Revision Course Notes [Session 3 & 4]
Revision 2 Acquisition and Mergers
Chapter 7 Acquisitions and Mergers versus Other Growth Strategies
1. Mergers and Acquisitions as a Method of Corporate Expansion
1.1 Advantages of M&As as an expansion strategy (Jun 14)
(a) Speed – Quicker way of implementing a business plan and reach a certain optimal level of production
(b) Lower cost – Cheaper way of acquiring productive capacity
(c) Acquisition of intangible assets, e.g. brand recognition, reputation, customer loyalty and intellectual property
(d) Access to overseas markets
1.2 Disadvantages (or risks) of M&As as an expansion strategy (Jun 14)
(a) Exposure to business risk – normally represent large investments and so if not successful, the effect may be catastrophic.
(b) Exposure to financial risk – for example, may have hidden liabilities
(c) Acquisition premium – difficult to estimate and if too large a premium may render the acquisition unprofitable
(d) Managerial competence – management may not have the experience and/or ability to deal with operations on the new larger scale
(e) Integration problems – each company has its own culture, history and ways of operation
1.3 Types of mergers
(a) Horizontal mergers
(i) same line of business
(ii) reduce competition
(b) Vertical mergers
(i) different stages of the same production chain,
(ii) or between firms that produce complementary goods
(iii) either backward with suppliers or forward with customers.
(c) Conglomerate mergers
(i) unrelated line of business
2. Evaluating the Competitive Position of a Given Acquisition Proposal
2.1 It should only be undertaken if it leads to an increase in the wealth of the shareholders.
2.2 Aspects of the impact on competitive position
(a) Market power
(b) Barriers to entry
(c) Supply chain security
(d) Economies of scale
(e) Economics of scope
(f) Tax and debt benefits
3. Developing an Acquisition Strategy
(Dec 14)
3.1 Acquire undervalued firms
(a) Find firms that are undervalued
(b) Access to necessary funds
(c) Skills in executing the acquisition
3.2 Diversify to reduce risk
(a) Acquiring firms in other industries
(b) Reduce firm-specific risk (unsystematic risk)
(c) Reduce in the volatility of cash flows, which may lead to better credit rating and a lower cost of capital
4. Criteria for Choosing an Appropriate Target for Acquisition
4.1 Criteria:
(a) Benefit for acquiring undervalued company
(b) Diversification
(c) Operating synergy
(d) Tax savings
(e) Increase the debt capacity
(f) Disposal of cash slack
(g) Access to cash resources
(h) Control of the company
(i) Access to key technology
5. Creating Synergies
(Jun 13)
5.1 Revenue synergies – higher revenues, higher return on equity or a longer period of growth
(a) Increased market power
(b) Economies of vertical integration
(c) Complementary resources – e.g. one company specialize in R&D and the another strong in marketing
5.2 Cost synergy – economies of scale
5.3 Financial synergy
(a) Eliminate inefficiency
(b) Tax shields/accumulated tax losses
(c) Surplus cash (cash slack)
(d) Debt capacity
6. High Failure Rate of Acquisitions in Enhancing Shareholder Value
(Jun 14)
6.1 Reasons of high failure rate:
(a) Agency theory – takeover are primarily motivated by the self-interest of the acquirer’s management
(b) Errors in valuing a target firm
(c) Lack of goal congruence
(d) Failure to integrate effectively
(e) Inability to manage change
Chapter 8 Valuation of Acquisitions and Mergers
1. The Overvaluation Problem
1.1 Market efficiency
(a) Stock markets are semi-strong, i.e. equity prices reflect all publicly available information However, this does not necessarily mean that the shares will be fairly valued.
(b) If the market does not fully understand the information available, it tends to overestimate the potential returns and so overvalue the equity.
(c) The price of overvalued equity may not be corrected by the market if:
(i) managers are deliberately misleading
(ii) there is collusion
1.2 Management responses to overvaluation
(a) the use of creative accounting
(b) may manipulate reported earnings to produce more favourable results
(c) poor acquisitions made using inflated equity to finance the purchase
2. Estimation of the Growth Levels of a Firm’s Earnings
2.1 There are three ways to estimate the growth rate of earnings of a company.
(a) By extrapolating past values, e.g.
Earliest earnings × (1 + g)n = Most recent earnings
(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 (Gordon’s growth approximation).
(Jun 08, Jun 10)
g = b × re
3. Valuation of a Type I Acquisition
3.1 A type I acquisition does not affect the acquiring company’s exposure to business or financial risk.
3.2 Type I acquisitions may be valued using one of the following valuation methods:
(a) Book value-plus models (asset-based models)
(b) Market relative models
(c) Cash flow models, including EVA, MVA
3.3 Book value-plus models or asset-based models (Jun 15)
(a) Historic basis – unlikely to give a realistic value as it is dependent upon the business’s depreciation and amortization policy.
