Mergers and Acquisitions The term merger and acquisition ("M&A") refers to the aspect of corporate strategy, corporate finance and 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 another business entity. Overview A merger is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. There are several different types of actions that a company can take when deciding to move forward using mergers and acquisitions ("M&A"). Usually mergers occur in a consensual (occurring by mutual consent) setting where executives from the target company help those 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 outstanding shares of a company in the open market against the wishes of the target's board. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill". Mergers can be heavily regulated, for example, in the U.S. requiring approval by both the Federal Trade Commission and the Department of Justice. The U.S. began their regulation on mergers in 1890 with the implementation of the Sherman Act. It was meant to prevent any attempt to monopolize or to conspire to restrict trade. However, based on the loose interpretation of the standard "Rule of Reason", it was up to 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). Acquisition
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Mergers and Acquisitions
The term merger and acquisition ("M&A") refers to the aspect of corporate strategy, corporate finance and 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 another business entity.
Overview
A merger is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. There are several different types of actions that a company can take when deciding to move forward using mergers and acquisitions ("M&A"). Usually mergers occur in a consensual (occurring by mutual consent) setting where executives from the target company help those 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 outstanding shares of a company in the open market against the wishes of the target's board. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".
Mergers can be heavily regulated, for example, in the U.S. requiring approval by both the Federal Trade Commission and the Department of Justice. The U.S. began their regulation on mergers in 1890 with the implementation of the Sherman Act. It was meant to prevent any attempt to monopolize or to conspire to restrict trade. However, based on the loose interpretation of the standard "Rule of Reason", it was up to 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).
Acquisition
An acquisition, also known as a takeover, is the buying of one company (the "target") by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target's board has no prior knowledge 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 established company and keep its name for the combined entity. This is known as a reverse takeover.
Types of acquisition
* 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, but since the company is acquired intact as a going business, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
* The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to "cherry-pick" the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller's shareholders.
The terms "demerger", "spin-off" and "spin-out" are sometimes used to indicate a situation where one company splits into two, generating a second company separately listed on a stock exchange.
Merger
In business or economics a merger is a combination of two companies into one larger company. Such actions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and in new branding; in some cases, terming the combination a "merger" rather than 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 the same industry.
* Vertical mergers occur when two firms, each working at different stages in the production of the same good, combine.
* Congeneric mergers occur where two merging firms are in the same general industry, but they have no mutual buyer/customer or supplier relationship, such as a merger between a bank and a leasing company. Example: Prudential's 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 expense and 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 Herfindahl index 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 the U.S. Federal Trade Commission may investigate anti-trust cases for monopolies dangers, and have the power to block mergers.
Accretive mergers are those in which an acquiring company's earnings per share (EPS) increase. An alternative way of calculating this is if a company with a high price to earnings ratio (P/E) acquires one with a low P/E.
Dilutive mergers are the opposite of above, whereby a company's EPS decreases. The company will be one 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, many mergers (in some industries, the majority) result in a net loss of value due to problems. Correcting problems caused by incompatibility—whether of technology, equipment, or corporate culture— diverts resources away from new investment, and these problems may be exacerbated by inadequate research or by concealment of losses or liabilities by one of the partners. Overlapping subsidiaries or redundant staff may be allowed to continue, creating inefficiency, and conversely the new management may cut too many operations or personnel, losing expertise and disrupting employee culture. These problems are similar to those encountered in takeovers. For the merger not to be considered a failure, it must increase shareholder value faster than if the companies were separate, or prevent the deterioration of shareholder value more than if the companies were separate.
Business valuation
The 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 Shareholder's Discretionary Cash Flow (SDCF) valuation. Professionals who valuate 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. These values are determined for the most part by looking at a company's balance sheet and/or income statement and withdrawing the appropriate information. The information in the balance sheet or income statement is obtained by one of three accounting measures: a Notice to Reader, a Review Engagement or an Audit.
Accurate business valuation is one of the most important aspects of M&A as valuations like these will have a major impact on the price that a business will be sold for. Most often this information is expressed in a Letter of Opinion of Value (LOV) when the business is being valuated for interest's sake. There are other, more detailed ways of expressing the value of a business. These reports generally get more detailed and expensive as the size of a company increases, however, this is not always the case as there are many complicated industries which require more attention to detail, regardless of size.
Financing M&A
Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:
Cash
Payment by cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders alone.
A cash deal would make more sense during a downward trend in the interest rates. Another advantage of using cash for an acquisition is that there tends to lesser chances of EPS dilution for the acquiring company. But a caveat in using cash is that it places constraints on the cash flow of the company.
Financing
Financing capital may be borrowed from a bank, or raised by an issue of bonds. Alternatively, the acquirer's stock may be offered as consideration. Acquisitions financed through debt are known as leveraged buyouts if they take the target private, and the debt will often be moved down onto the balance sheet of the acquired company.
Hybrids
An acquisition can involve a combination of cash and debt, or a combination of cash and stock of the purchasing entity.
Motives behind M&A
These motives are considered to add shareholder value:
* Economies of scale: This refers to the fact that the combined company can often reduce duplicate departments 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 be absorbing a major competitor and thus increase its power (by capturing increased market share) to set prices.
* Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's 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 target's loss as their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring 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 more confidence 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 the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.
These motives are considered to not add shareholder value:
* Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.
* Manager's hubris: manager's overconfidence about expected synergies from M&A which results in overpayment for the target company.
* Empire building: Managers have larger companies to manage and hence more power.
* Manager's compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a 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 that compensation 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 product at a cheaper cost, the other end now has lower revenue. In addition, the supplier may find more difficulty in supplying to competitors of its acquirer because the competition would not want to support the new conglomerate.
M&A marketplace difficulties
No marketplace currently exists for the mergers and acquisitions of privately owned small to mid-sized companies. Market participants often wish to maintain a level of secrecy about their efforts to buy or sell such companies. Their concern for secrecy usually arises from the possible negative reactions a company's employees, bankers, suppliers, customers and others might have if the effort or interest to seek a transaction were to become known. This need for secrecy has thus far thwarted the emergence of 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. A transaction typically requires six to nine months and involves many steps. Locating parties with whom to conduct a transaction forms one step in the overall process and perhaps the most difficult one. Qualified and interested buyers of multimillion dollar corporations are hard to find. Even more difficulties attend bringing a number of potential buyers forward simultaneously during negotiations. Potential acquirers in
an industry simply cannot effectively "monitor" the economy at large for acquisition opportunities even though some may fit well within their company's operations or plans.
An industry of professional "middlemen" (known variously as intermediaries, business brokers, and investment bankers) exists to facilitate M&A transactions. These professionals do not provide their services cheaply and generally resort to previously-established personal contacts, direct-calling campaigns, and placing advertisements in various media. In servicing their clients they attempt to create a one-time market for a one-time transaction. Certain types of merger and acquisitions transactions involve securities and may require that these "middlemen" be securities licensed in order to be compensated. Many, but not all, transactions use intermediaries on one or both sides. Despite best intentions, intermediaries can operate inefficiently because of the slow and limiting nature of having to rely 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 which they have no interest. These marketing problems typify any private negotiated markets. Due to these problems and other problems like these, brokers who deal with small to mid-sized companies often deal with much more strenuous conditions than other business brokers. Mid-sized business brokers have an average life-span of only 12-18 months and usually never grow beyond 1 or 2 employees. Exceptions to this are few and far between. Some of these exceptions include The Sundial Group, Geneva Business Services and Robbinex.
The market inefficiencies can prove detrimental for this important sector of the economy. Beyond the intermediaries' high fees, the current process for mergers and acquisitions has the effect of causing private companies to initially sell their shares at a significant discount relative to what the same company might sell for were it already publicly traded. An important and large sector of the entire economy is held back by the difficulty in conducting corporate M&A (and also in raising equity or debt capital). Furthermore, it is likely that since privately held companies are so difficult to sell they are not sold as often as they might or should be.
Previous attempts to streamline the M&A process through computers have failed to succeed on a large scale because they have provided mere "bulletin boards" - static information that advertises one firm's opportunities. Users must still seek other sources for opportunities just as if the bulletin board were not electronic. A multiple listings service concept was previously not used due to the need for confidentiality but there are currently several in operation. The most significant of these are run by the California Association of Business Brokers (CABB) and the International Business Brokers Association (IBBA) These organizations have effectivily created a type of virtual market without compromising the confidentiality of parties involved and without the unauthorized release of information.
A merger occurs when one firm assumes all the assets and all the liabilities of another. The acquiring firm retains its identity, while the acquired firm ceases to exist. A majority vote of shareholders is generally required to approve a merger. A merger is just one type of acquisition. One company can acquire another in several other ways, including purchasing some or all of the company's assets or buying up its outstanding shares of stock.
In general, mergers and other types of acquisitions are performed in the hopes of realizing an economic gain. For such a transaction to be justified, the two firms involved must be worth more together than they were apart. Some of the potential advantages of mergers and acquisitions include achieving economies of scale, combining complementary resources, garnering tax advantages, and eliminating inefficiencies. Other reasons for considering growth through acquisitions include obtaining proprietary rights to products or services, increasing market power by purchasing competitors, shoring up weaknesses in key business areas, penetrating new geographic regions, or providing managers with new opportunities 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 today's global business environment, companies may have to grow to survive, and one of the best ways to grow is by merging with another company or acquiring other companies," consultant Jacalyn Sherriton told Robert McGarvey in an interview for Entrepreneur. "Massive, multibillion-dollar corporations are becoming the norm, leaving an entrepreneur to wonder whether a merger ought to be in his or her plans, too," McGarvey continued.
When a small business owner chooses to merge with or sell out to another company, it is sometimes called "harvesting" the small business. In this situation, the transaction is intended to release the value locked up in the small business for the benefit of its owners and investors. The impetus for a small business owner to pursue a sale or merger may involve estate planning, a need to diversify his or her investments, 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 with or acquire other small businesses.
In principle, the decision to merge with or acquire another firm is a capital budgeting decision much like any other. But mergers differ from ordinary investment decisions in at least five ways. First, the value of a merger may depend on such things as strategic fits that are difficult to measure. Second, the accounting, tax, and legal aspects of a merger can be complex. Third, mergers often involve issues of
corporate control and are a means of replacing existing management. Fourth, mergers obviously affect the value of the firm, but they also affect the relative value of the stocks and bonds. Finally, mergers are often "unfriendly."
TYPES OF ACQUISITIONS
In general, acquisitions can be horizontal, vertical, or conglomerate. A horizontal acquisition takes place between two firms in the same line of business. For example, one tool and die company might purchase another. In contrast, a vertical merger entails expanding forward or backward in the chain of distribution, toward the source of raw materials or toward the ultimate consumer. For example, an auto parts manufacturer might purchase a retail auto parts store. A conglomerate is formed through the combination of unrelated businesses.
Another type of combination of two companies is a consolidation. In a consolidation, an entirely new firm is created, and the two previous entities cease to exist. Consolidated financial statements are prepared under the assumption that two or more corporate entities are in actuality only one. The consolidated statements are prepared by combining the account balances of the individual firms after certain 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 management or by tender offer. In a tender offer, the acquiring firm makes the offer to buy stock directly to the shareholders, thereby bypassing management. In contrast to a merger, a stock acquisition requires no stockholder voting. Shareholders wishing to keep their stock can simply do so. Also, a minority of shareholders may hold out in a tender offer.
A bidding firm can also buy another simply by purchasing all its assets. This involves a costly legal transfer of title and must be approved by the shareholders of the selling firm. A takeover is the transfer of control from one group to another. Normally, the acquiring firm (the bidder) makes an offer for the target firm. In a proxy contest, a group of dissident shareholders will seek to obtain enough votes to gain control of the board of directors.
