ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 9: Mergers and acquisitions

In other countries, there are protectionist measures against the acquisition of

domestic companies by foreign acquirers, especially companies in ‘strategic

industries’ (however these are defined by government policy or national law).

Takeover rules

The law or other regulations might impose regulations on the conduct of a takeover

bid. In the UK, when the target company is a listed company, a ‘Takeover Code’

applies. The Takeover Code sets out rules that the bidding company must follow.

For example, the bidding company is allowed to buy shares in the target company

in the stock market, but only up to a certain proportion of the total number of shares

in issue. To acquire more shares, it must then make a formal offer for all the shares

in the target company. This rule prevents a buying company from acquiring a target

company by stealth, through the purchase of a controlling interest in the shares by

means of stock market purchases. It also ensures that the shareholders in the target

company are treated equally by the bidder.

Competition law

Most countries have some form of competition law to protect the interests of the

consumer or general public. The purpose of competition law is to prevent any

company from acquiring such a large share of the market by means of a merger or

acquisition that it will be able to exert a strong influence over:

 prices

 output or

 other market conditions.

An ability to ‘control’ the market could be against the public interest and unfair to

consumers.

In the UK, a proposed acquisition that might give the acquirer undue influence over

the market can be referred to a government-appointed commission (the

Competition Commission) for investigation. The Commission has the power to

prohibit an acquisition, or to allow an acquisition to go ahead only on condition that

the acquirer complies with certain conditions that would reduce its market

influence. For example, if one company that operates a chain of supermarkets

proposes to acquire a rival company, the acquisition might be referred to the

Competition Commission. The Commission might allow the acquisition to go ahead

only on condition that the acquirer agrees to dispose of certain stores operated by

the target company.

1.7 Defences against a hostile takeover bid

In a friendly takeover bid, the company wanting to make the acquisition makes a

bid that the board of the target company will recommend to their shareholders. In

this situation, the target company will allow the acquirer access to its accounts,

records and management information, so that the acquirer is able to carry out ‘due

diligence’ and satisfy themselves that they are offering a fair price for the business.

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A hostile bid occurs when the board of the target company rejects a takeover offer

and refuses to recommend it to the shareholders.

A hostile takeover bid is risky, because the bidder has to make the offer for the

target company’s shares without the benefit of management information about the

company (for example, management accounting information about current financial

performance). If the takeover bid is ‘friendly’ and welcomed by the board of

directors of the target company, confidential information will probably be made

available to the bidder.

The directors of a target company have several defences against a takeover bid.

These vary between countries. In the UK, the terms of the offer for the company’s

shares must be given to the company’s shareholders, who are then free to decide

whether or not to accept the offer for their shares. If enough shareholders accept the

offer, the bid will be successful.

The most important defence against a hostile takeover (in the UK) is to persuade the

shareholders to reject the bid. There are several ways in which this might be done.

In each case, the directors of the company must deal honestly with the shareholders,

and should not give them information that is incorrect or misleading.

Methods of persuading the shareholders to reject a bid include the following:

 Announcing that the company expects to increase its profits substantially in the

future; therefore the offer price from the bidder is too low.

 Announcing an intention to return a large amount of equity to the shareholders

in the near future, in the form of an increased dividend or a share buy-back;

therefore the offer price from the bidder is too low.

 Explaining the future strategy of the board of directors for increasing the

company’s profits in the future.

When it is uncertain whether shareholders will be persuaded to reject the offer,

other methods of defence in the UK are:

 To try to get the takeover referred to the Competition Commission, which has

the power to prevent a takeover if it is likely to affect competition adversely in

the industry, for example by creating a monopoly company in the industry.

 To find a ‘white knight’. A white knight is another company that is prepared to

make its own takeover bid for the company, at a higher price or on better terms.

1.8 Will shareholders in the target company accept an offer for their

shares?

A company making a takeover bid wants to win sufficient acceptances from

shareholders in the target company that it acquires full control of the company. The

willingness of shareholders to accept a bid for their shares will depend on several

factors:

 the offer price: share price valuations are explained in the following sections of

this chapter

Chapter 9: Mergers and acquisitions

 the purchase consideration – cash, debt capital or shares in the bidding

company: the significance of the purchase consideration is explained later

 job security: when the directors, managers and employees of the target company

are major shareholders, job security might be relevant. These shareholders might

reject an offer if they are concerned about their job security after a takeover.

 alternative options: there might be the possibility of a rival and more attractive

offer.

