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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 34
ACQUISITIONS
In this hand out we will take up following topics:
Acquisition Consideration
Valuation of shares
Acquisition Consideration
The predator and target will need to agree on following bais issues surrounding the consideration:
a) Whether shares or assets to be purchased.
b) type of consideration
c) valuation issues
a) Asset or Share Purchase
there's a difference between acquisition through assets purchase and share purchase methods.
Under asset purchase method, the purchasor only buys asset of the target company at negotiated prices
without assuming any liability.
An assets purchase will enable the predator compnay to claim some tax related allowances on assets
acquired. The target will have some adverse tax issues relating to the disposal of assets, which is normally
higher than the book value.
A share purchase is more complex because of the fact that predator has to own the laibilities as well. The
administration and documentation is much more complicated and lenghty coupled with the consultancy
costs.
There is a technique called hivedown which can reduce the risks and disadvantages of share purchase
method. This is applied when only part of the business is being taken over by the purchaser. The part is
transferred to a new entity of the vendor without raising any tax adverse consequences.
Type of consideration:
The financial consideration to be paid to target company in mergers can be classified in to following
categories:
Cash
Share ­ ordinary or preferences
Debt
The value of ordinary shares is generally the market value at the time of merger. However, normally the
negotiated value per share is higher than the market value. The following points should be kept in mind in
case shares are the consideration of merger transaction:
Depression of shares: the purchasor may feel that current prices will rise in future because the share
market is bearish or the value of acquiring company's shares are temporarily depressed. Thus, vendor may
be getting the shares cheap.
Dilution of shareholding: Issuing new shares to be paid to target cmpany will result in dilution of
shareholdings of existing shareholders and they may feel it unpleasant.
Unquoted share: there is problem in valuation of private company's share because there's no mechanism for
this. The price or value is determined through series of tense negotiations.
Debt / Equity ratio: issuing new shares will throw off debt equity ratio and any large variance is difficult
to bridge and may take years to restore.
Valuation of shares:
when the consideration of merger transaction has been decided to be settled in shares, then comes the stage
to determine the value of share. There are some reason why we need to value the shares.
-  to set up the terms of takeovers
-  to value the company for stock exchange listing
-  for tax purposes
-  to value shares ­ for establishing value of share of retirng directors
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Corporate Finance ­FIN 622
VU
The different values are returned by different methods of valuation and sometimes these are wide apart. In
this scenario, the final value will be a matter of negotiations between the both parties.
Quoted shares:
We have already coverd that shares should be traded to the point where the present value of future dividend
stream is equal to the current share price. This is what meant by the value of share. Given the fact that
markets are not perfect as to the availbility of information to investors, the prices quoted on stock
exchanges are normally a easure of the value at which the last bargain was made.
More importantly it is the measure of the price at which stock market investors are prepared to deal in
relatively small quantity of shares.
In an efficient market share prices should reflect alll publicly available information and if available are
normally considered to be the best guide for valuation. In practice in an acquisition it is unlikely that the
bidding company would succeed by offering less than current market price, there is normally significant
premium over market prices.
Unquoted Shares:
The valuation of unquoted shares is a matter to be handled by the accountants. The method of share
valuation of shares in private compan involves comparison of its activities with those of similar quoted
company.
However, we may employ following valuation methods for unquoted shares. We divide them into two
broad categories:
Income based approach:
-  Present value method
-  Dividend valuation
-  P/E ratio
Asset based approach:
-  book value
-  replacement cost
-  break up value
Income Based Approach ­ Present value method:
This approach has its foundation in the present value rule, where the value of any asset is the present value
of expected future cash flows that the asset generates.
Value =CFt/ (1+r) t
where
n = Life of the asset
CFt = Cash flow in period t
r = Discount rate reflecting the risky-ness of the estimated cash flows
The cash flows will vary from asset to asset -- dividends for stocks, coupons (interest) and the face value for
bonds and after-tax cash flows for a real project. The discount rate will be a function of the riskiness of the
estimated cash flows, with higher rates for riskier assets and lower rates for safer projects. You can in fact
think of discounted cash flow valuation on a continuum. At one end of the spectrum, you have the default-
free zero coupon bond, with a guaranteed cash flow in the future. Discounting this cash flow at the risk less
rate should yield the value of the bond. A little further up the spectrum are corporate bonds where the cash
flows take the form of coupons and there is default risk.
