formula,

Current Assets - Current Liabilities

Major components of working capital are its current assets and current liabilities. The difference
between them makes up the working capital of a business. Current Assets majorly comprise of trade
receivables, inventory, cash, bank balances and current liabilities majorly comprise of trade payables.
The efficient management of these components not only ensures the profitability of the business but
also ensures the smooth running of the business.

There are four Main Components of Working Capital;

Trade Receivables – This is what the business expects to receive from customers. This rises due to the
selling of the goods and services on credit. A crafted receivables management policy ensures timely
collection and avoidance of bad debts for the business.

Inventory -This refers to the goods and materials that a business holds for the ultimate goal of resale,
production or utilization. Inventory Management begins with inventory control and involves the timely
purchase, proper storage, and efficient utilization to maintain even and orderly flow of finished goods to
meet timely commitment by the business and at the same time to avoid excess working capital in
holding of inventory as that will result in a delay in cash conversion cycle and also increase the risk of
obsolescence and increase working capital requirement which adversely impacts the profitability of the
business.

Cash and Bank Balances - Cash is the king and also an essential component of current asset and cash
involves not just cash only but all liquid securities which can be readily converted into cash. Proper Cash
Management goes a long way in keeping the working capital cycle in order and also enables the
business to manage its operating cycle.

Trade Payables - These are the amount which the business has to pay for credit purchases made by it. A
crafted payables management policy goes a long way in ensuring timely payment and cordial business
relations with vendors and creditors.

Working Capital Management.

Refers to all the strategies adopted by the company to manage the relationship between its short-term
assets and short term-liabilities with the objective of ensuring that it continues with its operations and
meet its debt obligations when they fall due. Efficient management of working capital is a fundamental
part of the overall corporate strategy.

Policies of different companies have an impact on the profitability, liquidity and structural health of the
organization. Although investment in sound long-term capital projects receives more emphasis than the
day-to-day work associated with managing working capital, companies that do not handle this financial
aspect (working capital) well will not attract the capital necessary to fund those highly visible ventures
implying that companies must get through the short run to get to the long run.

Why Manage Working Capital?

Working capital management helps maintain the smooth operation of the net operating cycle, also
known as the cash conversion cycle (CCC) which is the minimum amount of time required to convert net
current assets and liabilities into cash.
Working capital management can improve a company's cash flow management and earnings quality
through the efficient use of its resources. Management of working capital includes inventory
management as well as management of accounts receivable and accounts payable.

Working capital management also involves the timing of accounts payable (i.e., paying suppliers). A
company can conserve cash by choosing to stretch the payment of suppliers and to make the most of
available credit or may spend cash by purchasing using cash. Such choices also affect working capital
management.

b) As a corporate Finance manager, what factors would you employ in determining the amount of
working capital to keep for a firm at a particular time?

 Nature of business: The management of working capital is completely different from industry to
industry. A simple comparison of the service industry and manufacturing industry can clarify the
point. In the service industry, there is no inventory and therefore, one big component of working
capital is already avoided and the manufacturing industry an optimal level is required at all
times. So, the nature of the industry is a factor in determining the working capital requirement.
 Production cycle time: The production cycle time refers to the time required for converting the
raw materials into finished goods. Higher, this time, higher would be the time of blocking funds
in the working capital.
 Seasonality of Industry and Production Policy: Businesses based on seasons like manufacturing
of ACs whose demand peaks in summer and dips in winter. The requirement of working capital
will be more in summer, in comparison to winter, if produced in the fashion of their demand.
The policy of producing throughout the year can smoothen the fluctuation of the working capital
requirement.
 Length of operating and cash cycle: The longer the operating and cash cycle, more is the
requirement of working capital.
 Level of Competition: If the industry is competitive, quick response to customer needs is
compulsory and therefore a higher level of inventory is maintained. Liberal credit terms are also
 mandatory with good service to survive in the market. So, the higher the competition, the higher
would be the requirement of working capital.
 Growth and Expansion: Some industries are static and others are growing. Obviously, a growing
industry grows the requirement of working capital also as compared to the static industry.
 Shortage of supply of Raw Material: If the raw material supply is not smooth for any reason,
companies tend to store more of raw materials than needed and that increased requirement of
working capital.
 Dividend Policy: Dividend policy determines the level of retained profits with the business and
retained profits are also used for working capital. This is how; dividend policy affects the need
for working capital.
 Price Levels: The price levels of inventory and other expenses such as labor rates increase the
working capital requirement. If the company also is able to increase the price of their finished
goods, it reduces this impact.

c) Giving examples in each case distinguish between ABC i and J.I.T inventory management technique.

ABC inventory management

ABC inventory management is a technique that’s based on putting products into categories in order
of importance, with A being the most valuable and C being the least. Not all products are of equal
value and more attention should be paid to more popular products. Although there are no hard-
and-fast rules, ABC analysis leans on annual consumption units, inventory value, and cost
significance.

The Pareto Principle says that most results come from only 20% of efforts or causes in any system.
Based on Pareto’s 80/20 rule, ABC analysis identifies the 20% of goods that deliver about 80% of the
value.

Therefore, most businesses have a small number of “A” items, a slightly larger group of B products and
a big group of C goods, a category that that defines the majority of items.

Advantages Disadvatages
  Aids demand forecasting by analyzing a
product’s popularity over time
 Allows for better time management
and resource allocation
 Helps determine a tiered customer
service approach
 Enables inventory accuracy
 Fosters strategic pricing
o Could ignore products that are just
starting to trend upwards
o Often conflicts with other inventory
strategies
o Requires time and human resources

How businesses in various industries employ the 80/20 ratio and ABC analysis:

Retail: Retailers use ABC analysis to identify the products most profitable to the business. They can
then use the data to promote those products across retail locations and ensure there is adequate
stock on hand.

Automotive: The ABC method enables automotive manufacturers to analyze the effectiveness of line
workers, obtain details that inform resource utilization, and determine what equipment is the
highest-performing. Inventory control also provides insight into the necessary raw materials and
valuable information to negotiate new or better contracts with suppliers.

Warehousing: In the warehouse, ABC analysis and segmentation allow the inventory controller to
focus on ways to better manage higher value inventory, including the correct amount of safety stock
to avoid stock outs. Data can also prompt rethinking products sold.

Manufacturing: In a manufacturing setting, ABC analysis helps increase profit margins by classifying
the top 20% of products by revenue. Manufacturers can use the analysis to determine the most
parts and materials those products require and margins. They can use these findings to prioritize
people, time and materials to make the greatest impact.

Just in Time (JIT) inventory management

 Just in Time (JIT) inventory management lowers the volume of inventory that a business keeps on
hand. It is considered a risky technique because you only purchase inventory a few days before it is
needed for distribution or sale. JIT helps organizations save on inventory holding costs by keeping
stock levels low and eliminates situations where deadstock - essentially frozen capital - sits on
shelves for months on end.

Advantages Disadvatages

 Lower inventory holding costs o Problems fulfilling orders on time

 Improved cash flow o Minimal room for errors

 Less deadstock o Risk of stockouts

One example of a JIT system is a car manufacturer, a manufacturer of cars operates with bare minimum
inventory levels as there is a strong reliance on the supply chain to deliver the parts required to
manufacture cars. The parts required in the manufacturing of cars do not arrive before or after they are
needed; rather, they arrive only when they are needed.

d). Uganda Bulldozer ltd mentioned in 1b) above produces products which the company sells
throughout the country. The demand for the products is 70,000 units per year costing SHS.8000 per unit
to produce. Ordering costs of materials used in making the products are SHS.10, 000 per order while
carrying costs are 20% of the production cost. The demand in the next year is expected to increase by
30%. The company’s objective is to minimize inventory costs as one of its prudent working capital
management practices.

Required;

i) Determine the present EOQ for Uganda Bulldozer ltd Sources.

 Economic order quantity (EOQ) is the reorder quantity which minimizes the total costs
associated with holding and ordering stock. This implies that holding costs and ordering costs
are at a minimum at EOQ

Data;

A-Demand- 70,000 units per year costing

P- Ugx8, 000 per unit to produce.

O- Ordering costs of materials used in making the products are Ugx.10, 000 per order

C- Carrying costs are 20% of the production cost.

Demand in the next year is expected to increase by 30%

Carrying cost =8000*20%= 1,600

EOQ = √ (2 * A * O) or √2AO
P*C C
How is EOQ formula derived?

