Chapter 8 Valuation of Acquisitions and Mergers

LEARNING OBJECTIVES

1. Discuss the problem of overvaluation.

2. Estimate the potential near-term and continuing growth levels of a corporation’s
earnings using both internal and external measures.
3. Assess the impact of an acquisition or merger upon the risk profile of the acquirer
distinguishing:
(a) Type I acquisitions that do not disturb the acquirer’s exposure to financial or
business risk.
(b) Type II acquisitions that impact upon the acquirer’s exposure to financial risk.
(c) Type III acquisitions that impact upon the acquirer’s exposure to both financial
and business risk.
4. Advise on the valuation of a type I acquisition of both quoted and unquoted entities
using:
(a) Book value-plus models
(b) Market based models
(c) Cash flow models, including EVA, MVA
5. Advise on the valuation of type II acquisitions using the APV value model.
6. Advise on the valuation of type III acquisitions using iterative revaluation procedures.
7. Demonstrate an understanding of the procedure for valuing high growth start-ups.
1. The Overvaluation Problem

1.1 Market efficiency

1.1.1 Empirical evidence suggests that stock markets are semi-strong efficient, i.e. equity
prices reflect all publicly available information. However, this does not necessarily
mean that the shares will be fairly valued.
1.1.2 If the market does not fully understand the information available – as was the
case in the late 1990s and early 2000s with some high-tech, telecommunications, and
internet ventures – it tends to overestimate the potential returns and so overvalue
the equity.
1.1.3 The price of overvalued equity may not be corrected by the market if:
(a) the data provided by managers is deliberately misleading;
(b) there is collusion by gatekeepers including investment and commercial banks,
and audit and law firms.

1.2 Management responses to overvaluation

1.2.1 Managers may be reluctant to correct the markets’ mistaken perceptions. This can lead
to :
(a) the use of creative accounting to produce the results the city is expecting.
(b) poor business decisions aimed at giving the impression of success.
(c) poor acquisitions made using inflated equity to finance the purchase.

1.3 The impact of overvaluation on reported earnings

1.3.1 Since managers may manipulate reported earnings to produce more favorable results,
the financial data they supply should be treated with caution. When valuing a
company the financial statements should first be analyzed and adjusted as necessary.
2. Estimation of the Growth Levels of a Firm’s Earnings

2.1 The growth rate of a company’s earnings is the most important factor in the value of
the company.
2.2 There are three ways to estimate the growth rate of earnings of a company.
(a) By extrapolating past values
(b) By relying on analysts’ forecasts – Analysts regularly produced forecasts on
the growth of a company and these estimates can be the base for forming a
view of the possible growth prospects for the company.
(c) Looking at the fundamentals of the company – it can be estimated by earnings
retention model (refer to Chapter 4).

Example 1 – By extrapolating past values

Year EPS
$
2014 0.53
2013 0.43
2012 0.37
2011 0.26
2010 0.25
2009 0.18

The average growth rate, g, may be calculated as follows.

0.18 × (1 + g)5 = 0.53
g = 0.241 or 24.1%

There are some problems associated with historical estimates:

(a) A decision needs to be made regarding the length of the estimation period. Too long
a period may reflect conditions that are no longer relevant for the future.
(b) Even if the same conditions prevail, the average value estimated may not be relevant
for the near term especially if growth rates are volatile. An average value may be
close to the expected future growth rate over the medium terms.
3. Valuation of a Type I Acquisition of Both Quoted and Unquoted Entities

3.1 Introduction

3.1.1 A type I acquisition does not affect the acquiring company’s exposure to business or
financial risk.
3.1.2 Type I acquisitions may be valued using one of the following valuation methods:
(a) Book value-plus models
(b) Market relative models
(c) Cash flow models, including EVA, MVA

3.2 Book value-plus models (asset-based methods)

3.2.1 Book value or asset-based methods of company valuation use the statement of
financial position as the starting point in the valuation process.

