Mergers and acquisitions


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Mergers and acquisitions

  1. 1. Mergers and AcquisitionsThe term merger and acquisition ("M&A") refers to the aspect of corporate strategy, corporate financeand management dealing with the buying, selling and combining of different companies that can aid,finance, or help a growing company in a given industry grow rapidly without having to create anotherbusiness entity.OverviewA merger is a tool used by companies for the purpose of expanding their operations often aiming at anincrease of their long term profitability. There are several different types of actions that a company cantake when deciding to move forward using mergers and acquisitions ("M&A"). Usually mergers occur ina consensual (occurring by mutual consent) setting where executives from the target company helpthose from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties.Acquisitions can also happen through a hostile takeover by purchasing the majority of outstandingshares of a company in the open market against the wishes of the targets board. In the United States,business laws vary from state to state whereby some companies have limited protection against hostiletakeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwiseknown as the "poison pill".Mergers can be heavily regulated, for example, in the U.S. requiring approval by both the Federal TradeCommission and the Department of Justice. The U.S. began their regulation on mergers in 1890 with theimplementation of the Sherman Act. It was meant to prevent any attempt to monopolize or to conspireto restrict trade. However, based on the loose interpretation of the standard "Rule of Reason", it was upto the judges in the U.S. Supreme Court whether to rule leniently (as with U.S. Steel in 1920) or strictly(as with Alcoa in 1945).AcquisitionAn acquisition, also known as a takeover, is the buying of one company (the "target") by another. Anacquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; inthe latter case, the takeover target is unwilling to be bought or the targets board has no priorknowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one.Sometimes, however, a smaller firm will acquire management control of a larger or longer establishedcompany and keep its name for the combined entity. This is known as a reverse takeover.Types of acquisition
  2. 2. * The buyer buys the shares, and therefore control, of the target company being purchased.Ownership control of the company in turn conveys effective control over the assets of the company, butsince the company is acquired intact as a going business, this form of transaction carries with it all of theliabilities accrued by that business over its past and all of the risks that company faces in its commercialenvironment. * The buyer buys the assets of the target company. The cash the target receives from the sell-off ispaid back to its shareholders by dividend or through liquidation. This type of transaction leaves thetarget company as an empty shell, if the buyer buys out the entire assets. A buyer often structures thetransaction as an asset purchase to "cherry-pick" the assets that it wants and leave out the assets andliabilities that it does not. This can be particularly important where foreseeable liabilities may includefuture, unquantified damage awards such as those that could arise from litigation over defectiveproducts, employee benefits or terminations, or environmental damage. A disadvantage of thisstructure is the tax that many jurisdictions, particularly outside the United States, impose on transfers ofthe individual assets, whereas stock transactions can frequently be structured as like-kind exchanges orother arrangements that are tax-free or tax-neutral, both to the buyer and to the sellers shareholders.The terms "demerger", "spin-off" and "spin-out" are sometimes used to indicate a situation where onecompany splits into two, generating a second company separately listed on a stock exchange.MergerIn business or economics a merger is a combination of two companies into one larger company. Suchactions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap isoften used as it allows the shareholders of the two companies to share the risk involved in the deal. Amerger can resemble a takeover but result in a new company name (often combining the names of theoriginal companies) and in new branding; in some cases, terming the combination a "merger" ratherthan an acquisition is done purely for political or marketing reasons.Classifications of mergers * Horizontal mergers take place where the two merging companies produce similar product in thesame industry. * Vertical mergers occur when two firms, each working at different stages in the production of thesame good, combine.
  3. 3. * Congeneric mergers occur where two merging firms are in the same general industry, but they haveno mutual buyer/customer or supplier relationship, such as a merger between a bank and a leasingcompany. Example: Prudentials acquisition of Bache & Company. * Conglomerate mergers take place when the two firms operate in different industries.A unique type of merger called a reverse merger is used as a way of going public without the expenseand time required by an IPO.The contract vehicle for achieving a merger is a "merger sub".The occurrence of a merger often raises concerns in antitrust circles. Devices such as the Herfindahlindex can analyze the impact of a merger on a market and what, if any, action could prevent it.Regulatory bodies such as the European Commission, the United States Department of Justice and theU.S. Federal Trade Commission may investigate anti-trust cases for monopolies dangers, and have thepower to block mergers.Accretive mergers are those in which an acquiring companys earnings per share (EPS) increase. Analternative way of calculating this is if a company with a high price to earnings ratio (P/E) acquires onewith a low P/E.Dilutive mergers are the opposite of above, whereby a companys EPS decreases. The company will beone with a low P/E acquiring one with a high P/E.The completion of a merger does not ensure the success of the resulting organization; indeed, manymergers (in some industries, the majority) result in a net loss of value due to problems. Correctingproblems caused by incompatibility—whether of technology, equipment, or corporate culture— divertsresources away from new investment, and these problems may be exacerbated by inadequate researchor by concealment of losses or liabilities by one of the partners. Overlapping subsidiaries or redundantstaff may be allowed to continue, creating inefficiency, and conversely the new management may cuttoo many operations or personnel, losing expertise and disrupting employee culture. These problemsare similar to those encountered in takeovers. For the merger not to be considered a failure, it mustincrease shareholder value faster than if the companies were separate, or prevent the deterioration ofshareholder value more than if the companies were separate.
  4. 4. Business valuationThe five most common ways to valuate a business are asset valuation, historical earnings valuation,future maintainable earnings valuation, Earnings Before Interest Taxes Depreciation and Amortization(EBITDA) valuation and Shareholders Discretionary Cash Flow (SDCF) valuation. Professionals whovaluate businesses generally do not use just one of these methods but a combination of some of them,as well as possibly others that are not mentioned above, in order to obtain a more accurate value. Thesevalues are determined for the most part by looking at a companys balance sheet and/or incomestatement and withdrawing the appropriate information. The information in the balance sheet orincome statement is obtained by one of three accounting measures: a Notice to Reader, a ReviewEngagement or an Audit.Accurate business valuation is one of the most important aspects of M&A as valuations like these willhave a major impact on the price that a business will be sold for. Most often this information isexpressed in a Letter of Opinion of Value (LOV) when the business is being valuated for interests sake.There are other, more detailed ways of expressing the value of a business. These reports generally getmore detailed and expensive as the size of a company increases, however, this is not always the case asthere are many complicated industries which require more attention to detail, regardless of size.Financing M&AMergers are generally differentiated from acquisitions partly by the way in which they are financed andpartly by the relative size of the companies. Various methods of financing an M&A deal exist:CashPayment by cash. Such transactions are usually termed acquisitions rather than mergers because theshareholders of the target company are removed from the picture and the target comes under the(indirect) control of the bidders shareholders alone.A cash deal would make more sense during a downward trend in the interest rates. Another advantageof using cash for an acquisition is that there tends to lesser chances of EPS dilution for the acquiringcompany. But a caveat in using cash is that it places constraints on the cash flow of the company.Financing
  5. 5. Financing capital may be borrowed from a bank, or raised by an issue of bonds. Alternatively, theacquirers stock may be offered as consideration. Acquisitions financed through debt are known asleveraged buyouts if they take the target private, and the debt will often be moved down onto thebalance sheet of the acquired company.HybridsAn acquisition can involve a combination of cash and debt, or a combination of cash and stock of thepurchasing entity.Motives behind M&AThese motives are considered to add shareholder value: * Economies of scale: This refers to the fact that the combined company can often reduce duplicatedepartments or operations, lowering the costs of the company relative to the same revenue stream,thus increasing profit. * Increased revenue/Increased Market Share: This motive assumes that the company will beabsorbing a major competitor and thus increase its power (by capturing increased market share) to setprices. * Cross selling: For example, a bank buying a stock broker could then sell its banking products to thestock brokers customers, while the broker can sign up the banks customers for brokerage accounts. Or,a manufacturer can acquire and sell complementary products. * Synergy: Better use of complementary resources. * Taxes: A profitable company can buy a loss maker to use the targets loss as their advantage byreducing their tax liability. In the United States and many other countries, rules are in place to limit theability of profitable companies to "shop" for loss making companies, limiting the tax motive of anacquiring company. * Geographical or other diversification: This is designed to smooth the earnings results of a company,which over the long term smoothens the stock price of a company, giving conservative investors moreconfidence in investing in the company. However, this does not always deliver value to shareholders(see below). * Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and theinteraction of target and acquiring firm resources can create value through either overcominginformation asymmetry or by combining scarce resources.
