ACCA P4 Advanced Financial Management - 2010 - Study text

Подождите немного. Документ загружается.

Chapter 9: Mergers and acquisitions

RFCI (4.00)

(4.00)

(4.00) (4.00)

IFCI (0.04)

(0.04)

(0.03)

(0.02)

(0.01) 0

IWCI (0.16)

(0.15)

(0.10)

(0.09)

(0.05) 0

Free cash flow 1.31

1.43

1.42

1.24

1.35 0.94

Discount factor at 10% 0.909

0.826

0.751

0.683

0.621 6.209

PV of free cash flow 1.19

1.18

1.07

0.85

0.84 5.84

Total PV of free cash flows: $10.97m

The value of the operational assets is $10.97 million, say $11.0 million.

Valuation of operational assets 11.0

Value of non-operational assets 2.0

Total value of all assets 13.0

Less: Value of debt (4.5)

Equals: Value of equity 8.5

Workings and assumptions:

1 Replacement fixed capital investment is equal to the annual depreciation

charge.

Discount factor at 10%

In perpetuity (1/0.10) 10.000

Years 1 – 5 3.791

Year 6 in perpetuity 6.209

Paper P4: Advanced Financial Management

256 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

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

 The origins of the EVA method

 The concept of economic value added

 Calculating EVA

 Market value added: MVA

 The link between EVA and MVA

 EVA and MVA as a valuation method for companies

 Advantages and disadvantages of EVA and MVA for valuation

5 Economic value added (EVA) and market value added

(MVA)

Another approach to the valuation of companies is to calculate how much value is

added to the company each year, and use this annual increase in value as a basis for

making a valuation for the company. One approach to calculating the increase in

value during a period is to measure economic value added or EVA®. (EVA is a

registered trade mark of the consultancy firm Stern Stewart.)

5.1 The origins of the EVA method

Economic value added or EVA is a measure of performance that provides a useful

assessment of how much shareholder value has been added during a period.

 One method of measuring the creation of shareholder value is to take the change

in the share price during the period and add dividend payments. However, this

measure of the increase in shareholder value is unreliable and so unsatisfactory,

because short-term movements in share prices are dependent on factors other

than financial performance.

 It is usual to assess management performance by the profit earned during a

period or the return on investment ROI (return on net assets RONA). However,

accounting profit is an unsatisfactory measurement of shareholder value added.

ROI is also criticised as a measure of performance because it can encourage

management decision-making that is not in the best interests of the company –

such as deferring capital investments and choosing not to invest in research and

development, because these would reduce ROI in the short-term.

EVA was developed as a measure of performance that is closely correlated to

shareholder wealth. In addition, when EVA is used as a basis for a management

incentive scheme, it can encourage management to make decisions that are in the

best interests of the company, such as investing for the longer term, in capital

expenditure, research and development (innovation) and brand-building.

Chapter 9: Mergers and acquisitions

5.2 The concept of economic value added

Measuring EVA is a complex calculation, but the basic concept is very simple. (It is

similar to the concept of residual income.)

 Managers should be charged for the capital that they use. This should include

equity capital as well as debt capital.

 A company, and each operating division within a company, should make

enough profits after tax to provide the returns that are expected by the providers

of capital (equity and debt).

 A charge for the use of capital should therefore be deducted from operating

profit after tax.

 If operating profit exceeds the capital charge, economic value has been added

and shareholder value has been created.

 If operating profit is not sufficient to cover the capital charge, value has been

lost. Providers of capital would be justified in wanting to move their capital to

an investment yielding higher returns, or in wanting to replace the current

managers with new management who are better at creating value.

The economic value added during a period is calculated as follows:

Net operating profit after tax – (Capital employed × Cost of capital %)

EVA = NOPAT - (Capital employed × WACC)

Where:

(1) WACC is the weighted average cost of capital.

(2) Capital employed is the capital employed at the beginning of the financial

year

, with some adjustments (as described later).

(3) The net operating profit figure is after deduction of a charge for tax (unlike

normal measurements of ROI and residual income). The cost of debt interest is

included in the capital charge; therefore interest costs are not deducted in arriving at

the figure for net operating profit. NOPAT is operating profit before deducting

interest charges but after deducting an amount for tax.

5.3 Calculating EVA

The concept of EVA was developed by the consultancy firm Stern Stewart.