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Valuation for mergers and acquisitions: book value plus and market

relative models

 The need for a valuation

 Valuation methods

 Valuation based on asset values

 Valuation based on earnings and P/E ratio

 Dividend valuation model: constant annual dividends

 Dividend valuation method: constant rate of growth in annual dividends

 Advantages and disadvantages of the dividend valuation models

2 Valuation for mergers and acquisitions: book value

plus and market relative models

2.1 The need for a valuation

Valuation and the offer price are key issues in a merger or acquisition. When a

merger is negotiated, the two companies need to reach agreement on the valuation

of shares in each company for the purpose of deciding the terms of the merger. In a

takeover:

 the acquiring company needs to decide what price it is prepared to offer for the

target company

 the directors of the target company need to decide whether the offer is

acceptable and whether it should be recommended to the shareholder, and

 the shareholders in the target company need to decide whether they are willing

to accept the offer made for their shares.

The target company might be a public company whose shares are already quoted on

a stock market. In such cases the current share price is a useful guide to valuation,

but a bidder will not succeed unless the offer price is higher than the current market

price. Without a higher offer, the shareholders in the target company have no reason

to accept and agree to sell their shares to the bidder.

When the target company is a private company, there is no market price that can act

as a benchmark or guide to an offer price.

In bidding for both public and private companies, the acquiring company therefore

needs to make estimates of the value of the target company, in order to decide what

price it might be prepared to offer. The price should be sufficiently high to win

acceptance from the target company shareholders, but not so high that the bidding

company pays too much. When an acquisition is over-priced, the return on the

investment will be low and the acquiring company will lose value for its

shareholders.

Chapter 9: Mergers and acquisitions

It is not usual to make a bid to buy the debt capital or the preference shares of a

target company. A valuation is required for the equity shares in the target company,

and not a valuation for the company as a whole.

Valuation is an art, not a science

It is important to remember that the valuation of companies for the purpose of a

merger or acquisition is not a science. Although there are valuation methods, these

are all based on estimates and assumptions.

Valuation methods can be used to decide on an offer price, or may be used to justify

an offer price. However, the final price is often agreed through negotiation, and the

management of the bidding company must use judgement in deciding how high a

price they might be willing to pay. The only ‘correct’ valuation is the price that the

bidder makes and the shareholders in the target company accept.

2.2 Valuation methods

You might be required in your examination to use several methods for valuation of

a target company. Each method will produce a different valuation, but each

valuation can provide useful information and help with deciding what the offer

price should be. You should be prepared to use each of the different valuation

methods, and then discuss the assumptions and estimates on which the valuation is

based. You might also be required to compare the different valuations produced by

each method, and then recommend (with reasons) a valuation that you consider

appropriate as a basis for making an offer to the target company shareholders.

There are several approaches to making a valuation of the shares in a company:

 A valuation based on the net asset value of the target company.

 Market-based valuations, using estimates of future earnings or dividends

 Cash-flow based valuations, using discounted cash flow of expected future

returns from the acquisition

 A valuation based on an expected value added (EVA) model: this is another

form of cash flow-based model.

2.3 Valuation based on asset values

Disposal value

The minimum value of a target company is the value of its net assets. (Net assets are

the value of the company’s total assets minus its liabilities.) If net assets can be

valued according to the disposal value of the assets, this would indicate the amount

that could be obtained for the shareholders of the company in the event that the

company is liquidated and its assets sold off.

However the net disposal value (or ‘break-up’ value) of the target company’s assets

is usually irrelevant, unless asset value is higher than the value of the business as a

going concern. A target company is usually acquired with the intention of

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continuing its business operations, and the value of assets in a going concern should

be higher than their break-up value.

In a takeover bid, it is also impractical to estimate the disposal value of the target

company’s assets, except perhaps as a very approximate estimate.

Book value

In practice, a minimum valuation for a target company might be based on the book

value of its assets. The minimum value of the equity would then be the book value

of the assets minus the book value of the liabilities.