  6. 6. These motives are considered to not add shareholder value: * Diversification: While this may hedge a company against a downturn in an individual industry it failsto deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifyingtheir portfolios at a much lower cost than those associated with a merger. * Managers hubris: managers overconfidence about expected synergies from M&A which results inoverpayment for the target company. * Empire building: Managers have larger companies to manage and hence more power. * Managers compensation: In the past, certain executive management teams had their payout basedon the total amount of profit of the company, instead of the profit per share, which would give the teama perverse incentive to buy companies to increase the total profit while decreasing the profit per share(which hurts the owners of the company, the shareholders); although some empirical studies show thatcompensation is linked to profitability rather than mere profits of the company. * Vertical integration: Companies acquire part of a supply chain and benefit from the resources.However, this does not add any value since although one end of the supply chain may receive a productat a cheaper cost, the other end now has lower revenue. In addition, the supplier may find moredifficulty in supplying to competitors of its acquirer because the competition would not want to supportthe new conglomerate.M&A marketplace difficultiesNo marketplace currently exists for the mergers and acquisitions of privately owned small to mid-sizedcompanies. Market participants often wish to maintain a level of secrecy about their efforts to buy orsell such companies. Their concern for secrecy usually arises from the possible negative reactions acompanys employees, bankers, suppliers, customers and others might have if the effort or interest toseek a transaction were to become known. This need for secrecy has thus far thwarted the emergenceof a public forum or marketplace to serve as a clearinghouse for this large volume of business.At present, the process by which a company is bought or sold can prove difficult, slow and expensive. Atransaction typically requires six to nine months and involves many steps. Locating parties with whom toconduct a transaction forms one step in the overall process and perhaps the most difficult one. Qualifiedand interested buyers of multimillion dollar corporations are hard to find. Even more difficulties attendbringing a number of potential buyers forward simultaneously during negotiations. Potential acquirers in
  7. 7. an industry simply cannot effectively "monitor" the economy at large for acquisition opportunities eventhough some may fit well within their companys operations or plans.An industry of professional "middlemen" (known variously as intermediaries, business brokers, andinvestment bankers) exists to facilitate M&A transactions. These professionals do not provide theirservices cheaply and generally resort to previously-established personal contacts, direct-callingcampaigns, and placing advertisements in various media. In servicing their clients they attempt to createa one-time market for a one-time transaction. Certain types of merger and acquisitions transactionsinvolve securities and may require that these "middlemen" be securities licensed in order to becompensated. Many, but not all, transactions use intermediaries on one or both sides. Despite bestintentions, intermediaries can operate inefficiently because of the slow and limiting nature of having torely heavily on telephone communications. Many phone calls fail to contact with the intended party.Busy executives tend to be impatient when dealing with sales calls concerning opportunities in whichthey have no interest. These marketing problems typify any private negotiated markets. Due to theseproblems and other problems like these, brokers who deal with small to mid-sized companies often dealwith much more strenuous conditions than other business brokers. Mid-sized business brokers have anaverage life-span of only 12-18 months and usually never grow beyond 1 or 2 employees. Exceptions tothis are few and far between. Some of these exceptions include The Sundial Group, Geneva BusinessServices and Robbinex.The market inefficiencies can prove detrimental for this important sector of the economy. Beyond theintermediaries high fees, the current process for mergers and acquisitions has the effect of causingprivate companies to initially sell their shares at a significant discount relative to what the samecompany might sell for were it already publicly traded. An important and large sector of the entireeconomy is held back by the difficulty in conducting corporate M&A (and also in raising equity or debtcapital). Furthermore, it is likely that since privately held companies are so difficult to sell they are notsold as often as they might or should be.Previous attempts to streamline the M&A process through computers have failed to succeed on a largescale because they have provided mere "bulletin boards" - static information that advertises one firmsopportunities. Users must still seek other sources for opportunities just as if the bulletin board were notelectronic. A multiple listings service concept was previously not used due to the need for confidentialitybut there are currently several in operation. The most significant of these are run by the CaliforniaAssociation of Business Brokers (CABB) and the International Business Brokers Association (IBBA) Theseorganizations have effectivily created a type of virtual market without compromising the confidentialityof parties involved and without the unauthorized release of information.
  8. 8. A merger occurs when one firm assumes all the assets and all the liabilities of another. The acquiringfirm retains its identity, while the acquired firm ceases to exist. A majority vote of shareholders isgenerally required to approve a merger. A merger is just one type of acquisition. One company canacquire another in several other ways, including purchasing some or all of the companys assets orbuying up its outstanding shares of stock.In general, mergers and other types of acquisitions are performed in the hopes of realizing an economicgain. For such a transaction to be justified, the two firms involved must be worth more together thanthey were apart. Some of the potential advantages of mergers and acquisitions include achievingeconomies of scale, combining complementary resources, garnering tax advantages, and eliminatinginefficiencies. Other reasons for considering growth through acquisitions include obtaining proprietaryrights to products or services, increasing market power by purchasing competitors, shoring upweaknesses in key business areas, penetrating new geographic regions, or providing managers with newopportunities for career growth and advancement. Since mergers and acquisitions are so complex,however, it can be very difficult to evaluate the transaction, define the associated costs and benefits,and handle the resulting tax and legal issues."In todays global business environment, companies may have to grow to survive, and one of the bestways to grow is by merging with another company or acquiring other companies," consultant JacalynSherriton told Robert McGarvey in an interview for Entrepreneur. "Massive, multibillion-dollarcorporations are becoming the norm, leaving an entrepreneur to wonder whether a merger ought to bein his or her plans, too," McGarvey continued.When a small business owner chooses to merge with or sell out to another company, it is sometimescalled "harvesting" the small business. In this situation, the transaction is intended to release the valuelocked up in the small business for the benefit of its owners and investors. The impetus for a smallbusiness owner to pursue a sale or merger may involve estate planning, a need to diversify his or herinvestments, an inability to finance growth independently, or a simple need for change. In addition,some small businesses find that the best way to grow and compete against larger firms is to merge withor acquire other small businesses.In principle, the decision to merge with or acquire another firm is a capital budgeting decision much likeany other. But mergers differ from ordinary investment decisions in at least five ways. First, the value ofa merger may depend on such things as strategic fits that are difficult to measure. Second, theaccounting, tax, and legal aspects of a merger can be complex. Third, mergers often involve issues of
  9. 9. corporate control and are a means of replacing existing management. Fourth, mergers obviously affectthe value of the firm, but they also affect the relative value of the stocks and bonds. Finally, mergers areoften "unfriendly."TYPES OF ACQUISITIONSIn general, acquisitions can be horizontal, vertical, or conglomerate. A horizontal acquisition takes placebetween two firms in the same line of business. For example, one tool and die company might purchaseanother. In contrast, a vertical merger entails expanding forward or backward in the chain ofdistribution, toward the source of raw materials or toward the ultimate consumer. For example, an autoparts manufacturer might purchase a retail auto parts store. A conglomerate is formed through thecombination of unrelated businesses.Another type of combination of two companies is a consolidation. In a consolidation, an entirely newfirm is created, and the two previous entities cease to exist. Consolidated financial statements areprepared under the assumption that two or more corporate entities are in actuality only one. Theconsolidated statements are prepared by combining the account balances of the individual firms aftercertain adjusting and eliminating entries are made.Another way to acquire a firm is to buy the voting stock. This can be done by agreement of managementor by tender offer. In a tender offer, the acquiring firm makes the offer to buy stock directly to theshareholders, thereby bypassing management. In contrast to a merger, a stock acquisition requires nostockholder voting. Shareholders wishing to keep their stock can simply do so. Also, a minority ofshareholders may hold out in a tender offer.A bidding firm can also buy another simply by purchasing all its assets. This involves a costly legaltransfer of title and must be approved by the shareholders of the selling firm. A takeover is the transferof control from one group to another. Normally, the acquiring firm (the bidder) makes an offer for thetarget firm. In a proxy contest, a group of dissident shareholders will seek to obtain enough votes to gaincontrol of the board of directors.TAXABLE VERSUS TAX-FREE TRANSACTIONSMergers and acquisitions can be either tax-free or taxable events. The tax status of a transaction mayaffect its value from both the buyers and the sellers viewpoints. In a taxable acquisition, the assets ofthe selling firm are revalued or "written up." Therefore, the depreciation deduction will rise (assets are
  10. 10. not revalued in a tax-free acquisition). But the selling shareholders will have to pay capital gains taxesand thus will want more for their shares to compensate. This is known as the capital gains effect. Thecapital gains and write-up effects tend to cancel each other out.Certain exchanges of stock are considered tax-free reorganizations, which permit the owners of onecompany to exchange their shares for the stock of the acquirer without paying taxes. There are threebasic types of tax-free reorganizations. In order for a transaction to qualify as a type A tax-freereorganization, it must be structured in certain ways. In contrast to a type B reorganization, the type Atransaction allows the buyer to use either voting or nonvoting stock. It also permits the buyer to usemore cash in the total consideration since the law does not stipulate a maximum amount of cash thatcan be used. At least 50 percent of the consideration, however, must be stock in the acquiringcorporation. In addition, in a type A reorganization, the acquiring corporation may choose not topurchase all the targets assets.In instances where at least 50 percent of the bidders stock is used as the considerationut otherconsiderations such as cash, debt, or nonequity securities are also usedhe transaction may be partiallytaxable. Capital gains taxes must be paid on those shares that were exchanged for nonequityconsideration.A type B reorganization requires that the acquiring corporation use mainly its own voting common stockas the consideration for purchase of the target corporations common stock. Cash must comprise nomore than 20 percent of the total consideration, and at least 80 percent of the targets stock must bepaid for by voting stock by the bidder.Target stockholders who receive the stock of the acquiring corporation in exchange for their commonstock are not immediately taxed on the consideration they receive. Taxes will have to be paid only if thestock is eventually sold. If cash is included in the transaction, this cash may be taxed to the extent that itrepresents a gain on the sale of stock.In a type C reorganization, the acquiring corporation must purchase 80 percent of the fair market valueof the targets assets. In this type of reorganization, a tax liability results when the acquiring corporationpurchases the assets of the target using consideration other than stock in the acquiring corporation. Thetax liability is measured by comparing the purchase price of the assets with the adjusted basis of theseassets.
