Table of Contents
British American Tobacco Plc. (BAT) is a manufacturing company that deals with production and marketing of cigarettes and the related tobacco products. It is a multinational company with segments in the Americas, Asia Pacific, Western and Eastern Europe, Africa and Middle East. Its brands include Dunhill, Lucky Strike, Kent, Rothmans and Pall Mall. It also has its portfolio including other international brands such as Viceroy, Vogue, and Benson & Hedge among others. The company has about forty four factories situated within over forty one countries across the world (BAT, 2011).
On the other hand, Reynolds American Inc. (RAI) is a holding company with segments such as RJR Tobacco, Santa Fe, American Snuff, and R.J Reynolds Tobacco Company, all of which consist of primary operations as subsidiaries of the holding company. The RJR Tobacco segment has been managing contract manufacture of cigarettes with BAT affiliates hence managing export of the tobacco products to duty free shops in the US and overseas US military bases (BAT, 2017). On the other hand, the American Snuff segment produces smokeless tobacco products (moist snuff) to adult consumers. Santa Fe segment produces and markets high class cigarettes and tobacco products under the brand of natural American spirit.
BAT has agreed to acquire Reynolds at $49.4 billion. Reynolds is the BAT’s rival in the US. This takeover will therefore, create the biggest listed tobacco company in the world. This merger transaction occur at a point when BAT already owns 42% of Reynolds. Therefore, the bid price comprise of the remaining 58% that is owned by other investors. The transaction agreement will be effected through a statutory merger where shareholders of Reynolds, except BAT, will be paid cash $29.44 and BAT ordinary shares 0.5260 for each share of Reynolds held. This means that BAT will pay approximately $24.4 billion in cash with the rest being paid as $25 billion BAT shares. This translates to a 26% premium over the price of common shares of Reynolds as of 20th October 2016, the day prior to the announcement when BAT proposed to acquire and merge with Reynolds.
BAT proposes that it will finance the cash component of this transaction using combined sources of fund such as existing cash resources, bank credit lines and issuance of bonds. If effected, this transaction will see BAT return to the lucrative high regulated US market. This will make BAT the only tobacco giant that has a leading presence in the international and American markets. The chronological events related to valuation effects that are experienced by BAT and RAI prior to and after the acquisition announcement are analysed in this report. Starting from January 16th 2016, a year before the announcement date then up to 17th March 2017, two months after the acquisition bid was announced. The one year period prior to the announcement date forms the estimation window while the period around January 16th 2017 is the even window when the news were released. The post event window is the period considered up to 17th of March 2017.
Company valuation approaches focus on either enterprise value, equity value, debt value or other aspects like options, preferred stock and minority interest (Imam, Barker & Clubb, 2008). Enterprise value refers to the valuation of productive activities of a company while equity valuation is the valuation of shares. Debt valuation focuses on establishing the value of company’s obligations. Enterprise value is the value of business activities established the present value of future cash flows. In this analysis, discounted free cash flow method has been used to establish enterprise value of the companies and the equity value. Equity value is used to determine the share price of each particular company.
BAT prosed to acquire Reynolds at $49.4 billion. This was the price to be paid and it represents 58% of the company because BAT already owns 42% of this company. Therefore, according to this stated figure, the total value of Reynolds is $85.17 billion. Valuation done in this analysis using discounted cash flow establishes that the value of Reynolds was $120.65 billion equity value above what BAT is offering for the transaction. The established present value per share of Reynolds is $84.33 while the value per share of BAT is 25.43 pounds per share. This shows that BAT is offering a lower value to Reynolds. Therefore, the BAT shareholders are likely to gain from this merger transaction. At the same time, the payment will be effected partly in cash and partly in terms of equity where shareholders of Reynolds, except BAT, will receive 0.526 BAT share for each share of Reynolds held (Fernandez, 2007).
Computation of Required Rate of Return based on CAPM
CAPM is a model that can be used in calculating required rate of return on stocks based on risk free rate, beta and market risk premium. For BAT, Re = Rf + beta [Return on S&P 500 (Rm) – Rf] (Bernanke 2006; Bridges 2014). Re = 0.025 + 1.022*(0.115 – 0.025) = 0.1170 = 11.70%. After tax Cost of debt (Kd) = 0.11*(1-0.3) = 0.077 = 7.70%. Therefore, the weighted average cost of capital (WACC) for BAT can be calculated as WACC = Wd*Kd + We*Ke. WACC = (0.827*0.077) + (0.173*0.1170) = 0.0839 = 8.39%. On the other hand, Reynolds required rate of return is calculated as 0.0445 + beta (NYSE Return-0.0445). Beta is obtained through regression analysis as shown in appendix 3. The multiple R of 0.36 obtained becomes the beta. Therefore, Re =4.45+0.36(6.8) =6.9%. The after tax cost of debt is 5(1-0.38) =3.10%. Therefore, the WACC for RAI is computed as Wd*Kd + We*Ke. This becomes 0.133*0.0310+0.867*0.049 =4.66%. Based on the established WACC and using Gordon’s dividend growth model, stock prices can be calculated. For BAT, stock price (P) = Do (1+g)/K-g. Prior to 21st October 2016, P = 1.06*(1+0.042)/(0.0839-0.0420). Stock Price (P) = £26.36. After 21st October 2016, P =1.19*(1+0.042)/(0.0839-0.0420) = £29.59. For RAI, growth rate is 5%. Prior to 21st October 2016, the company’s dividend was 0.46 while dividend after that date, it was 0.51. Stock price prior to 21st October was 0.46*(1+0.05)/0.069-0.0618 =$66.77. After 21st October, stock price became 0.51*(1+0.05)/0.069-0.0618 =$74.03.
