Applied financial markets
This assignment is marked out of 120 and will be converted to 30% of your final assessment.
There is no word limit per se. However, finance is a discipline where “less is more”.
The assignment can be either typed or handwritten, or both. Scan your handwritten work as a pdf copy for electronic submission purposes.
The company of choice for this assignment is Touch corp (ASX: TCH).Founded in 2000 by brothers Keith and Adrian Cleeve, it’s a technology solutions company listed on the Australian Securities Exchange (technology and telecommunications sector), and providing services across three business units including payments and mobility, health and government and e-services for retail businesses. Under the touch system platform, the company has built a software platform that enables customers to simply and quickly purchase products through a secure self-service method through a range of devices and platforms such as mobile, interactive voice recognition, websites etc. The platform also enables individuals and businesses to grow their transactions reduce costs and improve competitiveness and manage security. Its services enable retailers to sell their products directly to consumers through any consumer channel whether mobile, IVR or website, healthcare providers to claim their funds electronically from insurance companies and enables retailers to easily process their transactions.
In the last financial year (2016), the company posted strong financial results across the three business segments, buoyed by the implementation of technology and that was developed in 2014/15. These saw transaction numbers grow by 8% resulting in at least 16% of transaction revenues. Overall, revenues were down to $36.8 Million from 42.3 million, although the profit was higher $11.6million, compared to $9.4 million in 2015, indicating greater efficiency in operations and costs management. Despite this performance, the company still continues to face significant risks relating to lengthy tendering and decision making especially with large retailers, banks and governments, changing customer needs and the emergence of new technology and the uncertain regulatory environment that characterizes the technology and communications sector. Despite these risks, the company strives to deliver long-term returns to shareholders regarding revenue growth and profitability. To achieve this, the company seeks to support organic growth of existing clients, increase its market share both locally and regionally, support innovation and new technology development, and consistently innovate so as to meet the customers changing needs.
Takeover analysis-Summary of target
Afterpay Pty Ltd (ASX: AFY) is a technology driven company that provides software infrastructure and services allowing its retail merchants to offer their customers the ability to buy goods from their websites and credit terms (buy now, pay later basis).It’s listed on the Australian securities exchange under the technology and telecommunications segment. As a fully owned subsidiary of Afterpay Holdings limited, the company was incorporated in 2014 and is based in Melbourne, Australia. The company was born out of the need to reimagine how earning and spending of money is done in modern business environments. It seeks to provide flexibility and simplicity in how payments are done, thus helping people to transact at their convenience.Its platform provides simple and interest-free installments that are available at retailers either on mobile, online or in the physical locations in real time. The company revenues for the year 2016 was 1.4 million, up from 0.02 million in 2015 indicating a 5700% increase, however, The company has been making losses, indicating the huge capital investment in infrastructure and the amortization of the older Afterpay system. Despite these operating and financial challenges, the company issued an IPO which attracted revenues of $25 million which was utilized to support the continuing company’s growth profile.
b) Classify the type of the takeover and describe the benefits associated with the takeover deal
The type of takeover deal in this scenario can be described as friendly. According to Rappaporrt & Sirower (1999), a friendly takeover occurs when the acquiring company discusses and agrees with the board of directors of the target their intention to acquire a controlling stake in their company. The said board then votes on the buyout and if they believe that the stock purchase would be beneficial, then the sale is approved. The acquiring company will then goes ahead and acquire the controlling interest in the target.
There are several benefits that would be realized in this deal. First, since Touchcorp and Afterplay are closely related, even complementary companies, the deal is likely to realize significant synergies in terms of financial, operations, risk management and cost reduction. Second, there is greater familiarity with the target’s business as there is the likelihood of unfettered access to proprietary information that would be useful in negotiations, thus improving the accuracy of negotiations in the valuation of the deal. Since most friendly deals are financed through stock options, any mistakes occurring in the valuation process are also borne by the target shareholders. Finally, friendly takeovers are more likely to be smooth as there is little opposition or disruption, which preserves the targets intangible assets and since it doesn’t mostly involve cash transactions, the acquiring company’s financial position is not significantly affected by the transaction and therefore its operations continue uninterrupted.
c) In the context of Real Option, outline the source of the synergy.
The deal will entail a combination of Afterpays commercial and sales track record with Touchcorps leading technical capability which is expected to create a strong market portfolio for the new company. Combining strong technical capabilities with market strength is a sure way to greatly capture the market and possibly ward of competition especially in the technology industry that is characterized by a lot of competition.
The deal also draws synergy from a strong level of transaction integrity and data analytics. Combining both companies leads to strong capacities to manage transaction integrity and ensure that data analytics is streamlined and enhanced. Efficiencies will also be created since their combined effort would lead to access to a broader transaction portfolio and database universe which leads to significant cost savings.
This deal will be beneficial in the deployment of advanced technology in transactions management and operational efficiency. The combined efforts of both companies is likely to inform the deployment of leading edge technology, buoyed Afterpays strong product and sales focus.
