Reference no: EM132682666 , Length: 1000 Words
Everest Sausages plc is based in Dublin, Ireland. It manufactures a wide range of sausages and other processed meats and exports them throughout the European Union. The Covid-19 pandemic has hit the company quite hard and, as a result, the recently announced annual sales of Everest Sausages plc in the last financial year have fallen by 38% to £394m. The operating profit has fallen by 62% to €47.28m. The company's EBITDA was €79.7m and the tax liability was €7.56m. The operating profit was calculated after allowing for expenditure of €13m on the development of new material handling software and a further €5m. which was spent on brand identity building.
Everest Sausages has 434 million shares in issue that are listed on the EURONEXT Dublin stock exchange and have had an historically stable beta of 0.85. Because of the impact of the Covid-19 pandemic, the company has recently been forced to move away from its normal all-equity capital structure and to take on a significant amount of medium-term bank debt at 2.38% interest. As a result, the company's gearing ratio, as measured by debt to EBITDA, is now 4.93X.
The financial position statement value of the company's equity capital is €650m which includes an investment in a South American meat processing company with a book value of €85m, and which has been recently valued at €160m. The company's sales growth is driven by a number of factors including population growth, disposable incomes, and consumer taste trends. The company's CFO is now forecasting average annual revenue growth - post-Covid - of 25% up to the end of the company's planning horizon in 4 years' time. This sales growth will require additional investment in non-current assets equal to 7% of incremental sales and additional working capital 3 investment equal to 2.5% of incremental sales, (both metrics based on past experience of the company's growth dynamics). The CFO of Everest Sausages has estimated that the recent ‘gearing-up' of the company's capital structure will have increased the equity beta to 0.97. The annual return on medium term European Central Bank bonds is 1.65% and the average annual Dublin stock market risk premium is 5.515%. The standard deviation of equity returns on the Dublin stock market is 7.2%.
Market interest rates have been stable for some time and this is expected to continue in the future. For some time, Everest Sausages has been planning to diversify its operations by undertaking a major expansion into canned meat products and into refrigerated trucking. The company has identified two companies that might make suitable Europe-based acquisitions: CanCo Foods and Teddy's Trucking. It is thought that CanCo Foods could be acquired for €360m and Teddy's Trucking could be acquired for £240m. It is estimated that Everest Sausages currently has a standard deviation of return of 12% and its existing sausage and other processed meats activities have a correlation coefficient of +0.75 with the two acquisition targets.
The rates of return on the two possible acquisitions is dependent on the state of the European Union economy and have been estimated as follows: EU economic conditions CanCo Foods Teddy's Trucking Good +20% +35% Average +10% +15% Poor +5% -12% The European Central Bank, the ECB, currently forecast that there is an equal 30% chance of good and poor economic conditions within the European Community. The CFO of Everest Sausages is due to give a presentation to some of its major shareholders to discuss these proposed acquisitions and, at the same time, she is keen to argue that the company's current share price - €3.62 per share - undervalues Everest Sausages.
She has recently returned from a Skype presentation with the company's financial advisors about the merits of shareholder value analysis and economic value added. However, the CFO is still uncertain about these two concepts, but believes that they might be used to help support her under-valuation argument in her forthcoming investor presentation. The CFO has asked you - her senior financial assistant - to undertake some work to support her forthcoming presentation.
The CFO has also requested that you undertake some analysis concerning the two potential acquisitions:
i) Estimate the expected rate of return and the standard deviation of return if the two acquisitions were treated as a simple two-asset investment portfolio. Critically discuss the significance of your calculations and the reasons for the observed amount of ‘risk reduction effect'.
ii) Calculate the impact on the total risk of Everest Sausages, as measured by its standard deviation of returns, if it were to acquire both CanCo Foods and Teddy's Trucking, and also estimate how the beta value of Everest Sausages may change from its estimated current value of 0.97. Assumption that, post-acquisition, the current correlation coefficient between Everest Sausages and the market portfolio remains unchanged.