Question 1: Mergers and Acquisition

(a) Why acquisitions are not successful, and possible steps Kedington Co could take
(10 marks = 20 mins)
Reasons acquisition are not successful (5 marks)
Cultural classhes
There may be cultural clashes between the two companies. For example, they may be
used to working different hours each day, or one may allow working from home where
the other company doesn’t. This can cause conflict and demotivated staff from the start.
Overpaying
The buyer may overpay for the company they are acquiring. This could be caused by
overly optimistic synergy predictions and assumptions, which then do not actually occur
in reality. This can lead to predicted cash flows in futures years being far lower than
expected.

System clashes
The two companies may have different systems, which require integration. If they are
not compatible, the integration process may cause key data to be lost, or it may take far
longer than expected and cause delays to the start of the new business activities.

Hidden issues
There may be issues that arise within the company being brought that were not
identified during due diligence checks. For example, there may be hidden financial
issues, or ongoing issues with staff, supplies or customers which mean the new
business is not able to trade as it intended.

Ineffective integration
The integration of two business needs managing very carefully to ensure a smooth and
quick formation of the new combined company. If this process is not managed properly,
it can lead to significant delays, confusion, mistakes and staff leaving due to the
uncertainty and stress caused.
Steps that Kedington could take (5 marks)
Cultural classhes
Kedington could meet Metfield’s management and visit the offices to ensure a good
cultural fit before making an offer. Both companies are in Boulge, so there should be
cultural similarities, but both sets of management need to decide how the company will
operate going forward.

Overpaying
Kedington need to carefully value Metfield, using prudent estimates to be safe. The
$1.25m cost saving seems fairly snesible, but the new P/E ration of 16 seems
optimistic. Kedington need to do scenario planning and sesitivity ananlysis to verify all
forecasts made.

System clashes
Kedington should evaluate both sets of systems to check how integration could work. If
necessary, advice shoul be sought from systems experts to see how long integration
could take, and what risks they may face to help minimise these to prevent delays or
data loss.

Hidden issues
Kedington need to perform detailed and accurate due diligence for he Metfeild
acquisition, for example looking into convenants in their $60m debt. They should ensure
every team involved has relevant experience of the retail industry and of Metfield to
cover all potential issues.

Ineffective integration
Kedington need to carefully plan and schedule the integration process. Given their
history of organic growth, they lack expereince of acquisitions and integration, so should
get external advice and support for this process to ensure it runs smoothly.
(b) Report for the board of director of Kedington Co

To: Kedington Board of Directors

From: Financial manager
Date: Today
Subject: Report into the acquisition of Metfield

Introduction
This report will estimate the value of Metfield, and propose a suitable share for share
exchange deal. It will consider the gain to both Kedington and Metfield, and discuss the
impact on shareholders. It will also consider the proposed reduction in dividend.

Report findings
i) Metfiled value
Please see appendix
ii) Share for share exchange
Please see appendix
iii) Percentage gain for shareholders
Please see appendix
iv) Reaction to the offer and assumptions made
Kedington Reaction
Kedington would make a gain of between 13.2% (share for share exchange) and 16.4%
(cash offer), assuming the assumptions made in th calculation are correct. Kedington
may prefer the share for share exchange as, although the gain is lower, it would avoid a
large cash outlay.
Under either method, this is a healthy gain which would please Kedington’s
shareholders as it would increase their share price. But there are significant risks
involved, including the risk of the acquisition not being successful as a few directors
have mentioned.
Metfield Reaction
Metfield would make a gain of between 15.0% (cash offer) and 29.7% (share for share
exchange), assuming the assumptions made in the calculations are correct.
The cash offer is below the normal premium in the retail industry of between 20% and
30%, and so Metfield may feel the cash offer is too low.
The share for share exchange is nearer the 30% mark so is more acceptable, but is
based on several assumptions and is not a certain figure – so they would want to do a
lot of further testing.

Assumptions
The calculation of Metfield’s share price assumed their free cash flow will grow at a
constant annual rate of 3.5% for the foreseeable future. Whilst this estimate seems
prudent, the retail industry is highly unpredictable and deprendent on consumer
behaviour – so growth is highly unlikely to be constant, which would change the share
price.
A cost of capital has been ‘estimated’ at 12%. Metfield’s valuations could change
dramaticaly if this figure is incorrect or changes – it’s assumed this ill remain constant in
perpetuity, but any change to Metfield’s gearing or risk profile would cause the to move.
It’s assumed Metfield’s new P/E ration will be 16. This seems optimistic given their ratio
is currently just under 10 ($80m equity value/$8.25m PAT), ans so may have
overvalued Metfield after the proposed acquisition.

v) Implication of reducing dividends (6 marks = 12 mins)

Possitive
Reducing dividends would mean Kedington could avoid having to raise debt fiance or
issue new equity, which would be more expensive. This approach would allow them to
minimise costs associated with both issuing and maintaining new debt or equity finance.
This approach could also be much quicker than raising new finance. This would allow
them to acquirer Metfield more quickly and access the south-east Boulge marked
sooner than having to wit to raise new finance.
Modigallani and Miller argued that dividend payments are irrelevant – this new
acquisition of Metfield will increase the value of Kedington’s shares, and so
shareholders may actually be indifferent about the reduction in their dividend as their
wealth is increasing through share price growth.
Negative
Kedington shareholders will be expecting to receive 50% of free cash flows, which has
been the policy for many years. Suddenly reducing the dividend to just 10% may signal
to some investors that Kedington are not performing well, and so they could be unhappy
and sell their shares.
Also some shareholders rely on dividend income as it is actual cash – they could use
this to pay their bills or have plans with the cash from Kedington. Changing the policy to
10% may annoy certain groups of shareholders who may then sell their shares.
Reducing the dividend may also affect Kedington shareholders’ tax planning, as
dividends and share price growth are taxed in different ways. Again, this may upset the
clientele of Kedington and cause shareholders to sell their shares.

