201512 Q1

201512 Q1
Cigno Co is a large pharmaceutical company, involved in
the research and development (R&D) of medicines and
other healthcare products. Over the past few years, Cigno
Co has been finding it increasingly difficult to develop new
medical products. In response to this, it has followed a
strategy of acquiring smaller pharmaceutical companies
which already have successful products in the market
and/or have products in development which look very
promising for the future. It has mainly done this without
having to resort to major cost-cutting and has therefore
avoided large-scale redundancies. This has meant that not
only has Cigno Co performed reasonably well in the stock
market, but it has also maintained a high level of corporate
reputation.
 201512 Q1
Anatra Co is involved in two business areas: the first area
involves the R&D of medical products, and the second area
involves the manufacture of medical and dental equipment.
Until recently, Anatra Co’s financial performance was
falling, but about three years ago a new chief executive
officer (CEO) was appointed and she started to turn the
company around. Recently, the company has developed
and marketed a range of new medical products, and is in
the process of developing a range of cancer-fighting
medicines.
 201512 Q1
This has resulted in a good performance in the stock
market, but many analysts believe that its shares are still
trading below their true value. Anatra Co’s CEO is of the
opinion that the turnaround in the company’s fortunes
makes it particularly vulnerable to a takeover threat, and
she is thinking of defence strategies that the company
could undertake to prevent such a threat. In particular, she
was thinking of disposing some of the company’s assets
and focussing on its core business.
 201512 Q1
Cigno Co is of the opinion that Anatra Co is being held
back from achieving its true potential by its equipment
manufacturing business and that by separating the two
business areas, corporate value can be increased. As a
result, it is considering the possibility of acquiring Anatra
Co, unbundling the manufacturing business, and then
absorbing Anatra Co’s R&D of medical products business.
Cigno Co estimates that it would need to pay a premium of
35% to Anatra Co’s shareholders to buy the company.
 201512 Q1
Financial information: Anatra Co
Given below are extracts from Anatra Co’s latest statement of
profit or loss and statement of financial position for the year
ended 30 November 2015.
2015
$ million
Sales revenue 21,400
Profit before interest and tax (PBIT) 3,210
Interest 720
Pre-tax profit 2,490
 201512 Q1
2015
$ million
Non-current liabilities 9,000
Share capital (50c/share) 3,500
Reserves 4,520

Anatra Co’s share of revenue and profits between the two

business areas are as follows:
Medical products R&D Equipment manufacturing
Share of revenue and profit 70% 30%
 201512 Q1
Post-acquisition benefits from acquiring Anatra Co
Cigno Co estimates that following the acquisition and
unbundling of the manufacturing business, Anatra Co’s
future sales revenue and profitability of the medical R&D
business will be boosted. The annual sales growth rate is
expected to be 5% and the profit margin before interest and
tax is expected to be 17·25% of sales revenue, for the next
four years. It can be assumed that the current tax allowable
depreciation will remain equivalent to the amount of
investment needed to maintain the current level of operations,
but that the company will require an additional investment in
assets of 40c for every $1 increase in sales revenue.
 201512 Q1
After the four years, the annual growth rate of the company’s
free cash flows is expected to be 3% for the foreseeable
future.
Anatra Co’s unbundled equipment manufacturing business is
expected to be divested through a sell-off, although other
options such as a management buy-in were also considered.
The value of the sell-off will be based on the medical and
dental equipment manufacturing industry. Cigno Co has
estimated that Anatra Co’s manufacturing business should be
valued at a factor of 1·2 times higher than the industry’s
average price-to-earnings ratio. Currently the industry’s
average earnings-per-share is 30c and the average share price
is $2·40.
 201512 Q1
Possible additional post-acquisition benefits
Cigno Co estimates that it could achieve further cash flow
benefits following the acquisition of Anatra Co, if it
undertakes a limited business re-organisation. There is some
duplication of the R&D work conducted by Cigno Co and
Anatra Co, and the costs related to this duplication could be
saved if Cigno Co closes some of its own operations.
However, it would mean that many redundancies would have
to be made including employees who have worked in Cigno
Co for many years. Anatra Co’s employees are considered to
be better qualified and more able in these areas of
duplication, and would therefore not be made redundant.
 201512 Q1
Cigno Co could also move its headquarters to the country
where Anatra Co is based and thereby potentially save a
significant amount of tax, other than corporation tax. However,
this would mean a loss of revenue for the government where
Cigno Co is based.
The company is concerned about how the government and the
people of the country where it is based might react to these
issues. It has had a long and beneficial relationship with the
country and with the country’s people.
Cigno Co has estimated that it would save $1,600 million
after-tax free cash flows to the firm at the end of the first year
as a result of these post-acquisition benefits. These cash flows
would increase by 4% every year for the next three years.
 201512 Q1
Estimating the combined company’s weighted average cost
of capital
Cigno Co is of the opinion that as a result of acquiring Anatra
Co, the cost of capital will be based on the equity beta and the
cost of debt of the combined company. The asset beta of the
combined company is the individual companies’ asset betas
weighted in proportion of the individual companies’ market
value of equity. Cigno Co has a market debt to equity ratio of
40:60 and an equity beta of 1·10.
 201512 Q1
It can be assumed that the proportion of market value of
debt to market value of equity will be maintained after the
two companies combine.
Currently, Cigno Co’s total firm value (market values of
debt and equity combined) is $60,000 million and Anatra
Co’s asset beta is 0·68.
 201512 Q1
Additional information
• The estimate of the risk free rate of return is 4·3% and
of the market risk premium is 7%.
• The corporation tax rate applicable to all companies is
22%.
• Anatra Co’s current share price is $3 per share, and it
can be assumed that the book value and the market
value of its debt are equivalent.
• The pre-tax cost of debt of the combined company is
expected to be 6.0%.
 201512 Q1
Important note
Cigno Co’s board of directors (BoD) does not require any
discussion or computations of currency movements or
exposure in this report. All calculations are to be
presented in $ millions. Currency movements and their
management will be considered in a separate report. The
BoD also does not expect any discussion or computations
relating to the financing of acquisition in this report, other
than the information provided above on the estimation of
the cost of capital
 201512 Q1
Required:
b) Prepare a report for the board of directors (BoD) of Cigno Co
which:
I. Estimates the value attributable to Cigno Co’s shareholders from
the acquisition of Anatra Co before taking into account the cash
benefits of potential tax savings and redundancies, and then after
taking these into account; (18 marks)
II. Assesses the value created from (b)(i) above, including a
discussion of the estimations made and methods used; (8 marks)
III. Advises the BoD on the key factors it should consider in relation
to the redundancies and potential tax savings. (4 marks)
Professional marks will be awarded in part (b) for the format, structure
and presentation of the report. (4 marks)
 201512 Q1 - Answer
(b) Report to the board of directors (BoD), CIGNO CO
This report assesses the potential value of acquiring Anatra Co
for the equity holders of Cigno Co, both with and without
considering the benefits of the reduction in taxation and in
employee costs. The possible issues raised by reduction in
taxation and in employee costs are discussed in more detail
below. The assessment also discusses the estimates made and
the methods used.
 201512 Q1 - Answer
Assessment of value created
Cigno Co estimates that the premium payable to acquire
Anatra Co largely accounts for the benefits created from the
acquisition and the divestment, before considering the benefits
from the tax and employee costs’ saving. As a result, before
these savings are considered, the estimated benefit to Cigno
Co’s shareholders of $128 million (see appendix 3) is marginal.
Given that there are numerous estimations made and the
methods used make various assumptions, as discussed below,
this benefit could be smaller or larger. It would appear that
without considering the additional benefits of cost and tax
reductions, the acquisition is probably too risky and would
probably be of limited value to Cigno Co’s shareholders.
 201512 Q1 - Answer
If the benefits of the taxation and employee costs saved are
taken into account, the value created for the shareholders is
$5,609 million (see appendix 4), and therefore significant.
This would make the acquisition much more financially
beneficial. It should be noted that no details are provided on
the additional pre-acquisition and post-acquisition costs or
on any synergy benefits that Cigno Co may derive in
addition to the cost savings discussed. These should be
determined and incorporated into the calculations.
 201512 Q1 - Answer
Basing corporate value on the price-earnings (PE) method
for the sell-off, and on the free cash flow valuation method
for the absorbed business, is theoretically sound. The PE
method estimates the value of the company based on its
earnings and on competitor performance. With the free cash
flow method, the cost of capital takes account of the risk the
investors want to be compensated for and the non-
committed cash flows are the funds which the business can
afford to return to the investors, as long as they are
estimated accurately.
 201512 Q1 - Answer
However, in practice, the input factors used to calculate the
organisation’s value may not be accurate or it may be
difficult to assess their accuracy. For example, for the free
cash flow method, it is assumed that the sales growth rate,
operating profit margin, the taxation rate and incremental
capital investment can be determined accurately and remain
constant. It is assumed that the cost of capital will remain
unchanged and it is assumed that the asset beta, the cost of
equity and cost of debt can be determined accurately. It is
also assumed that the length of the period of growth is
accurate and that the company operates in perpetuity
thereafter.
 201512 Q1 - Answer
With the PE model, the basis for using the average
competitor figures needs to be assessed, for example, have
outliers been ignored; and the basis for the company’s
higher PE ratio needs to be justified as well. The
uncertainties surrounding these estimates would suggest
that the value is indicative, rather than definitive, and it
would be more prudent to undertake sensitivity analysis and
obtain a range of values.
 201512 Q1 - Answer
Key factors to consider in relation to the redundancies
and potential tax savings
It is suggested that the BoD should consider the impact of
the cost-savings from redundancies and from the tax
payable in relation to corporate reputation and ethical
considerations.
At present, Cigno Co enjoys a good reputation and it is
suggested that this may be because it has managed to avoid
large scale redundancies. This reputation may now be under
threat and its loss could affect Cigno Co negatively in terms
of longterm loss in revenues, profits and value; and it may
be difficult to measure the impact of this loss accurately.
 201512 Q1 - Answer
Whilst minimising tax may be financially prudent, it may
not be considered fair. For example, currently there is
ongoing discussion and debate from a number of
governments and other interested parties that companies
should pay tax in the countries they operate and derive their
profits, rather than where they are based. Whilst global
political consensus in this area seems some way off, it is
likely that the debate in this area will increase in the future.
Companies that are seen to be operating unethically with
regard to this, may damage their reputation and therefore
their profits and value.
 201512 Q1 - Answer
Nonetheless, given that Cigno Co is likely to derive
substantial value from the acquisition, because of these
savings, it should not merely disregard the potential savings.
Instead it should consider public relations exercises it could
undertake to minimise the loss of reputation, and perhaps
meet with the government to discuss ways forward in terms
of tax payments.
 201512 Q1 - Answer
Conclusion
The potential value gained from acquiring and unbundling
Anatra Co can be substantial if the potential cost savings are
taken into account. However, given the assumptions that are
made in computing the value, it is recommended that
sensitivity analysis is undertaken and a range of values
obtained. It is also recommended that Cigno Co should
undertake public relations exercises to minimise the loss of
reputation, but it should probably proceed with the
acquisition, and undertake the cost saving exercise because
it is likely that this will result in substantial additional value.
 201512 Q1 - Answer
Report compiled by:
Date:

Appendix 1: Estimate of value created from the sell-off of the equipment

manufacturing business
Average industry PE ratio = $2·40/$0·30 = 8
Anatra Co’s equipment manufacturing business PE ratio = 8 × 1·2 = 9·6

Value from sell-off of equipment manufacturing business

Share of pre-tax profit = 30% × $2,490 million = $747m
After tax profit = $747 million × (1 – 0·22) = $582·7m
Value from sell-off = $582·7 million × 9·6 = $5,594m (approximately)
 201512 Q1 - Answer
Appendix 2: Estimate of the combined company cost of capital
Anatra Co, asset beta = 0·68
Cigno Co, asset beta:
Equity beta =1·10
Proportion of market value of debt = 40%; Proportion of market value of equity = 60%
Asset beta = 1·10 × 0·60/(0·60 + 0·40 × 0·78) = 0·72
Combined company, asset beta
Market value of equity, Anatra Co = $3 × 7,000 million shares = $21,000m
Market value of equity, Cigno Co = 60% × $60,000 million = $36,000m
Asset beta = (0·68 × 21,000 + 0·72 × 36,000)/(21,000 + 36,000) = 0·71 (approximately)
Combined company equity beta = 0·71 x (0·6 + 0·4 × 0·78)/0·6 = 1·08
Combined company, cost of equity = 4·3% + 1·08 × 7% = 11·86%
Combined company, cost of capital = 11·86% × 0·6 + 6·00% × 0·78 × 0·4 = 8·99, say 9%
 201512 Q1 - Answer
Appendix 3: Estimate of the value created for Cigno Co’s equity holders from the acquisition
Anatra Co, Medical R&D value estimate:
Sales revenue growth rate = 5%
Operating profit margin = 17·25%
Tax rate = 22%
Additional capital investment = 40% of the change in sales revenue
Cost of capital = 9% (Appendix 2)
Free cash flow growth rate after four years = 3%
Current sales revenue = 70% × $21,400m = $14,980m
 201512 Q1 - Answer
Cash flows, years 1 to 4 ($ millions)
Year 1 2 3 4
Sales revenue 15,729 16,515 17,341 18,208
––––––– ––––––– ––––––– –––––––
Profit before interest and tax 2,713 2,849 2,991 3,141
Tax 597 627 658 691
Additional capital investment 300 314 330 347
––––––– ––––––– ––––––– –––––––
Free cash flows 1,816 1,908 2,003 2,103
––––––– ––––––– ––––––– –––––––
Present value of cash flows 1,666 1,606 1,547 1,490
(9% discount)
 201512 Q1 - Answer
Value, years 1 to 4: $6,309m
Value, year 5 onwards: [$2,103 × 1·03 / (0·09 – 0·03)] × 1·09–4 = $25,575m
Total value of Anatra Co’s medical R&D business area = $31,884m
Total value of Anatra Co following unbundling of equipment manufacturing
business and absorbing medical R&D business:
$5,594m (appendix 1) + $31,884m = $37,478m (approximately)
Anatra Co, current market value of equity = $21,000m
Anatra Co, current market value of debt = $9,000m
Premium payable = $21,000m × 35% = $7,350m
Total value attributable to Anatra Co’s investors = $37,350m
Value attributable to Cigno Co’s shareholders from the acquisition of Anatra Co
before taking into account the cash benefits
of potential tax savings and redundancies = $128m
 201512 Q1 - Answer
Appendix 4: Estimate of the value created from savings in tax and
employment costs following possible redundancies
Cash flows, years 1 to 4 ($ millions)
Year 1 2 3 4
Cash flows (4% increase p.a.) 1,600 1,664 1,731 1,800
Present value of cash flows (9%) 1,468 1,401 1,337 1,275

Total value = $5,481m

Value attributable to Cigno Co’s shareholders from the acquisition of Anatra

Co after taking into account the cash benefits of potential tax savings and
redundancies = $5,609m
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