These bonds can be valued by discounting the expected cash flows at an interest rate that reflects the
default risk. Moving up the risk ladder, we get to equities, where there are expected cash flows with
substantial uncertainty around the expectation. The value here should be the present value of the expected
cash flows at a discount rate that reflects the uncertainty.
The Underpinnings of Discounted Cash flow Valuation
In discounted cash flow valuation, we try to estimate the intrinsic value of an asset based upon its
fundamentals. What is intrinsic value? For lack of a better definition, consider it the value that would be
attached to the firm by an all-knowing analyst, who not only knows the expected cash flows for the firm but
also attaches the right discount rate(s) to these cash flows and values them with absolute precision.
Hopeless though the task of estimating intrinsic value may seem to be, especially when valuing young
companies with substantial uncertainty about the future, we believe that these estimates can be different
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Corporate Finance ­FIN 622
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from the market prices attached to these companies. In other words, markets make mistakes. Does that
mean we believe that markets are inefficient? Not quite. While we assume that prices can deviate from
intrinsic value, estimated based upon fundamentals, we also assume that the two will converge sooner rather
than latter.
The value of equity is obtained by discounting expected cash flows to equity, i.e., the residual cash flows
after meeting all expenses, reinvestment needs, tax obligations and net debt payments (interest, principal
payments and new debt issuance), at the cost of equity, i.e., the rate of return required by equity investors in
the firm.
Value of Equity = CF to Equity (t)/ (1+k e)t
Where
CF to Equity (t) = Expected Cash flow to Equity in period t
Key = Cost of Equity
The dividend discount model is a specialized case of equity valuation, where the value of the equity is the
present value of expected future dividends.
The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows
after meeting all operating expenses, reinvestment needs and taxes, but prior to any payments to either debt
or equity holders, at the weighted average cost of capital, which is the cost of the different components of
financing used by the firm, weighted by their market value proportions.
Value of Firm =CF to Firm (t) / (1+WACC)  t
Where
CF to Firm (t) = Expected Cash flow to Firm in period t
WACC = Weighted Average Cost of Capital
The value of the firm can also be obtained by valuing each claim on the firm separately. In this approach,
which is called adjusted present value (APV), we begin by valuing equity in the firm, assuming that it was
financed only with equity. We then consider the value added (or taken away) by debt by considering the
present value of the tax benefits that flow from debt and the expected bankruptcy costs.
Value of firm = Value of all-equity financed firm + PV of tax benefits + Expected Bankruptcy Costs
In fact, this approach can be generalized to allow different cash flows to the firm to be discounted at
different rates, given their riskiness.
In short, the present value approach may take a form of:
Let us assume that X plc was considering the acquisition of Y plc:
Then the value of Y plc would be computed as:
Present value of future earnings of X and Y combined at
Discount rate reflecting the systematic risk of both
Less:
PV of future earnings of predator firm y using discount rate appropriate for systematic risk of firm
X is equal to = maximum value of firm Y
Income Based Approach - Dividend Valuations:
Please refer to your earlier handouts for dividend valuations as we have already covered. Just to recall to
your mind, here is the summary of dividend valuations.
We can use no-growth and constant growth models in mergers & acquisitions
Po = do/ke no-growth model
Po = d1/ke ­ g
constant growth model
We need to determine ke = shareholders' required return and future dividends.
Shareholders' required rate of return can be estimated with the help of CAPM.
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Corporate Finance ­FIN 622
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Cost of equity of other firms in industry can be used and adjusted by considering beta.
When comparing with other firms we must ensure that the company is of equal size and is in same
business line.
Future dividend stream can be estimated from the past dividends utilizing statistical techniques.
Income based approach ­ P/E method:
P/E ratio can be defined as = Price per share / EPS (latest)
As with the dividend yield this formula is then modified to work out value of unquoted shares. That is:
Value per share = EPS X appropriate P/E ratio
The basic choice for P/E rationshould be a quoted firm comparable to company being acquired in terms of
size and falling in the same industry.
Some problems are associated with using P/E ratios and those should be considered:
High P/E ratio may be due to:
- The company may be experiencing consistent growth over the recent past years.
- Based on some future expectations
- Share price may have gone up in wake of takeover bid.
- High security shares
Low P/E ratio may be due to:
Low profit & losses mix in recent past
Expected future losses
Low security
Difficulties in using this method:
A firm may not have exact similar size company and growth prospects.
P/E ratio is based on past data, where as future earnings are center point of target company in m & a.
Anyways this cannot be ignored because of its importance.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk