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Merger & Acquisition Valuation Techniques
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Harsh
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F - 3
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R. No. 19
TABLE OF COTENTS INTRODUCTION INCOME APPROACH DISCOUNTED CASH FLOW TECHNIQUE FREE CASH FLOW FROM EQUITY TECHNIQUE MARKET APPROACH ASSET APPROACH NET ASSET VALUE TECHNIQUE ECONOMIC VALUE ADDED TECHNIQUE MARKET VALUE ADDED TECHNIQUE CONCLUSION
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A merg rge er is sai aid d to occ ccu ur wh whe en two or mor ore e bus usin ine ess combine into one. This can happen through absorption of an existing company by another. In a consolidation, which is a form fo rm of me merg rger er,, a ne new w co comp mpan any y is fo form rmed ed to ta take keov over er exis ex isti ting ng bus usin ines ess s of tw two o or mo more re co comp mpan anie ies. s. In In Indi dia, a, mergers are called amalgamations in legal parlance. The The ac acqu quis isit itio ion n refe refers rs to the the ac acqu quis isit itio ion n of co cont ntro roll llin ing g inte intere rest st in an exis existi ting ng co comp mpan any. y. A ta take keov over er is sa same me as acquisition, except that a takeover has a flavor of hostility in majority of cases. For this reason, the company taken over is usua usuall lly y ca call lled ed the the ta targ rget et co comp mpan any y and and the the ac acqu quir irer er is called the predator. The merge rgers are differ ferent from acquisitions in the sense that acquisitions generally do not involve liquidation of the target company. Why Mergers and Acquisitions take place? The common objective of both the parties in a M&A transaction is to seek synergy in operating economies by combining their resources and efforts. Now we shall see the reasons for M&A from the perspective of both, the buyer company as well as the seller company.
Objectives in a M&A transaction? Objectives An opportunity for achieving faster growth
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Obtaining tax concessions Eliminating competition Achieving diversification with minimum cost Improving corporate image and business value Gaining access to management or technical talent
Objective for Companies to offer themselves for sale? Declining earnings and profitability To raise funds for more promising lines of business Desire to maximize growth Give itself the benefit of image of larger company Lack of adequate management or technical skills M&A under the Companies Act, 1956 The procedure for putting through a M&A transaction under the Companies Act, 1956 is very tedious and a lot of time is consumed in completion of the process. Sections 391 to 396 deal deal with with the the proc proced edur ure, e, powe powers rs of the the co cour urtt and and alli allied ed matters. “The “The basic difference between a merger and an acquisition is that the transferor company will be dissolved in case of a merg me rger er,, wh wher erea eas s in ca case se of ac acqu quis isit itio ion n th the e tr tran ansf sfer eror or company continues to exist.” M&A under the Income Tax Act, 1961 Tax implications can be understood from the following three perspectives: a) Tax concessions to the Amalgamated (Buyer) Company b) Tax concessions to the Amalgamating (Seller) Company c) Tax concessions to the shareholders of an Amalgamating Company
Valuation of Target Company
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The The prin princi cipa pall ince incent ntiv ive e fo forr a merg merger er is that that the the busi busine ness ss value of the combined business is expected to be greater than than the the sum sum of the the inde indepe pend nden entt busi busine ness ss valu values es of the the merg mergin ing g enti entiti ties es.. The The diffe differe renc nce e betw betwee een n the the co comb mbin ined ed value and the sum of the values of individual companies is the synergy gain attributable to the M&A transaction. Hence, Value of acquirer + Stand alone value of Target + Value of Synergy = Combined Value. There is also a cost attached to an acquisition. The cost of acquisiti acquisition on is the price premium paid over the market market value plus other costs of integration. Therefore, the net gain is the value of synergy minus premium paid. Suppose VA = Rs. 200 (Merging Company, or Acquirer) VB = Rs. 50 (Merging Company, or Target) VAB = Rs. 300 (Merged or Amalgamated Entity) Therefore, Synergy = VAB – ( VA + VB ) = Rs. 50. If the premium paid for this merger is Rs. 20, Net gain from merger of A and B will be Rs. 30 (i.e. Rs. 50 – Rs. 20). It is this 30, because of which companies merge or acquire. One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range of models in practice for measuring the value of the Target firm. These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such such a clas classi sifi fica cati tion on:: it is ea easi sier er to unde unders rsta tand nd wher where e indi indivi vidu dual al mode models ls fit fit into into the the bigg bigger er pict pictur ure, e, why why they they provide different results and where they have fundamental errors in logic. There are only three approaches to value a business or business interest. However, there are numerous techniques within each one of the approaches that the analysts may 5
consid cons ider er in perf perfor ormi ming ng a valu valuat atio ion. n. The The Appr Approa oach ches es and and Techniques are as follows: -
Income Approach The In Inco come me Ap Appr proac oach h is one of three major groups of methodologies, methodol ogies, called valuation approaches , used by appraisers. It is parti pa rticul cular arly ly com commo mon n in com comme merci rcial al re real al est estate ate app appra raisa isall and in business appraisal. The fundamental math is similar to the methods used us ed for fin financ ancial ial val valua uatio tion, n, sec secur uriti ities es ana analys lysis, is, or bon bond d pri pricin cing. g. Howev Ho wever, er, the there re are som some e sig signif nifica icant nt and imp import ortan antt mo modif difica icatio tions ns when used in real estate or business valuation.
