Calculates a range of possible valuations which prospective

Question

FAIRWEATHER LIMITED

Fairweather Limited is a well-established, privately owned machine components distribution company which has been trading for 15 years. It has four shareholders, two of whom are full-time directors of the company, each holding 25% of the ordinary shares of the company.

The company's accounting year end is 31 December. Summary financial information for the last four years is shown below.

	2016 Actual £m	2015 Actual £m	2014 Actual £m	2013 Actual £m
INCOME STATEMENT (extracts)
Turnover	115.0	102.0	98.0	87.0
Profit before tax and interest	19.5	18.6	15.8	15.4
Exceptional Items	6.8
Interest paid	(2.4)	(2.1)
Corporation Tax	(6.2)	(4.3)	(4.1)	(4.0)
Profit after interest and tax	17.7	12.2	11.7	11.4
Preference Dividend	(0.5)	(0.5)	(0.5)	(0.5)
Ordinary Dividend	(8.1)	(8.1)	(8.1)	(8.1)
Retained Earnings	9.1	3.6	3.1	2.8
BALANCE SHEET (extracts)
Assets
Tangible Non-Current Assets	77.0	74.7	40.3	38.1
Patents and Trade Marks	11.5	8.0	7.0	6.5
Goodwill	7.0	9.0	11.0	13.0
Current Assets	59.2	47.2	41.9	37.4
Current Liabilities	(48.7)	(41.9)	(36.8)	(34.7)
12 year bank loan	(30.0)	(30.0)	0.0	0.0
Net Assets	76.0	67.0	63.4	60.3
Financing
Preference Shares 6.5%	8.0	8.0	8.0	8.0
Ordinary Shares	4.5	4.5	4.5	4.5
Share Premium	18.0	18.0	18.0	18.0
Capital Reserve	15.0	15.0	15.0	15.0
Retained Earnings	30.5	21.5	17.9	14.8
Shareholders' Funds	76.0	67.0	63.4	60.3

Notes:

The exceptional items, shown above, for 2016 comprise the profit on disposal of non-current assets of £9.8 million less redundancy and reorganisation costs incurred of £3.0 million.

The nominal value of the preference shares is £1.00 each and of the ordinary shares is £0.25 each.

The company has grown steadily for several years but increasingly competitive market conditions are forecast for 2017. The directors, the main shareholders, now believe it would be preferable if the company were to become part of a more internationally-based organisation in order to achieve greater efficiencies and to speed the development of new income streams.

The directors have now appointed Universal Bank as financial advisors and instructed them to search for companies who might be interested in buying the ordinary share capital of Fairweather. The company's four year plan forecasts a profit after interest, tax and preference dividend of £15.2 million for 2017, with a further projected increase of 5.25% a year over each of the following three years.

As part of their preparations to sell the company, the directors of Fairweather have had all their land and buildings revalued in the Spring of 2017 by an independent expert, whose valuation is £4.5 million higher than the net book values reflected in the Balance Sheet as at 31 December 2016.

Global Parts plc, Engineering Supplies plc, Euro Spares plc, Robinson Components plc and GB Replacement Products plc, five companies listed on the UK Stock Exchange are in the same industry as Fairweather Limited, and their latest key investor ratios are shown below:

	Dividend Yield	P/E Ratio
Global Parts plc	6.4%	12.0
Engineering Supplies plc	5.7%	13.5
Euro Spares plc	2.1%	21.0
Robinson Components plc	6.1%	12.5
GB Replacement Products plc	6.8%	10.5

Large companies in the same industry typically apply a risk-adjusted, after-tax cost of capital of about 14% to acquisition proposals.

The estimated net cash flows which would accrue to a purchasing company, after allowing for interest charged, taxation, preference dividend and the capital expenditure required after the acquisition to achieve Fairweather's twelve year strategic plan, are as follows:

Year 1	£14 million
Year 2	£19 million
Year 3	£21 million
Year 4	£23 million
Year 5	£27 million
Year 6	£28 million
Year 7	£31 million
Year 8	£29 million
Year 9	£35 million
Year 10	£37 million
Year 11	£39 million
Year 12	£42 million

Chisso Corporation, an international publicly quoted Japanese-based replacement parts distribution company, has expressed an interest in buying Fairweather, as part of its strategic development plan to widen its component distribution business in the UK. Chisso Corporation has total shareholders' funds of 28 billion Yen and total debt of 24 billion Yen on its latest Balance Sheet.

Required:

1. Assume you are the appointed financial advisor to Fairweather Limited. Write a report to the board which:

a) Calculates a range of possible valuations which prospective purchasers might make for the ordinary shares of the company, based on the following seven different methods of share valuation:

1. net asset value (market values)

2. P/E basis

3. dividend yield (no growth)

4. dividend growth valuation model (using your own assessments about future growth rates)

5. discounted cash flow (over a 12 year period)

6. "super" profits (based on a fair return of 12.5% and using a multiple of 5.25 to value goodwill)

7. an earn-out arrangement based on an initial amount equal to the net asset value (market values) plus a deferred payment equal to 71.5% of the sum of projected profits after tax, interest and preference dividend for the years 2017, 2018, 2019 and 2020.

b) Critically appraises the valuation methods used and contrasts the differences in the results arising from each of the seven valuation methods in a).

2. Comment on how the risk-adjusted, after-tax cost of capital rate of 14% referred to in the question might have been arrived at and provide a critical analysis of four alternative methods available that allow for risk.

3. Assume you are an executive of the financial advisors to Chisso Corporation. Write a report to the Managing Director of Chisso Corporation advising on the relative advantages and disadvantages of the alternative methods available of financing a bid for Fairweather.

4. Evaluate the possible synergies that might arise if Chisso Corporation takes over Fairweather. You should also highlight the potential problems that may occur in the achievement of such synergies and suggest how these might be overcome.