It is argued that accounting measurements of operating profit and capital employed

are unreliable and unrealistic in various respects. The figures that should be used

are:

 the economic value of capital employed, and

 an estimate of economic profit.

These figures can be estimated by making adjustments to the accounting figures for

capital employed and profit. Stern Stewart have identified a large number of

Paper P4: Advanced Financial Management

258 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

adjustments that should be made to the accounting figures for profit and capital

employed. Originally they identified 164 adjustments that should be made.

However making all these adjustments would be time-consuming and many of

them would not have a material impact on the resulting figure for EVA.

In practice, companies using EVA therefore make about 5 to 15 adjustments, which

affect EVA by a material amount. Some of these are explained here.

Adjustments to capital employed

Several adjustments should be made to the accounting (balance sheet) value of

capital employed to arrive at an estimate for the economic value of capital

employed.

 Expenditure on some ‘intangible items’ is treated as an expense in the income

statement, and written off in the year that it is incurred. However, some

spending on intangibles adds to the economic value of a company’s assets. The

expenditure should therefore be capitalised and amortised over a number of

years. An important example is spending on research and development. It could

also be argued that some spending on training and on advertising to develop a

brand name are items that should be capitalised and amortised over several

years.

 Provisions or allowances in the accounting balance sheet are not ‘real’ reductions

in capital, and should be added back. In particular, any deferred tax reserve and

allowance for doubtful debts should be added back to capital.

 On the other hand, long-term leases should not be capitalised. If they have been

capitalised, they should be deducted from capital. The rent paid on a lease is a

measure of its economic cost. Instead of including depreciation of a leased asset

and a finance charge in the income statement, these should be replaced by the

actual lease rental for the period.

Capital employed can be measured in either of two ways:

Assets method Liabilities and equity method

Current assets minus non-interest bearing

current liabilities (such as trade payables)

Interest-bearing current liabilities (for example, a

bank overdraft)

Plus Plus

Non-current assets net of depreciation and

impairment

Interest-bearing non-current liabilities (for example,

bonds and long-term loans)

Plus (or minus) Plus (or minus)

Adjustments to assets/equity as described

above

Adjustments to assets/equity as described above

Equals: Capital employed Equals: Capital employed

Adjustments to NOPAT

Some adjustments must also be made to the accounting figure for NOPAT in order

to reach an estimate of the economic profit before capital charge.

 Amounts charged as an expense in the income statement that should be

capitalised (such as research and development expenditure) should be added

Chapter 9: Mergers and acquisitions

back to profit, but an amortisation charge should be made to reflect the loss of

economic value in the intangible asset during the period.

 Depreciation and finance charges for leased assets (finance leases) should be

added back to profit, but the actual lease rental should be deducted.

 Any addition to the deferred taxation reserve should be added back to NOPAT

(or any reduction in deferred tax should be subtracted from NOPAT). The tax

charge in calculating NOPAT should be the actual amount of tax that the

company expects to pay on its profits for the year.

 A calculation of NOPAT might also allow for the fact that the ‘cash’ tax charge

includes tax relief on debt interest. The tax relief on debt interest is allowed for

in the weighted average cost of capital; including tax relief in the tax charge

would be ‘double-counting’. The tax charge should therefore be increased by

the amount of tax relief on debt interest.

Capital charge

The capital charge for the year is the economic value of capital employed multiplied

by the company’s weighted average cost of capital. Usually, the WACC is applied to

the capital employed as at the beginning of the year.

EVA and depreciation and impairment of non-current assets

You might notice that the adjustments to capital employed and NOPAT do not

include any adjustment for the depreciation and impairment of non-current assets.

Assets lose economic value each year, and it is appropriate to make a charge for the

loss of economic value – economic depreciation or economic impairment. A figure

for economic depreciation should be used in calculating EVA, and this should

replace the accounting figure for depreciation.

 Economic depreciation must be recovered from the company’s cash flows. It

might help to think of this as cash that is needed for the essential replacement of

worn-out assets. There must be a charge for economic depreciation in calculating

EVA.

 It is often assumed that accounting depreciation is a reasonable approximation

of economic depreciation of tangible non-current assets.

 For these reasons, there is no adjustment to EVA for accounting depreciation

charges.

It is also appropriate to assume that any charge for impairment of assets (including

goodwill) in the accounting balance sheet is an appropriate measure of the

impairment of economic value.