The total cost function and derivation of EOQ formula Purchase cost: This is the variable cost of goods:
purchase unit price × annual demand quantity. This is P × D. Ordering cost: This is the cost of placing
orders: each order has a fixed cost K, and we need to order D/Q times per year. This is K × D/Q

Therefore;

Where A-annual sales, O-cost per order, P-Purchase price per unit, C- carrying Cost

=√ (2*70,000*10,000)
(8000*1600)
= √1,400,000,000
12,800,000
= √ (109.375)
Ans. = 10.45 Units.
 ii) What would be the optimal number of orders per year at the level of EOQ in i) above.
Annual demand = 70000
EOQ 10.45
= 6,699 orders.
iii) Determine the total cost of inventory at that level.
Total Inventory Cost is the sum of the Purchase cost, carrying cost and the ordering cost of
inventory.
Purchase cost = Annual Requirement * Purchase price per unit
= 8000*6,699
= 53,592,000
≈ 53,592,000 + 10,000 + 10,718,400 = 64,320,400.

iv) What would be the EOQ for Uganda Bulldozer ltd next year?
EOQ = √ [(2 * A * O) / (P * C)]

=√ [(2*91,000*10,000)/ (8000*1600)
= √ (1,820,000,000/12,800,000)
= √ (142.1875)
= 11.92 Units.

Question Five

a) You are a Finance Manager of a company described by the recently hired financial analyst as:
‘currently facing challenges of overtrading’. Write a memo to the CEO regarding meaning of the
term overtrading and how it differs from over capitalization. In your explanation, indicate the
signs and causes of both overtrading and overcapitalization that would convincingly tell the CEO
more about your company’s current financial situation.
 Overtrading
Overtrading is the practice of conducting more business than can be supported by a firm’s
working capital. When this happens, a company usually runs out of cash, placing it at
considerable risk of bankruptcy.
In this case, a company seeking more sales offers easy credit to its customers on long payment
terms. The outcome is that the firm has to pay for the goods it sold to the customers but will not
have any proceeds from the sales for a long time, and so does not have sufficient cash to pay its
suppliers.

Overtrading can be avoided by regularly updating a cash forecast, as well as maintaining a line of
credit with a lender. Importantly, overtrading can occur even when a business is profitable. It is
an issue of working capital and cash flow. This is so because the firm will have committed their
credit sales for a longer time payment. In this, it implies that the company will not be able to pay
up when required.

Signs of over trading

 High revenue growth but low gross and operating profit margins
 Persistent use of a bank overdraft facility
 Significant increases in the payables days and receivables days ratios
 Significant increase in the current ratio
 Very low inventory turnover ratio
 Low levels of capacity utilization

Causes of Over trading.

 Growth is achieved by making significant capital investment in production or operations capacity

before revenues are generated
 Sales are made on credit and customers take too long to settle amounts owed
 Significant growth in inventories is required in order to trade from the expanding capacity
  A long-term contract requires a business to incur substantial costs before payments are made by
customers under the contract.

Overcapitalization

Overcapitalization occurs when a company has issued more in debt and equity than its assets are worth.
If this is the case, the market value of the company is less than the total capitalized value of the
company. An overcapitalized company might be paying more in interest and dividend payments than it
can sustain in the long term.

Causes of Overcapitalization.

1. Over-issue of capital:

Defective financial planning may lead to excessive issue of shares or debentures. The issue would be
superfluous and a constant burden on the earnings of the company.

2. Acquiring assets at inflated prices:

Assets may be acquired at inflated prices or at a time when the prices were at their peak. In both the
cases, the real value of the company is below its book value and the earnings are very low.

3. Formation during the boom period:

If the establishment of a new company or the expansion of an existing concern takes place during the
boom period, it may be a victim of over- capitalization. The assets are acquired at fabulous prices. But
when boom conditions increase prices of products decline resulting in lower earnings. The original value
of assets remains in books while earning capacity dwindles due to depression. Such a state of affairs
results in over- capitalization.

4. Over- estimation of earnings:

The promoters or the directors of the company may over-estimate the earnings of the company and
raise capital accordingly. If the company is not in a position to invest these funds profitably, the
company will have more capital than required. Consequently, the rate of earnings per share will be less.
5. Inadequate depreciation:

Absence of suitable depreciation policy would make the asset-values superfluous. If the depreciation or
replacement provision is not adequately made, the productive worth of the assets is diminished which
will definitely depress the earnings. Lowered earnings bring about fall in share values, which represents
over-capitalization.

6. Liberal dividend policy:

The company may follow a liberal dividend policy and may not retain sufficient funds for self- financing.
It is not a prudent policy as it leads to over-capitalization in the long run, when the book value of the
shares falls below their real value.

7. Lack of reserves:

Certain companies do not believe in making adequate provision for various types of reserves and
distribute the entire profit in the form of dividends. Such a policy reduces the real profit of the company
and the book value of the shares lags much behind its real value. It represents over-capitalization.

8. Heavy promotion and organization expenses:

“A certain degree of overcapitalization,” says Beacham, “may be caused by heavy issue expenses”. If
expenses incurred for promotion, issue and underwriting of shares, promoters’ remuneration etc.,
prove to be higher compared to the benefits they provide, the enterprise will find itself over-capitalized.

9. Shortage of capital:

If a company has small share capital it will be forced to raise loans at heavy rate of interest. This would
reduce the net earnings available for dividends to shareholders. Lower earnings bring down the value of
shares leading to over-capitalization.

10. Taxation policy:

High rates of taxation may leave little in the hands of the company to provide for depreciation and
replacement and dividends to shareholders. This may adversely affect its earning capacity and lead to
over-capitalization.
Signs of Over Capitalization.

 The amount of capital invested in the company’s business is much more than the real value of its
assets.
 Earnings do not represent a fair return on capital employed.
 A part of the capital is either idle or invested in assets which are not fully utilized.

b) What are the consequences over capitalization from;

i. Company’s point of view.

 Loss of goodwill. In an over-capitalised company, there is a reduced earning capacity resulting in

the fall of market price of its shares and thereby shaking up the investor’s confidence. A
company whose shares sell below the face value may find it difficult to improve its goodwill in
the market.
 Poor creditworthiness. Reduced earnings of an over-capitalised company affect its
creditworthiness and as a result, it becomes difficult for it to get loans or credit at cheaper rates
of interest.
 Difficulties in obtaining capital. For a company faced with a situation of over-capitalisation, it is
very difficult to obtain further capital for its growth and expansion programmes. It is so because
the investors have already lost confidence in the company.
 Decline in efficiency of the company. To cover for one loss, other losses are incurred by the
company and in the process overall efficiency of the company declines. Such a company usually
does not make adequate provisions for depreciation, repairs and renewals, etc., leading to
further decline in its efficiency.
 Loss of market. Over-Capitalised companies fail to produce goods at competitive costs and,
hence, often lose their market to competitors.
  Inflated profits. In order to regain the confidence of its investors, over-capitalised companies
generally resort to manipulation of accounts and over-statement of their profits. These inflated
profits lead to payments of dividends out of capital.
 Liquidation of company. An over-capitalised company goes into liquidation unless drastic steps
are taken to re-organise the whole capital structure, and re-organisation would itself lead to a
lot of problems.

ii. Society’s point of view

 Loss to Consumers

In order to prevent declining trend of income, an over-capitalised concern resorts to increased prices
and reduction in quality of its products hence consumers have to suffer by paying more for the poorer
quality.

 Loss to Workers:

An over-capitalised company tends to reduce wages and welfare facilities of the workers to reduce
losses of the earnings. No consideration is given to the demands of the workers and some of them even
lose their jobs because of layoffs and retrenchment and closure of such units.

 Under or Misutilisation of Resources:

An over-capitalised concern either misutilises or under utilises its resources. Hence, the scarce
resources of society are not properly utilised.

 Gambling in Shares:

Another social evil of over-capitalisation is promotion of gambling habits by providing scope for
gambling in shares of such a company.

 Recession:

Over-capitalisation leads to increased losses, poor quality of products, retrenchment or unemployment

of workers, decline in wage rates and purchasing power of labour. This tendency gradually affects the
entire industry and the society, and may lead to recession of economy.
iii. Shareholders’ point of view.

 Reduced dividends. An over-capitalised company will not be able to pay a fair rate of dividend to
its shareholders because it is earning a low rate of return (earnings) on its capital. More so, the
payment of dividend becomes uncertain and irregular.
 Fall in the value of shares. Low rate of earnings and reduced dividends cause fall in the market
value of shares of the over-capitalised company. Thus, shareholders have to suffer a loss in
capital due to depreciation of their investments.
 Unacceptable as collateral security. The shares of an over-capitalised company have small value
as collateral security. Banks and other financial institutions are reluctant to lend money against
such securities. Hence, it is very difficult for the shareholders to borrow money against the
security of their shares.
 Loss on speculation, the prices of the shares of an over-capitalised company remain unstable
because of speculative dealings in such shares. This malpractice further adds to the losses of the
shareholders.
 Loss on re-organisation. An over-capitalised company has to often resort to reorganisation and
reduction of its capital in order to write off the accumulated losses. This results in the reduction
of face value of shares and loss to its owners.

c) Explain the remedies for the overtrading and over capitalization challenges.

Remedies for over trading.