Some assets might be under-valued, but where non-current assets are re-valued

regularly book value might be sufficient for an asset-based valuation without the

need for further adjustments.

If you are required to make an asset-based valuation in your examination, you

should be prepared to consider some adjustments to the valuation of certain assets,

where information in the question indicates that the valuation of certain assets

(particularly intangible assets) might be too high or too low.

A valuation based on the book value of net assets should be considered a minimum

valuation, and not one that the target company shareholders are likely to accept. An

offer price would have to be in excess of book value (‘book value plus’) for the bid

to have any chance of success.

Example

The following information is available about a private company, Company Z.

$000

Tangible non-current assets 250

Intangible non-current assets 75

Current assets 60

385

Ordinary shares of $1 50

Revaluation reserve 80

Retained profits 145

275

Bank loans 90

Current liabilities 20

385

Required

Provide an asset-based valuation of the shares in Company Z.

Chapter 9: Mergers and acquisitions

Answer

The book value of the net assets is $275,000 or $5.50 per share. However, this

valuation is based on the assumption that the tangible non-current assets are

suitably valued, and that $75,000 represent a realistic value for the intangible non-

current assets.

It is therefore unlikely that the target company shareholders will accept an offer

below $5.50 per share, and the offer will almost certainly need to be higher than

$5.50 if the takeover is to succeed.

Valuations based on other valuation methods should be compared with the asset-

based valuation. There should be some concern (for the bidding company) if a

valuation based on expected earnings, dividends or cash flows is lower than the

asset-based valuation.

2.4 Valuation based on earnings and P/E ratio

A simple method of estimating a value for a company in the absence of a stock

market value is to use earnings per share and a price-earning ratio:

Value = EPS × Estimated P/E ratio.

The problem with this valuation method for a private company is that a suitable

estimate must be obtained for both EPS and the P/E ratio.

 The EPS might be the EPS of the target company in the previous year, an

average EPS for a number of recent years or a forecast of EPS in a future year.

Any of these estimates for EPS could be used.

 Since a private company does not have a market value for its shares, the shares

do not have a P/E ratio. A P/E ratio must therefore be selected by looking at the

P/E ratio for similar companies whose shares are traded on a stock market. The

P/E ratio selected might be based on the average P/E ratio of a number of

similar companies whose shares are traded on a stock market, for which a

current P/E ratio is therefore available.

However, shares in public companies should be worth more than shares in an

identical private company, because they are more ‘liquid’. They can be sold on the

stock market at any time, whereas shares in a private company cannot be sold at all

unless a willing private buyer can be found.

Since shares in a quoted company ought to have a higher price than an identical

private company, the P/E ratio of a quoted company should also be higher than the

P/E ratio applied to a valuation of the private company’s shares.

For example, if a quoted company has a P/E ratio of 11.5 times, the P/E ratio used

to value shares in a similar private company in the same industry should be less

than 11.5. Unfortunately, there is no reliable method of deciding how much lower

than 11.5 a suitable P/E ratio should be.

Another problem with selecting a suitable P/E ratio is that it might not be possible

to identify quoted companies that are very similar to a private company. Some

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quoted companies might operate in the same industry, and might even be

competitors of the private company in some markets. However, a comparable

quoted company is likely to be larger than the private company, and might well

operate in a wider range of markets and in different geographical markets.

Example

The EPS of a private company, ABC Company, was $2.50 last year and is expected

to rise to $2.80 next year. Similar companies whose shares are quoted on the stock

market have P/E ratios ranging from 10.0 to 15.6. The average P/E ratio of these

companies is 12.5.

A valuation of the company might be to take the prospective EPS and apply the

average P/E ratio for similar companies:

Valuation = $2.80 × 12.5 = $35.00 per share.

An alternative evaluation might be to take the actual EPS last year and apply the

lowest P/E ratio of any other similar stock market company, reduced by, say, 10%

to allow for the fact that ABC Company is a private company and does not have a

stock market quotation.

Valuation = $2.80 × (90% × 10) = $25.20.

Here, a P/E ratio of 9 (90% × 10) has been used in the valuation.

Another valuation might be to use the EPS for last year and a P/E ratio of 9. This

would give a share value of $2.50 × 9 = $22.50.