Example 1
The summary statement of financial position of ABC Co is as follows.
Non-current assets $ $
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
260,000
Goodwill 20,000
Current assets
Inventory 80,000
Receivables 60,000
Short-term investments 15,000
Cash 5,000 160,000
Total assets 440,000

Equity and liabilities

Equity
Ordinary shares of $1 80,000
Reserves 140,000
4.9% preference shares of $1 50,000
270,000
Non-current liabilities
12% loan notes 60,000
Deferred taxation 10,000 70,000

Current liabilities
Payables 60,000
Taxation 20,000
Proposed ordinary dividend 20,000 100,000
440,000

What is the value of an ordinary share using the net assets basis of valuation?

Solution:

If the figures given for asset values are not questioned, the valuation would be as follows.

$ $
Total value of assets less current liabilities 340,000
Less: Intangible asset (goodwill) 20,000
Total value of assets less current liabilities 320,000
Less: Preference shares 50,000
Loan notes 60,000
Deferred taxation 10,000 120,000
Net asset value of equity 200,000

No. of ordinary shares 80,000

Value per share $2.50

3.3 Market value models (P/E ratio)

3.3.1 The P/E method is a very simple method of valuation. It is the most commonly used
method in practice.
3.3.2 Value of company = Total post-tax earnings × P/E ratio

Value per share = EPS × P/E ratio

3.4 Market to book ratio – based on Tobin’s Q ratio

3.4.1 Tobin’s market to book ratio
Market value of target company = Market to book ratio × book value of target
company’s asset

Where market to book ratio = Market capitalization / Book value of assets for a
comparator company (or take industry average)

3.4.2 This method assumes a constant relationship between market value of the equity
and the book value of the firm.

Example 2
The industry sector average Market to Book ratio for the industry of X plc is 4.024.

The book value of X plc is $3,706m and it has 1,500m shares in issue.

Required:

Calculate the predicted share price.

Solution:

Predicted value of X plc = $3,706 × 4.024 = $14,912.94m

Predicted share price = $14,912.94m / 1,500m = 994.2c

3.5 Free cash flow models

3.5.1 The free cash flow approach has been explained in detail in Chapter 5. The procedure
for valuing a target company on the basis of its predicted cash flow is the same.

Free cash flow = EBIT

– Tax on EBIT
+ Non cash charges (e.g. depreciation)
– Capital expenditure
– Net working capital increases
+ Net working capital decreases
+ Salvage value received

Free cash flow to equity = Free cash flow ± net borrowing – net interest paid

3.5.2 There are two approaches to valuing a company using the free cash flow basis.

Approach 1 Approach 2
1 Identify the free cash flows of the target 1 Identify the free cash flow to equity of
company (before interest) the target company (after interest)
2 Discount FCF at WACC to obtain NPV 2 Discount FCFE at cost of equity (Ke)
to obtain NPV
3 Value of target = NPV of company – 3 Value of target = NPV
debt

Example 3
ABC Inc is planning on making a bid to take over BBC Inc which is in the same industry.
Both companies have similar gearing level of 18%.

ABC Inc has estimated that the takeover will increase its annual cash flows over the next
few years by the following amounts.

Year After-tax (but before interest) cash flows

$m
2011 14.00
2012 18.50
2013 20.75
 2014 onwards 30.25

BBC Inc has 6.5% irredeemable debentures of $37.5 million trading at par.

The risk-free rate is 6.5% and the market rate is 12%. ABC Inc’s equity beta is 2.450 and the
corporation tax rate is 28%.

Required:

If ABC Inc was prepared to bid $100 million for the entire share capital of BBC Inc,
would the acquisition increase shareholder wealth? Use both approaches given above
to illustrate your answer.

Solution:

Ke (using CAPM) = 6.5% + 2.45 × (12% – 6.5%) = 19.98% (say 20%)

i  (1  T ) 6.5  (1  0.28)
Kd =   4.68%
P0 100
WACC = 20% × 0.82 + 4.68% × 0.18 = 17.2%, say 17%

Approach 1

2011 2012 2013 2014 onwards

$m $m $m $m
Cash flow (after tax, before interest) 14.00 18.50 20.75 30.25
Perpetuity (1 / 0.17) 177.94 5.882
Net cash flow 14.00 18.50 198.69
Discount at 17% 0.855 0.731 0.624
PV 11.97 13.51 123.98

