Navidale, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years ago, Navidale Limited pursued a strategy of organic growth. Since then, it has followed an aggressive policy of acquiring smaller engineering companies, which it feels have developed new technologies and methods, which could be used in its manufacturing processes. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have successfully increased the companys shareholder value.

Navidale Limited is currently considering acquiring Lochinvar, an unlisted company, which has three departments. Department A manufactures machinery for industrial companies, Department B produces electrical goods for the retail market, and the smaller Department C operates in the construction industry. Upon acquisition, Department A will become part of Navidale, as it contains the new technologies which Navidale is seeking, but Departments B and C will be unbundled, with the assets attached to Department C sold and Department B being spun off into a new company called Ndege Co.

Given below are extracts of financial information for the two companies for the year ended 30 April 2014.

	Navidale Co R million	Lochinvar Co R million
Sales Revenue	790.2	124.6
Profit before depreciation, interest and tax (PBDIT)	244.4	37.4
Interest	13.8	4.3
Depreciation	72.4	10.1
Pre-Tax Profit	158.2	23.0
Non-Current assets	723.9	98.2
Current assets	142.6	46.5
7% unsecured bond	-	40.0
Other non-current & current liabilities	212.4	20.2
Share Capital (50/share)	190.0	20.0
Reserves	464.1	64.5

Share of current and non-current assets and profits of Navidale Cos three departments:

	Department A	Department B	Department C
Share of current and Non-current assets	40%	40%	20%
Shere of PBDIT and pre-tax profit	50%	40%	10%

Other information

(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value, but its current assets realisable value is only 90% of their book value. The costs related to closing Department C are estimated to be R3 million.

(ii) The funds raised from the disposal of Department C will be used to pay off Lonchivar Cos other non-current and current liabilities.

(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of the bond is equal to its book value.

(iv) At present, around 10% of Department Bs PBDIT come from sales made to Department C.

(v) Ndege Cos cost of capital is estimated to be 10%. It is estimated that in the first year of operation Ndege Cos free cash flows to firm will grow by 20%, and then by 52% annually thereafter.

(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation on its non-current assets. It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to maintain Ndege Cos operations.

(vii) Navidale Cos current share price is R3 per share and it is estimated that Lochinvar Cos price-to-earnings (PE) ratio is 25% higher than Navidale Cos PE ratio. After the acquisition, when Department A becomes part of Navidale Co, it is estimated that Navidale Cos PE ratio will increase by 15%.

(viii) It is estimated that the combined companys annual after-tax earnings will increase by

R7 million due to the synergy benefits resulting from combining Navidale Co and Department A.

Required:

4.1 Estimate, showing all relevant calculations, the maximum premium Navidale Co could pay to acquire Lonchivar Co, explaining the approach taken and any assumptions made. (14 marks)

4.2 Discuss the possible actions Navidale Co could take to reduce the risk that the acquisition of Lochinvar Co fails to increase shareholder value (7)