Market efficiency relates stock prices and the available information. The various forms of market efficiency differ based on the available information to investors because the effect of their investment decisions relies heavily on the available information in attempts to predict behavior of stock prices. Weak form market efficiency implies that the stock prices reflect only the past information regarding stock volumes, interest rates and other market performance. Therefore, under this form, analysts and prospective investors can beat the market through predicting effect of news and other information on stock prices. On the other hand, under semi-strong market efficiency, stock prices reflect all publicly available information at a particular point in time. The information that is publicly available includes trading data, fundamentals such as dividends, accounting practices, management information, mergers and acquisitions and patents. When such information is reflected in the stock prices, an investor cannot beat the market through analysis of such information. However, focusing on the private information, analysis can be done to beat the market. The strong form of market efficiency implies that the stock prices reflect both private and public information. In this sense, even insider trading cannot lead to private gains through market analysis. Market efficiency is applicable in event studies which involve econometric techniques for measuring impact of a particular event on the stock prices of a firm. Event studies involve events which include public announcements regarding a particular action by the management. These include mergers, earnings, dividends, inclusion in the S&P 500 index, lawsuits, interest rate hikes among others (Angwin, 2007).
When BAT announced a merger-acquisition bid with Reynolds, this was a significant event for BAT and Reynolds. Changes in stock prices after such announcements may portray market overreaction, efficient reaction or under-reaction. The chart in Appendix 1 shows that there were no market overreactions on the BAT shares before and after the announcement. Similarly, appendix 2 shows that even for Reynolds, the merger news did not have a significant effect on the share prices. The market reaction was efficient. Therefore, evaluating the extent to which stock prices were affected by the announcement reveal that there were no significant changes. This derives insights from efficient market hypothesis in the sense that if the companies were trading under weak form efficient market hypothesis, then there could have been market overreaction after the news were released leading to significant changes in prices. For a strong form efficient market hypothesis, the effect of news does not reflect changes in stock prices. This is what is observable in the case of BAT and Reynolds. Even after the event, stock prices remained in their original trend a in the estimation and event window.
The event analysis conducted to test EMH shows that there could be no significant abnormal returns associated with the event because stock prices of the two companies already reflected that information. This implies that the stock prices for the two companies reflected both public and private information hence trading under strong market efficiency. This has been shown through the event analysis on the excel document. In this analysis, it has been verified that the effect of BAT’s announcement to acquire Reynolds had no significant influence on the share price. The test done using steyx to investigate significance of the abnormal returns resulting from the announcementshow that the abnormal returns were not significant (Demirakos, Strong & Walker, 2004). Therefore, whether the news were available or not, the stock prices were not affected. This is a test of strong form market efficiency. The established insignificant abnormal return has an implication that an investor cannot make a gain from analyzing this event because it was reflected in the stock prices before it occurred. This is a strong form of efficient market hypothesis.
This merger-acquisition event cannot occur at a strong form of market efficiency where even insider trading could not make an investor gain from the event. BAT is offering an amount that is far much below the established value of Reynolds. Even though Reynolds stands to gain due to synergy and more internationalized market, this will be attainable due to proportion of shareholding given to the current Reynolds shareholders. However, BAT offers only 0.526 share for every one share of Reynolds held. This implies that the shareholding attributable to the current Reynolds shareholders in the new combined business will be minimal since they are going to receive part of the payment in cash. Therefore, before accepting the offer, Reynolds should consider these factors and negotiate for better terms leading to a payment that reflects the current value of the company.
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Appendix 3: Beta for RAI
|Adjusted R Square||0.113494|
|Coefficients||Standard Error||t Stat||P-value||Lower 95%||Upper 95%||Lower 95.0%||Upper 95.0%|
|X Variable 1||3.98E-07||1.35E-07||2.946426||0.004597||1.28E-07||6.69E-07||1.28E-07||6.69E-07|