TAXABLE VERSUS TAX-FREE TRANSACTIONS
Mergers and acquisitions can be either tax-free or taxable events. The tax status of a transaction may affect its value from both the buyer's and the seller's viewpoints. In a taxable acquisition, the assets of the selling firm are revalued or "written up." Therefore, the depreciation deduction will rise (assets are
not revalued in a tax-free acquisition). But the selling shareholders will have to pay capital gains taxes and thus will want more for their shares to compensate. This is known as the capital gains effect. The capital 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 one company to exchange their shares for the stock of the acquirer without paying taxes. There are three basic types of tax-free reorganizations. In order for a transaction to qualify as a type A tax-free reorganization, it must be structured in certain ways. In contrast to a type B reorganization, the type A transaction allows the buyer to use either voting or nonvoting stock. It also permits the buyer to use more cash in the total consideration since the law does not stipulate a maximum amount of cash that can be used. At least 50 percent of the consideration, however, must be stock in the acquiring corporation. In addition, in a type A reorganization, the acquiring corporation may choose not to purchase all the target's assets.
In instances where at least 50 percent of the bidder's stock is used as the considerationut other considerations such as cash, debt, or nonequity securities are also usedhe transaction may be partially taxable. Capital gains taxes must be paid on those shares that were exchanged for nonequity consideration.
A type B reorganization requires that the acquiring corporation use mainly its own voting common stock as the consideration for purchase of the target corporation's common stock. Cash must comprise no more than 20 percent of the total consideration, and at least 80 percent of the target's stock must be paid for by voting stock by the bidder.
Target stockholders who receive the stock of the acquiring corporation in exchange for their common stock are not immediately taxed on the consideration they receive. Taxes will have to be paid only if the stock is eventually sold. If cash is included in the transaction, this cash may be taxed to the extent that it represents a gain on the sale of stock.
In a type C reorganization, the acquiring corporation must purchase 80 percent of the fair market value of the target's assets. In this type of reorganization, a tax liability results when the acquiring corporation purchases the assets of the target using consideration other than stock in the acquiring corporation. The tax liability is measured by comparing the purchase price of the assets with the adjusted basis of these assets.
FINANCIAL ACCOUNTING FOR MERGERS AND ACQUISITIONS
The two principal accounting methods used in mergers and acquisitions are the pooling of interests method and the purchase method. The main difference between them is the value that the combined firm's balance sheet places on the assets of the acquired firm, as well as the depreciation allowances and 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 to replace it. The two firms' assets and liabilities are combined at their historical book values as of the acquisition date. The end result of a pooling of interests transaction is that the total assets of the combined firm are equal to the sum of the assets of the individual firms. No goodwill is generated, and there are no charges against earnings. A tax-free acquisition would normally be reported as a pooling of interests.
Under the purchase method, assets and liabilities are shown on the merged firm's books at their market (not book) values as of the acquisition date. This method is based on the idea that the resulting values should reflect the market values established during the bargaining process. The total liabilities of the combined firm equal the sum of the two firms' individual liabilities. The equity of the acquiring firm is increased by the amount of the purchase price.
Accounting for the excess of cost over the aggregate of the fair market values of the identifiable net assets acquired applies only in purchase accounting. The excess is called goodwill, an asset which is charged against income and amortized over a period that cannot exceed 40 years. Although the amortization "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 most assets is usually less than fair value because of inflation. For tax purposes, however, depreciation does not increase because the tax basis of the assets remains the same. Since depreciation under pooling accounting is based on the old book values of the assets, accounting income is usually higher under the pooling method. The accounting treatment has no cash flow consequences. Thus, value should be unaffected by accounting procedure. However, some firms may dislike the purchase method because of the goodwill created. The reason for this is that goodwill is amortized over a period of years.
HOW TO VALUE AN ACQUISITION CANDIDATE
Valuing an acquisition candidate is similar to valuing any investment. The analyst estimates the incremental cash flows, determines an appropriate risk-adjusted discount rate, and then computes the net present value (NPV). If firm A is acquiring firm B, for example, then the acquisition makes economic sense 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 cash flows for the two firms as separate companies. The gain from the merger is the present value of this difference in cash flows.
SOURCES OF GAINS FROM ACQUISITIONS The gains from an acquisition may result from one or more of the following five categories:1) revenue enhancement, 2) cost reductions, 3) lower taxes, 4) changing capital 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, economies of distribution, and a better mix of products. Strategic benefits represent opportunities to enter new lines of business. Finally, a merger may reduce competition, thereby increasing market power. Such mergers, 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 will fall as production volume increases. A vertical merger may allow a firm to decrease costs by more closely coordinating production and distribution. Finally, economies may be achieved when firms have complementary resourcesor example, when one firm has excess production capacity and another has insufficient capacity.
Tax gains in mergers may arise because of unused tax losses, unused debt capacity, surplus funds, and the write-up of depreciable assets. The tax losses of target corporations can be used to offset the acquiring corporation's future income. These tax losses can be used to offset income for a maximum of 15 years or until the tax loss is exhausted. Only tax losses for the previous three years can be used to offset future income.
Tax loss carry-forwards can motivate mergers and acquisitions. A company that has earned profits may find 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 must continue to operate the pre-acquisition business of the company in a net loss position. The tax benefits may be less than their "face value," not only because of the time value of money, but also because the tax loss carry-forwards might expire without being fully utilized.
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, if they 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, gaining additional depreciation benefits.
Interest payments on debt are a tax-deductible expense, whereas dividend payments from equity ownership 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 that borrows much less than it could may be an acquisition target because of its unused debt capacity. While the use of financial leverage produces tax benefits, debt also increases the likelihood of financial distress in 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 the money as a dividend or using it to repurchase shares will increase income taxes for shareholders. With an 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 target firm has redundant assets that may be divested.
The cost of debt can often be reduced when two firms merge. The combined firm will generally have reduced variability in its cash flows. Therefore, there may be circumstances under which one or the other of the firms would have defaulted on its debt, but the combined firm will not. This makes the debt safer, 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 create any value because stockholders can accomplish the same thing as the merger by buying stock in both firms.
