Answers to Test Your Understanding questions

Test your understanding 1

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£000 Explanation I justification

Non current assets
1,500 Ray pic is buying the business, so would
have to buy the machinery from scratch if
it decided on the alternative of organic
growth. The realisable value will be a
useful minimum value from Ribbon Ltd's
perspective, but it is not relevant to Ray
pic.

Current assets 414 The inventory and receivables relating to

the bankrupt customer will not be acquired
(564-120-30) by Ray pic. They are therefore excluded
from the valuation.

Less Current liabilities
(518) In order for Ray pic to takeover Ribbon
Ltd, it needs to buy the equity of the
business. After the takeover, Ray pic will
be responsible for meeting these liabilities,
so they should be included in the valuation
of Ribbon Ltd.

Less Loan (600)

Total net assets value 796

. . " ;»i '.,. N ~

Test your understanding 2 <

.'

(a) and (b) See Interactive Question 1 answer on ICAEW Study Manual p 216

(c) Po = 250,000 xAF 1-3 (14%) + [(250,000x1.04) I 0.14-0.04)] x DF 3 (14%)

= £2,335,334
.;.
Test your understanding 3
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Briefing note for the management of AB

AS intends to make a bid for XV. In order to decide what level of bid would be
appropriate, we shall prepare some calculations to assess the value to AS of
taking over XY (i.e. including synergies), but we shall also consider the value of
XY independently (since this is the value that the shareholders of XY will expect
as an absolute minimum bid).

Value of XY independently

XY is not a listed company, so we shall have to use a proxy PIE ratio.

The three similar listed companies have an average PIE of 12 (i.e.
(10.7+11.1 +14.2)/3)

XY's most recent earnings (PAT) were £S5m, but assuming the exchange losses
in the most recent year were a one-off expense, the sustainable earnings are
£100m (£S5m + £15m)

Hence, value = 12 x £1OOm= £1,200m.

It could be argued that the PIE ratio should have been reduced because

• XY is unlisted so its shares are less marketable

• the average PIE is possibly distorted because one of the values is much
higher than the others.

However, on the other hand, XY's shareholders will expect a premium to be

offered on a takeover, so it is prudent to consider that £1,200m is likely to be
around the minimum amount that they would accept.

Value of XY to AB

If AB and XY combine, the combined sustainable earnings (PAT) is likely to be

£325m (i.e. £200m from AB, (£S5m + £15m) from XY and £25m synergy).

For the combined company, it is difficult to calculate a PIE ratio specifically, but
we could assume that the combined PIE would be the same as AB's before the
takeover.(on the basis that if the market applied a PIE of 14 to the company
before the takeover, it may continue to consider the company to have similar
prospects and growth expectations thereafter).

N.B. Other assumptions could have been made here.

Using this assumption, the expected value of the combined company is

14 x £325m = £4,550m
Since A is worth 14 x £200m = £2,SOOmat the moment, this means that the value
of XY (and associated synergies) to AB is £4,550m - £2,SOOm= £1,750m.

Recommendation

The absolute maximum that AB should be prepared to pay for XY is £1,750m,

while the minimum that XY shareholders would accept is likely to be around
£1,200m.

AB should open the bidding towards the lower end of this range (say £1,300m) but
be prepared to increase the bid if necessary up towards £1,750m.
Test you; understanding 4
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£m Year 1 Year 2 Year 3 etc

Sales (x1.03x1.05) 308.3 333.5 360.6

Cost of sales (x1.05) (126.9) (133.3) (140.0)

Gross profit 181.4 200.2 220.6

Operating expenses (66.9) (66.9) (66.9)

Operating profit (EBIT) 114.5 133.3 153.7

Less: Tax (26%) (29.8) (34.7) (40.0)

Add: Depn 12.3 12.3 12.3

Less: Capex (15.0) (15.0) (15.0)

Less: WC investment (2.0) (2.0) (2.0)

Free Cash Flow 80.0 93.9 109.0

Discount factors (12%) 0.893 0.797 0.797/0.12

Present value 71.4 74.8 723.9

Net present value = £870.1m (= value of equity and debt)

Therefore, value of equity = £870.1 m - £200m = £670.1m