  11. 11. FINANCIAL ACCOUNTING FOR MERGERS AND ACQUISITIONSThe two principal accounting methods used in mergers and acquisitions are the pooling of interestsmethod and the purchase method. The main difference between them is the value that the combinedfirms balance sheet places on the assets of the acquired firm, as well as the depreciation allowancesand charges against income following the merger.The pooling of interests method assumes that the transaction is simply an exchange of equity securities.Therefore, the capital stock account of the target firm is eliminated, and the acquirer issues new stock toreplace it. The two firms assets and liabilities are combined at their historical book values as of theacquisition date. The end result of a pooling of interests transaction is that the total assets of thecombined firm are equal to the sum of the assets of the individual firms. No goodwill is generated, andthere are no charges against earnings. A tax-free acquisition would normally be reported as a pooling ofinterests.Under the purchase method, assets and liabilities are shown on the merged firms books at their market(not book) values as of the acquisition date. This method is based on the idea that the resulting valuesshould reflect the market values established during the bargaining process. The total liabilities of thecombined firm equal the sum of the two firms individual liabilities. The equity of the acquiring firm isincreased by the amount of the purchase price.Accounting for the excess of cost over the aggregate of the fair market values of the identifiable netassets acquired applies only in purchase accounting. The excess is called goodwill, an asset which ischarged against income and amortized over a period that cannot exceed 40 years. Although theamortization "expense" is deducted from reported income, it cannot be deducted for tax purposes.Purchase accounting usually results in increased depreciation charges because the book value of mostassets is usually less than fair value because of inflation. For tax purposes, however, depreciation doesnot increase because the tax basis of the assets remains the same. Since depreciation under poolingaccounting is based on the old book values of the assets, accounting income is usually higher under thepooling method. The accounting treatment has no cash flow consequences. Thus, value should beunaffected by accounting procedure. However, some firms may dislike the purchase method because ofthe goodwill created. The reason for this is that goodwill is amortized over a period of years.HOW TO VALUE AN ACQUISITION CANDIDATE
  12. 12. Valuing an acquisition candidate is similar to valuing any investment. The analyst estimates theincremental cash flows, determines an appropriate risk-adjusted discount rate, and then computes thenet present value (NPV). If firm A is acquiring firm B, for example, then the acquisition makes economicsense if the value of the combined firm is greater than the value of firm A plus the value of firm B.Synergy is said to exist when the cash flow of the combined firm is greater than the sum of the cashflows for the two firms as separate companies. The gain from the merger is the present value of thisdifference in cash flows.SOURCES OF GAINS FROM ACQUISITIONS The gains from an acquisition may result from one or more ofthe following five categories:1) revenue enhancement, 2) cost reductions, 3) lower taxes, 4) changingcapital requirements, or 5) a lower cost of capital. Increased revenues may come from marketing gains,strategic benefits, and market power. Marketing gains arise from more effective advertising, economiesof distribution, and a better mix of products. Strategic benefits represent opportunities to enter newlines of business. Finally, a merger may reduce competition, thereby increasing market power. Suchmergers, of course, may run afoul of antitrust legislation.A larger firm may be able to operate more efficiently than two smaller firms, thereby reducing costs.Horizontal mergers may generate economies of scale. This means that the average production cost willfall as production volume increases. A vertical merger may allow a firm to decrease costs by moreclosely coordinating production and distribution. Finally, economies may be achieved when firms havecomplementary resourcesor example, when one firm has excess production capacity and another hasinsufficient capacity.Tax gains in mergers may arise because of unused tax losses, unused debt capacity, surplus funds, andthe write-up of depreciable assets. The tax losses of target corporations can be used to offset theacquiring corporations future income. These tax losses can be used to offset income for a maximum of15 years or until the tax loss is exhausted. Only tax losses for the previous three years can be used tooffset future income.Tax loss carry-forwards can motivate mergers and acquisitions. A company that has earned profits mayfind value in the tax losses of a target corporation that can be used to offset the income it plans to earn.A merger may not, however, be structured solely for tax purposes. In addition, the acquirer mustcontinue to operate the pre-acquisition business of the company in a net loss position. The tax benefitsmay be less than their "face value," not only because of the time value of money, but also because thetax loss carry-forwards might expire without being fully utilized.
  13. 13. Tax advantages can also arise in an acquisition when a target firm carries assets on its books with basis,for tax purposes, below their market value. These assets could be more valuable, for tax purposes, ifthey were owned by another corporation that could increase their tax basis following the acquisition.The acquirer would then depreciate the assets based on the higher market values, in turn, gainingadditional depreciation benefits.Interest payments on debt are a tax-deductible expense, whereas dividend payments from equityownership are not. The existence of a tax advantage for debt is an incentive to have greater use of debt,as opposed to equity, as the means of financing merger and acquisition transactions. Also, a firm thatborrows much less than it could may be an acquisition target because of its unused debt capacity. Whilethe use of financial leverage produces tax benefits, debt also increases the likelihood of financial distressin the event that the acquiring firm cannot meet its interest payments on the acquisition debt.Finally, a firm with surplus funds may wish to acquire another firm. The reason is that distributing themoney as a dividend or using it to repurchase shares will increase income taxes for shareholders. Withan acquisition, no income taxes are paid by shareholders.Acquiring firms may be able to more efficiently utilize working capital and fixed assets in the target firm,thereby reducing capital requirements and enhancing profitability. This is particularly true if the targetfirm has redundant assets that may be divested.The cost of debt can often be reduced when two firms merge. The combined firm will generally havereduced variability in its cash flows. Therefore, there may be circumstances under which one or theother of the firms would have defaulted on its debt, but the combined firm will not. This makes the debtsafer, and the cost of borrowing may decline as a result. This is termed the coinsurance effect.Diversification is often cited as a benefit in mergers. Diversification by itself, however, does not createany value because stockholders can accomplish the same thing as the merger by buying stock in bothfirms.VALUATION PROCEDURES The procedure for valuing an acquisition candidate depends on the source ofthe estimated gains. Different sources of synergy have different risks. Tax gains can be estimated fairly
  14. 14. accurately and should be discounted at the cost of debt. Cost reductions through operating efficienciescan also be determined with some confidence. Such savings should be discounted at a normal weightedaverage cost of capital. Gains from strategic benefits are difficult to estimate and are often highlyuncertain. A discount rate greater than the overall cost of capital would thus be appropriate.The net present value (NPV) of the acquisition is equal to the gains less the cost of the acquisition. Thecost depends on whether cash or stock is used as payment. The cost of an acquisition when cash is usedis just the amount paid. The cost of the merger when common stock is used as the consideration (thepayment) is equal to the percentage of the new firm that is owned by the previous shareholders in theacquired firm multiplied by the value of the new firm. In a cash merger the benefits go entirely to theacquiring firm, whereas in a stock-for-stock exchange the benefits are shared by the acquiring andacquired firms.Whether to use cash or stock depends on three considerations. First, if the acquiring firms managementbelieves that its stock is overvalued, then a stock acquisition may be cheaper. Second, a cash acquisitionis usually taxable, which may result in a higher price. Third, the use of stock means that the acquiredfirm will share in any gains from merger; if the merger has a negative NPV, however, then the acquiredfirm will share in the loss.In valuing acquisitions, the following factors should be kept in mind. First, market values must not beignored. Thus, there is no need to estimate the value of a publicly traded firm as a separate entity.Second, only those cash flows that are incremental are relevant to the analysis. Third, the discount rateused should reflect the risk associated with the incremental cash flows. Therefore, the acquiring firmshould not use its own cost of capital to value the cash flows of another firm. Finally, acquisition mayinvolve significant investment banking fees and costs.HOSTILE ACQUISITIONSThe replacement of poor management is a potential source of gain from acquisition. Changingtechnological and competitive factors may lead to a need for corporate restructuring. If incumbentmanagement is unable to adapt, then a hostile acquisition is one method for accomplishing change.Hostile acquisitions generally involve poorly performing firms in mature industries, and occur when theboard of directors of the target is opposed to the sale of the company. In this case, the acquiring firmhas two options to proceed with the acquisition tender offer or a proxy fight. A tender offer represents