As a result, no adjustments are made to the depreciation charge or the amounts

written off for impairment of tangible non-current assets, goodwill or other

intangible non-current assets in the accounting balance sheet.

Paper P4: Advanced Financial Management

260 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Note

EVA is NOT an estimate of cash flow profits and should not be confused with cash

flows or ‘free cash flow’.

 NOPAT is an estimate of economic profit, and it includes charges for

depreciation and amortisation.

 The charge for the cost of capital includes a charge for the cost of equity, which

is not a cash item of cost.

A simplified example is shown below to illustrate how EVA might be calculated.

Example

At the beginning of a financial year, a company’s balance sheet capital employed

was $150 million (accounting measurements).

During the year, the company’s profits were as follows in the financial accounts:

$ million

Profit before interest and tax

24.0

Interest

4.0

20.0

Taxation

Tax on current year profits 6.0

Deferred tax 2.0

8.0

Profit after tax

12.0

Dividends

5.0

Retained profit for the year

7.0

The following additional information is available:

(1)

For the first time, the company has invested in research and development.

Expenditure during the year was $5 million and the full cost has been written

off as an expense in the income statement. To measure EVA, it should be

assumed that the amortisation charge for R&D for the year should be $1

million.

(2)

There was an increase in the allowance for doubtful debts from $1.5 million to

$2 million.

(3)

Taxation is 30% of profits.

(4)

The company’s weighted average cost of capital is 10%.

Required

(a) Calculate an estimate of economic value added for the year. Assume for the

purpose of this example that the capital charge is calculated using the

year-

end

value of capital employed, before adding EVA for the year.

(b)

Calculate the economic value of the company’s capital employed as at the

beginning of the following financial year.

Chapter 9: Mergers and acquisitions

Answer

Capital employed

$ million

At the beginning of the year (no adjustments)

150.0

Adjustments for:

Allowance for doubtful debts 2.0

Research and development 4.0

($5 million minus $1 million amortisation)

Year-end economic value of capital employed

156.0

Note: The capital charge will be calculated in this example on the year-end

value of the capital employed before adding EVA. In practice, the beginning-

of-the-year value of capital employed is normally used.

Method 1 Method 2

Profit before interest and tax

24.0

Accounting profit after tax 12.0

Tax charge on profit (6.0)

Tax relief on interest (1.2)

Plus tax relief on interest (1.2)

Add back

16.8

Interest charge

4.0

Adjustments

Deferred tax

2.0

Increase in allowance for doubtful

debts

0.5

16.8

R&D expenditure capitalised

5.0

Adjustments for

Amortisation of R&D (1.0)

Increase in allowance for doubtful

debts

0.5

NOPAT

21.3

R&D capitalised 5.0

Amortisation of R&D (1.0)

NOPAT

21.3

Economic value added

$ million

NOPAT

21.3

Capital charge ($156 million × 10%)

15.6

EVA 5.7

Economic value of capital employed

$ million

Year-end value before adding EVA

156.0

EVA for the year 5.7

Dividends paid 5.0

At the beginning of the next financial year

156.7

5.4 Market value added: MVA

Market value added or MVA is a measurement of value that builds on the Stern

Stewart EVA model. EVA measures the economic value that has been added to a

company during a specific period of time, such as a financial year. MVA provides a

link between EVA and the market valuation of companies.

Measuring MVA

MVA can be calculated as follows:

 Take the total amount of money that has been invested in the company, through

share issues, borrowing and retained earnings. Make adjustments to retained

earnings, to allow for differences between accounting profit and economic value.

The resulting figure should be the economic book value of the capital employed

in the company.

Paper P4: Advanced Financial Management

 Calculate the current total market value of the company’s capital – equity and

debt.

 Calculate the difference between these two amounts, to obtain MVA.

MVA = [Current market value of equity and debt] minus [Economic value of

assets/capital employed]

MVA is therefore the premium over the economic book value of the company’s

assets that investors have given to the company’s securities.

 If MVA increases, value has been created.

 If MVA falls, value has been lost or destroyed.

 Over time, if a company adds shareholder value each year, and has a positive

EVA, MVA should increase.

5.5 The link between EVA and MVA

Another way of defining MVA is as follows:

If MVA is positive, it represents a premium that investors place on the company’s

securities, in excess of the economic book value of its assets. It therefore represents a

value that investors give to the expected future growth opportunities for the

company. This value can be defined as the present value given by investors to the

expected EVA that the company will create in future years.

Market value of the

company’s equity and

debt

MVA

= PV of expected future EVAs

Economic book value of

assets

5.6 EVA and MVA as a valuation method for companies

EVA and MVA could be used as a method of putting a valuation to a company

(public or private company) or to an operating division of a company. A valuation

could be obtained as follows:

Current economic value of assets X

Add Estimated MVA Y

Equals Valuation of company/division X + Y

The MVA can be calculated by estimating the expected EVA for the company or

division over a selected number of years into the future. These EVAs should then be

discounted to a present value using a suitable cost of capital, to obtain a valuation

for MVA.

Chapter 9: Mergers and acquisitions

Example

ABC, a public limited company, is considering a takeover bid for XYZ, a private

company. The takeover will be ‘friendly’, but ABC needs to decide a price that it is

prepared to offer for the acquisition of the shares in XYZ.

The accounts of XYZ for the past few years have been analysed, and adjustments

have been made to obtain an estimated economic book value of the assets of XYZ,

which is $50 million. It has also been estimated that for each of the past five years,

XYZ has made economic value added of $4 million.

ABC is prepared to pay for the economic value of XYZ’s assets plus a premium

based on MVA. It proposes to calculate MVA as the present value of expected

annual EVAs for the next ten years. It is estimated that EVA will be $4.5 million per

year in the future. A suitable cost of capital to apply to the valuation is 9%.

The price that ABC will offer is therefore calculated as follows:

$ million

Current economic value of assets 50.0

Estimated MVA (see working) 28.9

Valuation of company 78.9

Working: Calculation of MVA

Annual EVA = $4.5 million

Discount factor, years 1 – 10, at 9% = 6.418

MVA = $4.5 million × 6.418 = $28.9 million

5.7 Advantages and disadvantages of EVA and MVA for valuation

There are several advantages with the EVA/MVA valuation method.

 The concept is quite simple, although the calculation of EVA might be complex.

 It can be applied to private companies and also to divisions of companies.

 It links the valuation of companies to the creation of shareholder value.

(Research appears to show that over time, changes in the MVA of companies

have been closely correlated to EVA.)

There are several disadvantages with the EVA/MVA valuation method.

 To use EVA for a company valuation, we use estimates of EVA in future years.

EVA was actually devised as a historical measure of past performance.

 It could be argued that a valuation based on the PV of free cash flows from the

acquired company is more appropriate than a valuation based on a conceptual

value such as EVA.

Paper P4: Advanced Financial Management

Other aspects of valuation

 Other factors to consider in pricing a takeover bid

 Valuation assumptions

 Choice of valuation method and cost of capital

 APV method of assessing a company valuation

 The iterative method of equity valuation

 Valuation of high-growth start-up companies

6 Other aspects of valuation

6.1 Other factors to consider in pricing a takeover bid

When a company is considering a takeover bid for another company, there a several

important factors to consider before deciding what offer price might be appropriate.

These include:

 Synergy

 Risk exposure. An acquisition or merger might alter the exposure to market risk,

and either increase or reduce the asset beta of the enlarged company. Before

masking a takeover bid, or deciding on a suitable offer price, the company

making the acquisition should consider what changes might happen to its risk

exposures, and how significant they might be.

 Real options. An acquisition might create real options to expand operations or

re-deploy at some time in the future. Real options are described in another

chapter. Briefly, a real option is an option to take a course of action at some time

in the future, often depending on how the business develops. If an acquisition

creates a real option, such as an option to expand into a new geographical

market at some time in the future, this option has some value.

 Financing. An acquisition often requires substantial financing, and the acquiring

company needs to consider how it might be able to raise the finance. It might be

difficult to raise new debt finance to acquire a highly-geared target company

(depending on conditions in the debt markets) when the acquiring company is

also highly-geared. Using retained earnings to finance acquisitions might have

implications for dividend policy.

 Valuation assumptions.

6.2 Valuation assumptions

In a takeover process, separate valuations for the target company are made by the

company making the takeover bid and the directors of the target company.

Shareholders in both companies might also have their own views on valuation.

Valuations are based on assumptions, but many assumptions are based on

judgements rather than ‘hard evidence’. Estimates might be unreliable, such as

estimates of the growth rate in future profits or free cash flows of the target

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

Подождите немного. Документ загружается.