Elimu Co, a listed company, is a major supplier of educational material, selling its products in many countries. It supplies schools and colleges and also produces learning material for business and professional exams. Elimu Co has exclusive contracts to produce material for some examining bodies. Elimu Co has a well-defined management structure with formal processes for making major decisions.

Although Elimu Co produces online learning material, most of its profits are still derived from sales of traditional textbooks. Elimu Co’s growth in profits over the last few years has been slow and its directors are currently reviewing its long-term strategy. One area in which they feel that Elimu Co must become much more involved is the production of online testing materials for exams and to validate course and textbook learning.

Elimu Co has recently made a bid for Mtandao Co, a smaller listed company. Mtandao Co also supplies a range of educational material, but has been one of the leaders in the development of online testing and has shown strong profit growth over recent years. All of Mtandao Co’s initial five founders remain on its board and still hold 45% of its issued share capital between them. From the start, Mtandao Co’s directors have been used to making quick decisions in their areas of responsibility. Although listing has imposed some formalities, Mtandao Co has remained focused on acting quickly to gain competitive advantage, with the five founders continuing to give strong leadership.

Elimu Co’s initial bid of five shares in Elimu Co for three shares in Mtandao Co was rejected by Mtandao Co’s board. There has been further discussion between the two boards since the initial offer was rejected and Elimu Co’s board is now considering a proposal to offer Mtandao Co’s shareholders two shares in Elimu Co for one share in Mtandao Co or a cash alternative of Kshs.22.75 per Mtandao Co share. It is expected that Mtandao Co's shareholders will choose one of the following options:

1. i. To accept the two-shares-for-one-share offer for all the Mtandao Co shares; or,
2. ii. To accept the cash offer for all the Mtandao Co shares; or,
3. iii. 60% of the shareholders will take up the two-shares-for-one-share offer and the remaining 40% will take the cash offer.

In case of the third option being accepted, it is thought that three of the company's founders, holding 20% of the share capital in total, will take the cash offer and not join the combined company. The remaining two founders will probably continue to be involved in the business and be members of the combined company's board.

Elimu Co’s finance director has estimated that the merger will produce annual post-tax synergies of Shs. 20 million. He expects Elimu Co’s current price-earnings (P/E) ratio to remain unchanged after the acquisition.

Extracts from the two companies’ most recent accounts are shown below:

	ELIMU KSHS ‘000’	MTANDAO KSHS ‘000’
Profit before finance cost and tax	446	182
Finance costs	(74)	(24)
Profit before tax	372	158
Tax	76	30
Profit after tax	296	128

Issued Kshs.1 nominal shares 340 million 90 million

P/E ratios, based on most recent accounts 14 15·9

Long-term liabilities (market value) (Kshs.m) 540 193

Cash and cash equivalents (Kshs.m) 220 64

The tax rate applicable to both companies is 20%.

Assume that Elimu Co can obtain further debt funding at a pre-tax cost of 7·5% and that the return on cash surpluses is 5% pre-tax.

Assume also that any debt funding needed to complete the acquisition will be reduced instantly by the balances of cash and cash equivalents held by Elimu Co and Mtandao Co.

Required:

Evaluate the funding required for the acquisition of Mtandao Co and the impact on Elimu Co’s earnings per share and gearing, for each of the three options given above.