(b) Replacement basis – if the assets are to be used on an on-going basis.
(c) Realisable basis – if the assets are to be sold, or the business as a whole broken up. This won’t be relevant if a minority shareholder is selling his stake, as the assets will continue in the business’s use.
3.4 Market value models – P/E ratio
(Jun 12, Jun 14, Dec 15)
Value per share = EPS × P/E ratio
3.5 Market to book ratio – based on Tobin’s Q ratio
Tobin’s market to book ratioMarket 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)
3.6 Free cash flow models
(Dec 07, Jun 10, Jun 11, Jun 12, Dec 13, Jun 14, Dec 15)
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 debt issued/paid (new borrowings less any repayment)
± Net share issued/repurchased
There are two approaches to valuing a company using the free cash flow basis.
Approach 1 / Approach 21 Identify the free cash flows of the target company (before interest) / 1 Identify the free cash flow to equity of 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 – debt / 3 Value of target = NPV
3.7 EVA approach
(Dec 07, Dec 09, Jun 13, Dec 14)
EVA = Net operating profit after tax (NOPAT) – (WACC × book value of capital employed)3.8 Market value added approach
MVA = Market value of debt + Market value of equity – Book value of equity – Book value of debt3.9 Dividend valuation basis
(Jun 08, Jun 15)
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 approach used in valuation can be summarized as follows:
Step 1 / Calculate the NPV as if ungeared – that is, KeStep 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
5. Valuation of Type III Acquisitions using Iterative Revaluation Procedures
(Jun 13, Dec 13, Dec 15)
5.1 A type III acquisition affects both financial and business risk exposure of the acquiring company.
5.2 / Type III acquisitionsIn 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.
6. Valuation of High Growth Start-ups
6.1. The valuation of start-ups (新創公司) presents a number of challenges for the methods that we have considered so far due to their unique characteristics which are summarized below:
(a) Most start-ups typically have no track record
(b) Ongoing losses
(c) Few revenues, untested products
(d) Unknown market acceptance, unknown product demand
(e) Unknown competition
(f) Unknown cost structures, unknown implementation timing
(g) High development or infrastructure costs
(h) Inexperienced management
7. Intangible Assets
7.1 Valuation of intangible assets of an enterprise
(a) Market-to-book values
= Market value of the firm – book value of tangible assets
(b) Calculated intangible values (CIV) – similar to the residual income technique, it calculates the company’s value spread or excess return
7.2 Valuation of individual intangible assets
(a) Relief from royalties method
(i) the value obtainable from licensing out the right
(ii) relieved from paying through being the owner
(b) Premium profits method
(i) Often used for brands
(ii) comparing the price of branded products and unbranded products
(iii) the estimated premium profits can then be capitalized by discounting at a risk-adjusted market rate
(c) Capitalization of earnings method
(i) often used for publishing titles
(ii) the maintainable earnings accruing to the intangible asset are estimated
(iii) earnings multiple is then applied to the earnings, taking account of expected risks and rewards
Examination Style Questions
Question 1 – WACC, free cash flows
Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base.
As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management.
Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the company’s existing credit rating. The key issues, according to the company’s advisors, are the terms of the deal and the likely effect of the acquisition on the company’s value and its financial leverage.
Both companies are quoted on an international stock exchange and below are relevant data relating to each company:
Financial data as at 30 November 2007
Burocolene / PetroFrancaisMarket value of debt in issue ($bn) / 3.30 / 5.80
Market value of equity in issue ($bn) / 9.90 / 6.70
Number of shares in issue (million) / 340.00 / 440.00
Share options outstanding (million) / 25.40 / -
Exercise price of options ($ per share) / 22.00 / -
Company tax rate (%) / 30.00 / 25.00
Equity beta / 1.85 / 0.95
Default risk premium / 1.6% / 3.0%
Net operating profit after tax and new reinvestment
($ million) / 450.00 / 205.00
Current EPS ($ per share) / 1.19 / 0.44
The global equity risk premium is 4·0% and the most appropriate risk free rate derived from the returns on government stock is 3·0%.
Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 2004. The vesting date is 30 November 2009 and the exercise date is 30 November 2010. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required. Your estimate is that the options have a time value of $7·31.
PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of $430 million.
You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene. Following your initial discussions with management, you decide that the following points are relevant:
1. The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment.
2. Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each company’s value.
3. The acquisition would be financed by a new debt issue by Burcolene.
Required:
(a) Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company. (16 marks)
(b) Write a briefing paper for management, advising them on:
(i) The validity of the free cash flow model, given the growth rate assumptions made by management for both firms;