Acquisition Consideration, Valuation of shares

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Corporate Finance FIN 622

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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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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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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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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