VALUATION PROCEDURES The procedure for valuing an acquisition candidate depends on the source of the estimated gains. Different sources of synergy have different risks. Tax gains can be estimated fairly
accurately and should be discounted at the cost of debt. Cost reductions through operating efficiencies can also be determined with some confidence. Such savings should be discounted at a normal weighted average cost of capital. Gains from strategic benefits are difficult to estimate and are often highly uncertain. 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. The cost depends on whether cash or stock is used as payment. The cost of an acquisition when cash is used is just the amount paid. The cost of the merger when common stock is used as the consideration (the payment) is equal to the percentage of the new firm that is owned by the previous shareholders in the acquired firm multiplied by the value of the new firm. In a cash merger the benefits go entirely to the acquiring firm, whereas in a stock-for-stock exchange the benefits are shared by the acquiring and acquired firms.
Whether to use cash or stock depends on three considerations. First, if the acquiring firm's management believes that its stock is overvalued, then a stock acquisition may be cheaper. Second, a cash acquisition is usually taxable, which may result in a higher price. Third, the use of stock means that the acquired firm will share in any gains from merger; if the merger has a negative NPV, however, then the acquired firm will share in the loss.
In valuing acquisitions, the following factors should be kept in mind. First, market values must not be ignored. 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 rate used should reflect the risk associated with the incremental cash flows. Therefore, the acquiring firm should not use its own cost of capital to value the cash flows of another firm. Finally, acquisition may involve significant investment banking fees and costs.
HOSTILE ACQUISITIONS
The replacement of poor management is a potential source of gain from acquisition. Changing technological and competitive factors may lead to a need for corporate restructuring. If incumbent management 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 the board of directors of the target is opposed to the sale of the company. In this case, the acquiring firm has two options to proceed with the acquisition tender offer or a proxy fight. A tender offer represents
an offer to buy the stock of the target firm either directly from the firm's shareholders or through the secondary market. In a proxy fight, the acquirer solicits the shareholders of the target firm in an attempt to obtain the right to vote their shares. The acquiring firm hopes to secure enough proxies to gain control 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 the firm or to protect their own self-interests. This can be done a number of ways. Target companies can decrease 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, the suitor cannot obtain control of the board immediately even though it may have acquired a majority ownership of the target via a tender offer. Under a supermajority amendment, a higher percentage than 50 percentenerally two-thirds or 80 percents required to approve a merger.
Other defensive tactics include poison pills and dual class recapitalizations. With poison pills, existing shareholders 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 class recapitalizations distribute a new class of equity with superior voting rights. This enables the target firm's 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 may file suit against the bidder alleging violations of antitrust or securities laws. Alternatively, the target may engage in asset and liability restructuring to make it an unattractive target. With asset restructuring, the target purchases assets that the bidder does not want or that will create antitrust problems, or sells off the assets that the suitor desires to obtain. Liability restructuring maneuvers include issuing shares to a friendly third party to dilute the bidder's ownership position or leveraging up the firm through a leveraged recapitalization making it difficult for the suitor to finance the transaction.
Other postoffer tactics involve targeted share repurchases (often termed "greenmail")n which the target repurchases the shares of an unfriendly suitor at a premium over the current market pricend golden parachuteshich are lucrative supplemental compensation packages for the target firm's management. These packages are activated in the case of a takeover and the subsequent resignations of the senior executives. Finally, the target may employ an exclusionary self-tender. With this tactic, the target firm offers to buy back its own stock at a premium from everyone except the bidder.
A privately owned firm is not subject to unfriendly takeovers. A publicly traded firm "goes private" when a group, usually involving existing management, buys up all the publicly held stock. Such transactions are typically structured as leveraged buyouts (LBOs). LBOs are financed primarily with debt secured by the 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 the market prices prevailing a month prior to the merger announcement.
The gains to acquiring firms are difficult to measure. The best evidence suggests that shareholders in bidding firms gain little. Losses in value subsequent to merger announcements are not unusual. This seems to suggest that overvaluation by bidding firms is common. Managers may also have incentives to increase firm size at the potential expense of shareholder wealth. If so, merger activity may happen for noneconomic reasons, to the detriment of shareholders.
Acquisition Valuation Methods
Overview of Acquisition Valuation Methods
There are a number of acquisition valuation methods. While the most common is discounted cash flow, it is
best to evaluate a number of alternative methods, and compare their results to see if several approaches
arrive 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 minimal historical
results, and especially for those growing quickly – all of their cash is being used for growth, so cash flow is an
If the target company is publicly held, then the buyer can simply base its valuation on the current market
price 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 stock
is not a good valuation tool if the stock is thinly traded. In this case, a small number of trades can alter the
market price to a substantial extent, so that the buyer’s estimate is far off from the value it would normally
assign to the target. Most target companies do not issue publicly traded stock, so other methods must be
used to derive their valuation.
When a private company wants to be valued using a market price, it can adopt the unusual ploy of filing for
an initial public offering while also being courted by the buyer. By doing so, the buyer is forced to make an
offer that is near the market valuation at which the target expects its stock to be traded. If the buyer
declines to bid that high, then the target still has the option of going public and realizing value by selling
shares 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 are
usually more than willing to accept a buyout offer if the price is reasonably close to the target’s expected
market value.
Valuation Based on a Multiple
Another option is to use a revenue multiple or EBITDA multiple. It is quite easy to look up the market
capitalizations and financial information for thousands of publicly held companies. The buyer then converts
this information into a multiples table, which itemizes a selection of valuations within the consulting
industry. 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 unusually
high or low, then eliminate these outlying values in order to obtain a median value for the company’s size
range. Also, it is better to use a multi-day average of market prices, since these figures are subject to
significant 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 companies
in the same revenue range is 1.4 times revenue, then the buyer could value the target at $140 million. This
method is most useful for a turn-around situation or a fast growth company, where there are few profits (if
any). However, the revenue multiple method only pays attention to the first line of the income
statement and completely ignores profitability. To avoid the risk of paying too much based on a revenue
multiple, it is also possible to compile an EBITDA (i.e., earnings before interest, taxes, depreciation, and
amortization) multiple for the same group of comparable public companies, and use that information to
value the target.