  15. 15. an offer to buy the stock of the target firm either directly from the firms shareholders or through thesecondary market. In a proxy fight, the acquirer solicits the shareholders of the target firm in an attemptto obtain the right to vote their shares. The acquiring firm hopes to secure enough proxies to gaincontrol of the board of directors and, in turn, replace the incumbent management.Management in target firms will typically resist takeover attempts either to get a higher price for thefirm or to protect their own self-interests. This can be done a number of ways. Target companies candecrease the likelihood of a takeover though charter amendments. With the staggered board technique,the board of directors is classified into three groups, with only one group elected each year. Thus, thesuitor cannot obtain control of the board immediately even though it may have acquired a majorityownership of the target via a tender offer. Under a supermajority amendment, a higher percentage than50 percentenerally two-thirds or 80 percents required to approve a merger.Other defensive tactics include poison pills and dual class recapitalizations. With poison pills, existingshareholders are issued rights which, if a bidder acquires a certain percentage of the outstanding shares,can be used to purchase additional shares at a bargain price, usually half the market price. Dual classrecapitalizations distribute a new class of equity with superior voting rights. This enables the targetfirms managers to obtain majority control even though they do not own a majority of the shares.Other preventative measures occur after an unsolicited offer is made to the target firm. The target mayfile suit against the bidder alleging violations of antitrust or securities laws. Alternatively, the target mayengage in asset and liability restructuring to make it an unattractive target. With asset restructuring, thetarget purchases assets that the bidder does not want or that will create antitrust problems, or sells offthe assets that the suitor desires to obtain. Liability restructuring maneuvers include issuing shares to afriendly third party to dilute the bidders ownership position or leveraging up the firm through aleveraged recapitalization making it difficult for the suitor to finance the transaction.Other postoffer tactics involve targeted share repurchases (often termed "greenmail")n which the targetrepurchases the shares of an unfriendly suitor at a premium over the current market pricend goldenparachuteshich are lucrative supplemental compensation packages for the target firms management.These packages are activated in the case of a takeover and the subsequent resignations of the seniorexecutives. Finally, the target may employ an exclusionary self-tender. With this tactic, the target firmoffers to buy back its own stock at a premium from everyone except the bidder.
  16. 16. A privately owned firm is not subject to unfriendly takeovers. A publicly traded firm "goes private" whena group, usually involving existing management, buys up all the publicly held stock. Such transactionsare typically structured as leveraged buyouts (LBOs). LBOs are financed primarily with debt secured bythe assets of the target firm.DO ACQUISITIONS BENEFIT SHAREHOLDERS?There is substantial empirical evidence that the shareholders in acquired firms benefit substantially.Gains for this group typically amount to 20 percent in mergers and 30 percent in tender offers above themarket prices prevailing a month prior to the merger announcement.The gains to acquiring firms are difficult to measure. The best evidence suggests that shareholders inbidding firms gain little. Losses in value subsequent to merger announcements are not unusual. Thisseems to suggest that overvaluation by bidding firms is common. Managers may also have incentives toincrease firm size at the potential expense of shareholder wealth. If so, merger activity may happen fornoneconomic reasons, to the detriment of shareholders.Acquisition Valuation MethodsOverview of Acquisition Valuation MethodsThere are a number of acquisition valuation methods. While the most common is discounted cash flow, it isbest to evaluate a number of alternative methods, and compare their results to see if several approachesarrive at approximately the same general valuation. This gives the buyer solid grounds for making its offer.Using a variety of methods is especially important for valuing newer target companies with minimalhistorical results, and especially for those growing quickly – all of their cash is being used for growth, socash flow is an inadequate basis for valuation.Valuation Based on Stock Market Price
  17. 17. If the target company is publicly held, then the buyer can simply base its valuation on the current marketprice per share, multiplied by the number of shares outstanding. The actual price paid is usually higher,since the buyer must also account for the control premium. The current trading price of a company’s stockis not a good valuation tool if the stock is thinly traded. In this case, a small number of trades can alter themarket price to a substantial extent, so that the buyer’s estimate is far off from the value it would normallyassign to the target. Most target companies do not issue publicly traded stock, so other methods must beused to derive their valuation.When a private company wants to be valued using a market price, it can adopt the unusual ploy of filing foran initial public offering while also being courted by the buyer. By doing so, the buyer is forced to make anoffer that is near the market valuation at which the target expects its stock to be traded. If the buyerdeclines to bid that high, then the target still has the option of going public and realizing value by sellingshares to the general public. However, given the expensive control measures mandated by the Sarbanes-Oxley Act and the stock lockup periods required for many new public companies, a target’s shareholders areusually more than willing to accept a buyout offer if the price is reasonably close to the target’s expectedmarket value.Valuation Based on a MultipleAnother option is to use a revenue multiple or EBITDA multiple. It is quite easy to look up the marketcapitalizations and financial information for thousands of publicly held companies. The buyer then convertsthis information into a multiples table, which itemizes a selection of valuations within the consultingindustry. The table should be restricted to comparable companies in the same industry as that of the seller,and of roughly the same market capitalization. If some of the information for other companies is unusuallyhigh or low, then eliminate these outlying values in order to obtain a median value for the company’s sizerange. Also, it is better to use a multi-day average of market prices, since these figures are subject tosignificant daily fluctuation.The buyer can then use this table to derive an approximation of the price to be paid for a target company.For example, if a target has sales of $100 million, and the market capitalization for several public companiesin the same revenue range is 1.4 times revenue, then the buyer could value the target at $140 million. Thismethod is most useful for a turn-around situation or a fast growth company, where there are few profits (ifany). However, the revenue multiple method only pays attention to the first line of the incomestatement and completely ignores profitability. To avoid the risk of paying too much based on a revenuemultiple, it is also possible to compile an EBITDA (i.e., earnings before interest, taxes, depreciation, andamortization) multiple for the same group of comparable public companies, and use that information tovalue the target.Better yet, use both the revenue multiple and the EBITDA multiple in concert. If the revenue multiplereveals a high valuation and the EBITDA multiple a low one, then it is entirely possible that the target isessentially buying revenues with low-margin products or services, or extending credit to financially weak
  18. 18. customers. Conversely, if the revenue multiple yields a lower valuation than the EBITDA multiple, this ismore indicative of a late-stage company that is essentially a cash cow, or one where management is cuttingcosts to increase profits, but possibly at the expense of harming revenue growth.If the comparable company provides one-year projections, then the revenue multiple can be re-nameda trailing multiple (for historical 12-month revenue), and the forecast can be used as the basis for a forwardmultiple (for projected 12-month revenue). The forward multiple gives a better estimate of value, becauseit incorporates expectations about the future. The forward multiple should only be used if the forecastcomes from guidance that is issued by a public company. The company knows that its stock price will dropif it does not achieve its forecast, so the forecast is unlikely to be aggressive.Revenue multiples are the best technique for valuing high-growth companies, since these entities areusually pouring resources into their growth, and have minimal profits to report. Such companies clearlyhave a great deal of value, but it is not revealed through their profitability numbers.However, multiples can be misleading. When acquisitions occur within an industry, the best financialperformers with the fewest underlying problems are the choicest acquisition targets, and therefore will beacquired first. When other companies in the same area later put themselves up for sale, they will use theearlier multiples to justify similarly high prices. However, because they may have lower market shares,higher cost structures, older products, and so on, the multiples may not be valid. Thus, it is useful to knowsome of the underlying characteristics of the companies that were previously sold, to see if the comparablemultiple should be applied to the current target company.Valuation Based on Enterprise ValueAnother possibility is to replace the market capitalization figure in the table with enterprise value. Theenterprise value is a company’s market capitalization, plus its total debt outstanding, minus any cash onhand. In essence, it is a company’s theoretical takeover price, because the buyer would have to buy all ofthe stock and pay off existing debt, while pocketing any remaining cash.Valuation Based on Comparable TransactionsAnother way to value an acquisition is to use a database of comparable transactions to determine what waspaid for other recent acquisitions. Investment bankers have access to this information through a variety ofprivate databases, while a great deal of information can be collected on-line through public filings or pressreleases.Valuation Based on Real Estate ValuesThe buyer can also derive a valuation based on a target’s underlying real estate values. This method onlyworks in those isolated cases where the target has a substantial real estate portfolio. For example, in theretailing industry, where some chains own the property on which their stores are situated, the value of the
