1. P4 Advanced Investment Appraisal

2. 2 2 Section D: Acquisitions and Mergers D1. Acquisitions and mergers versus other growth strategies D2. Valuation for acquisitions and mergers D4. Financing acquisitions and mergers Designed to give you the knowledge and application of:

3. 3  Argument and the problem of overvaluation.  Potential near-term and continuing growth levels of a firm's earnings using both internal and external measures.  Impact of an acquisition or merger upon the risk profile of the acquirer distinguishing: i. type 1 acquisitions ii. type 2 acquisitions iii. type 3 acquisitions  Advise on the valuation of a type 1 acquisition of both quoted and unquoted entities using: i. 'book value-plus' models ii. market relative models iii. cash flow models, including EVA , MVA  Valuation type 2 acquisitions using the adjusted net present value model.  Valuation type 3 acquisitions using iterative revaluation procedures.  Understanding of the procedure for valuing high growth start-ups. D2: Valuation for acquisitions and mergers Learning Outcomes

4. 4 Argument and problem of overvaluation Situations of overvaluation When the shares of the acquiring company are overvalued When the target company itself is overvalued Overvaluation of shares of acquiring company If a share is traded at a price that is unjustifiable by its earnings, then it would have a higher P/E ratio, thus indicating overvaluation. (P/E = current market price per share / earnings per share  Bad mergers & acquisitions  Exaggerated performance of projects & business operations  Insider trading  Overestimated potential returns  Lack of information Reasons Consequences

5. 5 Overvaluation of target company When the acquiring company pays more for the target company than the market value, the problem of overvaluation arises. Consequences  Uneconomical decision  Failure of merger or acquisition Reasons  Agency problem  Volatile market  Overestimation of the synergies

6. 6 Estimate growth levels of a firm’s earnings Methods of estimating the growth level of a company's earnings Retained earnings model Historic earnings pattern Objective While valuing the target company, it is vital for the acquiring company to estimate the growth rate of the target. This will help in deciding the purchase consideration.

7. 7 Retained earnings model / Gordon's growth approximation Assumptions Growth rate depends on reinvestment of retained earnings Company retains a portion of its earnings each year Formula for growth rate: g = br e Where, g= growth rate of earnings b= proportion of profits re-invested = EPS – DPS x 100 EPS r e = post-tax return on equity = profit after tax. Shareholders’ opening funds

8. 8 Past earnings pattern Assumptions Growth rate is assumed to be same each year i.e. constant Formula : g = -1 Where, N = number of years of earnings growth Current earnings Earnings ‘n’ years ago 1/n Past growth rate in earnings will continue in the future Useful only in the short term Cannot be used for new companies as past data is not available Growth rates cannot be constant if companies operate in uncertain and volatile markets Drawbacks Refer to example (page 333)

9. 9 Impact of an acquisition / merger upon the risk profile of the acquirer  No business risk or financial risk  Acquisitions are usually small compared to the size of the acquiring company  Only financial risk but no business risk  Market value of acquirer also changes due to changes in WACC  Both financial risk and business risk  Business risk also changes as the nature of business of the two companies is different.  Value of target company NPV of future cash flows from target company discounted at acquiring company’s WACC Risk of acquiring company does not change  Value of target company NPV of future cash flows from target company discounted by re-gearing the WACC of the acquiring company  Value of target company Difficult to calculate WACC. Iterative process can be used. Comparison between Type 1, 2 & 3 acquisitions Type 1Type 2Type 3 Refer to the table (page 334)

10. 10 Valuation of Type 1 acquisitions Assets are valued at the carrying cost at which they appear in the SOFP Net assets = total value of assets – total value of liabilities Methods for valuation of Type 1 acquisitions Book-value plus Market relative Cash flow Value only goodwill - no other intangibles Value of company = net assets + (m x annual profit) Book value-plus model Asset based methods (ignoring value of the intangibles) Asset based methods (considering the value of the intangibles)

11. 11 Valuation of intangibles (VOI) Method is criticised because VOI assets fluctuate with the market value of the firm Market value method Market value of company is deducted from book value of company Removes drawback of market value method Calculated intangible value (CIV) Gives fixed VOI, which does not fluctuate with market value of the firm If return of assets (ROA) of the company is higher than ROA of industry, it is due to intangible assets Industry ROA is applied to assets employed & effects of taxation and growth are considered to arrive at VOI assets

12. 12 Market relative models Price / earnings Earnings Yield Tobin’s Q Market value to book value Market relative models: based on market value of shares of the company

13. 13 Price / Earnings (P/E) ratio-based model Current market price per share P/E ratio = Earnings per share (EPS) Where, EPS = Profits attributable to ordinary shareholders Weighted average no. of ordinary shares Market value per share = EPS x P/E ratio Value of company = total earnings x P/E ratio Adjustments to P/E required for difference between quoted and unquoted company Uncertainty of earnings Marketability Transferability Size and status Earnings to use:  Most recent historic EPS: this is simple and easy to apply  Average historic EPS: this is an average  Forecast EPS: this may be the best estimate of the future Refer to example (page 343)

14. 14 Earnings yield approach Earnings per share Earnings yield (E/P) = x100 Market price per share Value of a share = EPS x P/E ratio 1 Value of a share = EPS x Earnings yield 1 Value of a company = Total earnings x Earnings yield

