CASE 32.

1 SARANGI ENGINEERING COMPANY (SEC)

SEC was established in 1953 to manuIacture industrial equipments Ior cement,
Iertilizer and textile industries. The co`s management is concerned about the
instability oI its earnings due to the cyclical nature oI its business. During the past
Iive years, SEC`s sales have grown about 11 p.a. the Iluctuating proIits oI the co.
have caused its P/E ratio oI 27 to be much lower than the industry average oI 45 (
see table 32.1.1 and 32.1.2 Ior SEC`s summarized Iinancial perIormance).
Currently, SEC`s share is selling Ior Rs 88.83 in the market.
SEC`s top management has chalked out a plan oI acquisition to reduce its earnings
instability. The co. laid down three criteria Ior acquisition. First, the target co.
should broadly belong to the related business. Second, it should be a well-known
co. in its Iield, but should be smaller than SEC in size. Third, it should have a wide
range oI product in growth markets with a high degree oI stability. Applying these
criteria, SEC has identiIied XL Equipment Company as possible target co. Ior
acquisition. XL is known Ior its quality oI products and strong distribution. Due to
poor management, the co.`s perIormance in the past Iew years has not been good.
Its sales have grown at an average rate oI 12 p.a. The co.`s earnings have been
low, and the average market price oI co.`s shares in recent times has been lower
than its book value (see tables 32.1.3 and 32.1.4 Ior XL`s summarized Iinancial
perIormance). The current price oI XL`s share is Rs 38.94.
SEC intends to totally merge XL`s business with its operations aIter acquisition to
gain the advantage oI synergy. Hence, it would like to acquire substantial number
oI XL`s shares. XL`s shares held by the promoters (23.5), Iinancial institutions
(22.7), mutual Iunds (12.3) and individuals (41.5). Promoters will be willing
to sell their shares iI the oIIer price is attractive. XL has borrowed Iunds estimated
that about 25 individual shareholders have short-term investment objectives and
would always look Ior proIitable opportunities to sell their holdings.
The management oI SEC thinks that they could turnaround XL aIter its acquisition.
SEC could increase XL`s growth rate to 12. The co. may be able to maintain the
high sales growth rate (12) Ior about seven years Iollowed by normal growth rate
oI 6 Ior 5 years, and eventually the sales growth may drop to zero under
competitive pressure. SEC also hopes to reduce XL`s cost oI goods sold to 65 oI
sales and selling and administrative expenses to 10. SEC does not anticipate
major capital expenditures Ior XL; amounts equal to depreciation would be
suIIicient Ior minor capital expenditures. The corporate tax rate is 35. Assume
average WDV depreciation rate oI 20 Ior the block oI assets.
SEC`s weighted average cost oI capital is 18. XL has equity beta oI 1.20. its debt
is rated BBB`. The current yield on BBB-rated corporate bonds is 9.38 that is
about 3.15 higher than the long-term government bonds. The historical average
oI return Irom the share market exceeds the average yield on the long-term
government bonds has by about 9.
Questions Ior the Discussion:
1. What is XL`s value to SEC? Explicitly state all assumptions.
2. How much price should SEC pay Ior XL`s share?
3. What are the consequences oI acquisitions Ior SEC`s shareholders? Should
SEC acquire XL?

Table 32.1.2: SEC: Summarized Balance Sheet as on 31
st
March 2003
Summarized ProIit and Loss Statement and Per Share Data
(Rs in lakh) 2 21 22 23 24
et Sales 8335.72 6378.06 11,057.40 11,464.28 12,805.60
Cost oI goods sold 5943.20 6857.54 8315.91 8349.43 9105.28
Depreciation 167.63 236.20 211.82 190.49 217.92
Selling & admin. Exp. 1021.01 1200.83 1497.99 1528.47 1554.37
Total Expenses 7131.84 8294.57 10,025.72 10,068.47 10,877.58
PBIT 1203.88 1083.49 1031.68 1395.89 1928.02
Interest 198.11 230.11 263.63 291.06 432.79
PBT 1005.77 853.38 768.04 1104.83 1495.23
Tax 307.77 266.26 256.53 385.58 518.85
PAT 698.01 587.13 511.52 719.24 976.39
EPS 4.65 3.91 3.41 4.79 5.19
DPS 2.00 2.00 2.00 2.75 3.25
P/E 26.54 33.27 34.59 28.79 27.16

Table 32.1.2: SEC: Summarized Balance Sheet as on 31
st
March 2003
alance Sheet Items (Rs in Lakh)
Sources oI Funds:
Shareholders Funds paid up capital
(150 lakh shares oI Rs 10 each) 1500.00
Reserves and surplus 8442.90 10,942.54
Borrowed Funds:
Secured 3040.16
Unsecured 2443.75 5483.91
Capital Employed 16,426.45
&808 of Fund8
Gross Block 15,746.65
Less: Depreciation 4109.16
et Block 11,637.51
Investment 73.29 11,710.80
Current Assets 9416.15
Less: Current Liabilities 4700.49
et Current Assets 4715.65
et Assets 16,426.45



Table 32.1.3: XL Equipment Company:
Summarized Balance Sheet as on 31
st
March 2004
alance Sheet Items (Rs in lakh)
Sources oI Funds:
Shareholders Funds paid up capital
(50 lakh shares oI Rs 10 each) 500.00
Reserves and surplus 940.80 1440.80
Borrowed Funds:
Secured 282.24
Unsecured 188.16 470.40
Capital Employed 1911.20
&808 of Fund8
Gross Block 1287.72
Less: Depreciation 558.60
et Block 729.12
Investment 45.08
Current Assets 1475.88
Less: Current Liabilities 338.88
et Current Assets 1137.00
et Assets 1911.20

Table 32.1.3: XL Equipment Company:
Summarized ProIit and Loss Statement and Per Share Data
(Rs in lakh) 2 21 22 23 24
et Sales 2579.74 2726.78 2895.84 3060.04 3247.31
Cost oI goods sold 1780.06 1923.70 2061.91 2171.10 2289.40
Depreciation 66.19 73.85 82.48 83.86 76.63
Selling & admin. Exp. 465.14 507.69 513.19 544.17 578.58
Total Expenses 2311.39 2505.24 2657.58 2799.13 2944.61
PBIT 268.35 221.54 238.27 260.90 302.70
Interest 33.99 27.69 42.15 46.59 57.47
PBT 234.36 193.85 196.11 514.31 245.22
Tax 70.78 67.85 97.07 74.41 86.32
PAT 163.58 126.00 129.04 139.90 158.91
EPS 3.27 2.52 2.58 2.80 3.18
DPS 1.20 1.20 1.20 1.30 1.50
P/E 8.7 11.8 11.5 9.27 7.5

Solution of Ca80 32.1:

Not0: (1) Market value weighted cost oI capital has been used as discount rate.
(2) Zero growth is assumed aIter 12 years. Hence salvage value is calculated as
perpetual Iree cash Ilow (at the end oI 12 year) discounted by WACC.