Report conclusion
Assuming the numbers provided and the assumptions made are correct, Metfield’s
shareholders are most likely to prefer a share for share exchange as the premim, and
within the suggested region for the industry.
Kedington should explore other financing options before deciding to cut the dividend,
which may upset shareholders during a time when they need stability if they plan to
proceed with the acquisition of Metfield.
However, Kedington should perform sensitivity analysis to all figures calculated and
undertake significant due diligence before making a formal offer for Metfield.

Appandixes
QUESTION 2: INVESTMENT APPRAISALS
25 marks = 49 minutes
- 9 minutes: Plan and Read
>>> Read the requirements
>>> Plan out answer with headings and sub-headings
>>> Read the exhibits
- 40 minutes: Write
>>> Write answer
>>> 2 minutes per mark
>>> be strict

Part a) Project Analysis (12 marks = 24 mins)

Please see appendix for calculations
Project 1
This project fulfils the criteria for NPV and duration, but as its VaR is greater than its
NPV, there is 95% confidence that the NPV would be negative – which does not meet
the criteria.
Project 2
This project fulfils the criteria for NPV and VaR, but its duration is over 3 years so it
does not meet this criteria.
Project 3
The project fulfils the cirteria for all 3 methods.
Recommendation
Assumming the information provided is correct, Hartest should proceed with project 3 –
it has the highest NPV, and approach all 3 criterias.

Part b) Appraisal methods (8 marks = 16 mins)

Issues involved
NPV
The NPV figures are based on several key assumptions, which could ultimately change
Hartest’s decision if they were to change.
One key assumption is the forecast flow figures being correct. All 3 projects move away
from Hartest’s current specialism (savoury snack foods), and it is very hard to know
hown well they will perform over the next 4 years in these new sectors. In project 3, for
example, there is a large fall in cash flow in year 4 – the cause of this would need to be
investigated.
This also assumes the cost of capital (9.01%) is both suitable and constant for 4 years.
This was based on an asset beta for the fruit drinks sector which is assumed to be valid
for this project, but may not be in line with Hartest’s plan for this project. If this is not
correct, the NPV could change drastically.

Duration
Duration allows projects to be chosen based on those that regenerate cash quickly.
However, the duration criteria is subjective – Hartest have set a target of 3 years, but
this could rule out good projects (like project 2) which are only just above the threshold,
but have a good positive NPV.

VAR
The value at risk (VAR) calcualtion is heavily dependent on the standard deviation
figure of $3.5m per year. As this a brand new project for Hartest, it would be very
difficult to calculate the volatility of returns in the future. It also assumes a normal
distribution of returns, which is often not the case in the real world.

Order of priority
NPV
Project 3 has by far the highest NPV of the 3 projects ($20.3m), ad so would be
priotised.
All three projects have a positive NPV and so would theoretically increase shareholder
wealth – however using these figures in isolation ignores the potential risks of the
projects, and so Hartest need to also consider the VAR of the projects.
This does ignore other factors such as the availability of real options for each of the
projecs, which could affect the decision.

Duration
The project 3 has the shortest duration (2.5 years) and again would be priotised.
On its own, duration doesn’t give the full context of the project though, but could be
used to decide between projects 1 and 2 which have an identical NPV.
VAR
The project 2 has the lowest VAR and so would be priotised on the basis of it being the
lowest risk.
However, VAR on its own ignores the overall likelihood of the project having a positive
NPV. Also, if Hartest are risk-seeking, having a high VAR is good because it means
that there is a change then NPV could be far higher than the mean.
QUESTION 3 – HEDGING RISK
a) Decisition not to use options (5 marks = 10mins)
If Durweston used otions on interest rate futures, it would require them to pay an upfornt
cash premium to arrange the hedge.
The option premium is likely to be significant and the implication is that the options will
be more expensive than the alternatives under the worst-case scenario.
The government is funding the regeneration project in Horshama, Since the funds
ultimately originate from the taxpayer, the government is accountable for any spending
decisions and has already been critised for cost overruns.
The new reward system is designed to reduce the potential for additional overruns and
avoid further cirticism, by aligning the directors’ incentives with the government’s
objective for cost control and overall attitude to risk.
Therefore, the board is unlikely to want to pay a large up front preium for options,
especially when the outcome of options is less certain than using FRAs, futures or
swaps.

b) Hedging strategy (15 marks = 30 mins)

Please see appendix for calculations.
FRA: 6.8%
Futures: 6.76%
Swap: 6.70%
All three hedging methods provide very similar results. In theory, they all satisfy
Durweston’s objective of achieving a fixed rate and a certain cash flow, despite the
concerns about a rate increase.
The FRA is marginally more expensive than the futures and swap, but it is a relatively
straightforward hedging method. The certain cash flow and reduced counterparty risk
may make it more attractive to Durweston Co’s board given their high risk aversion.
The future market outcome is less certain – it is subject to basis risk and the cash flow
disadvantages associated with margin requirements, including the need for initial and
variation margin payments.
The swap is the cheapest, but comes with a counterparty risk since Durweston Co
agreed this swap itself, without the benefit provided by an intermediary gurantee. If
Keyneston were to default, there is a risk that Durweston could lose out.
Overall, the FRA provides most certainty, and is through Durweston’s existing bank, so
is recommended.