The combined business will leverage from a rapidly growing transaction volume to lower input costs and achieve economies of scale. Since the two companies are closely related, with Touchcorp leading in design and technology while Afterpay champions the payment portfolio, the deal will lead to a reduction in costs as transactions increase.
The wider scope of operations will result in the streamlining of overheads and reduction in the overall operating costs. This will have a positive impact on the combined business efficiency, effectiveness, and profitability and shareholders wealth and risk management profile.
Finally, opportunities for expansion will be explored, given the combined financial, technical and marketing capabilities of the new entity. The fast evolving technology and telecommunications sector in Australia presents clear opportunities for expansion and innovation to meet changing customer needs and demand, and therefore there are significant gains in this area that will accrue from this deal.
d) Calculate the market capitalization of the target, the synergy and hence advise the management of the existing company on the offer price
Market capitalization is calculated as the number of outstanding shares multiplied by the market price per share.
Number of issued shares (ASX: AFY) = 77,340,000
Price per share (Closing 5/5/2017) $2.45
Total market capitalization = 189,483,000
Proposed value of deal =$500,000,000
Premium on valuation =$ 500,000,000- $189,483,000
Premium on valuation= $310,517,000
Offer price = offer amount/ number of shares
= 500,000,000/ 77,340,000
Synergy = Net present value of the new company + premium
e) How should the merger be paid for? Cash, stock or a combination of both? Give reasons.
There are various methods of paying for mergers and acquisition consideration, the most common ones being cash, stocks or a combination of both. The decision on which method to use for settlement of a merger and acquisition transaction is often based on the advantages and disadvantages of each, as well as the company’s unique factors. For this transaction, we propose consideration in the form of stocks due to the many advantages that will accrue to both the predator and target.
First, unlike in cash transactions where risks are assumed entirely by the acquiring shareholders, in stock transactions, risks are shared between the parties in their proportion according to the new ownership structure. In cash transactions for instance, once shareholders receive their cash (share price premium), they no longer assume any risks even if the combined company underperforms but if the consideration is in the form of stocks, then they are affected by the company’s performance by virtue of their shareholding (Rappaporrt & Sirower,1999). For instance supposing that Touchcorp Company completes a purchase of Afterpay through share exchange and the expected synergies do not materialize. If they had paid a premium of $1.2 billion in cash to the seller, they lose 100% but if in their share ratio after the merger was 55% to 45%, then their loss would only be $660 million.
In most cases, the acquirer is often much larger than the target and therefore the acquired shareholders end up owning just a negligible portion of the company. This means that issuing shares in consideration for the target doesn’t affect the controlling of the company. Additionally, the acquiring company doesn’t need to raise cash for the transaction, leaving such funds for use in the company’s expansion strategy.
The use of shares in settlement of mergers and takeover transactions has a tax benefit in that such share premium would not be taxed, unlike in cash transactions where the shareholders who receive the cash are required to immediately pay capital gains tax on their shares. In stock transactions, shareholders only pay taxes on their stocks when they dispose them, and not at the time of the transaction.
f) Estimate the cost, the NPV of the merger and the post-merger price.
|Touch Corp||Afterpay||Touchcorp post acquisition|
|Number of shares||131,812,080||77,340,000||209,152,080|
|Earnings per share||0.1||(0.05)||0.04|
|Price per share||1.49||$2.45||1.84|
|Market value of stock||196,399,999||189,483,000||385,882,999|
Post-merger price is the share price after the acquisition. In the above computation, we assume that all the shares of Afterpay will be acquired by Touchcorp at their market prices.
- Should they raise the capital using internal funds, debt, equity, hybrid securities or a combination of the above? State the reasons.
This paper proposes that capital should be raised through debt as opposed to the other methods, backed by the reasons detailed below.
Tax benefits- interest accrued on debt is a tax allowable expense, which helps reduce the cost of debt and ultimately the company’s overall cost of capital. Tax deductible expenses benefit a company in that it reduces the company’s tax burden which has a positive impact on the earnings attributable to shareholders.
Managerial participation- Unlike equity holders, debt holders have no right to participate in the running of the company, as they are paid a fixed interest. This means that for the borrower, there is no risk of loss of control to lenders as they have no equity rights and the company’s liability to them is limited only to their debt portfolio. Such debt holders have no representation in the management of the company.
Debt holders do not earn dividends from the company. Even if the company makes huge amounts of money, debt holders will still be paid their fixed amount. The fixed nature of interest on debt enables a company to easily plan on liquidating such debts, unlike equity holders who have a continuing interest in the company.
Debt financing is deemed to be the cheapest form of raising capital due to the fact that in most cases, the debt would attract an interest of say between 4 to about 10%, while the cost of equity sometimes goes as high as 25%. This encourages businesses to heavily rely on debt as opposed to equity, up to a level of leverage beyond which the company would be excessively geared.
Since there is very high surety that debt would most likely be repaid, with the accruing interest, there is never a guarantee that a company would perform well and therefore debt is in most cases very attractive to lenders and therefore easier as a form of raising capital as opposed to equity, which has more regulatory requirements and may not always be subscribed.
- If the capital required is raised via a share issue, should the company engage in a right issue or private placement?
A rights issue is a method of raising capital in which the existing shareholders are given an opportunity to buy shares at a discounted rate in accordance to their existing shareholding portfolio. A Company may, for instance, give the existing shareholders a right to buy one share for every three held, at a discount. The private placement, on the other hand, is a method of raising capital in which shares, stocks or bonds are sold directly to a select investor (s), other than offering them to the general public (Cronqvist & Nilsson, 2005). For this case, a rights issue is proposed, due to the advantages explained below.
With a rights issue, the controlling of the company is not diluted, as it’s retained with the existing shareholders. A rights issue is basically an equitable distribution of shares in a manner that doesn’t disturb the existing equilibrium of shareholders since rights are issued to only those people that were holding shares at the date of issue and at a rate that is proportionate to their equity shares.
In a rights issue, existing shareholders do not in the real sense; suffer from the dilution of the value of their shares. The apparent decrease in share value is compensated by the getting of new shares at a price lower than that in the market. If rights are not issued and the company has to raise funds, the shareholders are still likely to suffer share dilution in the event such shares are offered to the public.
A rights issue would be beneficial at it would significantly avoid most of the expenses related to a public offering of shares. This is because a rights issue has less regulatory requirements, publicity costs, administration expense and other related charges that would otherwise be necessary for a public offer of shares in the public.
A rights issue is a reflection of the confidence that the existing shareholders have on their company (Damodaran, 2010). By choosing to increase their shareholding, shareholders are passing a message that their company is stable and they are happy to remain as shareholders, that outsiders are unwelcome. It’s, therefore, a great way to enhance the company’s image. This is unlike a private placement, which is often construed to mean that the company has poor fundamentals, which is likely to lead to a decline in the share price.
A rights issue is an almost sure way of getting capital compared to a public offer. This is because, existing shareholders already know the value of the company and are likely to take up the offer and additionally, since rights issues are done at a discounted rate, they are likely to be taken up.
Since rights issues are done proportionate to the existing shareholding, directors and officers of the company may not influence control of the company by issuing shares to their friends or relatives, which preserves the integrity of the process.
- How does it affect the wealth of the existing shareholders in each scenario?
In a rights issue, the voting power of shareholders doesn’t change since the shares are issued proportionately to their previous shareholding and since shares are only issued to existing shareholders and therefore there is no transfer of wealth.
Rights issue affect shareholders wealth through share price dilution. Say for instance existing shareholders of Touchcorp are offered a right to buy 3 shares for each 10 held. Since a shareholder holds 1000 shares, they are entitled to buy 300 shares. Let’s say that the market value of shares is $1.49 and the new shares are issued, at a discounted rate of $1.2, the total price paid is $900. The new share price after the rights issue is calculated as follows
Existing shares 1000 @ $1.49 $1,490
New shares 300@ $1.2 $ 360
Value of 1300 shares $1,850
Price of shares ex-rights ($1,850/1300 shares
Notably, the new share price is lower than the market price, indicating the loss of shareholder value as a result of the rights issue. It’s important, however, to note that the loss of value as a result of the rights share issue is compensated by the acquisition of more shares at a much lower value during the rights issue.
In a private placement, the percentage of equity held by the existing shareholders is diluted by the issuance of new shares since it increases the number of outstanding shares, with the extent of dilution equaling the size of a private placement. The dilution of shares, just as shown in the rights issue computation above, leads to a corresponding share price decline in the short run. The long-term impact on share price and shareholders wealth is depended mainly on how effectively the company employs the additional capital that is raised through the rights issue.
Several risks often characterize mergers and takeover deals. The main reasons for these transactions are that at least one company, mostly the acquiring company, expects to reap certain benefits from either acquiring or merging with the target. The most important risk in this case, therefore, is the realization that such benefits/synergies may not be realized. This means that the premiums paid to the target would be lost if there are no significant gains that arise from the transaction.
Mergers and acquisition transactions are complex, especially since they involve a lot of assumptions with regard to the cost of capital, synergy and other valuation metrics. This is complicated by the fact that some information may not be available or may not be made available or may be manipulated by the target, with the aim of looking attractive to the buyer. The risk, in this case, is the probability that the target would be overvalued, or that the valuation would not be accurate as it may lead to loss of money for the shareholders.
Mergers and takeovers are often subject to stringent approvals from the Australian Securities Exchange and other regulators and therefore, there is always the underlying risk that there will be regulatory hurdles to this deal.
Rappaporrt, A & Sirower, M.L (1999) The tradeoffs for buyers and sellers in mergers and acquisitions
Cronqvist, H., Nilsson, M., (2005). The choice between rights offerings and private equity placements. Journal of Financial Economics 78, 375-407.
Damodaran, A (2010) Acquisition valuation. Available at http://people.stern.nyu.edu/adamodar/pdfiles/AcqValn.pdf