  19. 19. real estate is greater than the cash flow generated by the stores themselves. In cases where the business isfinancially troubled, it is entirely possible that the purchase price is based entirely on the underlying realestate, with the operations of the business itself being valued at essentially zero. The buyer then uses thevalue of the real estate as the primary reason for completing the deal. In some situations, the prospectivebuyer has no real estate experience, and so is more likely to heavily discount the potential value of any realestate when making an offer. If the seller wishes to increase its price, it could consider selling the realestate prior to the sale transaction. By doing so, it converts a potential real estate sale price (which mightotherwise be discounted by the buyer) into an achieved sale with cash in the bank, and may also record aone-time gain on its books based on the asset sale, which may have a positive impact on its sale price.Valuation Based on Product Development CostsIf a target has products that the buyer could develop in-house, then an alternative valuation method is tocompare the cost of in-house development to the cost of acquiring the completed product through thetarget. This type of valuation is especially important if the market is expanding rapidly right now, and thebuyer will otherwise forego sales if it takes the time to pursue an in-house development path. In this case,the proper valuation technique is to combine the cost of an in-house development effort with the presentvalue of profits foregone by waiting to complete the in-house project. Interestingly, this is the onlyvaluation technique where most of the source material comes from the buyer’s financial statements, ratherthan those of the seller.Valuation Based on Liquidation ValueThe most conservative valuation method of all is the liquidation value method. This is an analysis of whatthe selling entity would be worth if all of its assets were to be sold off. This method assumes that theongoing value of the company as a business entity is eliminated, leaving the individual auction prices atwhich its fixed assets, properties, and other assets can be sold off, less any outstanding liabilities. It isuseful for the buyer to at least estimate this number, so that it can determine its downside risk in case itcompletes the acquisition, but the acquired business then fails utterly.Valuation Based on Replacement CostThe replacement value method yields a somewhat higher valuation than the liquidation value method.Under this approach, the buyer calculates what it would cost to duplicate the target company. The analysisaddresses the replacement of the seller’s key infrastructure. This can yield surprising results if the sellerowns infrastructure that originally required lengthy regulatory approval. For example, if the seller owns achain of mountain huts that are located on government property, it is essentially impossible to replace themat all, or only at vast expense. An additional factor in this analysis is the time required to replace thetarget. If the time period for replacement is considerable, the buyer may be forced to pay a premium inorder to gain quick access to a key market.
  20. 20. While all of the above methods can be used for valuation, they usually supplement the primary method,which is the discounted cash flow method.IntroductionThis unit presents a comprehensive approach to corporate valuation. It provides a unique combinationof practical valuation techniques with the most current thinking to provide an up-to-date synthesis ofvaluation theory, as it applies to mergers, buyouts and restructuring. The unit will provide theunderstanding and the answers to the problems encountered in valuation practice, including detailedtreatments of free cash flow valuation; financial and valuation of leveraged buyouts.ObjectivesAfter studying this unit, you should be able to:Define the concept of Valuation of corporate merger and acquisitionDiscuss the valuation in relation to merger and acquisition activityDiscuss the valuation of operation and financial synergyDiscuss the valuation of LBOMeaning and Valuation ApproachesOnce a firm has an acquisition motive, there are two key questions that need to be answered.The first relates to how to best identify a potential target firm for an acquisitionThe second is the more concrete question how to value a target firm
  21. 21. Valuation is the process of estimating the market value of a financial asset or liability. Valuations can bedone on assets or on liabilities. Valuations are required in many contexts including merger andacquisition transactions. Valuation is the starting point of any merger, buyout or restructuring decision.Before any mergers & acquisitions take place, a valuation of the intended firm must be conducted inorder to determine the true financial worth of the company in question. Valuation is the device to assessthe worth of the enterprise. Valuation of both companies is necessary for fixing the considerationamount to be paid in the form of exchange of shares. Such valuation helps in determining the value ofshares of the acquired company as well as the acquiring company to safeguard the interest of the shareholders of both the companies. Valuation is necessary for the decision making by shareholders to selltheir interest in the company in the form of shares. To enable shareholders of both the companies, totake decision in favour of amalgamation, valuation of shares is needed. The valuation should giveanswer to the following basic questions:What is the maximum price that should be paid to the shareholder of the merged company?How is the price justified with reference to the value of assets, earnings, cash flows, balance sheetimplications of the amalgamation?What should be the strength of the surviving company reflected in market price or enhanced earning,capacity with reference to the acquires strategies to justify the consideration of the merged company?The above questions find answers in valuation and fixation of exchange ratios. There are two final pointsworth making here, before we move on to valuation. The first is that firms often choose a target firmand a motive for the acquisition simultaneously, rather than sequentially. That does not change any ofthe analysis in these sections. The other point is that firms often have more than one motive in anacquisitions, say, control and synergy. If this is the case, the search for a target firm should be guided bythe dominant motive.Basis of ValuationValuation of business is done using one or more of these types of models:Relative value models determine the value based on the market prices of similar business.
  22. 22. Absolute value models determine the value by estimating the expected future earnings from owning thebusiness discounted to their present valueAn accurate valuation of companies largely depends on the reliability of the company’s financialinformation. Inaccurate financial information can lead to over and undervaluation. In an acquisition, duediligence is commonly performed by the buyer to validate the representations made by the seller.The financial analysis required to be made in the case of merger or takeover is comprised of valuation ofthe assets and stocks of the target company in which the acquirer contemplates to invest large amountof capital. The financial evaluation of a merger is needed to determine the earnings and cash flows,areas of risk, the maximum price payable to the target company and the best way to finance the merger.In M & A, the acquiring firm must pay a fair consideration to the target firm. But, sometimes, the actualconsideration may be more than or less than the fair consideration. A merger is said to be at a premiumwhen the offer price is higher than the target firm’s pre-merger market value. It may have to paypremium as an incentive to the target firm’s shareholders to induce then to sell their shares.The value of the firm depends not only upon its earnings but also upon the operating and financialcharacteristics of the acquiring firm. It is therefore, not possible to place a single value for the acquiredfirm. Instead, a range of values is determined, which would economically justifiable to the prospectiveacquirer. To determine an acceptable price for a firm, a number of factors, qualitative (managerialtalent, strong sales staff, excellent production department etc) as well as quantitative (value of an asset,earnings of the firm etc) are relevant. Therefore, the focus of determining the firm’s value is on severalquantitative variables. There are several basis of valuation as listed below:Asset ValueThe business is taken as going concern and realizable value of assets is considered which include bothtangible and intangible assets. The value of goodwill is added to the value of the tangible assets whichgives value of the company as a going concern. Goodwill represents the company’s excess earningpower capitalized on the basis of certain number of year’s purchases.Capitalized earnings
  23. 23. This is the predetermined rate of return expected by an investor. In other words, this is simple rate ofreturn on capital employed. Under this method, the expected profit will be divided by the expected rateof return to calculate the value of the acquisition.Market Value of listed stocksMarket value is the value quoted for the stocks of listed company at stock exchanges. The market pricereflects investors anticipation of future earnings, dividend payout ratio, confidence in management ofcompany, operational efficiency etc. The temporary factors causing volatility are eliminated byaveraging the quotations over a period of time to arrive at a fair market value. The acquirer pays onlymarket value in hostile takeover. The market value approach is one of the most widely used indetermining value, especially of large listed firms. The market value provides a close approximation ofthe true value of a firm.Earnings Per ShareThe value of a prospective acquisition is considered to be a function of the impact of the merger on theearnings per share. The analysis could focus on whether the acquisition will have a positive impact onthe EPS after the merger or if it will have the effect of diluting the EPS. The future EPS will affect thefirm’s share prices, which is the function of price-earning (P/E) ratio and EPS.Investment valueInvestment value is the cost incurred (original investment plus the interest accrued thereon) to establishan enterprise. This determines the sale price of the target company which the acquirer may be asked topay for the negotiated merger.Book ValueBook value represents the total worth of the assets after depreciation but with revaluation. Book valueis the audited written down money worth of the total net tangible assets owned by a company. Thetotal net assets are composed of gross working capital plus fixed assets minus outside liabilities. Thebook value, as the basis of determining a firm’s value, suffers from a serious limitation as it is based on