15. 15 Tobin’s Q  Measure of performance  Q is a quotient  Can determine whether shares are overvalued or undervalued  If Q < 1; replacement cost of firm’s assets is greater than share value, so undervalued  If Q > 1; replacement cost of firm’s assets is lower than share value, so overvalued Formula: Market value of the company Q= Replacement cost of the assets

16. 16 Market capitalisation Market-to-book ratio = Book value of assets Where, Book value = total assets – total liabilities Current share price Market-to-book ratio = Book value per share Thus, Current share price = Market-to-book ratio x Book value per share Formula Drawbacks  Not directly related to the ability of the company to generate profits / cash for shareholders  Does not consider the value of intangible assets Market-to-book ratio  Also known as price-to-book ratio or price / equity ratio.  Used to compare company’s book value with its current market price

17. 17 Cash flow models- income based model Constant annual dividend model Dividend growth model / Gordon’s model Discounted cash flow model Economic value added model (EVA TM ) Market value added (MVA) Cash flow models- income based model

18. 18 Constant annual dividend model  Assumes the price of the share is not more than what it will provide investors in current and future dividends.  Determines changes in the value of the share as a result of a change in the expected annual dividend. Formula: Expected dividend (D) Price of share at time zero (P o ) = Expected return (r e ) Formula

19. 19 Discounted cash flow model Steps for discounted cash flow model 1 2 Determine time horizon for cash flows Calculate free cash flow to firm (FCFF) for each year 3 Determine company’s WACC 4 Discount FCFF each year by WACC to get NPV of FCFF 5 Value of equity = NPV – value of debt 6 Value per share = value of equity/number of shares

20. 20 Economic value added model (EVA TM )  Determines economic value created above shareholders’ / lenders’ required return  Determines amount by which earnings exceed or fall short of required minimum return to shareholders / lenders EVA  = NOPAT - (c x K) Where, NOPAT is net operating profit after tax c is the weighted average cost of capital (WACC) K is capital employed (book value of all assets – non-interest bearing current liabilities) Formula EVA  = (r – c) K Where, r = return on capital invested = NOPAT K Value of company = K + present value of future EVA  EVA  year 1 EVA  year 2 PV of EVA  =+ and so on (1+c)(1+c)(1+c) Value of equity = Value of company – Value of debt NOPAT = Accounting profit + interest on debt capital. NOPAT for EVA 

21. 21 Market Value added (MVA)  Determines whether the company has added value or not.  MVA is present value of future expected EVA.   This model faces the problem of obtaining the market value of the company in unquoted small companies. MVA = MV - K Where, MVA is market value added MV is the market value of the firm, including value of firm’s equity and debt K is capital invested in the firm Formula

22. 22 1 Determine time horizon for cash flows 2 Calculate FCFF for each year 3 Determine company ’ s unlevered (ungeared) cost of equity 4 Discount FCFF each year by unlevered cost of equity to find NPV 5 Calculate interest tax-shields & discount these at pre-tax cost of debt to discover PV of interest tax shields 6 Calculate the total value of the firm (results of step 4 + step 5) + excess cash / marketable securities – contingent liabilities 7 Value of equity = Value of firm (step 6) – Value of debt If required, value per share = value of equity/number of ordinary shares 8 APV of proposed acquisition = equity value of step 7 – proposed investment If APV is positive, acquisition should proceed Steps to value type 2 acquisitions Valuation of Type 2 acquisitions Valuation of Type 2 acquisitions is done using the adjusted present value (APV) model APV = Base case NPV + PV (tax benefits) – PV (issue costs and bankruptcy costs)

23. 23 Valuation of Type 3 acquisitions More complicated as both financial and business risk changes V = V 1 + V 2 + V 3 Where, V 1 is value of acquiring company’s FCFF, discounted at acquiring company’s cost of capital V 2 is value of target company’s FCFF, discounted at target company’s cost of capital V 3 is the value of the synergy generated from the acquisition Formula Cannot calculate value of company without combined WACC Iterative process Cannot calculate combined WACC without combined beta Cannot calculate combined beta without value of company

24. 24 Steps to value Type 3 acquisitions 1 2 Calculate combined asset beta Calculate levered beta of combined firm 3 Calculate cost of equity of combined firm 4 Calculate WACC of combined firm 5 Discount combined cash flows to produce value of company 6 Value of equity = Value of firm – value of debts

25. 25 Valuing high growth start-ups High growth start up companies Companies that are new to the market and expect short-term high growth. Valuation Identifying factors that affect projected profits and cash flows Period of projection Determining the growth rate Determining the valuation methods to be used (asset based, market based or discounted cash flow) Reasons for difficulty in valuation No past track record Significant losses in initial years Highly uncertain / volatile environment

26. 26 Recap  Argument and the problem of overvaluation.  Potential near-term and continuing growth levels of a firm's earnings using both internal and external measures.  Impact of an acquisition or merger upon the risk profile of the acquirer distinguishing: i. type 1 acquisitions ii. type 2 acquisitions iii. type 3 acquisitions  Advise on the valuation of a type 1 acquisition of both quoted and unquoted entities using: i. 'book value-plus' models ii. market relative models iii. cash flow models, including EVA , MVA  Valuation type 2 acquisitions using the adjusted net present value model.  Valuation type 3 acquisitions using iterative revaluation procedures.  Understanding of the procedure for valuing high growth start-ups.

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