Financial Management 2

Neros Pasta Inc. Case Study Analysis

Neros Pasta Inc. Case Study Analysis


SECTION 1
GROUP 9


Name FT No.
Aman Abbi FT-14105
Bansi Simaria FT-14115
Mrinal Jha FT-14137
Sathis Raj FT-14163
Arindam Roy FT-14184
Neha Singhal FT-141108


Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 1:

The economically justifiable rationales for mergers are synergy and tax
consequences. Synergy occurs when the value of the combined firm exceeds the
sum of the values of the firms taken separately.(if synergy exists, then the whole
is greater than the sum of the parts, and hence synergy is also called the 2 + 2 =
5 effect.)

A synergistic merger creates value that must be apportioned between the
stockholders of the companies involved.Synergy can arise from four sources:
(1) Operating economies of scale in management, production, marketing, or
distribution;
(2) Financial economies, which could include higher debt capacity, lower
transactions costs, or better coverage by securities analysts that can lead
to higher demand and, hence, higher prices;
(3) Differential management efficiency, which implies that new management
can increase the value of a firms assets; and
(4) Increased market power due to reduced competition.

Operating and financial economies are socially desirable, as are mergers that
increase managerial efficiency. However, mergers that reduce competition are
both undesirable and at times, illegal.

Another valid rationale behind mergers is tax considerations.For example, a firm
that is highly profitable and consequently in the highest corporate tax bracket
could acquire a company with large accumulated tax losses, and immediately use
those losses to shelter its current and future income.

The motives that are generally less supportable on economic grounds are risk
reduction, purchase of assets at below replacement cost, control, and
globalization.Managers often state that diversification helps to stabilize a firms
earnings stream and thus reduces total risk, and hence benefits
shareholders.Stabilization of earnings is certainly beneficial to a firms
employees, suppliers, customers, and managers.However, if a stock investor is
concerned about earnings variability, he or she can diversify more easily than
can the firm. Why should Firm A and Firm B merge to stabilize earnings when
stockholders can merely purchase both stocks and accomplish the same thing?
Further, we know that well-diversified shareholders are more concerned with a
stocks market risk than its stand-alone risk, and higher earnings instability does
not necessarily translate into higher market risk.

Sometimes a firm will be touted as a possible acquisition candidate because the
replacement value of its assets is considerably higher than its market value.For
example, in the early 1980s, oil companies could acquire reserves more cheaply
by buying out other oil companies than by exploratory drilling.However, the
value of an asset stems from its expected cash flows, not from its cost.Thus,
paying $1 million for a slide rule plant that would cost $2 million to build from
scratch is not a good deal if no one uses slide rules.

Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 2:

In a friendly merger, there is an agreement between the management of the
acquiring firm and the management of the target firm. In most cases, the acquiring
firm initiates the action, and the rest of the time, the target initiatesit.The
managements of both firms get together and work out terms that they believe to be
beneficial to both sets of shareholders.At times, the management may also
encourage shareholders to tender their shares at the agreed price. Then they issue
statements to their stockholders recommending that they agree to the merger.Of
course, the shareholders of the target firm normally must vote on the merger, but
managements support generally assures that the votes will be favorable.

If a target firms management resists the merger, or there is disagreement between
the acquiring firm and the target firm, then the acquiring firms advances are said to
be hostile rather than friendly.In this case, the acquirer, if it chooses to, must make a
direct appeal to the target firms shareholders.This takes the form of a tender offer,
whereby the target firms shareholders are asked to tender their shares to the
acquiring firm in exchange for cash, stock, bonds, or some combination of the
three.If 51 percent or more of the target firms shareholders tender their shares,
then the merger will be completed over managements objection. A key point to
note is that the management of the target company discourages the tendering of
stockholders shares.

Hostile takeovers generally end up in the acquiring company offering (and
sometimes winning) a premium price for the price of a share. This is to win over the
stockholders of the target firms who may be skeptical regarding the fair value of
the price and / or to tempt them with monetary incentive. Additionally, a premium
generally detracts other prospective, competing, acquiring firms.

Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 3:

1996 1997 1998 1999
Net Sales $20,000,000 $25,000,000 $31,250,0
00
$39,062,500
Variable Operating
Costs
1,70,00,000 2,12,50,000 2,65,62,50
0
3,30,62,500
Depreciation 2,50,000 3,00,000 3,60,000 4,32,000
Fixed Operating
Costs
7,50,000 9,00,000 10,80,000 12,96,000
Interest Expense 2,50,000 3,00,000 3,60,000 4,32,000
Earnings Before
taxes
17,50,000 22,50,000 28,87,500 36,69,375
Taxes 7,00,000 9,00,000 11,55,000 14,79,750
Net Income 10,50,000 13,50,000 17,32,500 22,19,625
Plus Depreciation 2,50,000 3,00,000 3,60,000 4,32,000
Cash Flow 13,00,000 16,50,000 20,92,500 26,51,625
Required Addition
to Equity
5,00,000 6,00,000 7,20,000 2,16,000
Available Cash
Flow
8,00,000 10,50,000 13,72,500 24,35,625
Expected Terminal
Value
2,59,51,539
Free Cash Flow 8,00,000 10,50,000 13,72,500 2,83,87,164

Interest Expenses are usually deducted in the merger cash flow statements to
deduce the actual free cash flow available to the company. However, for capital
budgeting cash flow analysis, the return required by the investors furnishing the
capital is accounted cost of capital discount rate, and hence including again
interest expenses in financing flows for capital budgeting would lead to "double
counting."

