Navidale, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years ago, Navidale Limited purshed 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 process. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have successfully increased the company's 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 technololgies which Navidale is seeking, but Departments B and C will be unbundled, whith the assets attached to Department C sold and Department B being spun off into a new company called Ndege Co.

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

Navidale Co Lochinvar Co

R Million R Million

Sales revenue: R790-2 R124.6

Profit before depreciation, interest and tax (PBDIT) R244.4 R37.4 million;

Interest R 13.8 R 4.3

Depreciation R 72.4 R 10.1

Pre tax profit R 158.2 R23.0

Non-current assets R723.9 R98.2

Current assets R142.6 R46.5

7% unsecured bond - R40.0

Other non-current and current liabilities R212.4 R20.2

Share capital (50c/share) R190.0 R20.0

Reserves R464.1 R64.5

Share of current and non-current assets and profit for Navidale Co's three departments:

Department A Department B Department C

Share of current and non-current assets 40% 40% 20%

Share 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 Co's 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 the Department B's PBDIT come from sales made to Department C.

(v) Ndege Co's cost of capital is estimated to be at 10%. It is estimated that in the first year of operation Ndege Co's free cash flows to firm will grow by 20% and then by 5-2% 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 Co's operations.

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

(viii) It is estimated that the combined company's 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 Discuss the possible reasons why Navidale Co may have switched its strategy of organic growth to one of growing by acquiring companies.(4)

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)

4.3 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)