Chikepe Co is a large listed company operating in the pharmaceutical industry with a current market value of equity of $12,600 million and a debt to equity ratio of 30:70, in market value terms. Institutional investors hold most of its equity shares. The company develops and manufactures antibiotics and anti-viral medicines. Both the company and its products have an established positive reputation among the medical profession, and its products are used widely. However, its rate of innovation has slowed considerably in the last few years and it has fewer new medical products coming into the market.At a recent meeting of the board of directors (BoD), it was decided that the company needed to change its current strategy of growing organically to one of acquiring companies, in order to maintain the growth in its share price in the future. The members of the BoD had different opinions on the type of acquisition strategy to pursue.Director A was of the opinion that Chikepe Co should follow a strategy of acquiring companies in different business sectors. She suggested that focusing on just the pharmaceutical sector was too risky and acquiring companies in different business sectors will reduce this risk.Director B was of the opinion that Director A’s suggestion would not result in a reduction in risk for shareholders. In fact, he suggested that this would result in agency related issues with Chikepe Co’s shareholders reacting negatively and as a result, the company’s share price would fall. Instead, Director B suggested that Chikepe Co should focus on its current business and acquire other established pharmaceutical companies. In this way, the company will gain synergy benefits and thereby increase value for its shareholders.Director C agreed with Director B, but suggested that Chikepe Co should consider relatively new pharmaceutical companies, as well as established businesses. In her opinion, newer companies might be involved in research and development of innovative products, which could have high potential in the future. She suggested that using real options methodology with traditional investment appraisal methods such as net present value could help establish a more accurate estimate of the potential value of such companies.The company has asked its finance team to prepare a report on the value of a potential target company, Foshoro Co, before making a final decision.Foshoro CoFoshoro Co is a non-listed pharmaceutical company established about 10 years ago. Initially Foshoro Co grew rapidly, but this rate of growth slowed considerably three years ago, after a venture capital equity backer exited the company by selling its stake back to the founding directors. The directors had to raise substantial debt capital to buy back the equity stake. The company’s current debt to equity ratio is 60:40. This high level of gearing means that the company will find it difficult to obtain funds to develop its innovative products in the future.The following financial information relates to Foshoro Co:Extract from the most recent statement of profit or loss
In arriving at the profit before interest and tax, Foshoro Co deducted tax allowable depreciation and other non-cash expenses totalling $112·0 million. It requires a cash investment of $98·2 million in non-current assets and working capital to continue its operations at the current level.Three years ago, Foshoro Co’s profit after tax was $83·3 million and this has been growing steadily to their current level. Foshoro Co’s profit before interest and tax and its cash flows grew at the same growth rate as well. It is likely that this growth rate will continue for the foreseeable future if Foshoro Co is not acquired by Chikepe Co. Foshoro Co’s cost of capital has been estimated at 10%.Combined company: Chikepe Co and Foshoro CoOnce Chikepe Co acquires Foshoro Co, it is predicted that the combined company’s sales revenue will be $4,200 million in the first year, and its operating profit margin on sales revenue will be 20% for the foreseeable future. After the first year, the sales revenue is expected to grow at 7% per year for the following three years. It is anticipated that after the first four years, the growth rate of the combined company’s free cash flows will be 5·6% per year.The combined company’s tax allowable depreciation is expected to be equivalent to the amount of investment needed to maintain the current level of operations. However, as the company’s sales revenue increases over the four-year period, the combined company will require an additional investment in assets of $200 million in the first year and then $0·64 per $1 increase in sales revenue for the next three years.It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ value of equity. It can also be assumed that the capital structure of the combined company remains at Chikepe Co’s current capital structure level, a debt to equity ratio of 30:70. Chikepe Co pays interest on borrowings at a rate of 5·3% per annum.Chikepe Co estimates that it will be able to acquire Foshoro Co by paying a premium of 30% above its estimated equity value to Foshoro Co’s shareholders.
The current annual government borrowing base rate is 2% and the annual market risk premium is estimated at 7%. Both companies pay tax at an annual rate of 20%.Chikepe Co estimates equity values in acquisitions using the free cash flow to firm method.Future acquisitionsThe BoD agreed that in the future it is likely that Chikepe Co will target both listed and non-listed companies for acquisition. It is aware that when pursuing acquisitions of listed companies, the company would need to ensure that it complied with regulations such as the mandatory bid rule and the principle of equal treatment to protect shareholders. The BoD is also aware that some listed companies may attempt to defend acquisitions by employing anti-takeover measures such as poison pills and disposal of crown jewels.Required: