Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base.

As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of

PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management.

Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the company's existing credit rating. The key issues, according to the company's advisors, are the terms of the deal and the likely effect of the acquisition on the company's value and its financial leverage. Both companies are quoted on an international stock exchange and below are relevant data relating to each company:

Financial data as at 30 November 20X7

Burcolene

PetroFrancais

Market value of debt in issue (Shs. bn)

3.30

5.80

Market value of equity in issue (Shs. bn)

9.90

6.70

Number of shares in issue (million)

340.00

440.00

Share options outstanding (million)

25.40

-

Exercise price of options (Shs.per share)

22.00

-

Company tax rate (%)

30.00

25.00

Equity beta

1.85

0.95

Default risk premium

1.6%

3.0%

Net operating profit after tax and new reinvestment (Shs.million)

450.00

205.00

Current EPS (Shs.per share)

1.19

0.44

The global equity risk premium is 4.0% and the most appropriate risk free rate derived from the returns on government stock is 3.0%.

Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 20X4. The vesting date is 30 November 20X9 and the exercise date is 30 November 20Y0. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required. Your estimate is that the options have a time value of Shs. 7.31.

PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of Shs. 430 million.

You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene.Following your initial discussions with management, you decide that the following points are relevant:

1The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment.

2Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each company's value.

3The acquisition would be financed by a new debt issue by Burcolene.

Required

(a)Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company.

(8 marks)

(b) briefing paper for management, advising them on:

(i)The validity of the free cash flow model, given the growth rate assumptions made by management for both firms

(ii)The implications of an acquisition such as this for Burcolene's gearing and cost of capital