Retained earnings are also deduced to as that money is accounted for reinvesting
in the company business & it should not be included in the free cash flow of the
company.


Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 4:

Beta Unlevering: Values
Beta of Nero 1.2
Debt 40%
Equity 60%
D/E 0.667
Tax 30%
Unlevered Beta 0.82


Beta Relevering Values
Unlevered Beta 0.82
Debt 50%
Equity 50%
Tax 40%
D/E 1
Relevered Beta 1.31


Column1 Values
Cost of Capital (WACC)

Constant Growth rate 5%
Rf 7%
Market Risk Premium 6%
Cost of Debt 10%
Cost of Equity Re= (Rf+(Rm-Rf)) 14.85%
Equity 50%
Debt 50%
WACC 10.43%


Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 5:

Terminal Value = Final year CF * (1 + Long term growth rate)/(Discount rate -
Long term growth rate)

= $2,35,32,574

If there is another firm that is evaluating Nero, they would get a different WACC
unless otherwise they keep the same capital structure and they have the same
operating risk


Question 6:

(a) Nero's management should employ as many defensive moves as it can to
dissuade a buyout pre-offer. The moves are: employing a staggered board
to maintain board continuity, using golden or preferably tin parachutes to
increase the cost of the buyout, usage of supermajority voting as
prerequisite for the merger.
Post the offer, a share repurchase can be used to decrease the number of
outstanding shares, or the management may replace equity with debt by
engaging in a Leveraged capitalization, or counter the hostile bid by
attempting to acquire the other company.
(b) Engaging a White Knight defense employs the firm to sell out to a party
that agrees to some concessions viz. payment of a higher price, not laying
off employees etc. Besides this additional buyers can be invited to bid for
the company so that competition leads to better compensation for the
shareholders.
(c) A White Squire tactic means that a party be invited so that it invests
significantly in the firm but votes with the management but does not buy
additional shares. This eliminates the problem of the firm losing its
independence as in the case of a White Knight defense. Also it protects the
shareholders from losing value by holding out against a takeover. A white
squire usually sells off its shares once the hostile bidder has withdrawn
his offer.
(d) Golden Parachute is a clause that provides the management (usually in a
high position) to be paid a sum if his/her contract is terminated, but this
is often employed as a deterrent to a bid. Instead a tin parachute should
be employed where all employees get benefits if contracts are terminated.
This acts both as a deterrent as well as gets rid of the agency problem.




Question 7:

NPV $1,87,11,198.24

Max offer per share $3.74

Financial Management 2
Neros Pasta Inc. Case Study Analysis
Max value per share 2.621119824 $2.62
Offer rate $2.62


Question 8:

The sharing of value between the acquired firm and the buyout firm is divided on
the basis of the distribution of shares between the two. According to present
scenario the bidders have 30% of the equity share. As the market share of the
buying firm increases, the premium commanded by the overtaking firm also
increases. A perfect synergy exists, when the buying and bought firm have an
equal market share.


Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 9:

The variable cost in the case is given as 85% of the sales. Now if it goes above
85% the net income will decrease and in turn the cash flow will be reduced. On
the other hand if the variable cost is below 85%, the cash flow for the years
increases.
The managers will be interested in the sensitivity analysis to determine the
effect that variable costs have on the price of the share. In this case, if the share
price has to be $3/share, the NPV of Nero should be
(3*5000000)=$15000000.The variable costs will be more than 85% of the sales.


Question 10:

Beta before merger = 1.2
According to Hamada's Equation-
Beta levered = beta unlevered * (1+(1-T)*D/S)
Beta before Merger- 1.2 = Beta* (1+(.7*2/3))
Beta After merger = 1.2* (1+ (.6*1))/1.47 = 1.3
Return on Equity = 7+ 1.3*6 = 14.8%
WACC= .5*14.8+.5*10*(1-.4)= 10.4%

Return on equity projected in the analysis is 42% for the year 1996.
Return on equity projected in the analysis is 45% for the year 1997.
Return on equity projected in the analysis is 48.13% for the year 1998.
Return on equity projected in the analysis is 51.38% for the year 1999.
The return on equity is increasing by 3% every year. More conservative
estimates on the various costs can lead to different values.


Question 11:

30% of the stocks is held by the management of Nero. But an acquisition
requires minimum of 51% of the stocks of the target company which implies that
the bidder should turn to the stockholders of the company.
ICI pays a premium as we have already discussed above.
Offering the ICIs stocks instead of Neros.
In both the options shareholders accept only if crosses or reaches their
perceived value. Otherwise, the stockholder could accept to a cash offer if there
is an open offer to offer a premium price over the current market price of the
stock. If the offer made is in stock, then the risk is transferred to Neros Pasta,
hence they will get a higher part of the synergy.




Financial Management 2
Neros Pasta Inc. Case Study Analysis
Question 12:

ICI should make an offer as below:
It should be a friendly deal with stock price at $2.00 if the Neros reject
the offer then increase the premium to 40% of $1.5 which is about $2.1
Neros present management should be included to mitigate the
operational risks. An advisory board can be set up from ICI to work hand
in hand with the present management of Neros Pasta; so that both the
parties can make the maximum benefit of the synergies.
However, if they try to reject the offers, ICI can have a hostile takeover.