PART I
Firstly, Firms acquire other firms in order to gain a larger market share and gain a competitive advantage. A firm may acquire another firm in order to improve its marketing and distribution network or acquire the clientele base of its competitor. Secondly, firm acquire other firms in order to diversify their market. A firm may acquire another firm operating in a different industry or in the same industry but a different market segment in order to diversify. Diversification is a risk management tool. Thirdly, a firm may acquire another firm in order to reduce its production and operational costs. Acquiring other firms creates opportunities for combining locations hence benefiting from economies of scale and integrating support functions hence reducing operating costs. Lastly, firms acquire other firms in order to learn or develop new capabilities. In case a firm is unable to learn a core competency of its main competitor, the easiest solution is to acquire it.
In most cases firms pay too much to acquire other firms. It is explained by the following reasons. First, companies enter into bidding wars hence the acquirer ends up paying a high price in an effort to outbid other firms. Secondly, the potential buyer has to offer an attractive premium above the market rate so as to entice the target company shareholders to accept the deal. Lastly, there are several transactional costs involved which inflate the acquisition cost. They include success fee paid to banks, valuation fees paid to investment banks, legal fees paid to lawyers and auditing fees paid to accountants.
So many mergers result in shareholder losses because the amount paid for acquisition is higher than the market value of the company. The result is that the market value of the predator company shares will reduce. This results in capital gain losses for shareholders.
PART II
Incremental Cash Flow
Direct cost was obtained by multiplying the sales by 45 per cent. Total Cash expenses were the sum of direct costs and indirect costs. Net Cash flow excluding depreciation was the difference between sales and cash expenses. Profit before tax was obtained by subtracting depreciation from the Net Cash flow excluding depreciation. Tax was obtained by multiplying profit before tax by 35 per cent. Profit after tax is the difference between profit before tax and tax. The net operating cash flow was obtained by adding depreciation to the profit after tax.
Pay Back Period
Payback period is the time taken to recover the initial investment in full. Only projects whose payback period is less than payback period policy of the company are accepted. It is calculated by the formula below;
Payback period = Years before full recovery + Amount to recovery/ Cash flow in the year of recovery
Initial Investment is given by the sum of investment in the new plant and investment in inventory
Cumulative Cash flow
The initial investment was fully recovered in the fourth year. Therefore, the full years before full recovery were 3 years. The fraction of the year in the year of full recover was computed by dividing the amount to full recovery by cash flow in year 4. Amount to full recovery is the difference between initial investment and the cumulative cash flow in year 3.
Net Present Value
Net Present Value is the difference between discounted cash inflows and the initial investment for a project. Only projects with a positive net present value are usually accepted while projects with a negative net present value should be rejected.
The discount factor was obtained by the following formula;
Discount factor = 1/ (1+10%) n where n is the year
Discounted Cash flow was obtained by multiplying the discount factor with the undiscounted cash flow. Total discounted cash flow is the sum of the cash flows in the 8 years. In year 8, the investment in inventory was added to the operating cash flow. This is because investment in working capital is usually recovered in the final year. The net present value was obtained by subtracting the initial investment from the discounted cash flows.
Decision to Accept or Reject
Basing on the payback period, the project should be rejected. Only projects whose payback period is less than payback period policy of the company are accepted while projects with a payback period that is greater than payback period policy of the company are rejected. The payback period for the project is 3.07 years which is greater than the payback period policy of the company which is 3 years. Therefore, the project should be rejected.
Basing on the net present value, the project should be accepted. Only projects with a positive net present value are usually accepted while projects with a negative net present value are rejected. This project has a positive net present value. Therefore, the project should be accepted.
How Additional Investment on Land would affect the Decision
An additional investment on land would not affect my decision based on payback period. An additional investment in land would increase the payback period. However, the project was already rejected because it had a greater payback period than the company payback policy. Therefore, it will not change the decision.
An additional investment on land may or may not affect my decision based on net present value. If the investment in land is higher than current net present value then it would result in a negative net present value. In which case, I would reject the project. However, if the investment in land is less than current net present value then it would result in a positive net present value. Therefore, I will still accept the project.
References
Banjerjee, B. (2005). Financial Policy And Management Accounting 7Th Ed. Delhi: PHI Learning Pvt. Ltd.
Petty, J., Titman, S., Keown, A. J., Martin, J. D., Martin, P., Burrow, M., et al. (2012). Financial Management, Principles and Applications (6th edition ed.). French Forest, NSW, Australia: Pearson Education.
Prasanna, C. (2011). Financial Management. New York: Tata McGraw-Hill Education.
Schlachter, C. T., & Hildebrandt, T. (2011, May 9). The Reasons for Mergers and Acquisitions. Retrieved July 5, 2013, from http://www.dummies.com: http://www.dummies.com/how-to/content/the-reasons-for-mergers-and-acquisitions.html
