Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products.

The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed.

Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Cos current capital structure level. Information on Pursuit Co and Fodder Co

Pursuit Co

Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 118. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million. Fodder Co, Income Statement Extracts

Year Ended All amounts are in $000	31 May 2019	31 May 2018	31 May 2017	31 May 2016
Sales revenue	16146	15229	14491	13559
Operating profit (after operating costs and tax allowable depreciation)	5169	5074	4243	4530
Net interest costs	489	473	462	458
Profit before tax	4680	4601	3781	4072
Taxation (28%)	1310	1288	1059	1140
After tax profit	3370	3313	2722	2932
Dividends	123	115	108	101
Retained earnings	3247	3198	2614	2831

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 153. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels.

However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.

For the next four years, Fodder Cos sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.

Information about the combined company

Following the acquisition, it is expected that the combined companys sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future.

After the first year the growth rate in sales revenue will be 58% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 64% on future borrowings.

The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the weighted average of the individual companies asset betas, weighted in proportion of the individual companies market value.

Other information

The current annual government base rate is 45% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Cos interest in Pursuit Co

There have been rumors of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Cos share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.

The rumors of SGF Cos interest have raised doubts about Pursuit Cos ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Cos board is keen to reduce the possibility of such a bid.

The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend.

Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Cos gearing level but suggested it may increase the companys share price and make Pursuit Co less appealing to SGF Co.

Required:

Assesses whether the Chief Financial Officers recommendation would provide a suitable defense against a bid from SGF Co and would be a viable option for Pursuit Co [15 Marks]