NPV 149.46
Less: Debt (37.50)
Value of equity 111.96
Approach 2

2011 2012 2013 2014

$m $m $m $m
Cash flow 14.00 18.50 20.75 30.25
Less: Interest (6.5% x $37.5m x 0.72) (1.76) (1.76) (1.76) (1.76)
Cash flow after interest and tax 12.24 16.74 18.99 28.49
Perpetuity (1/0.2) 142.45 5.00
Net cash flow 12.24 16.74 161.44
Discount at 20% 0.833 0.694 0.579
PV 10.20 11.63 93.43

NPV 115.25

Under both approaches, as value of equity > the proposed bid, the shareholders’ wealth
would increase if the target was acquired.

3.6 EVA approach

3.6.1 EVA is an estimate of economic profit. It can be used as a means of measuring

managerial performance, by addressing the NPV of revenues (profits) less resources
used (capital employed).
3.6.2 EVA is calculated as follows:

EVA = Net operating profit after tax (NOPAT) – (WACC × book value of capital
employed)

3.6.3 Note that NOPAT cannot simply be lifted from the financial statements. There are
numerous adjustments that may have to be made such as:
(a) Intangibles (for example, advertising, research and development, training).
These are viewed as investments and are added to the statement of financial
position.
(b) Goodwill written off and accounting depreciation. These are replaced by
economic depreciation, which is a measure of the actual decline in the market
value of the assets.
(c) Net interest on debt capital – debt is included in capital employed and the
 cost of debt is included in the WACC.

Example 4
ABC plc has a NOPAT as adjusted for EVA purposes of $562.98 million. It currently has
invested capital of $5,609.48 million and a WACC of 7.25%. The company has total debt of
$1,500 million.

Find the EVA for ABC plc, the value of the firm and the value of the firm’s equity.

Solution:

EVA = NOPAT – (WACC × Capital employed)

EVA = $562.98m – (7.25% × $5,609.48) = $156.30m

Firm value = Capital employed + EVA / WACC

Firm value = $5,609.48 + $156.30m / 7.25% = $7,765.34m

Equity = Firm value – value of debt

Equity = $7,765.34m – $1,500m = $6,265.34m

3.7 Market value added approach

3.7.1 The market value added (MVA) of a company is defined as:

MVA = Market value of debt + Market value of equity – Book value of equity –
Book value of debt

3.7.2 The MVA shows how much the management of a company has added to the value
of the capital contributed by the capital providers.
3.7.3 The MVA is related to EVA because MVA is simply the PV of the future EVA of the
company. In terms of the notation used in the previous section:

MVA = PV of EVA

3.7.4 If the market value and the book value of debt is the same, then the MVA simply
measures the difference between the market value of common stock and the equity
 capital of the firm.

3.8 Dividend valuation basis

3.8.1 Dividend Valuation Model

The dividend valuation model is based on the theory that an equilibrium price for
any share on a stock market is:
(a) The future expected stream of income from the security.
(b) Discounted at a suitable cost of capital.

Equilibrium market price is thus a present value of a future expected income

stream. The annual income stream for a share is the expected dividend every
year in perpetuity.

The basic dividend-based formula for the market value of shares is expressed in the
DVM (assume no growth) as follows:

D D D D
Market value (ex div) P0    ...  

(1  K e ) (1  K e ) 2
(1  K e ) Ke

If the dividend has constant growth, dividend growth model can be applied:
D (1  g ) D0 (1  g ) 2 D0 (1  g )  D0 (1  g ) D1
P0  0   ...  
 
(1  K e ) (1  K e ) 2
(1  K e ) Ke  g Ke  g
Where: D0 = Current year’s dividend
g = Growth rate in earnings and dividends
D0(1+g) = D1 = Expected dividend in one year’s time
Ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable
4. Valuation of Type II Acquisitions Using the APV Model

4.1 A type II acquisition affect the acquiring company’s exposure to financial risk only
– it does not affect exposure to business risk.
4.2 The theory behind the APV has been explained in Chapter 4. An acquisition is valued
by discounting free cash flows to the firm by the ungeared cost of equity and then
adding the PV of the tax shield.
4.3 The approach used in valuation can be summarized as follows:

Step 1 Calculate the NPV as if ungeared – that is, Ke

Step 2 Add the PV of the tax saved as a result of the debt used in the
project
Step 3 Deduct the debt of the target company to obtain the value of
equity and then deduct the proposed cost of the acquisition

Example 5
ABC Co is considering the acquisition of BBC Co, an unquoted company. The shareholders
of BBC Co are hoping to receive $75 million for the sale of their shares.