Under this approach two primary used methods to value a business interest include: a) Discounted Cash flow method b) Capitalized Cash flow method Each of these methods depends on the present value of an enterprise’s future cash flows.
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Discounted Cash flow Technique The Discounted Cash flow valuation is based upon the notion that hat the valu value e of an as ass set is the prese resen nt valu value e of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. The nature of the cash ca sh flow flows s will will depe depend nd upon upon the the as asse set, t, divi divide dend nds s fo forr an equity share, coupons and redemption value for bonds and the post tax cash flows for a project. The Steps involved in valuation under this method are as under: Step Step I: Estim Estimate ate free free cash cash flows flows avai availa labl ble e to all all the the supp suppli lier ers s of the the ca capi pita tall viz. viz. equi equity ty ho hold lder ers, s, pref prefer eren ence ce investors and the providers of debt. Free Cash Flow = EBIT (1- T) + Depreciation – CAPEX ΔNWC, where: • EBIT is earnings before interest and taxes. • T is the marginal cash (not average) tax rate, which should be inclusive of federal, State and local, and foreign jurisdictional taxes. • Depreciation is noncash operating charges including depreciation, depletion, and Amortization recognized for tax purposes. • CAPEX is capital expenditures for fixed assets. • ΔNWC is the change in net working capital. Step II: Estim timate ate a suit suitab ablle Dis Discou count Rate ate for acqu ac quis isit itio ion, n, whic which h is no norm rmal ally ly repr repres esen ente ted d by weig weight hted ed aver averag age e of the the co cost sts s of all all so sour urce ces s of ca capi pita tal, l, whic which h are are based on the market value of each of the components of the capital. 7
WACC = Wd*kd*(1-T) + We*ke , where: • k d is the interest rate on new debt. • ke is the cost of equity capital (see below). • Wd, We are target percentages of debt and equity (using market values of debt and equity.) T is the marginal tax rate. Step III: III: Cash flows computed in Step I are discounted at the rate arrived at in Step II. Step IV: IV: Estimate the Terminal Value of the business, which is the prese resen nt valu value e of ca cash sh flo flows oc occu curr rrin ing g afte afterr the forecast period. TV = CFt (1+ g) , k-g where, CF t t is the cash flow in last year, g is constant growth rate and k is k is the discount rate Step V: V: Add the present value of free cash flows as arrived at in Step III and the Terminal Value as arrived at in Step IV. This will give the value of firm. Step VI: VI: Subtract the value of debt and other obligations assumed by the acquirer to arrive at the value of equity. So, in all Terminal Value is,
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FCFE Technique (Free Cash Flow From Equity) The Capitalized Cash flow technique of income approach is the abbreviated version of Discounted Cash flow technique where the growth rate (g) and the discount rate (k) are assume ass umed d to remain remain consta constant nt in perpe perpetui tuity. ty. This This model model is represented as under: Value of Firm = Net Cash flow in year one (k–g)
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Market Approach The origin of market approach of business valuation is esta es tabl blis ishe hed d in the the ec econ onom omic ic rati ration onal ale e of co comp mpet etit itio ion. n. It states that in case of a free market, the demand and supply effects direct the value of business properties to a particular balan alance ce.. The The purc urchase hasers rs are are not read ready y to pay hig higher her amounts for the business and the vendors are not ready to receive any amount, which is lower in comparison to the value of a corresponding commercial entity. It the value of a firm by performing a comparison between the firm firms s co conc nce erne rned wit with or org ganiz anizat atio ions ns in the the simil imila ar location, of equal volume or operating in the similar sector. It has a large number of resemblances with the comparable sales technique, which is generally utilized in case of real estate estimation. The market value of shares of companies that hat are are trad raded publicl licly y and and are are invo involv lved ed in ide identic ntical al commercial activities may be a logical signal of the value of commercial operation. In this case the company shares are bought and sold in an open and free market. This process allows purposeful comparison of the market value of shares. The problem exists in distinguishing public companies, which are adequately corresponding to the company concerned for this intention. In addition, in case of a private company, the liquidity of the equity is lower (put differently, its shares are difficult to trade) in comparison to a public company. The value is regarded as somewhat lesser in comparison to that a market-based valuation will render. E.g. E.g. - Suppose a company operating in the same industry as ABC with comparable size and other situations has been sold at Rs. 500 crores in last week provides a good measurement for valuat valuation ion of busine business. ss. Consid Consideri ering ng the circum circumsta stance nces, s,
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valu value e of the the busi busine ness ss of AB ABC C shou should ld be arou around nd Rs. Rs. 500 500 crores under market approach.