Better yet, use both the revenue multiple and the EBITDA multiple in concert. If the revenue multiple reveals
a high valuation and the EBITDA multiple a low one, then it is entirely possible that the target is essentially
buying revenues with low-margin products or services, or extending credit to financially weak customers.
Conversely, if the revenue multiple yields a lower valuation than the EBITDA multiple, this is more indicative
of a late-stage company that is essentially a cash cow, or one where management is cutting costs 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-named
a trailing multiple (for historical 12-month revenue), and the forecast can be used as the basis for a forward
multiple (for projected 12-month revenue). The forward multiple gives a better estimate of value, because it
incorporates expectations about the future. The forward multiple should only be used if the forecast comes
from guidance that is issued by a public company. The company knows that its stock price will drop if 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 are usually
pouring resources into their growth, and have minimal profits to report. Such companies clearly have 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 financial
performers with the fewest underlying problems are the choicest acquisition targets, and therefore will be
acquired first. When other companies in the same area later put themselves up for sale, they will use the
earlier 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 know
some of the underlying characteristics of the companies that were previously sold, to see if the comparable
multiple should be applied to the current target company.
Valuation Based on Enterprise Value
Another possibility is to replace the market capitalization figure in the table with enterprise value. The
enterprise value is a company’s market capitalization, plus its total debt outstanding, minus any cash on
hand. In essence, it is a company’s theoretical takeover price, because the buyer would have to buy all of
the stock and pay off existing debt, while pocketing any remaining cash.
Valuation Based on Comparable Transactions
Another way to value an acquisition is to use a database of comparable transactions to determine what was
paid for other recent acquisitions. Investment bankers have access to this information through a variety of
private databases, while a great deal of information can be collected on-line through public filings or press
releases.
Valuation Based on Real Estate Values
The buyer can also derive a valuation based on a target’s underlying real estate values. This method only
works in those isolated cases where the target has a substantial real estate portfolio. For example, in the
retailing industry, where some chains own the property on which their stores are situated, the value of the
real estate is greater than the cash flow generated by the stores themselves. In cases where the business is
financially troubled, it is entirely possible that the purchase price is based entirely on the underlying real
estate, with the operations of the business itself being valued at essentially zero. The buyer then uses the
value of the real estate as the primary reason for completing the deal. In some situations, the prospective
buyer has no real estate experience, and so is more likely to heavily discount the potential value of any real
estate when making an offer. If the seller wishes to increase its price, it could consider selling the real estate
prior to the sale transaction. By doing so, it converts a potential real estate sale price (which might
otherwise be discounted by the buyer) into an achieved sale with cash in the bank, and may also record a
one-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 Costs
If a target has products that the buyer could develop in-house, then an alternative valuation method is to
compare the cost of in-house development to the cost of acquiring the completed product through the
target. This type of valuation is especially important if the market is expanding rapidly right now, and the
buyer 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 present
value of profits foregone by waiting to complete the in-house project. Interestingly, this is the only valuation
technique where most of the source material comes from the buyer’s financial statements, rather than those
of the seller.
Valuation Based on Liquidation Value
The most conservative valuation method of all is the liquidation value method. This is an analysis of what
the selling entity would be worth if all of its assets were to be sold off. This method assumes that the
ongoing value of the company as a business entity is eliminated, leaving the individual auction prices at
which its fixed assets, properties, and other assets can be sold off, less any outstanding liabilities. It is useful
for the buyer to at least estimate this number, so that it can determine its downside risk in case it completes
the acquisition, but the acquired business then fails utterly.
Valuation Based on Replacement Cost
The 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 analysis
addresses the replacement of the seller’s key infrastructure. This can yield surprising results if the seller
owns infrastructure that originally required lengthy regulatory approval. For example, if the seller owns a
chain of mountain huts that are located on government property, it is essentially impossible to replace them
at all, or only at vast expense. An additional factor in this analysis is the time required to replace the target.
If the time period for replacement is considerable, the buyer may be forced to pay a premium in order to
gain quick access to a key market.
While all of the above methods can be used for valuation, they usually supplement the primary method,
which is the discounted cash flow method.
Introduction
This unit presents a comprehensive approach to corporate valuation. It provides a unique combination of practical valuation techniques with the most current thinking to provide an up-to-date synthesis of valuation theory, as it applies to mergers, buyouts and restructuring. The unit will provide the understanding and the answers to the problems encountered in valuation practice, including detailed treatments of free cash flow valuation; financial and valuation of leveraged buyouts.
Objectives
After studying this unit, you should be able to:
Define the concept of Valuation of corporate merger and acquisition
Discuss the valuation in relation to merger and acquisition activity
Discuss the valuation of operation and financial synergy
Discuss the valuation of LBO
Meaning and Valuation Approaches
Once 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 acquisition
The second is the more concrete question how to value a target firm
Valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets or on liabilities. Valuations are required in many contexts including merger and acquisition 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 in order to determine the true financial worth of the company in question. Valuation is the device to assess the worth of the enterprise. Valuation of both companies is necessary for fixing the consideration amount to be paid in the form of exchange of shares. Such valuation helps in determining the value of shares of the acquired company as well as the acquiring company to safeguard the interest of the share holders of both the companies. Valuation is necessary for the decision making by shareholders to sell their interest in the company in the form of shares. To enable shareholders of both the companies, to take decision in favour of amalgamation, valuation of shares is needed. The valuation should give answer 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 sheet implications 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 points worth making here, before we move on to valuation. The first is that firms often choose a target firm and a motive for the acquisition simultaneously, rather than sequentially. That does not change any of the analysis in these sections. The other point is that firms often have more than one motive in an acquisitions, say, control and synergy. If this is the case, the search for a target firm should be guided by the dominant motive.
Basis of Valuation
Valuation 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.
