Unit 3 Lecture 9

02 June 2021 10:56 AM

Illustration 10: (Merger as a capital budgeting decision)

The Hypothetical Limited wants to acquire Target Ltd. The balance sheet of Target Limited as at 31st March (Current Year) has the
following assets and liabilities.

Liabilities rs s. Assets Rs.

Equity share capital(2,00,000 shares of Rs.10 2000000 00 Fixed assets 19,00,000

each)

13% Preference share capital 100000 00 Investments 1,00,000

Retained earnings 400000 Inventories 5,00,000

12% Debentures 300000 debtors 4,00,000

Current liabilities 2,00,000 bank 1,00,000

Total 30,00,000 T total 30,00,000

Negotiations to take over of Target Ltd result in its acquisition by Hypothetical Ltd.
The purchase consideration consists of:
i) Rs. 3,30,000, 13% debentures of Hypothetical Ltd for redeeming 12% debentures of Target Ltd.
ii) Rs.1,00,000,12% convertible preference shares in Hypothetical Ltd for the payment of the 13% preference share capital of Target Ltd. iii) 1,50,000 equity shares of
Hypothetical Ltd to be issued at its current market price of Rs.15.
iv) Hypothetical Ltd would meet the dissolution expenses estimated to cost Rs.30,000
The breakup figures of eventual disposition by Hypothetical Ltd of un-required assets and liabilities of Target Ltd. are investments Rs. 1,25,000, Debtors Rs. 3,50,000,
Inventories Rs. 4,25,000 and payment of current liabilities Rs. 1,90,000.
The following are the projected incremental free cash flows (FCFF) expected from acquisition for 6 years.

d FCFF (Rs.)

1 6,00,000

2 6,50,000

3 7,00,000

4 7,50,000

5 8,00,000

6 8,50,000

It is estimated that fixed assets of Target Ltd. would fetch Rs. 3,00,000 at the end of 6th year. The free cash flow (FCFF) of Target Limited is expected to grow at 3% per
annum after 6 years.
iv) Given the risk complexion of Target Limited, cost of capital relevant for Target Limited cash flows has been decided at 15%. Advise the company regarding the financial
feasibility of the acquisition.
 [ Present value of cash flows for Re.1 @15%- Year 1: 0.870;Year 2:0.756;Year 3:0.658;Year 4:0.572;Year 5:0.496; Year 6:0.432] MACR Unit 3 Page 1

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Modification in the growth rate of FCFF in the above Problem:

Question: Would your decision for acquiring Target Limited change, if FCFF after the forecast period is assumed to
be; i) constant after 6 years
ii) decline by 10% per annum after 6 years.
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