By making different assumptions, the earnings-based valuation method has

provided valuations in a wide range of $22.50 to $35. From this example, it might be

apparent that the P/E ratio valuation method has a number of weaknesses:

 It is based on subjective opinions about what EPS figure and what P/E ratio

figure to use.

 It is not an objective or scientific valuation method.

 It is based on accounting measures (EPS) and not cash flows. However, the value

of an investment such as an investment in shares is derived from the cash that

the investment is expected to provide to the investor (shareholder).

The valuation can be compared with valuations using other valuation methods.

2.5 Dividend valuation model: constant annual dividends

The dividend valuation model is a more objective and cash-based approach to the

valuation of shares. It is based on the view that the value of a share to shareholders

is the value of all the future dividends that they expect to receive from the shares in

the future.

Chapter 9: Mergers and acquisitions

If the fair value of a share represents the value of all expected future dividends, this

value can be estimated by discounting expected future dividends to a present value.

All expected future dividends ‘in perpetuity’ may be discounted to a present value

at the shareholders’ cost of capital. The shareholders’ cost of capital is the return on

investment that shareholders expect to receive from their shares in the company.

Without going into the mathematics to prove the valuation model, it can be shown

that if it is assumed that the company will pay a constant annual dividend every

year into the foreseeable future, the present value of those dividends, and so the

value of the shares, is:

where:

is the current value of the share ex dividend

D is the amount of the annual cash dividend.

is the shareholders’ cost of capital expressed as a proportion (so 9% = 0.09, etc).

This valuation model assumes that the dividend is paid annually. This is the

assumption that is commonly used in examination questions.

A share price ex dividend is a price that excludes the value of the annual dividend

in the current year. For an ‘exact’ valuation using this model, it should be assumed

the next dividend is payable in one year’s time.

If the annual dividend in the current year has not yet been paid, but will soon be

paid, the value of the share is its value ‘cum dividend’.

Value cum dividend

= Value ex dividend + Amount of the dividend soon to be paid.

Example

A company is expected to pay an annual dividend of $0.48 per share into the

foreseeable future and the shareholders’ cost of capital is 12%. The most recent

annual dividend has just been paid.

Using the dividend valuation model, the value of the share (ex dividend) ought to

be $0.48/0.12 = $4.00.

If expectations about future annual dividends change from $0.48 per share to $0.54

per share, the valuation of the share will also change, to $4.50 (= $0.54/0.12).

If future annual dividends are expected to be $0.48 per share, but the shareholders’

cost of capital changes to 12.5%, the valuation of the share will fall to $3.84 (=

$0.48/0.125).

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The dividend valuation model therefore provides an explanation of how the value

of shares will rise or fall when there are changes in either:

 the expected annual dividend, or

 the shareholders’ required rate of return (the equity cost of capital).

Note on the cost of shareholder equity

To use the dividend valuation model (or the dividend growth model for valuation,

which is described next) we need an estimate of the cost of equity capital. When the

bidding company is a quoted company, it could use its own cost of equity to make

the valuation. Estimating the cost of a company’s equity is described in the chapter

on the cost of capital.

If the bidding company is also a private company, an estimate of the cost of equity

is required. This might be obtained from estimates of the cost of equity of similar

quoted companies.

2.6 Dividend valuation method: constant rate of growth in annual dividends

An alternative assumption in the dividend valuation model is that the annual

dividend will grow in the future. A valuation for shares in a company can therefore

be obtained by making a forecast of what the future rate of dividend growth each

year will be.

A simplifying assumption is that the dividends will grow at a constant annual

percentage rate.

If it is assumed that the company will pay an annual dividend that grows by a

constant percentage amount every year into the foreseeable future, the present value

of those dividends, and so the value of the shares, is:

−g

where:

is the current value of the share ex dividend

is the expected amount of the annual cash dividend in one year’s time (next

year)

is the shareholders’ cost of capital expressed as a proportion (so 9% = 0.09, etc)

g is the expected annual growth rate in dividends expressed as a proportion (3% =

0.03 etc)

This is the valuation of the share ex dividend. Note that this valuation formula is

based on the assumptions that:

 the dividend is paid annually, and

 the dividend for the current year has just been paid.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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