Absolute value models determine the value by estimating the expected future earnings from owning the business discounted to their present value
An accurate valuation of companies largely depends on the reliability of the company’s financial information. Inaccurate financial information can lead to over and undervaluation. In an acquisition, due diligence 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 of the assets and stocks of the target company in which the acquirer contemplates to invest large amount of 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 actual consideration may be more than or less than the fair consideration. A merger is said to be at a premium when the offer price is higher than the target firm’s pre-merger market value. It may have to pay premium 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 financial characteristics of the acquiring firm. It is therefore, not possible to place a single value for the acquired firm. Instead, a range of values is determined, which would economically justifiable to the prospective acquirer. To determine an acceptable price for a firm, a number of factors, qualitative (managerial talent, 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 several quantitative variables. There are several basis of valuation as listed below:
Asset Value
The business is taken as going concern and realizable value of assets is considered which include both tangible and intangible assets. The value of goodwill is added to the value of the tangible assets which gives value of the company as a going concern. Goodwill represents the company’s excess earning power capitalized on the basis of certain number of year’s purchases.
Capitalized earnings
This is the predetermined rate of return expected by an investor. In other words, this is simple rate of return on capital employed. Under this method, the expected profit will be divided by the expected rate of return to calculate the value of the acquisition.
Market Value of listed stocks
Market value is the value quoted for the stocks of listed company at stock exchanges. The market price reflects investors anticipation of future earnings, dividend payout ratio, confidence in management of company, operational efficiency etc. The temporary factors causing volatility are eliminated by averaging the quotations over a period of time to arrive at a fair market value. The acquirer pays only market value in hostile takeover. The market value approach is one of the most widely used in determining value, especially of large listed firms. The market value provides a close approximation of the true value of a firm.
Earnings Per Share
The value of a prospective acquisition is considered to be a function of the impact of the merger on the earnings per share. The analysis could focus on whether the acquisition will have a positive impact on the EPS after the merger or if it will have the effect of diluting the EPS. The future EPS will affect the firm’s share prices, which is the function of price-earning (P/E) ratio and EPS.
Investment value
Investment value is the cost incurred (original investment plus the interest accrued thereon) to establish an enterprise. This determines the sale price of the target company which the acquirer may be asked to pay for the negotiated merger.
Book Value
Book value represents the total worth of the assets after depreciation but with revaluation. Book value is the audited written down money worth of the total net tangible assets owned by a company. The total net assets are composed of gross working capital plus fixed assets minus outside liabilities. The book value, as the basis of determining a firm’s value, suffers from a serious limitation as it is based on the
historical costs of the assets of the firm. Historical costs do not bear a relationship either to the value of the firm or to its ability to generate earnings. However, it is relevant to the determination of a firm’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 and study of these factors is particularly appropriate and necessary in mergers
Cost basis valuation
Cost of the assets less depreciation becomes the basis under this method. This method ignores intangible assets like goodwill. It does not give weight to changes in price level.
Reproduction Cost
Reproduction cost method is based on assessing the current cost of duplicating the properties or constructing similar enterprise in design and material. It does not take into account the intangible assets for valuation purpose.
Substitution cost
Substitution cost is the estimate of the cost of construction of the undertaking or enterprise in the same utility and capacity.
Out of the above nine methods of valuation, the important methods are: assets based valuation, earning based valuation and market price valuation. These methods are the frequently used in the corporate mergers and acquisition.
Valuation Methods
The financial consideration generally is the form of exchange of shares. This requires that relative value of each firm’s share and based on this value a particular exchange ratio is determined. The determination of the exchange ratio is therefore, based on the value of the shares of the company involved in the merger.
The valuation of an acquisition is not fundamentally different from the valuation of any firm, although the 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 in steps, starting with a relative and discounted cash flow valuation (status quo valuation of the firm), and following up with a value for control and a value for synergy.
Relative Valuation
If the motive for acquisitions is under valuation, the target firm must be under valued. How such a firm will 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 or sales) well below that of the rest of the industry, after controlling for significant differences on fundamentals. For instance, a bank with a price to book value ratio of 1.2 would be an undervalued bank, if other banks have similar fundamentals (return on equity, growth, and risk) but trade at much higher price to book value ratios.
In discounted cash flow valuation approaches, an under valued stock is one that trades at a price well below the estimated discounted cash flow value.
Discounted Cash Flow (DCF) Methods
It may be started with the valuation of the target firm by estimating the firm value with existing investing, financing and dividend policies. This valuation provides a base from which the control and synergy premiums can be estimated. The value of the firm is a function of its cash flows from existing assets, the expected growth in these cash flows during a high growth period, the length of the high growth period, and the firm’s cost of capital.
In a merger or acquisition, the acquiring firm is buying the business of the target company rather than a specific 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 cash flows) in the future. The merger will be advantageous to the acquiring company, if the present value of the target merger is greater than the cost of acquisition. In order to apply DCF techniques, the following information is required.
Estimation of cash flows
Timing of cash flows
Discount rate
The 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 cash flows adjusted for time value. The future cash flow set is made up of cash flows within the determined forecast period and a continuing value that represents a steady state cash flow stream after the forecast period, known as the Terminal Value. In conducting a valuation of a firm, cash flow is usually the main consideration. There is a five-step process for evaluating a company’s cash flow:
i)Analyze operating activities
ii)Analyze the investments necessary to buy new property or business
iii)Analyze the capital requirements of the firm
iv)Project the annual operating flows and terminal value of the firm
v)Calculate the Net Present Value of those cash flows to calculate the firm’s value
In nutshell, the following steps are involved in the financial evaluation of a merger:
Identify growth and profitability assumptions and scenarios
Project cash flows magnitudes and their timing
Estimate the cost of capital
Compute NPV for each scenario
Decide if the acquisition is attractive on the basis of NPV
Decide if the acquisition should be financed through cash or exchange of shares
Evaluate the impact of the merger on EPS and P/E Ratio
1. Estimating Free Cash Flows
The 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 Sales
Less: Cost of goods sold
Selling & Admn. Exp
Depreciation
Total Exp
PBT
Tax @ %
PAT
(+) Depreciation
Funds from operation
(-) Increase in NWC
Cash from operation
(-) Capital Expenditure
Free Cash Flow
+ Salvage Value
(at the end of the year)
P.V. Factor
Present Value
The 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; and
Delta CAPEX means changes in capital expenditure.
