Kunla Ltd and Cann Ltd intend to merge. The following were observed just before
ID: 2798639 • Letter: K
Question
Kunla Ltd and Cann Ltd intend to merge. The following were observed just before the merger announcement.
Kunla Ltd
Cann Ltd
Market price per share
GH¢ 400
Number of shares
Market value of firm
GH¢ 800,000,000
GH¢ 200,000,000
The proposed merger will create GH¢50,000,000 in synergies. Kunla Ltd intends to pay GH¢ 130,000,000 cash for Cann Ltd.
What is the cost of the merger to Kunla Ltd?
Compute the NPV of the merger.
The managers of these firms have proposed to merge to diversify their activities and to reduce risk. Should you pay a premium for the merged firm?
What convincing reasons can these managers give for the proposed merger?
What roles do investment banks play in facilitating M&A deals?
Kunla Ltd
Cann Ltd
Market price per share
GH¢ 400
GH¢ 200Number of shares
2,000,000 1,000,000Market value of firm
GH¢ 800,000,000
GH¢ 200,000,000
Explanation / Answer
Acquirer : Kunla Ltd and Target: Cann Ltd
Standalone Value of Kunla Ltd = PV(A) = GH¢ 800,000,000 and Standalone Value of Cann Ltd = PV(B) = GH¢ 200,000,000.
Synergistic Gains from Merger = GH¢50,000,000
Cash Paid by Kunla for Cann's Equity = GH¢ 130,000,000
Therefore, Cost of Acquisition to Kunla = Cash Paid - PV(B) = GH¢ 130,000,000 - GH¢ 200,000,000 = - GH¢ 70,000,000. This means that Kunla is actually making a gain of GH¢ 70,000,000 by purchasing Cann at a discount (price less than) to Cann's market value.
Therefore, Acquisition NPV to Kunla = Syngergistic Gain + Gain from Buying Cann Cheap = GH¢ 50,000,000 + 70,000,000 = GH¢ 120,000,000.
The stated reason by the manager's for merging is to diversify firm activity and reduce risk might make sense if Cann has established operations in fields which are yet untouched by Kunla. A merger gives Kunla ready access to Cann's expertise, markets, customers, technology, operational knowhow, labour, fixed assets, intellectual property rights and more in this particular field, thereby ensuring a successful diversification of operation for Kunla. Diversification through inorganic means (by starting a new business instead of acquiring an existing one) might prove to be costly and difficult for Kunla owing to high entry barriers, regulatory restrictions, high existing competition and more. The merger makes even more sense when we consider the fact that Kunla might actually buy Cann at a price less than its market value. This could be due to multiple reasons such as availability of other similar acquisition targets, poor operational or financial health of the target, rogue or tarnished management team at the target, depressed margins and/or stock prices of the target, lack of product innovation or offerings by the target, declining market share, revenue or margins of the target and more. Paying a premium if all of these conditions are true is not advisable. It might be if the benefits of diversification to Kunla outweigh the potential losses of acquiring a poor performing firm like Cann.
Since, Kunla is trying to acquire Cann at a discounted price it might be possible that Cann has not been performing well in terms of its operations and financials. In such a scenario, the merger is sensible only if the revenue increment and cost reduction synergies of the merger outweigh the potential downsides of merging with a poorly performing company like Cann.
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