Assets Approach The first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuation date. Each Each reco record rded ed as asse sett incl includ udin ing g inta intang ngib ible le as asse sets ts must must be identified, examined and adjusted to fair market value. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived as above to reach at the fair market value of equity of the business. It is important to note no te here here that that any unrec unrecord orded ed ass assets ets or liabil liabiliti ities es should should also be considered while arriving at the value of business by the assets approach.
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Net Asset Value Approach Net asset value (NAV) is a term used to describe the value of an entity's assets less th the e va valu lue e of it its s liabilities liabilities.. The te terrm is most commonly used in relation to open-ended or mutual funds due to the fact that shares of such funds are redeemed at their net asset value. The Th e NA NAV V wi will ll usu sual ally ly be be belo low w th the e ma mark rket et pr pric ice e fo forr th the e following reasons: The NAV describes the company's current asset and liability position. Investors might believe that the company has significant growth prospects, in which case they would be prepared to pay more for the company than its NAV.
The current value of a company's assets may be higher than the historical financial statements used in the NAV calculation. Cert rta ain assets, such as goodwill (w (whi hich ch br broa oadl dly y represents a company's ability to make future profits), are not necessarily included on a balance sheet and so will not appear in an NAV calculation.
For valuation purposes it is common to divide net assets by the number of shares in issue to give the net assets per share. This is the value of the assets that belong to each share, in much the same way that PE Ratio measures profit per share. E.g. - One way to calculate NAV is to divide the net worth of the company company by the total total numb number er of ou outst tstand anding ing shares shares.. Say, a company’s share capital is Rs. 100 crores (10 crores shar shares es of Rs. Rs. 10 ea each ch)) and and its its rese reserv rves es and and surp surplu lus s is another Rs. 100 crores. Net worth of the company would be Rs. 200 crores (equity and reserves) and NAV would be Rs. 12
20 per share (Rs. outstanding shares).
200
crores
divided
by
10
crores
NAV can also be calculated by adding all the assets, and then subtracting all the outside liabilities from them. This will again boil down to net worth only. One can use any of the two methods to find out NAV. One can compare the NAV with the going market price while taking investment decisions.
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Economic Value Added (EVA) Approach Economic Econo mic Value Add Added ed or EV EVA A is an est estima imate te of eco econom nomic ic prof pr ofit it,, wh whic ich h ca can n be de dete term rmin ined ed,, am amon ong g ot othe herr wa ways ys,, by mak akin ing g co corr rre ect ctiv ive e ad adju just stm ment nts s to GAAP accounting, including deducting the oppo opportuni rtunity ty cost of equity capital. The concept of EVA is in a sense nothing more than the trad tr adit itio iona nal, l, co comm mmon onse sens nse e id idea ea of "p "pro rofi fit, t,"" ho howe weve ver, r, th the e utility of having a separate and more precisely defined term such as EVA or Residual Cash Flow is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while in fact being in the final approach to becoming insolvent. EVA can ca n be me meas asur ured ed as Ne Nett Op Oper erat atin ing g Pr Prof ofit it Af Afte terr Ta Taxe xes( s(or or NOPAT)) less the money cost of capital. EVA is similar to NOPAT Residual Income (RI), although under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Another, much older term for economic value added is Residual Cash Flow. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital). The Th e am amor orti tiza zati tion on of go good odwi will ll or ca capi pita tali liza zati tion on of br bran and d advertising and other similar adjustments are the translations that can be made to Economic Profit to make it EVA.
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MARKET VALUE ADDED APPROACH (MVA) Market Value Added (MVA) is the difference between the current market value of a firm and the capital contributed by investors.. If MVA is positive, the firm has added value. If it investors is negative, the firm has destroyed value. The amount of value added needs to be greater than the firm's investors could have achieved investing in the market portfolio, adjusted for the leverage (beta (beta coefficient) coefficient) of the firm relative to the market. The formula for MVA is: MVA = V - K Where: MVA is market value added V is the market value of the firm, including the value of the firm's equity and debt K is the capital invested in the firm
The higher the MVA the better it is. A high MVA indicates the company has created substantial wealth for the shareholders. A negative MVA means that the value of management's management's actions and investments are less than the value of the capital contributed to the company by the
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capital market (or that wealth and value have been destroyed). MVA is the present value of a series of EVA values. MVA is economically equivalent to the traditional NPV measure of wort wo rth h fo forr ev eval alua uati ting ng an af afte terr-ta tax x ca cash sh fl flow ow pr prof ofil ile e of a project if the cost of capital is used for discounting. None of the above methods is the best or none of them is the worst but each one has its own advantages and viewpoints different from others. All these methods should be used in combinations to arrive at proper valuation of the business.
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CONCLUSION These These aspect aspects, s, which which we talked talked about about in this this articl article, e, will will jus justi tify fy the the exch exchan ange ge proc proces ess s in a Me Merg rger er & Ac Acq quisi uisiti tion on transaction if they are duly considered and their impact is properly arrived at. Hence their review becomes a prime and critical stage before proceeding with the big deal. These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, techniques, which allows meaningful comparison between businesses that are similarly situated. I would also say that no method is Perfect. Every situation demands different approaches to be applied, and quite often more than one approach would be used.
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