Here it should be noted that the discount rate should be average cost of capital.
2. Terminal Value
Terminal value is the value of cash flows after the horizon period. It is difficult to estimate the terminal value of the firm as the firm is normally acquired as going concern. The terminal value is the present
value of free cash flow after the forecast period. Its value can be determined under three different situations as below:
When terminal value is likely to be constant till infinity:
TV = FCFt-1 / Ko
When 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 average cost of capital.
Example
ABC Company Limited targeted to acquire XYZ Company Ltd. The Projected Post Merger Cash Flow Statements for the XYZ Company Ltd is given below:
(Rs. in millions)
Year 1
Year 2
Year 3
Year 4
Year 5
Net Sales
Rs. 105
Rs. 126
Rs. 151
Rs. 174
Rs. 191
Cost of goods sold
80
94
111
127
136
Selling and administration Expenses
10
12
13
15
16
Depreciation
8
8
9
9
10
EBIT
7
12
18
23
29
Interest*
3
4
5
6
7
EBT
4
8
13
17
22
Taxes (40%) $
1.6
3.2
5.2
6.8
8.8
Net Income
2.4
4.8
7.8
10.2
13.2
Add Depreciation
8
8
9
9
10
Free Cash Flows
10.4
12.8
16.8
19.2
23.2
Less retention needed for growth #
4
4
7
9
12
Add Terminal Value @
126.3
Net Cash Flows**
6.4
8.8
9.8
10.2
137.5
* Interest payments are estimated based on XYZ Co’s existing debt, plus additional debt required to finance growth
$ The taxes are the full corporate taxes attributable to XYZ’s operation
# Some of the cash flows generated by the XYZ after the merger must be retained to finance asset replacements and growth, while some will be transferred to ABC to pay dividends on its stock or for redeployment within the company. These retentions are net of any additional debt used to help finance growth.
@ 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 constant growth 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 million
The Rs. 126.3 million is the present value at the end of Year 5 of the stream of cash flows for Year 6 and thereafter. 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 cash flows could be used for dividend payments to ABC share holders, finance asset expansion in ABC’s other divisions and subsidiaries and so on.
The current value of XYZ to ABC’s shareholders is the present value of the cash flows expected from XYZ discounted at 15.4% :
(Rs. 10.2) / (1.154)4 + (Rs.137.5)/(1.154)5 = Rs. 91.5 million
Thus, 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 merger value plus any value created by operating or financial synergies. In this example, it is assumed that target company’s capital structure and tax rate constant. Therefore, the only synergies were operating synergies, and these effects were incorporated into the forecasted cash flows. If there had been financial synergies, the analysis would have to be modified to reflect this added value.
Market Multiple Analysis
The 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 a precise 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 a company. The specific ratio to be used depends on the objective of the valuation. The valuation could be designed to estimate the value of the operation of the business or the value of the equity of the business.
To explain the concept, note that XYZ company’s projected net income Rs. 2.4 million in Year 1 and it rises to Rs. 13.2 million in Year 5, for an average of Rs.7.7 million over five year projected period. The average P/E ratio for publicly traded companies similar to XYZ is 12. To estimate XYZ’s value using the market P/E multiple approach, simply multiply its Rs. 7.7 million average net income by market multiple of 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 here that we used the average net income over the coming five years to value XYZ. The market P/E multiple of 12 is based on the current year’s income of comparable companies, but XYZ’s current income does not 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.
EBITDA is another commonly used measure in the market multiple approach. When calculating the value of the operation, the most commonly used ratio is the EBITDA multiple, which is the ratio of EBITDA (Earnings before Interest Taxes Depreciation and Amortization) to the Enterprise Value (Equity Value plus Debt Value). This multiple is based on total value, since EBITDA measures the entire firm’s performance. Multiplying the Target Company’s EBITDA by the market multiple gives an estimate of the targets’ total value. To find the target’s estimated stock price per share, subtract debt from total and then divide by the number of equity shares.
Earnings Analysis
When valuing the equity of a company, the most widely used multiple is the Price Earnings Ratio (P/E Ratio) of stocks in a similar industry, which is the ratio of Stock price to Earnings per Share of any public company. Earning per share (EPS) is the earning attributable to share holders which are reflected in the market price of the shares. Using the sum of multiple P/E Ratio’s improves reliability but it can still be necessary 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/E ratio 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 such cases, merger will lead to dilution in EPS and adversely affect share prices. If the exit ratio of Target Company 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 if business is acquired by exchange of shares.
Example
ABC Company Ltd takes over XYZ Company Ltd. The merger is not expected to yield in economies of scale and operating synergy. The relevant data for two companies are as follows:
ABC Ltd
XYZ Ltd
No. of Shares
10,000
5,000
Total Earnings
1,00,000
50,000
EPS
10
10
P/E Ratio
2
1.5
ABC 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 ratio will be: 15/20 = 0.75. That is for every one share of XYZ Ltd., 0.75 share of ABC Ltd will be issued. In total 3750 (0.75×5000) shares of ABC Ltd will need to be issued in order to acquire XYZ Ltd. Hence, the total number of shares in combined company will be 13,750 (10000 + 3750).
ABC Ltd shareholders have gained in the combined company from the merger because as the P/E ratio of target company (XYZ) is less than that of the acquirer.
Valuing Operating and Financial Synergy
The third reason to explain the significant premiums paid in most acquisitions is synergy. Synergy is the potential additional value from combining two firms. It is probably the most widely used and misused rationale for mergers and acquisitions.
1. Sources of Operating Synergy
Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. It can be categorized operating synergies into four types:
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 in higher margins and operating income.
c)Combination of different functional strengths, as would be the case when a firm with strong marketing skills 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 would be the case, when a multinational consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products.
Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition.
2. Sources of Financial Synergy
Synergy can also be created from purely financial factors. With financial synergies, the payoff can take the 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 firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that were taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses.
Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit can either be shown 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 net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase 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 that synergy can be valued and, if so, how to value it.
3. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many takeovers. Synergy can be valued 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 economies of scale)?
Will it increase future growth (e.g., when there is increased market power) or the length of the growth period?
Synergy, to have an effect on value, has to influence one of the four inputs into the valuation process:
a longer growth period (from increased competitive advantages)
a lower cost of capital (higher debt capacity)
When will the synergy start affecting cash flows?
Synergies can show up instantaneously, but they are more likely to show up over the time. Since the value 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 discounted cash flow techniques.
First, we value the firms involved in the merger independently, by discounting expected cash flows to each 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 for each firm in the first step.
Third, we build in the effects of synergy into expected growth rates and cash flows, and we value the combined firm with synergy.
The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.
Value Creation through Synergy
Synergy is a stated motive in many mergers and acquisitions. If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and 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 independently
V(Q) = Value of firm Q, operating independently
Merger will create an economic advantage (EA) through synergy when the combined present value of the merger firms is greater than the sum of their individual present values as separate entities. If firm P and firm Q merge, and they are separately worth VP and VQ respectively, and worth VPQ in combination then 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 - VQ
The net economic advantage of merger (NEA) is positive if the economic advantage exceeds the cost of merging. Thus,
Net Economic Advantage = Economic Advantage – Cost of Merging
represent the benefit results from operating efficiency and synergy when two firms merge. If the acquiring firm pays cash equal to the value of the acquired firm, then the entire advantage of merger will accrue to the shareholders of acquired firm. In practice, the acquiring and the acquired firm may share the economic advantage between themselves.
Valuing Corporate Control
If the motive for the merger is control, the target firm will be a poorly managed firm in an industry where 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 the presumption that incumbent management will continue to run the firm. Many hostile takeovers are justified on the basis of the existence of a market for corporate control. Investors and firms are willing to pay large premiums over the market price to control the management of firms, especially those that they perceive to be poorly run.
The value of wresting control of a firm from incumbent management is inversely proportional to the perceived quality of that management and its capacity to maximize firm value. In general, the value of control will be much greater for a poorly managed firm that operates at below optimum capacity than for a well managed firm. The value of controlling a firm comes from changes made to existing management policy that can increase the firm value. Assets can be acquired or liquidated, the financing mix can be changed and the dividend policy re-evaluated, and the firm can be restructured to maximize value. If we can identify the changes that we would make to the target firm, we can value control. The value of control can then be written as:
Value of Control = Value of firm,
Optimally managed - Value of firm with current management
The value of control is negligible for firms that are operating at or close to their optimal value, since a restructuring will yield little additional value. It can be substantial for firms operating at well below optimal, since a restructuring can lead to a significant increase in value.
Valuing Leveraged Buyouts
Leveraged buyouts are financed disproportionately with debt. This high leverage is justified in several ways as pointed below:
First, if the target firm initially has too little debt relative to its optimal debt ratio, the increase in debt can be explained partially by the increase in value moving to the optimal ratio provides. The debt level in most leveraged buyouts exceeds the optimal debt ratio, however, which means that some of the debt will 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 to invest free cash flows wisely for their stockholders; they need the discipline of debt payments to maximize cash flows on projects and firm value.
A third rationale is that the high debt ratio is temporary and will disappear once the firm liquidates assets 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 the fixed payments to debt holders in the firm. Thus, the cost of equity has to be adjusted to reflect the higher 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 in each period. In valuing a leveraged buyout, then, we begin with the estimates of free cash flow to the firm, just as we did in traditional valuation. The DCF approach is used to value an LBO. However, instead of discounting these cash flows back at a fixed cost of capital, we discount them back at a cost of capital that will vary from year to year. Once we value the firm, we then can compare the value to the total amount paid for the firm. As LBO transactions are heavily financed by debt, the risk of lender is very high. Therefore, in most deals they require a stake in the ownership of the acquired firm.
Summary
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 parameters
The Five Principles of Corporate Finance
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 diversificationo the Capital Asset Pricing
Modelo the required return on
equity investments Making real investment decisions Case study: Costa Rica Forest
Resources Basing investments on cash flows:
finding a company's free cash flows
Exercise: Free Cash Flows at Actavis
Financing Techniques, the Cost of Capital, and Capital Structure
Sources of corporate finance The capital structure decision:
debt versus equity Cost of capital
o cost of debto cost of equity
o weighted-average cost of capital
Case study: Life Time Fitness: Find this company's 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 client's beta and cost of funds be affected by a higher level of debt?
Ratings and debt pricing Using debt and derivatives to
manage financial risks
Developing 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 doesn't?
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 acquisitionso Asset-based and balance-sheet approacheso Market value approacheso Multiples and comparables
o Enterprise value and EBITDA Dividend- and cashflow-discount models
o Establishing required rates of returno 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 analysiso Financial restructuring analysiso Break-up valuation
Case study: MTC-Celtel. Teams value the synergies resulting from a potential acquisition, adjusting for risk and cost-of-capital effects and employing sensitivity analysis on the hoped-for synergy gains.
Sensitivity analysis Case study: Active Generation. Participants value a private company for acquisition, using both
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 exercise including
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 this cross-border
merger and develop a due diligence checklist.
Tailoring due diligence to the company and industry
Day 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
Refinancing strategies Case study: Madras Appliances. Teams evaluate a variety of creative financing techniques in the context
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 company's security
services division. How much of the purchase cost could be financed with debt? Paydown and exit analysis
Post-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 pitfalls and alternative
approaches to post-merger integration success. They prepare an action plan for the effective integration of two companies.
Group Exercise
Case Study: Flexics. Participants employ the tools and ideas of the course to a competitive situation featuring a leveraged acquisition proposal. They negotiate key features, including:
Valuation of the target Raising the funding Summary "term sheet" agreement Post-merger integration plan