  24. 24. the historical costs of the assets of the firm. Historical costs do not bear a relationship either to thevalue of the firm or to its ability to generate earnings. However, it is relevant to the determination of afirm’s value for the following reasons:i)It can be used as a starting point to be compared and complemented by other analyses.ii)The ability to generate earnings requires large investments in fixed assets and working capital andstudy of these factors is particularly appropriate and necessary in mergersCost basis valuationCost of the assets less depreciation becomes the basis under this method. This method ignoresintangible assets like goodwill. It does not give weight to changes in price level.Reproduction CostReproduction cost method is based on assessing the current cost of duplicating the properties orconstructing similar enterprise in design and material. It does not take into account the intangible assetsfor valuation purpose.Substitution costSubstitution cost is the estimate of the cost of construction of the undertaking or enterprise in the sameutility and capacity.Out of the above nine methods of valuation, the important methods are: assets based valuation, earningbased valuation and market price valuation. These methods are the frequently used in the corporatemergers and acquisition.Valuation Methods
  25. 25. The financial consideration generally is the form of exchange of shares. This requires that relative valueof each firm’s share and based on this value a particular exchange ratio is determined. Thedetermination of the exchange ratio is therefore, based on the value of the shares of the companyinvolved in the merger.The valuation of an acquisition is not fundamentally different from the valuation of any firm, althoughthe existence of control and synergy premiums introduces some complexity into the valuation process.Given the inter-relationship between synergy and control, the safest way to value a target firm is insteps, starting with a relative and discounted cash flow valuation (status quo valuation of the firm), andfollowing up with a value for control and a value for synergy.Relative ValuationIf the motive for acquisitions is under valuation, the target firm must be under valued. How such a firmwill be identified depends upon the valuation approach and model used.With relative valuation, an under valued stock is one that trades at a multiple (of earnings, book value orsales) well below that of the rest of the industry, after controlling for significant differences onfundamentals. For instance, a bank with a price to book value ratio of 1.2 would be an undervaluedbank, if other banks have similar fundamentals (return on equity, growth, and risk) but trade at muchhigher price to book value ratios.In discounted cash flow valuation approaches, an under valued stock is one that trades at a price wellbelow the estimated discounted cash flow value.Discounted Cash Flow (DCF) MethodsIt may be started with the valuation of the target firm by estimating the firm value with existinginvesting, financing and dividend policies. This valuation provides a base from which the control andsynergy premiums can be estimated. The value of the firm is a function of its cash flows from existingassets, the expected growth in these cash flows during a high growth period, the length of the highgrowth period, and the firm’s cost of capital.
  26. 26. In a merger or acquisition, the acquiring firm is buying the business of the target company rather than aspecific asset. Thus, merger is special type of capital budgeting decision. The acquiring firm incurs a cost(in buying the business of the target firm) in the expectation of a stream of benefits (in the form of cashflows) in the future. The merger will be advantageous to the acquiring company, if the present value ofthe target merger is greater than the cost of acquisition. In order to apply DCF techniques, the followinginformation is required.Estimation of cash flowsTiming of cash flowsDiscount rateThe appropriate discount rate depends on the risk of the cash flows.Discounted cash flow is a method for determining the current value of a company using future cashflows adjusted for time value. The future cash flow set is made up of cash flows within the determinedforecast period and a continuing value that represents a steady state cash flow stream after the forecastperiod, known as the Terminal Value. In conducting a valuation of a firm, cash flow is usually the mainconsideration. There is a five-step process for evaluating a company’s cash flow:i)Analyze operating activitiesii)Analyze the investments necessary to buy new property or businessiii)Analyze the capital requirements of the firmiv)Project the annual operating flows and terminal value of the firm
  27. 27. v)Calculate the Net Present Value of those cash flows to calculate the firm’s valueIn nutshell, the following steps are involved in the financial evaluation of a merger:Identify growth and profitability assumptions and scenariosProject cash flows magnitudes and their timingEstimate the cost of capitalCompute NPV for each scenarioDecide if the acquisition is attractive on the basis of NPVDecide if the acquisition should be financed through cash or exchange of sharesEvaluate the impact of the merger on EPS and P/E Ratio1. Estimating Free Cash FlowsThe steps in the estimation of the cash flow are as follows:The first step in the estimation of cash flow is the projection of sales.The second step is to estimate expenses.The third step is to estimate the additional capital expenditure and depreciation.Final step is to estimate changes in net working capital due to change in sales.The above mentioned steps can be presented in the form of below mentioned model.Net SalesLess: Cost of goods sold
  28. 28. Selling & Admn. Exp Depreciation Total Exp PBT Tax @ % PAT(+) Depreciation Funds from operation(-) Increase in NWC Cash from operation(-) Capital Expenditure Free Cash Flow
  29. 29. + Salvage Value (at the end of the year) P.V. Factor Present ValueThe above steps can be presented in a mathematical equation as below to calculate cash flows:Where,NCF means net cash flows;EBIT means earnings before interest and tax;T means Tax Rate;DEP means depreciation;Delta NWC means changes in working capital; andDelta CAPEX means changes in capital expenditure.Here it should be noted that the discount rate should be average cost of capital.2. Terminal ValueTerminal value is the value of cash flows after the horizon period. It is difficult to estimate the terminalvalue of the firm as the firm is normally acquired as going concern. The terminal value is the present
  30. 30. value of free cash flow after the forecast period. Its value can be determined under three differentsituations as below:When terminal value is likely to be constant till infinity: TV = FCFt-1 / KoWhen terminal value is likely to grow at a constant rate TV = FCFt-1 (1+g)/(Ko-g)When terminal value is likely to decline at a constant rate TV = FCFt-1(1-g)/(Ko+g)Where, FCFt-1 refers to the expected cash flow in first year after the horizon period, Ko refers averagecost of capital.ExampleABC Company Limited targeted to acquire XYZ Company Ltd. The Projected Post Merger Cash FlowStatements for the XYZ Company Ltd is given below: (Rs. in millions)Year 1Year 2Year 3Year 4Year 5
  31. 31. Net SalesRs. 105Rs. 126Rs. 151Rs. 174Rs. 191Cost of goods sold8094111127136Selling and administration Expenses1012131516Depreciation88
  32. 32. 9910EBIT712182329Interest*34567EBT48131722
  33. 33. Taxes (40%) $ Income2.44.87.810.213.2Add Depreciation889910Free Cash Flows10.412.816.8
  34. 34. 19.223.2Less retention needed for growth #447912Add Terminal Value @126.3Net Cash Flows*** Interest payments are estimated based on XYZ Co’s existing debt, plus additional debt required tofinance growth$ The taxes are the full corporate taxes attributable to XYZ’s operation
  35. 35. # Some of the cash flows generated by the XYZ after the merger must be retained to finance assetreplacements and growth, while some will be transferred to ABC to pay dividends on its stock or forredeployment within the company. These retentions are net of any additional debt used to help financegrowth.@ XYZ’s available cash flows are expected to grow at a constant 6% rate after Year 5.The value of all post- Year 5 cash flows as on December 31, Year 5 is estimated by use of the constantgrowth model to be Rs. 126.3 million: TV(Year 5) = FCF(Year 6)/(k-g) = {Rs.23.2 – Rs.12.0)(1.06)}/(0.154 -0.06) = Rs. 126.3 millionThe Rs. 126.3 million is the present value at the end of Year 5 of the stream of cash flows for Year 6 andthereafter. Here, it estimated 15.4 per cent as cost of capital.** These are the net cash flows projected to be available to ABC by virtue of the acquisition. The cashflows could be used for dividend payments to ABC share holders, finance asset expansion in ABC’s otherdivisions and subsidiaries and so on.The current value of XYZ to ABC’s shareholders is the present value of the cash flows expected from XYZdiscounted at 15.4% :Value (Year 0) = (Rs.6.4)/(1.154)1 + (Rs. 8.8) / (1.154)2 + (Rs.9.8)/ (1.154)3 +
  36. 36. (Rs. 10.2) / (1.154)4 + (Rs.137.5)/(1.154)5 = Rs. 91.5 millionThus, the value of Target Company to ABC shareholders is Rs. 91.5 million.It should be noted that in a merger analysis, the value of the target consists of the target’s pre mergervalue plus any value created by operating or financial synergies. In this example, it is assumed thattarget company’s capital structure and tax rate constant. Therefore, the only synergies were operatingsynergies, and these effects were incorporated into the forecasted cash flows. If there had beenfinancial synergies, the analysis would have to be modified to reflect this added value.Market Multiple AnalysisThe another method of valuing a target company is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, sales, and book value or number of subscribers(in case of cable TV or cellular telephone systems). While DCF method applies valuation concept in aprecise manner, focusing on expected cash flows, market multiple analysis is more judgmental.This method uses sample ratios from comparable peer groups for determining the current value of acompany. The specific ratio to be used depends on the objective of the valuation. The valuation could bedesigned to estimate the value of the operation of the business or the value of the equity of thebusiness.To explain the concept, note that XYZ company’s projected net income Rs. 2.4 million in Year 1 and itrises to Rs. 13.2 million in Year 5, for an average of Rs.7.7 million over five year projected period. Theaverage P/E ratio for publicly traded companies similar to XYZ is 12. To estimate XYZ’s value using themarket P/E multiple approach, simply multiply its Rs. 7.7 million average net income by market multipleof 12 to obtain the value(Rs.7.7 x 12) Rs. 92.4 million. This is the equity or the ownership value of the firm. It can be noted herethat we used the average net income over the coming five years to value XYZ. The market P/E multipleof 12 is based on the current year’s income of comparable companies, but XYZ’s current income doesnot reflect synergistic effects or managerial changes that will be made. By averaging future net income,we are attempting to capture the value added by ABC to XYZ’s operations.
  37. 37. EBITDA is another commonly used measure in the market multiple approach. When calculating thevalue of the operation, the most commonly used ratio is the EBITDA multiple, which is the ratio ofEBITDA (Earnings before Interest Taxes Depreciation and Amortization) to the Enterprise Value (EquityValue plus Debt Value). This multiple is based on total value, since EBITDA measures the entire firm’sperformance. Multiplying the Target Company’s EBITDA by the market multiple gives an estimate of thetargets’ total value. To find the target’s estimated stock price per share, subtract debt from total andthen divide by the number of equity shares.Earnings AnalysisWhen valuing the equity of a company, the most widely used multiple is the Price Earnings Ratio (P/ERatio) of stocks in a similar industry, which is the ratio of Stock price to Earnings per Share of any publiccompany. Earning per share (EPS) is the earning attributable to share holders which are reflected in themarket price of the shares. Using the sum of multiple P/E Ratio’s improves reliability but it can still benecessary to correct the P/E Ratio for current market conditions. A reciprocal of this ratio (EPS/P)depicts yield. Share price (P) can be determined as P = EPS x P/E Ratio. While planning for takeover, P/Eratio plays significant role in decision making for the acquirer in the following ways:Target Company’s P/E ratio is exit ratio and higher the ratio means the acquirer has to pay more. In suchcases, merger will lead to dilution in EPS and adversely affect share prices. If the exit ratio of TargetCompany is less than the acquirer then shareholders of both companies benefit.A company can increase its EPS by acquiring another company with a P/E ratio lower than its own ifbusiness is acquired by exchange of shares.ExampleABC Company Ltd takes over XYZ Company Ltd. The merger is not expected to yield in economies ofscale and operating synergy. The relevant data for two companies are as follows:ABC LtdXYZ LtdNo. of Shares
  38. 38. 10,0005,000Total Earnings1,00,00050,000EPS1010P/E Ratio21.5ABC Ltd acquires XYZ at share-for –share exchange. The exchange ratio has been calculated as under:Assume that XYZ Ltd is going to exchange its share with ABC Ltd at its market price. The exchange ratiowill be: 15/20 = 0.75. That is for every one share of XYZ Ltd., 0.75 share of ABC Ltd will be issued. In total3750 (0.75×5000) shares of ABC Ltd will need to be issued in order to acquire XYZ Ltd. Hence, the totalnumber of shares in combined company will be 13,750 (10000 + 3750).Impact of merger on ABC Ltd shareholders:
  39. 39. EPS on merger = (100000 + 50000) / 13750 = Rs. 10.91Net gain in EPS = Rs. 10.91 – Rs. 10.00 = Re. 0.91Market Price of share (after merger) = EPS x P/E Ratio = Rs. 10.91 x 2 = 21.82Net gain in Market Price = Rs. 21.82 – Rs. 20.00 = Rs. 1.82Impact of Merger on XYZ Ltd shareholders: New EPS = 0.75 x 10.91 = Rs. 8.18 EPS dilution (Net Loss) = Rs. 10.00 – Rs. 8.182 = Rs. 1.82ABC Ltd shareholders have gained in the combined company from the merger because as the P/E ratioof target company (XYZ) is less than that of the acquirer.Valuing Operating and Financial SynergyThe third reason to explain the significant premiums paid in most acquisitions is synergy. Synergy is thepotential additional value from combining two firms. It is probably the most widely used and misusedrationale for mergers and acquisitions.1. Sources of Operating SynergyOperating synergies are those synergies that allow firms to increase their operating income, increasegrowth or both. It can be categorized operating synergies into four types:
  40. 40. a)Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable.b)Greater pricing power from reduced competition and higher market share, which should result inhigher margins and operating income.c)Combination of different functional strengths, as would be the case when a firm with strong marketingskills acquires a firm with a good product line.d)Higher growth in new or existing markets, arising from the combination of the two firms. This wouldbe the case, when a multinational consumer products firm acquires an emerging market firm, with anestablished distribution network and brand name recognition, and uses these strengths to increase salesof its products.Operating synergies can affect margins and growth, and through these the value of the firms involved inthe merger or acquisition.2. Sources of Financial SynergySynergy can also be created from purely financial factors. With financial synergies, the payoff can takethe form of either higher cash flows or a lower cost of capital. Included are the following:A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firmwith high-return projects (and limited cash) can yield a payoff in terms of higher value for the combinedfirm. The increase in value comes from the projects that were taken with the excess cash that otherwisewould not have been taken. This synergy is likely to show up most often when large firms acquiresmaller firms, or when publicly traded firms acquire private businesses.
  41. 41. Debt capacity can increase, because when two firms combine, their earnings and cash flows maybecome more stable and predictable. This, in turn, allows them to borrow more than they could have asindividual entities, which creates a tax benefit for the combined firm. This tax benefit can either beshown as higher cash flows, or take the form of a lower cost of capital for the combined firm.Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of netoperating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be ableto use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able toincrease its depreciation charges after an acquisition will save in taxes, and increase its value.Clearly, there is potential for synergy in many mergers. The more important issues are whether thatsynergy can be valued and, if so, how to value it.3. Valuing Operating SynergyThere is a potential for operating synergy, in one form or the other, in many takeovers. Synergy can bevalued by answering two fundamental questions:What form is the synergy expected to take?Will it reduce costs as a percentage of sales and increase profit margins (e.g., when there are economiesof scale)?Will it increase future growth (e.g., when there is increased market power) or the length of the growthperiod?Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process:cash flows from existing assets,higher expected growth rates (market power, higher growth potential)a longer growth period (from increased competitive advantages)a lower cost of capital (higher debt capacity)When will the synergy start affecting cash flows?
