ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 9: Mergers and acquisitions

Example

A company has just paid an annual dividend of $0.48. Dividends are expected to

grow by 4% each year into the foreseeable future. The shareholders’ cost of capital is

12%.

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

is:

0.48 1.04

()

0.12 − 0.04

= $6.24

This provides a useful guide to a potential buyer of the shares, to suggest what the

valuation of the shares should be.

If there is no expected growth in annual dividends, and the company is expected to

pay a constant annual dividend in the future, the share valuation would have been

$4.00 (see the earlier example). Because the annual dividend is expected to increase

every year, the valuation is much higher.

Using the dividend growth model, the fair value of shares changes with:

 changes in expected future dividends (for example, changes in the expected

annual growth rate in dividends), or

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

Example

In the previous example, if the expected growth rate in annual dividends falls from

4% to 3%, the valuation of the shares will fall to:

$0.48 1.03

()

(0.12−0.03)

= $5.49

Change in the annual rate of dividend growth

The dividend growth model can also be used to value shares when the expected

growth rate in dividends is expected to change.

Example

A company has just paid an annual dividend of $0.63. This dividend is expected to

remain constant for two more years, but from Year 3 it is expected to grow by 3%

each year into the foreseeable future. The cost of shareholders’ funds is 10%.

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The expected value of the shares (ex dividend) at the end of Year 2 can be

calculated using the dividend growth model:

0.63 1.03

()

0.10 − 0.03

= $9.27

The expected current value of the share is:

 this valuation at the end of Year 2 discounted to a Year 0 value,

 plus the present value of the expected dividends at the end of Year 1 and Year 2.

Year

Discount

factor at 10%

1 Dividend 0.63

0.909

0.57

2 Dividend 0.63

0.826

0.52

2 End of Year 2 value 9.27

0.826

7.66

Share value

8.75

Note on retained earnings: Gordon’s growth model

Gordon’s growth model was explained in the earlier chapter on cost of capital.

Dividend growth can be achieved by retaining some profits (retained earnings) for

reinvestment in the business. Reinvested earnings should provide extra profits in

the future, so that higher dividends can be paid. When a company retains a

proportion of its earnings each year, the expected annual future growth rate in

dividends can be estimated using the formula:

g = br

where:

g = annual growth rate in dividends in perpetuity

b = proportion of earnings retained (for reinvestment in the business)

r = the shareholders’ required return on capital, which is also assumed to be the rate

of return that the company will make on its investments of retained earnings.

Example

A company has just achieved annual earnings per share of $0.50, of which 60% has

been paid in dividends and 40% has been reinvested as retained earnings. The

company is expected to retain 60% of its earnings every year and pay out the rest as

dividends. The return on investment achieved by the company is expected to be

10% per annum.

The anticipated annual growth in dividends = 40% × 10% = 4% or 0.04.

Using the dividend growth model, the expected value per share is:

0.30 1.04

()

0.10 − 0.04

= $5.20

Chapter 9: Mergers and acquisitions

2.7 Advantages and disadvantages of the dividend valuation models

The dividend valuation models provide a present value of expected future

dividends that is based on future cash flows (dividends) for a shareholder. It is

therefore a form of cash flow based model as well as a market-based model of

valuation.

The main weakness of the dividend growth model for the valuation of shares in an

acquisition is that the bidding company hopes to win control of the target company.

When it obtains control, it will decide the dividend policy of the acquired company.

It might decide to increase or reduce the dividend payout ratio (as a percentage of

earnings). This would affect the expected dividend growth rate.

It can also be argued that a more appropriate method of valuation should be one

based on the total cash flows of the acquired company, not just the dividends that

will be remitted to the parent company.

Cash flow-based company valuations are described in the next three sections of this

chapter.

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Valuation for mergers and acquisitions: cash flow models

 The advantages of a cash flow basis for business valuation

 Net present value method

3 Valuation for mergers and acquisitions: cash flow

models

3.1 The advantages of a cash flow basis for business valuation

Cash flow models of valuation are based on obtaining a valuation for a company or

business operation by putting a value to future expected cash flows. There are

several strong arguments in favour of a cash flow approach to valuation.

 Cash flows earned by a business are much more closely correlated to value and

shareholder wealth than accounting profits. Valuations should therefore be

based on expectations of future cash flows rather than expectations of profit or

accounting return on investment.