 Accurate Cash flow Forecasting - If a business intends to adopt an aggressive and ambitious
growth strategy, it must match the planning with accurate cash flow forecasting. Thus, improved
and accurate cash flow forecasting plays an integral role in managing working capital and
reducing the impact of overtrading.
 Arrange A Financing Facility - overdrafts and other short-term bank loans can help a business in
managing its working capital needs. If the business has an adequate leverage level, it should opt
for long-term bank loans. It can help reduce overtrading effects as well as manage working
capital in the long run.
  Negotiate Credit Terms With The Suppliers - Negotiations with suppliers for better credit terms
can help a business solve working capital issues. That, in turn, will help it to reduce overtrading
problems.
Once the suppliers allow for better credit terms, the business will be able to turn its inventory
into cash frequently. It will ease the liquidity pressure and reduce a firm’s dependency on
borrowed money as well.
 Rearrange Supply Orders - An effective way of reducing overtrading impact is to rearrange the
supply orders. A business can take supplier orders that take fewer days to complete.
Alternatively, a business can complete the supplier orders that offer quick cash payments.
 Enforcing better payment terms with customers (e.g. through prompt-payment discounts)

Remedies for Over-Capitalization:

 Efficient Management:
Management should try to become more efficient and try to curb excess expenditure. Earning
capacity should be improved and care must be taken to spend every single rupee in the most
profitable and economic manner.
 Redemption of Preference Shares:
Preference shares carrying high rate of dividend should be redeemed out of retained earnings in
order to raise the share of equity shareholders.
 Reduction of Funded Debts:
Debentures, public deposits and loans taken at higher rates of interest should be prepaid out of
accumulated profits or out of fresh borrowings at lower rates of interest, if there are no
accumulated profits.
 Reorganization of Equity Share Capital:
The face value or the number of equity shares may be reduced in order to rectify over-
capitalization. Sometimes, shareholders may oppose to this proposal but actually their
proportionate interest in the equity is not reduced. The amount available due to reorganization
of share capital is utilized for writing off the fictitious assets and other over-valued assets.
D) Using examples, illustrations, advantages and disadvantages in each case if any, explain what you
understand by the following strategies as applied in corporation growth and corporate failure.

I. Withdrawal or abandonment: This is an act of surrendering a claim to or interest in a particular

asset. It could also mean a permitted withdrawal from a forward contract that is made for the
purchase of deliverable securities. Abandonment options are commonly used in bilateral
agreements without a set time frame for expiry. Usually, one party may decide to exit from the
relationship without penalty if the salvage value of the project completed to date exceeds the
present value of the project's expected cash flows over the life of the project's contract. The
business contract must explicitly state the option as part of a contract's terms and specifies that
neither party will incur any penalties should either of them invoke the abandonment clause. A
good example would be if an employee withdraws from an employment contract containing an
abandonment option. In this case, employer cannot contest this withdrawal.
II. Management buy outs. This is a form of acquisition in which a company’s existing managers
acquire a large part or all of the company. E.g. Company XYZ is a listed company where the
owner owns 60 % of the company’s stock, and the remaining 40% is stock traded in public.
Company planned management buyout, as per the plan, management of XYZ Ltd will undertake
arrangement to acquire appropriate shares from the public so that they possess a controlling
interest of around 51% of the company’s total shares. To finance this arrangement, the
management may look to a bank, financial capitalist or VCs to help them in funding and set up
the acquisition of the target company.
One of the major advantages is that Confidentiality can be maintained i.e. all the details can be
confidential as no external person will be involved in the acquisition process. WHILE a major
disadvantage is the difficulty in rising funding to buy necessary shares.
III. Leverage buy out: This is the acquisition of another company using a significant amount of
borrowed money to meet the cost of acquisition. In this arrangement, assets of both companies
(acquiring and to be acquired) are used as collateral to the borrowed funds. An example of this
could involve the delisting of a publically traded company to make it private. A major advantage
of this is that the High debt and low capital mean lower taxes as interest costs are deductible.
LBOs are sometimes referred to as “going private” transactions, because after the acquisition of
 a publicly traded company, the target company’s equity is substantially no longer publicly
traded. LBO managers seek to add value from improving company operations, growing revenue
and ultimately increasing profits and cashflows.
IV. Buy-in: repurchasing of shares by an investor because the original seller failed to deliver the
shares as promised. A buy-in can also be an agreement to purchase shares of something, in
some cases to buy a stake in a company that also has other owners.
V. Spin offs and Sell off: A spin off is a situation in which a company offers stock in one of its
wholly-owned subsidiaries or dependent divisions such that subsidiary or division becomes an
independent company. The parent company may or may not maintain a portion of ownership in
the newly spun-off company. (add an example)