The ungeared (asset) beta factor for BBC Co is 1.20, the risk free rate of interest is 3% and
the market risk premium is 5.8%.

Forecast free cash flows for BBC Co are as follows:

Year 1 2 3 4
$m $m $m $m
Free cash flow 10.3 11.5 13.8 14.9

Annual cash flows after year 4 are expected to stay constant into perpetuity.

BBC Co has $50 million of 6% debt, repayable in 4 years. The tax rate is 30%.

Required:

Using the APV method of valuation, calculate whether ABC Co should be prepared to
pay the $75 million required by the shareholders of BBC Co.
Solution:

Ungeared cost of equity = 3% + 1.2 × 5.8% = 9.96%, say 10%

1 2 3 4
$m $m $m $m
Free cash flow 10.30 11.50 13.80 14.90
Perpetuity (1/0.1) 149.00 10.00
Net cash flow 10.30 11.50 162.80
Discount at 10% 0.909 0.826 0.751
PV 9.36 9.50 122.26

NPV 141.12

PV of tax relief on debt interest:

$m
Debt amount 50.0

Annual tax relief (50m × 6% × 30%) 0.9

Annuity factor (6%) for 4 years × 3.465
PV of tax shield 3.12

APV calculation
$m
Base case NPV 141.12
Add: PV of tax shield 3.12
144.24
Less: Debt (50.00)
Equity value 94.24

This is significantly more than the $75 million that the shareholders are hoping fro, so ABC
Co should pay the $75 million and take over BBC Co.
5. Valuation of Type III Acquisitions Using Iterative Revaluation Procedures

5.1 A type III acquisition affects both financial and business risk exposure of the
acquiring company.

5.2 Type III acquisitions

In practice, valuing a type III acquisition is a complex process requiring the
iterative procedures.

For exam purposes, we often simplify the method as follows:

Step 1: Calculate the asset beta of both companies.
Step 2: Calculate the average asset beta for the new combined company after the
acquisition.
Step 3: Regear this beta to reflect the post-acquisition gearing of the new combined
company.
Step 4: Calculate the combined company’s WACC.
Step 5: Discount the post-acquisition free cash flows using the WACC.
Step 6: Calculate the NPV and discount the value of debt to give the combined
company’s value of equity.

Example 6
Anderson Co is planning to take over Webb Co, a company in a different business sector,
with a different level of risk. Anderson Co’s free cash flows are forecast to be $50m per
annum in perpetuity, Webb Co’s free cash flows are forecast to be $10m per annum in
perpetuity and there are expected to be annual post-tax cash synergies of $5m if the
acquisition goes ahead.

The combined company will pay tax at 30% and will have a pre-tax cost of debt of 5%. The
risk free rate is 3% and the equity risk premium is 5.8%.

Currently, Anderson Co has an asset beta of 1.25 and Webb Co has an asset beta of 1.60.
Assume that the beta of debt is zero.

The current financing of the two companies is:

 Debt Equity
$m $m
Anderson Co 50 450
Webb Co 20 80

Anderson Co is planning to make a cash offer of $80m to buy 100% of the shares of Webb
Co. The cash offer will be funded by additional borrowing.

Required:

Calculate the gain in wealth for Anderson Co’s shareholders if the acquisition goes
ahead.

