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Chakulawordpdf

Chakula listed company operates in food and drink production. It plans to demerge its coffee business Kawa into a separate unlisted company. Lahla unlisted company in the hotel business wants to purchase Kawa. The report estimates Kawa's value if demerged and the value created by combining Kawa and Lahla. It finds a share exchange offers the highest returns for shareholders of both companies and improves Lahla's capital structure by reducing financial distress, though it forfeits tax shields. A cash offer increases Lahla's gearing significantly.

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Mishhal Hamza P.K
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104 views3 pages

Chakulawordpdf

Chakula listed company operates in food and drink production. It plans to demerge its coffee business Kawa into a separate unlisted company. Lahla unlisted company in the hotel business wants to purchase Kawa. The report estimates Kawa's value if demerged and the value created by combining Kawa and Lahla. It finds a share exchange offers the highest returns for shareholders of both companies and improves Lahla's capital structure by reducing financial distress, though it forfeits tax shields. A cash offer increases Lahla's gearing significantly.

Uploaded by

Mishhal Hamza P.K
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Chakula listed company.

  (1) Food and drink production   (2) Coffee shops Unbundle the coffee business into
a new seperate company, kawa co. (1) demerge kawa into a seperate company      (2) sell kawa Shareholding
is 1:1 in kawa co. Lahla unlisted company. Hotel business and is looking to diversify into coffee. Project
specific wacc. Lahla company have plans to purchase kawa co.   Purchase consideration   (1) cash     (2)
share for share offer

(a) Explain why a regulatory framework related to mergers and acquisitions is necessary to protect the
interests of shareholders and other stakeholders. (5 marks)  

The key reasons for a regulatory framework to exist in mergers and acquisitions (M&A) is to protect the
interest of shareholders and other stakeholders. This is required if the natural market forces are not sufficient
on their own to ensure this happens.

A regulatory framework ensure that:

1. Minority shareholders rights are protected

2. All the shareholders are treated equally

3. All informations related to the acquisition are passed on to the relevant parties on which they can taken
meaningful decisions

4. All decisions taken by the BOD should be done as per the best interest of the shareholders.

With respect to other stakeholders, a regulatory framework ensures that the takeover doesnt hinder
competition. Also the framework will try to protect the interest of consumers, suppliers, employees who are
dealing with the organisation.

(b) Discuss the two theoretical propositions, as raised by Lahla Co’s board of directors (BoD), in relation
to a company’s capital structure. (6 marks)  

MM theory with tax

The first proposiiton states that debt is cheaper than equity due to the low risk faced by the debt holders and
also due to the tax shield attached to the debt finance. This proposition is presented in MM theory with tax
model.

Since interest is paid before tax, but dividends are not, company will be able to reduce the profit on which
tax is paid. This is referred as tax shielf. The presence of this tax shield reduces the cost of capital as debt
increases.

Static trade off theory

The second proposition states that although debt carries an advatnage of tas shield, at higher level of debt,
there is a disadvantage of financial distress caused by bankruptcy and non bankruptcy costs.

At a higher level of debt, the risk faced by the equity holders will increase and they will demand higher
return leading to a higher cost on equity. Also the cost of debt also might increase. This might over ride the
benefit available on debt from tax shield, resulting in an increase in cost of capital.
(c) Prepare a report for the BoD of Lahla Co which:  

(i) Estimates the value of each Kawa Co share if it is demerged and listed as an independent company; (12
marks)

(ii) Estimates;    

• the additional equity value created when combining Lahla Co and Kawa Co;   • the percentage gain to each
of Lahla Co’s and Kawa Co’s shareholder group under each payment method;     

• the impact on Lahla Co’s capital structure under each payment method; and (12 marks)

REPORT

TO,

THE DIRECTORS

LAHLA CO

INTRODUCTION

This report evaluates and discusses the value of each Kawa Co share if it is demerged and listed as an
independent company and alsp Estimates the additional equity value created when combining Lahla Co and
Kawa Co. The report also evaluates the impact on Lahla Co’s capital structure under both of the payment
method

EVALUATION

Kawa shareholders

Upon demerger, and creation of a seperate company, the value of kawa companies equity shares is becoming
$0.74 per share as seen in APPENDIX 1. Kawa companies old share price is $0.6 per share and this
represents a (0.14/0.6) 23.3% increase.

However, if Kawa company share holders are selling their shareholding to Lahala company, the cash offer
will result in a 10% increase in their share value where as share offer will result in a 27% increase in value. 

So a share for share offer is recommended in case Chakula co have plans to sell Kawa. This is the best option
purely on financial grounds.

However additional factors should also be considered before taking a decision. If Kawa company is running
as a seperate compamy, the control of the company will belong to the exisitging shareholders. But if Kawa
company is sold to Lahla company, the shareholders of Kawa wont gain control in the combined entity as
their holding will only be 35.7%. Kawas shareholders holding in new company = 2000x1/3     /    1867    =>
35.7% so control is lost.

Also since Lahla company is an unlisted company,the shareholders would find it difficult to sell the shares in
Lahla.
Lahla shareholders

The additional value created upon the combination of both lahla and kawa is $650m as seen in APPENDIX
2.

Lahla company shareholders will prefer to give a cash offer as, giving share offer will only lead to a 14%
increase in their value compared to the 22% increase arising from cash offer. Also share offer might lead to
dilution of control for Lahla companies shareholders.

But paying cash might lead to a decrease in cash balance and increase in gearing.

Capital structure of Lahla (APPENDIX 2)

The existing gearing of Lahla company is at 40%. This will increase significantly and become 53.1% if the
purchase consideration is paid by cash. The MVd is getting more than MVe in this case. This will lead to a
increase in cost of debt and overall cost of capital and will create a financial distress and also the companies
future borrowing capacity would decline.

On the other hand, share for share exchnage increases the equity to 68%. This will reduce the fiinancial
distress but the company cannot claim the tax shield as dividend is not tax deductible.

CONCLUSION

The share for share offer gives the highest return for kawa companies shareholders and also provides a better
return for lahla company shareholders. Also cash offer will increase the gearing for Lahla company. So, both
the companies might prefer share for share offer.

The current cash offer might not be accepted by kawa shareholders as it is not creating any additional benefit
if kawa is set up as an independant company. So if Lahla company wishes to acquire kawa by cash payment,
more amount need to be paid.

REPORT PREPARED BY:

DATE

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