A sell off is the rapid sale of a security by a large number of holders. This increases the supply of
the security available for sale and therefore drives down the price. This could be due to a
company issuing a negative earnings report, or if there are reports of a new technology
rendering the company's product obsolete, or if the company's costs rise. (Add an example)

VI. Demergers: A de-merger is a corporate restructuring in which a business is broken into

components, either to operate on their own, or to be sold or to be liquidated as a divestiture.
Companies demerge the units which form the core business or the potential units which it
proposes to focus from the rest of its business.
The demerged businesses derive the benefit of focused leadership which in turn is helping to
streamline the business.
One such example is of RCOM (Reliance Communication), who demerged its non-core assets to
form Reliance Property Limited; this step was taken to divest the non-core assets and to focus
on the core assets.
VII. Going private: Refers to a transaction or series of transactions that convert a publicly traded
company into a private entity. Once a company goes private, its shareholders are no longer able
to trade their shares in the open market. Examples of companies that have been delisted from
the New York Stock Exchange in the past include; Jos International Breweries, West Africa Glass
Industries Plc.
VIII. Company liquidation: The term liquidation refers to the formal insolvency procedure, in which a
company is brought to a close by an appointed licensed insolvency practitioner.
IX. Company reconstruction schemes: Is a scheme whereby a company reorganizes its capital
structure by changing the rights of its shareholders etc. This happens when a company is in
financial difficulties, but also when a company is seeking floatation or being acquired.
d) Predicting company failure: The financial failure of a company can have a devastating effect on
all seven users of financial statements e.g. present and potential investors, customers, creditors,
employees, lenders, the general public, etc. As a result, users of financial statements are
interested in predicting not only whether a company will fail, but also when it will fail e.g. to
avoid high profile corporate failures like Enron. Users of financial statements can predict the
financial position of an organization using financial statements i.e. balance sheet, income
statements, and cash flow statements. They use ‘Z’ score model in order to assess the financial
position of the company e.g. shareholders of a firm may use ‘Z ‘score to provide an early warning
signal of failure. If the ‘Z’ score is negative, it shows that the business is at risk and customers
might opt for alternative product. However this model is limited given that it requires use of
historical data.

e) Luzira sugar corporation plc is a large sugar-refining business that is currently considering the
takeover of Delta plc, an engineering business. Financial information concerning each Business is as
follows:

Income statements for the year ended 30 June 2021

Luzira Plc Delta plc

SHS. million SHS. Million

Sales revenue 432.5 242.6

Operating profit 64.8 35.0

Interest payable (20.6) (13.2)

Profit before taxation 44.2 21.8

Taxation (10.6) (7.4)

Profit for the period 33.6 14.4

Other financial information

Ordinary shares (Shs. 1.00 nominal) 120.0m 48.0m

Dividend payout ratio 30% 35%

Price/earnings ratio 20 16

The board of directors of Luzira Plc has offered shareholders of Delta plc 10 shares in Lexus plc for every
5 shares held. If the takeover is successful, the price/earnings ratio of the enlarged business is expected
to be 20 times. The dividend payout ratio will remain unchanged. As a result of the takeover, after-tax
savings in head office costs of shs.10.6m per year are expected.

You are required to:

Calculate

(i) The total value of the proposed bid;

Data,
No. of shares for Luzira – 120,000,000
NO. of shares for Delta – 48,000,000
PE-for Luzira –20x
PE for Delta- 16x
PAT of Luzira – 33.6Mn
PAT of Delta – 14.4Mn
Let Luzira be L and Delta D

Value of Proposal Bid.

=PvLD-PvD
But PvLD is the value of L that D shareholders will get.
PxL,
 EPS= PAT
No. of shares
= 33,600,0000 = 0.28
120,000,000

PxD
EPS= PAT
No. of shares

= 14,400,000 = 0.3
48,000,000

BUT, Px for Luzira

PE = Px
EPS

=Px= PE* EPS

=20*0.28

=5.6

Px for Delta

PE = Px
EPS

=Px= PE* EPS

=16*0.3

=4.8

From the formula

Pv LD-PvD
PvLD is the value of L that D shareholders will get

Using Swap ratio of 10 for every 5 owned which is equal to 2:1

This implies that a shareholder of Delta will earn 2 shares of Luzira for every 1 owned.

Market Cap. – No. of outstanding shares * Price

Luzira – 120m * 5.6m = 672m

Delta – 48m* 4.8m = 230.4m

PvLd = 672 + 230 = 902m.

Cost of takeover = PVld – Pvd.

Where PvLd = Value in luzira that delta shareholders get after take over.

= 120m + (48*5)

= 216m.