  42. 42. Synergies can show up instantaneously, but they are more likely to show up over the time. Since thevalue of synergy is the present value of the cash flows created by it, the longer it takes for it to show up,the lesser its value.Once we answer these questions, we can estimate the value of synergy using an extension of discountedcash flow techniques.First, we value the firms involved in the merger independently, by discounting expected cash flows toeach firm at the weighted average cost of capital for that firm.Second, we estimate the value of the combined firm, with no synergy, by adding the values obtained foreach firm in the first step.Third, we build in the effects of synergy into expected growth rates and cash flows, and we value thecombined firm with synergy.The difference between the value of the combined firm with synergy and the value of the combined firmwithout synergy provides a value for synergy.Value Creation through SynergySynergy is a stated motive in many mergers and acquisitions. If synergy is perceived to exist in atakeover, the value of the combined firm should be greater than the sum of the values of the biddingand target firms, operating independently.V(PQ) > V(P) + V(Q)Where,V(PQ) = Value of a firm created by combining P and Q (Synergy)V(P) = Value of firm P, operating independentlyV(Q) = Value of firm Q, operating independently
  43. 43. Merger will create an economic advantage (EA) through synergy when the combined present value ofthe merger firms is greater than the sum of their individual present values as separate entities. If firm Pand firm Q merge, and they are separately worth VP and VQ respectively, and worth VPQ in combinationthen the economic advantage will occur if:The economic advantage is equal to:Merger and acquisition involves costs. The Cost of merging to P in the above example is:Cash Paid - VQThe net economic advantage of merger (NEA) is positive if the economic advantage exceeds the cost ofmerging. Thus,Net Economic Advantage = Economic Advantage – Cost of Merging
  44. 44. represent the benefit results from operating efficiency and synergy when two firms merge. If theacquiring firm pays cash equal to the value of the acquired firm, then the entire advantage of mergerwill accrue to the shareholders of acquired firm. In practice, the acquiring and the acquired firm mayshare the economic advantage between themselves.Valuing Corporate ControlIf the motive for the merger is control, the target firm will be a poorly managed firm in an industrywhere there is potential for excess returns. In addition, its stock holdings will be widely dispersed(making it easier to carry out the hostile acquisition) and the current market price will be based on thepresumption that incumbent management will continue to run the firm. Many hostile takeovers arejustified on the basis of the existence of a market for corporate control. Investors and firms are willing topay large premiums over the market price to control the management of firms, especially those thatthey perceive to be poorly run.The value of wresting control of a firm from incumbent management is inversely proportional to theperceived quality of that management and its capacity to maximize firm value. In general, the value ofcontrol will be much greater for a poorly managed firm that operates at below optimum capacity thanfor a well managed firm. The value of controlling a firm comes from changes made to existingmanagement policy that can increase the firm value. Assets can be acquired or liquidated, the financingmix can be changed and the dividend policy re-evaluated, and the firm can be restructured to maximizevalue. If we can identify the changes that we would make to the target firm, we can value control. Thevalue of control can then be written as:Value of Control = Value of firm,Optimally managed - Value of firm with current managementThe value of control is negligible for firms that are operating at or close to their optimal value, since arestructuring will yield little additional value. It can be substantial for firms operating at well belowoptimal, since a restructuring can lead to a significant increase in value.
  45. 45. Valuing Leveraged BuyoutsLeveraged buyouts are financed disproportionately with debt. This high leverage is justified in severalways as pointed below:First, if the target firm initially has too little debt relative to its optimal debt ratio, the increase in debtcan be explained partially by the increase in value moving to the optimal ratio provides. The debt level inmost leveraged buyouts exceeds the optimal debt ratio, however, which means that some of the debtwill have to be paid off quickly in order for the firm to reduce its cost of capital and its default risk.A second explanation is provided by Michael Jensen, who proposes that managers cannot be trusted toinvest free cash flows wisely for their stockholders; they need the discipline of debt payments tomaximize cash flows on projects and firm value.A third rationale is that the high debt ratio is temporary and will disappear once the firm liquidatesassets and pays off a significant portion of the debt.The extremely high leverage associated with leveraged buyouts creates two problems in valuation.First, it significantly increases the risk of the cash flows to equity investors in the firm by increasing thefixed payments to debt holders in the firm. Thus, the cost of equity has to be adjusted to reflect thehigher financial risk the firm will face after the leveraged buyout.Second, the expected decrease in this debt over time, as the firm liquidates assets and pays off debt,implies that the cost of equity will also decrease over time.Since the cost of debt and debt ratio will change over time as well, the cost of capital will also change ineach period. In valuing a leveraged buyout, then, we begin with the estimates of free cash flow to thefirm, just as we did in traditional valuation. The DCF approach is used to value an LBO. However, insteadof discounting these cash flows back at a fixed cost of capital, we discount them back at a cost of capitalthat will vary from year to year. Once we value the firm, we then can compare the value to the totalamount paid for the firm. As LBO transactions are heavily financed by debt, the risk of lender is veryhigh. Therefore, in most deals they require a stake in the ownership of the acquired firm.Summary
  46. 46. Merger should be undertaken when the acquiring company’s gain exceeds the cost. The cost is the premium that the acquiring company pays for the target company over its value as a separate entity. Merger benefits may result from economies of scale, increased efficiency, tax shield or shared resources. Discounted cash flow technique can be used to determine the value of the target company to the acquiring company. This unit described different techniques for the valuation of target companies on the basis of various parametersThe Five Principles of CorporateFinance Mergers and Acquisitions: the fundamental economics Corporate Finance: the decisions that create shareholder value o Investment, financing, payback and risk management o The five guidelines for corporate finance Identifying value drivers in a company Valuation methods as investment tools o NPV and IRR The risk-return tradeoff o diversification o the Capital Asset Pricing Model o the required return on equity investments Making real investment decisions Case study: Costa Rica Forest Resources Basing investments on cash flows: finding a companys free cash flows Exercise: Free Cash Flows at ActavisFinancing Techniques, the Cost ofCapital, and Capital Structure Sources of corporate finance The capital structure decision: debt versus equity Cost of capital o cost of debt o cost of equity
  47. 47. o weighted-average cost of capital Case study: Life Time Fitness: Find this companys cost of capital Optimal capital structure: how to get there Adjusting the costs of debt and equity for leverage Exercise: Leveraging Life Time. How would the clients beta and cost of funds be affected by a higher level of debt? Ratings and debt pricing Using debt and derivatives to manage financial risksDeveloping an Acquisition Strategy Identify your competitive advantages Define your acquisition objectives and specific acquisition criteria Case study: ISS 101. How would you define the growth and acquisition strategy at ISS? Selecting advisors -- valuation, negotiation, legal and due diligence, and financing An opportunity arises: is it the right target? What fits our criteria, what doesnt? What aspects of the business should be kept, what sold? Dealing with private owners Dealing with defensive strategies: poison pills and other devices Dealing with rival bidders What will it take after doing the deal to make it all work? Is it a "fixer-upper?" Are shareholders going to like the deal? Why? Developing the negotiation strategy -- what are sellers motivations and needs?Day 2 Valuation in Mergers and Acquisitions: Tools and Applications Valuation for acquisitions o Asset-based and balance-sheet approaches o Market value approaches
  48. 48. o Multiples and comparables o Enterprise value and EBITDA Dividend- and cashflow-discount models o Establishing required rates of return o Free cash flows to firm Case study: Valuing Actavis.. Using two different appraoches, we value a company. Restructuring checklist Total cost computation Valuing the synergies o Operating synergy analysis o Financial restructuring analysis o Break-up valuation Case study: MTC-Celtel. Teams value the synergies resulting from a potential acquis risk and cost-of-capital effects and employing sensitivity analysis on the hoped-for syne Sensitivity analysis Case study: Active Generation. Participants value a private company for acqui comparables and cash flow methods and incorporating the results of potential synergies Negotiating the Merger Structuring the deal: How much should we pay? How should we pay? The proposed basic Term Sheet The legal structure Keep the romance alive during due diligence and while you secure financing Closing the deal Case study: Lifetime-Active Generation. Participants engage in a hands-on negotiating valuation, setting the price and payment terms of the merger, and negotiating control Assessment and Due Diligence Required performance improvements embedded in acquisition premiums Competitive conditions that must drive valuations What due diligence can reveal – and what it cannot The winner’s curse and morning-after woes Case study: The Acquisition of Allied Colloids. We follow the sequence of events in merger and develop a due diligence checklist. Tailoring due diligence to the company and industryDay 3 Financing Acquisitions Finding the optimal capital structure: debt, equity or mezzanine? Capital structure considerations Case study: Photronics. Financing the Singapore acquisition at a technology company Raising the acquisition financing Asset-based finance Bridge financing Mezzanine debt Debt with warrants High-yield bonds Subordinated seller notes Private equity sources
  49. 49. Refinancing strategies Case study: Madras Appliances. Teams evaluate a variety of creative financing techniq of this challenging acquisition situation. Raising the Money: Debt Capacity Analysis Focus: synthetic ratings and debt pricing Case Study: Nukem Security Services. A management team hopes to acquire the cservices division. How much of the purchase cost could be financed with debt? Paydown and exit analysisPost-Merger Integration Major factors determining success of post-merger integration Checklist of areas of risk Compensation and motivation issues Setting milestones Divestitures Case study: The Merger of Penn State and Geisinger. Participants discuss pitfal approaches to post-merger integration success. They prepare an action plan for the e of two companies.Group Exercise Case Study: Flexics. Participants employ the tools and ideas of the course to a co featuring a leveraged acquisition proposal. They negotiate key features, including: Valuation of the target Raising the funding Summary "term sheet" agreement Post-merger integration planSummary and Conclusions