Solution:

Step 1: Calculate the asset beta of both companies

Anderson’s asset beta = 1.25
Webb’s asset beta = 1.60

Step 2: Calculate the average asset beta

The asset beta of the combined company
500 100
= 1.25   1.60   1.31
600 600

Step 3: Regear this beta to reflect the post-acquisition gearing of the new combined
company
Ve
a  e 
Ve  Vd (1  T )
530
1.31   e 
530  150  (1  30%)
 e  1.57

Hence, using CAPM, the cost of equity Ke = 3% + 1.57 × 5.8% = 12.1%

Step 4: Calculate the combined company’s WACC

530 150
WACC = 12.1%   5%  (1  30%)   10.2%
680 680
Step 5: Discount the post-acquisition free cash flows using this WACC
50m  10m  5m
Discounted free cash flows =  $637m
10.2%

Step 6: Calculate the value of equity

Value of equity = $637m – $150m = $487m

Hence the shareholder wealth of the Anderson Co shareholders has increased from $450m to
$487m as a consequence of the acquisition.

Question 1
ABC Inc is considering making a bid for 100% of BBC Inc, a company in a completely
different industry. The bid of $200 million, which is expected to be accepted, will be
financed entirely by new debt with a post-tax cost of debt of 7%.

Pre-acquisition information
ABC Inc
ABC has debt finance totaling $60 million at a pre-tax rate of 7.5%. There are 50 million
equity shares with a current market value of $22 each and an equity beta of 1.37.

Post-tax operating cash flows are as follows.

Year 1 Year 2 Year 3 Year 4 Year 5

$m $m $m $m $m
60.3 63.9 67.8 71.8 76.1

BBC Inc
BBC has an equity beta of 2.5 and 65 million shares with a total current market value of
$156 million. Current debt – which will also be taken over by ABC – is $12.5 million.

Post-acquisition information
Land with a value of $14 million will be sold.

Post-tax operating cash flows of BBC’s current business will be

Year 1 Year 2 Year 3 Year 4 Year 5

 $m $m $m $m $m
15.2 15.8 16.4 17.1 17.8

If the acquisition goes ahead, ABC will experience an improvement in its credit rating and
all existing debt will be charged at a rate of 7%.

Cash flows after year 5 will be grow at a rate of 1.5% per annum.

General information
The risk-free rate is 5.2% and the market risk premium is 3%. Corporation tax rate is 28%.
Debt beta is 0.

Required:

Should ABC Inc go ahead with the acquisition of BBC Inc? Give reasons for your
answer.

Question 2
Mercury Training was established in 1999 and since that time it has developed rapidly. The
directors are considering either a flotation or an outright sale of the company.

The company provides training for companies in the computer and telecommunications
sectors. It offers a variety of courses ranging from short intensive courses in office software
to high level risk management courses using advanced modelling techniques. Mercury
employs a number of in-house experts who provide technical materials and other support
for the teams that service individual client requirements. In recent years, Mercury has
diversified into the financial services sector and now also provides computer simulation
systems to companies for valuing acquisitions. This business now accounts for one third of
the company’s total revenue.

Mercury currently has 10 million, 50c shares in issue. Jupiter is one of the few competitors
in Mercury’s line of business. However, Jupiter is only involved in the training business.
Jupiter is listed on a small company investment market and has an estimated beta of 1.5.
Jupiter has 50 million shares in issue with a market price of 580c. The average beta for the
financial services sector is 0.9. Average market gearing (debt to total market value) in the
financial services sector is estimated at 25%.
Other summary statistics for both companies for the year ended 31 December 2007 are as
follows:

Mercury Jupiter
Net assets at book value ($m) 65 45
EPS (cents) 100 50
DPS (cents) 25 25
Gearing (debt to total market value) 30% 12%
Five year historic earnings growth (annual) 12% 8%

Analysts forecast revenue growth in the training side of Mercury’s business to be 6% per
annum, but the financial services sector is expected to grow at just 4%.

Background information:
The equity risk premium is 3.5% and the rate of return on short-dated government stock is
4·5%.
Both companies can raise debt at 2.5% above the risk free rate.
Tax on corporate profits is 40%.

Required:

(a) Estimate the cost of equity capital and the WACC for Mercury Training.
(8 marks)
(b) Advise the owners of Mercury Training on a range of likely issue prices for the
company. (10 marks)
(c) Discuss the advantages and disadvantages, to the directors of Mercury Training,
of a public listing versus private equity finance as a means of disposing of their
interest in the company. (7 marks)
(Total 25 marks)