

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 riskyness
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 aftertax 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 allknowing 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 allequity 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 nogrowth and constant
growth models in mergers &
acquisitions
Po =
do/ke nogrowth 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
VU
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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