 Returns on an investment, such as the acquisition of another company, must be

sufficient to cover the costs of the finance used to make the acquisition. This

includes the cost of equity finance as well as the cost of any debt finance. It is

therefore appropriate to assess the value future cash flows from an acquisition in

terms of whether they provide a return in excess of the total cost of financing.

A key point to note is that if the purchase price for an acquisition exceeds the value

of the returns that will be obtained from the acquisition, allowing for the acquirer’s

cost of capital, the acquisition will destroy value. The value of the acquisition will be

less than the acquirer pays for it.

This is a strong argument for suggesting that businesses should be valued on the

basis of expected future cash flows and the cost of capital.

Three cash flow models will be described:

 The net present value method

 The shareholder value added (SVA) method of valuation

 Economic value added (EVA) and market value added (MVA)

3.2 Net present value method

The net present value method is straightforward. The valuation of a company or a

business should be calculated as the net present value of expected future cash flows

from the business, discounted at an appropriate cost of capital.

The following steps are required to apply the NPV valuation method.

 Estimate the relevant incremental cash flows from the business to be acquired.

Chapter 9: Mergers and acquisitions

 Discount these cash flows at an appropriate cost of capital that reflects the risk of

the investment.

 The maximum price that should be paid for the business is the present value (or

net present value) of these future expected cash flows.

The NPV method might be appropriate where the future cash flows from an

acquired business will be affected by the acquisition. For example, the acquirer

might have plans to invest extra capital in the acquired business after the acquisition

has taken place. This additional investment will affect future cash flows, and so

should affect the valuation.

Example

QX Company is considering the acquisition of an operating division from a

multinational company. If it acquires the division, it will invest an additional $12

million immediately to modernise equipment.

It has been estimated that the annual after-tax cash flows after the acquisition and

additional investment will be as follows:

Year $ million

1 6

2 8

3 10

4 8

5 onwards (per year) 4

An appropriate after-tax cost of capital for valuing the acquisition is 8%.

Required

Estimate the maximum amount that QX Company should be prepared to pay to

acquire the operating division from the multinational company.

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Answer

Year Cash flow

Discount

factor

$ million

0 (12)

1.000

(12.000)

1 6

0.926

5.556

2 8

0.857

6.856

3 10

0.794

7.940

4 8

0.735

5.880

5 onwards (per year) 4

9.188

36.752

50.984

Working:

Discount factor at 8%

In perpetuity (1/0.08) 12.500

Years 1 – 4 3.312

Year 5 in perpetuity 9.188

The maximum price to pay for the operating division is about $51 million.

Example

Company WY is considering the acquisition of another company, Company BN.

Company BN has 4 million shares in issue.

After the acquisition Company WY intends to invest a further $6 million for the

purchase of new operating assets in Company B. It is expected that annual cash

flows for equity will be $1.0 million in the first year following the acquisition, and

that these will increase by 8% each year for the next four years, after which the rate

of growth in annual cash flows will fall to 3%.

The cost of capital is 10%.

Required

Calculate a valuation of the equity capital of Company BN.

Answer

Year Cash flow Discount factor

at 10%

Present

value

$000 $000

0 (6,000) 1.000 (6,000)

1 1,000 0.909 909

2 1,080 0.826 892

3 1,166 0.751 876

4 1,260 0.683 861

5 1,360 0.621 845

6 onwards 20,615 0.621 12,802

Valuation

+ 11,185

Chapter 9: Mergers and acquisitions

A valuation based on the projected cash flows is $11.185 million or about $4.10 per

share for the 4 million shares.

Workings

After Year 5 the annual rate of growth in cash flows falls to 3%, so the cash flow in

Year 6 (in $000) will be 1,401.

The valuation of $1,401,000 in Year 6, rising by 3% in perpetuity, can be calculated

using the dividend growth model formula. The end of Year 5 present value of these

cash flows is:

PV in $000 = 1,401(1.03)

(0.10 – 0.03)

= (in $000) 20,615.

This is an end-of-Year 5 discounted value, which needs to be converted to a present

value using the Year 5 discount rate.

Note on the method of calculation used in this example

Make sure that you understand the technique for valuation of annual cash flows

from a year in the future, where the cash flows are expected to grow by a constant

percentage amount each year in perpetuity. This use of the Gordon’s growth model

for an NPV valuation or shareholder value added valuation could well feature n an

examination question.

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Shareholder value added (SVA) method of valuation

 Seven value drivers

 The steps in the SVA valuation method

 Valuation of the operational assets

 Definition of free cash flow

4 Shareholder value added (SVA) method of valuation

4.1 Seven value drivers

The shareholder value added method of valuation of a business is also based on

estimated cash flows and present values. The cash flows used for the valuation are

the ‘free cash flows’ of the business. The definition of free cash flows for the purpose

of SVA is explained later.

The SVA method also identifies seven factors or value drivers in the valuation.

These are as follows:

 Sales growth. Sales growth is expressed as a percentage growth in sales revenue

each year.

 Operating profit margin. This is the expected operating profit as a percentage of

sales revenue.

 Tax rate. This is the rate of tax on operating profit. It is a ‘cash’ tax rate, and

ignores deferred taxation.

 IWCI. This is the incremental working capital investment each year. An

additional working capital investment reduces free cash flow.

 RFCI and IFCI. RFCI is replacement fixed capital investment, which is the

amount of investment needed to replace non-current assets that reach the end of

their economic life. Ignoring inflation, it is often assumed that RFCI is equal to

the annual depreciation charge for non-current assets. IFCI is incremental fixed

capital investment, which is investment each year in non-current assets in excess

of the amount needed for the replacement of existing non-current assets. IFCI

reduces free cash flow.

 The cost of capital. This is used to discount future free cash flows to a present

value, for the purpose of valuation of the business.

 The ‘competitive advantage period’ or ‘value growth duration’. This is the

period of time during which the business is expected to achieve growth in its

current form, and obtain a return in excess of its cost of capital. After the

competitive advantage period, it is often assumed that annual free cash flows

will be a constant annual amount.

Chapter 9: Mergers and acquisitions

4.2 The steps in the SVA valuation method

There are three steps in the SVA method.

 Step 1. Calculate the value of the operational assets of the business.

 Step 2. Add the value of the non-operational assets, such as cash and

investments.

 The sum of the value of operational assets and non-operational assets is the total

value of the business assets.

 Step 3. Subtract from this total the value of the company’s debt. This gives a

valuation for the business equity.

4.3 Valuation of the operational assets

The most complex part of the valuation is the valuation of the operational assets of

the business. This is calculated as follows:

 For each year of the competitive advantage period, calculate the expected free

cash flow.

 Discount these annual cash flows to a present value, using the cost of capital.

Add these PVs to obtain the value of all expected future free cash flows during

the competitive advantage period.

 Calculate a present value for all the expected annual free cash flows after the

competitive advantage period. This is an annual free cash flow in perpetuity,

usually assuming no further growth.

 Add the value of free cash flows during the competitive advantage period and

those after the competitive advantage period to obtain a total valuation for the

operational assets of the business.

4.4 Definition of free cash flow

For the purpose of the SVA method, the following definition of annual free cash

flow is used:

Operating profit X

Less: Tax (X)

Equals: Profit after tax X

Add back: annual depreciation charge X

Equals: Operating cash flow X

Adjustments for

RFCI (X)

ICFI (X)

IWCI (X)

Equals: Free cash flow X

Paper P4: Advanced Financial Management

Notes:

RFCI, IFCI and ICWI are all additional capital investments when the business

is expected to grow. They are all therefore reductions in free cash flow.

It is often assumed that the annual depreciation charge and RFCI are the same

amount each year.

Example

You are required to use the SVA method to obtain a valuation for the equity of a

company that is the target for a takeover bid. The following information is available:

Current annual sales: $10 million

Competitive advantage period: 5 years

Cost of capital: 10%

Other value driver information:

Year 1

4 5 After year

5 (annual)

$m $m $m

Sales growth (%) 8

5 4 0

Operating profit margin (% of sales) 20

15 15 10

Tax rate (%) 30

30 30 30

IFCI (as a % of growth in sales) 5

4 2 0

IWCI (as a % of growth in sales) 20

15 10 0

Annual depreciation charges are $4 million.

The company has investments with a market value of $2 million and the total value

of its debt liabilities is $4.5 million.

Answer

Year 1

5 6

onwards

$m $m

Sales 10.80

11.56

12.25

12.86

13.38 13.38

Increase in sales 0.80

0.76

0.69

0.61

0.52 0

Operating profit

(margin % × sales)

2.16

2.31

2.21

1.93

2.01 1.34

Tax rate (%) 30

30 30

Operating profit after tax 1.51

1.62

1.55

1.35

1.41 0.94

Depreciation 4.00

4.00

4.00 4.00

Operating cash flow 5.51

5.62

5.55

5.35

5.41 4.94

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

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