Question

Question 12 (3+5+7= 15 marks) Big Apple Inc. has recently announced its intention to acquire Small Orange Inc. Big Apple has estimated that its annual net cash flow will increase from $1.15m per year (at present) to $1.9m per year in perpetuity, with the first increase occurring exactly 5 years from the acquisition. If the acquisition were to proceed, Big Apple will however incur re-organization and integration costs of $250,000 per annum at the end of the first two years after the acquisition. Big Apple's current market capitalization is $50m and its current share price is $20. Small Orange's current market capitalization is $20m with share price of $10 each. The chairman of Big Apple suggests making a cash bid for all outstanding shares of Small Orange and offers $11.50 per share to Small Orange's shareholders. The appropriate opportunity cost of capital is 12% per annum. a) Assuming the acquisition occurred immediately, use the information provided above and calculate the gain from the acquisition. Show detailed workings. b) Catherine Smith is a shareholder of Big Apple who owns 5,000 shares of the company. Assuming the acquisition occurred immediately, use the information provided above and calculate the wealth impact for Catherine Smith. Show detailed workings After a more careful and comprehensive analysis, John Howard, the CFO of Big Apple's board determines that the economic benefit (in present value terms) from the proposed takeover is $5,500,000. He also proposes that instead of paying cash Big Apple should make a stock swap offer to Small Orange. Further, he suggests that an offer of 4.5 shares of Big Apple for every 8 shares of Small Orange is reasonable, as he believes that this will ensure that the synergy is shared equally (that is 50% each) between Big Apple Inc. and Small Orange Inc. c) Evaluate the offer as proposed by John Howard. Specifically, determine if he is correct in believing that the synergy will be shared equally between the two firms if the offer of 4.5 shares of Big Apple for every 8 shares of Small Orange is made. Show detailed workings.

Answer 1

The gain from the acquisition is $3,923,381.27. The wealth impact for Catherine Smith is $98,084.53. The offer proposed by John Howard does not result in an equal share of the synergy.

Step-by-step explanation:

To calculate the gain from the acquisition, we need to consider the net cash flows and the re-organization and integration costs.

The net cash flow of Big Apple will increase from $1.15 m to $1.9 m per year after the acquisition, starting 5 years from now. The present value of this cash flow is:

(1.9m/1.12⁵) - (1.15m//1.12⁵) = $4.31m

The re-organization and integration costs will be incurred at the end of the first two years after the acquisition. The present value of these costs is:

($250,000/1.12) + ($250,000/1.12²) = $386,618.73

Therefore, the gain from the acquisition is:

$4.31 m - $386,618.73 = $3,923,381.27

(2) To calculate the wealth impact for Catherine Smith, we need to multiply the gain from the acquisition by her shareholding percentage. Catherine Smith owns 5,000 shares of Big Apple, which represents 5,000/200,000 = 0.025 or 2.5% of the shares. The wealth impact for Catherine Smith is:

2.5% x $3,923,381.27 = $98,084.53

(3) The offer proposed by John Howard suggests a stock swap of 4.5 shares of Big Apple for every 8 shares of Small Orange. To evaluate if the synergy will be shared equally, we need to compare the market capitalization of the two companies based on this offer. The market capitalization of Big Apple with the stock swap is:

(4.5 x $20m) + $50m = $140m

The market capitalization of Small Orange would be:

(8 x $11.50) = $92

Therefore, the share of Big Apple in the combined market capitalization is:

($140m / ($140m + $92m)) x 100% = 60.34%

This means that Big Apple will have a greater share of the synergy, not an equal share as proposed by John Howard.