Assignment – AFm

Analytical data for the Finance Manager of Aera Co

Subject: Acquisition of Equal Experts - Strategic Evaluation and Financial Analysis

I. Introduction
Aera Co, a prominent software company specializing in product development, has been experiencing
challenges in developing new software products. In response, Aera Co has adopted a strategy of acquiring
smaller software companies with successful products and promising developments.
One such potential acquisition is Equal Experts, a company which has two core business operations:
i. Software development (which contributes to 80% of its Revenue & profits)
ii. Software upgradation (which contributes to 20% of its Revenue & profits)
This report presents a strategic evaluation and financial analysis of the proposed acquisition.

II. Strategic Rationale

Aera Co's strategy of acquiring companies with successful products and minimal cost-cutting aligns with
its goal of expanding its product portfolio and maintaining a strong corporate reputation. Equal Experts'
recent performance improvement, including the development of new software products and accounting
packages, positions it as an attractive target for acquisition.

However, its shares may still be undervalued. Equal Experts' CEO is concerned about potential takeover
threats due to its improved performance, leading to considerations of defence strategies, such as asset
disposal and focusing on the core business.

Aera Co believes that separating Equal Experts' software upgradation business could unlock its full
potential. The proposed acquisition involves
i. unbundling the upgradation business and
ii. absorbing Equal Experts' software development business.

III. Financial Analysis

Given below are extracts from Equal Experts’ latest statement of profit or loss and statement of financial
position for the year ended 30th December 2023

Particulars Amount (m$)

Sales Revenue 74,900
Profit before interest and tax (PBIT) 11,235
Interest 2,520
Pre-tax profit 8,715
Tax @ 30% 2,615
Profit after tax 6,100
Software Development Business (80% of revenues & profits)
i. Anticipated growth in the software development includes a 6% annual sales increase and a 20%
operating profit margin (PBIT) for the next four years. After the anticipated four years, the market
growth rate thereafter is estimated to be 3% till perpetuity.
ii. The company is expected to pay interest at constant rate (without any inflation) it is paying right
now and loan will be completely paid off at end of third year.
iii. The depreciation is expected to be 25% on WDV method. The value of PPE as per IAS 16 of Equal
Experts is $1,000 million. And this PPE is completely used for software development business and
not utilised for upgradation business. The PPE will be completely written off at end of four years.
iv. The Asset Replacement cost will be 1% of increase in sales every year.
v. Aera Co could further benefit from limited business reorganization, although it may involve
redundancies. Potential tax savings by relocating headquarters could save $4,000 million in after-tax
free cash flows in the first year, increasing by 5% annually for three years.

Software Upgradation Business (20% of revenues & profits)

The unbundled software upgradation business will be divested based on a factor of 1.5 times higher than
the industry's average price-to-earnings ratio. Currently the industry’s average earnings-per-share is 50c
and the average share price is $3.10.

IV. Weighted Average Cost of Capital (WACC)

Aera Co's approach to estimating the combined company's WACC involves the equity beta and cost of debt,
considering the individual companies' asset betas weighted by the market value of equity.
i. Standard debt-equity ratio in software industry is 40:60 and equity beta is 1.35
ii. Equal Experts Asset Beta is 0.89
iii. Post merger value of debt-equity ratio the company wants to maintain is 30:70
iv. Risk-free rate of return is 5%
v. Market Rate of Return is 12%
vi. Pre-Tax Cost of Debt is expected to be 6.9%

V. Conclusion
The proposed acquisition of Equal Experts presents a significant opportunity for Aera Co. The strategic
rationale aligns with Aera Co's growth objectives, and the financial analysis demonstrates the potential
value creation. However, key considerations revolve around redundancies, potential tax savings, and the
reaction of stakeholders. Thorough planning and stakeholder engagement are critical to ensure a smooth
transition. Based on the report submitted by the finance manager, the Board of Directors will proceed with
a comprehensive due diligence process, exploring potential synergies and addressing the concerns of both
companies to make an informed decision on the acquisition of Equal Experts.

VI. Required:
Prepare a report for the board of directors (BoD) of Aera Co which estimates the value attributable to
Aera Co’s shareholders from the acquisition of Equal Experts from separating both the operations of
software development & upgradation.

Note: All calculations are to be made in a spreadsheet (like MS Excel) and show all relevant working notes
and assumptions wherever needed.