Shares offered to delta * market price/ share of luzira) – Market capitalization od delta

= (96m*5.6)- 230

=537.6 – 230.4 = 307.2m

Proportion that Delta shareholders get on luzira’s capital structure

96m/120 + 96m = 0.4444

True cost or merger = PvLD – PVd

=(0.4444 * 902.4) – 230.4 = 170.6667m.

Value of Proposed Bid

PvLd – Pvd

=902.4 – 170.67

= 731.73m
ii) The expected earnings per share and price of Luzira PLC after the take over

= Acquirers Pat + Targets Pat +/- Incremental adjusments

Acquirers shares outstanding + new shares given out.
= 33.6 + 14.4 + 10.6
216
= 0.2713.

Share Price = Expected P/E * EPS

= 20*0.2173
= 5.43.

(b) Evaluate the proposed takeover from the viewpoint of an investor holding 10,000 shares in
(i) Luzira Plc
Before at price of 5.6 = 5.6* 10,000
= 56,000.
After price of 5.43 = 5.43* 10,000
= 54,300.
(ii) Delta plc.
Before at price of 4.8 = 4.8*10,000
= 48,000.
After price of 5.43 = 5.43*(10,000*10/5)
= 108,600.
Question six

a) Giving examples, types, advantages and disadvantages in each case, distinguish between
mergers and acquisitions as extensions of capital budgeting decision.

Types, advantages, and disadvantages of merger

Merger

A merger is a corporate strategy to combine with another company and operate as a single legal entity.
The companies agreeing to mergers are typically equal in terms of size and scale of operations.

Examples are; Exxon & Mobil that merged in 1999 to form ExxonMobil, Manji Holdings’ Yo Kuku merged
with South Africa’s RCL food’s Enkoko to form a new firm, HMH-Rainbow, with both sides describing it
as the “biggest chicken firm in the region.”

Types of mergers

1. Congeneric/Product extension merger

Such mergers happen between companies operating in the same market. The merger results in the
addition of a new product to the existing product line of one company. As a result of the union,
companies can access a larger customer base and increase their market share. Example is the
acquisition of Pizza Hut by Pepsi Co.

2. Conglomerate merger

Conglomerate merger is a union of companies operating in unrelated activities. The union will take
place only if it increases the wealth of the shareholders. One example of a conglomerate merger was
the merger between the Walt Disney Company and the American Broadcasting Company.

3. Market extension merger

Companies operating in different markets, but selling the same products, combine in order to access a
larger market and larger customer base. Think about two companies that both sell clothing and fashion
accessories. Company A sells clothes in the outskirts, whereas company B sells to people that are in the
main town. By merging the two companies, all categories of people would be targeted with the
resulting product line.

4. Horizontal merger

Companies operating in markets with fewer such businesses merge to gain a larger market. A horizontal
merger is a type of consolidation of companies selling similar products or services. It results in the
elimination of competition. An example of this is the Integration of Facebook, Whatsapp, Instagram &
Messenger.

5. Vertical merger

A vertical merger occurs when companies operating in the same industry, but at different levels in the
supply chain, merge. Such mergers happen to increase synergies, supply chain control, and efficiency.
An example is the merger between Walt Disney and Pixar.

Advantages of a Merger

• Increases market share

• Reduces the cost of operations

• Avoids replication

• Expands business into new geographic areas

• Prevents closure of an unprofitable business

Disadvantages of a Merger

• Raises prices of products or services

• Creates gaps in communication

• Creates unemployment

• Prevents economies of scale

Types, advantages and disadvantages of acquisitions

Acquisitions

Acquisition is the process of acquiring one or more companies by acquirer without affecting the acquirer
brand name or autonomy. The targeted company or companies will exist and continue their operations
but they have to work under acquirer name and their terms. This ownership change takes place.

Example: Kenya’s Brookside Dairy acquired Sameer Agriculture and Livestock, which had been a key
player in the milk industry in Uganda

Types of acquisitions

• Horizontal acquisition − If one company acquires, another company in the same industry is called
horizontal acquisition. An example is the acquisition of Chrysler by Daimler-benz.

• Vertical acquisition − If one company acquires another company, who are the suppliers or
distributors of their products is called vertical acquisition. For example, if a clothing company acquires a
textile factory, this is considered a vertical acquisition.

• Conglomerate acquisition − If one company acquires another company in a different sector or in

different industry to diversify is called conglomerate acquisition.

• Congeneric acquisition − If one company acquires another company who are having similar
technology, distribution line or similar production is called congeneric acquisition.

