BLOCK TWO REVISION- ADVANCED FINANCIAL MANAGEMENT

Questions and answers

Question 1

Questions

• The directors of ABC Electronics Ltd. are considering a takeover bid for XYZ Electronics Ltd. However,
  they recognize that there are potential problems with any proposed bid. First, the directors of ABC Ltd.
  believe that any take-over bid would be resisted by the directors of XYZ Ltd.
  Secondly, ABC Ltd. is short of cash and so any offer made to the shareholders of XYZ Ltd. would have to
  be either in form of a share-for-share exchange or a loan capital-for-share exchange.
  Required:
• Identify and discuss four reasons why a company seeking to maximise the wealth of its shareholders
  may wish to take over another company.
•  Evaluate the share-for-share exchange and loan capital-for-share exchange options as methods of
  purchase consideration from the viewpoint of the shareholders of both companies.
• Identify and discuss six defensive tactics the directors of XYZ Ltd. may employ to resist an
  unwelcome bid.

Question 2

• Agency problems can be resolved by proper corporate governance. Corporate governance lays emphasis on
  shareholders rights and enhancement of shareholder value. In many countries including Kenya, the concept
  of corporate governance has gained increasing prominence in recent times as evidenced by the issue of
  corporate governance guidelines by the Capital Markets Authority (CMA).
  Required:
•  Explain the reasons motivating the increasing interest in corporate governance.
•  Identify the benefits of good corporate governance to shareholders.
•  Write short notes on any five corporate governance guidelines issued by the Capital Markets
  Authority (CMA) or similar authority in your country.

Answers

Question 1

Four reasons why a company seeking to maximise shareholders wealth may wish to take over another company are as follows:

• It may wish to eliminate the competition in a particular market. By taking over a rival company it may be possible to obtain a larger market share for its products and this in turn, should lead to increases in profits.
• It may view another company as an opportunity to exploit under utilised resources. The target company may have a weak opportunity team in place which does not take advantage of profitable opportunities. By taking over the company and introducing a stronger management team it may be possible to improve sales and profit.
• The takeover of another company will result in the creation of a larger business entity which may enable economies of scale to be achieved.
• The target company may possess complimentary resources which when combined with the resources of the takeover company will result in profits over and above those achieved by the two businesses operating as separate entities.

Acquisition of a more efficient management team:

Others: -Diversification-Tax saving-Investing the surplus cash.

• The offer of shares in ABC Ltd in exchange for shares in XYZ Ltd overcomes the problems of raising cash but will result in a dilution of control for existing shareholders in the bidding company in addition, equity shares represent a more costly form of financing that loan capital. The issue of new shares by ABC Ltd will reduce the gearing position of the company however, the overall level of gearing of the combined company will also be influenced by the gearing of ABC Ltd.
• Shareholders of XYZ Ltd may find a share-for-share exchange attractive as no immediate liability for capital gains tax will arise as a result of the transaction. They will also still have a continuing interest in the business although it will now become part of a larger business entity. An offer for cash or loan capital would involve transaction costs if the investors wished to hold shares instead. When evaluating a share-for-share exchange, comparisons of dividends per share, earning per share and share values over time will be extremely important to investors.
• The offer of loan capital in exchange for shares also overcomes the problem of raising cash and avoids any dilution of control for existing shareholders. However, it will increase the gearing of ABC Ltd and hence, the level of financial risk. When combined with the gearing of XYZ Ltd. it is possible that the total gearing will be unacceptable to the shareholders of ABC Limited. The obligations to make interest payments and capital repayments may become onerous in the future if profits are low.
• Loan capital may be an attractive form of consideration, however, to the shareholders of XYZ Ltd. The offer of a fixed return and security for the investment may be welcome if investors are unsure of the future success of the combined business entity.
• Defensive tactics employed by XYZ Ltd.Divestiture – the targets firm spins-off some its business into an independent subsidiary company this reducing attractiveness of existing business for the predator.
• Green mail – incentive given by management of target firm to the bidder (predator) for not pursuing the takeover e.g offering the predator a higher price than the market price.
• Golden parachutes – where generous compensation is given to managers of the target company if they get ousted due to a takeover.
• Crown jewels – sale of the attractive business that makes the target attractive.
• White knight – where the target firm offers itself to be acquired by a friendly company to escape from a hostile takeover.
• Poison pill– the predator may become a target when it is targeting other firms. The predator (acquiring firm) may make itself unattractive to potential bidder. This is called poison pills e.g borrowing heavy debt to increase leverage thus becoming unattractive.
• Change of state of incorporation – move to another country where forced takeover laws are more protective and restrictive.
• Dual class recapitalization – the equity shares are divided into two or more classes with different voting rights. The core or family owners are granted greater voting power under a one share, one vote rule.
• Litigation by the target company – the management of the target could bring anti-trust suits against the bidder. This will delay the control contest.
• Going private transactions – this is the opposite of going public. It involves buying shares from the stock exchange and making the company private

Question 2

Driving forces/factors behind keen interest in corporate governance. Increasing corporate fixtures e.g collapse of sugar factories, financial institutions, manufacturing concerns etc.

Increasing fraudulent and corrupt behaviour e.g money laundering bribery, abuse of corporate power etc. e.g golden berg scandal, bad debt crisis in the banking sector, fraudulent claims in insurance sector.

A growing demand by stakeholders for transparency, accountability as the world embraces wider issues of democratization and good governance. This has increased shareholders activism. Powerful and dominant BOD that manipulates shareholders and other stakeholders of the firm. The BOD perceive most shareholders as illiterate to understand fully issues in the business sector. Structures that demand academic and professional gratifications e.g some boards never demand basic qualifications of the board members. Shareholding and influencing are used as a benchmark to get a seat in the board.

The growth of multi-nationals and transnational firms.

The global governance revolution resulting from globalization of firms and economic liberalization. Separation of ownership from control.

Advantages of good corporate governance

• Protection of investors rights.
• Enhances corporate performance, capital formation and maximisation of shareholders wealth (promotes corporate growth).
• Promotes standards of self regulation.
• Greater investor‟s confidence and access to capital
• Less risk of costly litigation and substantial compensation payouts.
• Efficient and responsible use of capital by companies
• Greater loyalty from customers and employees
• Creates mechanism that selects, monitor and replaces the managers in a timely manner.Enhanced corporate image

Guidelines/principles of corporate governance as issued by CMA

• Audit committees – consisting of at least 3 independent non-executive directors who shall report to the board.The committee has written terms of reference which deal clearly with its authority and duties
• Directors remuneration – their package should be competitive and comparable to similar firms so as to retain the best directors and to ensure decisions made are not affected by inadequate
• Supply of information – relevant, accurate and timely information should always be provided.
• Directors – the BOD should assume a primary role of fostering the long term business of the corporation consistent with their fiduciary responsibility to shareholders.
• Board balance – the composition of the BOD should be as such that at least a 3rd of the members are non-executive directors.
• Appointment to the board – a formal and transparent system of appointment should be in place.
• Re-election of directors – this should happen at least every 3 years and no director should be allowed to continue serving if this contribution has declined.
• Remuneration committee – the BOD should appoint a remuneration committee consisting of independent non-executive directors with a mandate to recommend to the board the remuneration of the executive directors and structure of their compensation package