Advantages of acquisition

• New markets and product lines.

• Increase in market share.

• Growth in revenues.

• Can withstand economic slump.

• Access to specialists.

• Capital gain.
• New ideas.

Disadvantages of acquisition

• Culture conflicts between two companies.

• Job cuts/ increase in unemployment.

• Clash between objectives between companies.

• Low productivity.

• Employee morale may decrease.

• Choosing the right company to acquire, otherwise it may damage the productive company.

• Brand value can be damaged.

• Production problems.

Distinguish between mergers and acquisitions as extensions of capital budgeting decision.

The primary difference between mergers and acquisitions is that a merger is the combining of two
organizations into an entirely new entity, while an acquisition is when a company absorbs another, but
no new organization is created.

In the acquisition, both the acquirer and the target still exist. The target continues to operate its
business as an independent organization.

After the acquisition is complete, the acquirer becomes a holding company, while the target company
becomes a subsidiary.

As stated, a merger occurs when two organizations combine to create an entirely new entity. Each party
holds a share of the ownership of the new company, and the two previous organizations are dissolved.
A new management structure is created, and it functions as an entirely new company.

Typically, mergers are friendlier than acquisitions. Both parties agree to combine together, and they
both stand to benefit from the agreement.
In a merger, negotiations primarily center on how much of a share each entity has in the new
organization. New shares are issued by the company and distributed proportionally between the parent
companies. In most cases, mergers don’t involve any cash.

Common Reasons to Merge

Companies that decide to merge often do so in order to expand their reach to new markets, reduce
operational costs, and improve profits. Each parent company may benefit from the operational capacity
and reach of the other, even if it means sacrificing some individual power to do so.

Acquisitions tend to be more hostile than mergers since there is usually a high imbalance in power. They
are also more common since it’s fairly rare for two companies of roughly equal standing to consent to
merging. Often, acquisitions are called mergers purely to avoid a negative connotation.

In an acquisition, one company buys the other. As such, the negotiations center on the purchase price,
and they often require high amounts of cash.

b) Assume that company A intends to acquire company B by issue of common stock. The finance data
on the potential acquisition at the time of consideration was as follows:

Company A Company B

Present earnings 600,000,000 150,000,000

Shares outstanding 150,000,000 60,000,000

Price per share 128 60

Earnings per share 4 2.5

Price/earnings ratio 32 24

a) To ascertain the post- merger position of the acquiring company A at the acquisition price of
SHS.70

Exchange Ratio = acquirer’s price / Price per share for Target’s

 70/60= 1.167

1.167 This means company A has to issue 1.167 of its own shares for every 1 share of the Target it plans
to acquire.

Post-merger EPS of company A. Acquirer’s Present earnings +target’s Present earnings

Acquirer’s share outstanding + (target’s share outstanding/ Exchange Ratio)

= 600,000,000 +150,000,000

150,000,000 + (60,000,000/1.167)

= 750,000,000

201,413,882

= 3.72

b) Using the same companies, A and B, supposing that the price offered and agreed upon per share to
be paid in company A’s stock for each share of B is SHS.90 instead of SHS.70 per share,

Determine the post- merger position of A at the acquisition price of SHS.90

Exchange Ratio = acquirer’s price / Price per share for Target’s

90/60

= 1.5
Post-merger EPS of company A. Acquirer’s Present earnings +target’s Present earnings

Acquirer’s share outstanding + (target’s share outstanding/ Exchange Ratio)

= 600,000,000 +150,000,000

150,000,000 + (60,000,000/1.5)

= 750,000,000

190,000,000

=3.95

REFERENCES

Corporate Finance by David Hillier, Stephen Ross, Randolph Westerfield, Jeffery Jaffe, Bradford Jordan
https://corporatefinanceinstitute.com/resources/knowledge/deals/merger/

 http://www.investopedia.com/  .

https://abdavid.com/mergers-acquisitions-in-uganda-recent-developments/

https://www.netsuite.com/portal/resource/articles/inventory-management/abc-inventory-
analysis.shtml#:~:text=%20ABC%20analysis%20is%20an%20inventory%20management
%20technique,group%20items%20into%20classes%20based%20on%20those%20criteria.

Components of Working Capital (Top 4) | Detailed Explained (wallstreetmojo.com)

Factors Determining Working Capital Requirement (efinancemanagement.com)

https://cleartax.in/s/just-in-time-jit-inventory-management/

What is Overtrading in Working Capital Management? - Accounting Hub (accountinghub-online.com)

How is EOQ formula derived? – TheKnowledgeBurrow.com