ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 9: Mergers and acquisitions

company. To allow for negotiations on price, the directors of the company making

the takeover bid should consider an initial offer price and a price that they might be

willing to go up to. The directors of the target company should consider whether to

reject an initial offer from the bidding company, but then consider the minimum

price they would be willing to agree to and recommend to their shareholders.

6.3 Choice of valuation method and cost of capital

Several valuation methods have been described in this chapter. A company

preparing to make a takeover bid should consider several valuation methods and

compare the different valuations they produce. Judgement should then be used to

arrive at a price that should be offered for the target company shares.

Another factor to consider in the choice of valuation method is the risk profile of the

acquiring company, and how this might change after the acquisition. There are two

aspects to the risk profile:

 Financial risk: the financial risk of the acquiring company might change because

of a change in financial gearing due to the method used to finance the

acquisition. For example, if gearing increases because the acquisition is financed

largely by debt capital, the financial risk of the company will increase as a

consequence of the acquisition.

 Business risk. The target company might operate in an industry or market sector

where the business risk is very different from the business risk profile of the

acquiring company. When this happens, the business risk profile of the company

will change as a result of the acquisition.

No change in the risk profile after the acquisition

If there is no change in the financial risk profile or business risk profile as a

consequence of the acquisition, the company’s current WACC can be used for a cash

flow-based valuation (NPV, SVA, EVA) and the current cost of equity can be used

for a dividend-based valuation.

Change in the financial risk but not the business risk

When there is a change in the financial risk of the acquiring company as a

consequence of an acquisition, one approach to valuation is to re-calculate a cost of

equity at the new gearing level and a new WACC (using the method described in

the earlier chapter on cost of capital).

An estimated valuation for a proposed acquisition can also be assessed using the

APV method.

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6.4 APV method of assessing a company valuation

The APV method was described in an earlier chapter in the context of capital

expenditure appraisal. The same method can be applied to the valuation of a target

company when the financial risk profile of the acquiring company changes as a

result of the acquisition.

An example will be used to illustrate the technique.

Example

Big Company is considering a takeover bid for Little Company. Big Company is

currently financed by 75% equity and 25% debt capital. The equity beta of the

company’s shares is 1.10. The debt capital is considered risk-free. Tax on profits is at

the rate of 30%. The market rate of return is 9.5%.

Big Company thinks it will be prepared to offer $15 million to acquire the share

capital of Little Company, and would finance the acquisition entirely with debt

capital at the risk-free rate of 6%. For simplicity, assume that the debt capital is

borrowed in perpetuity.

The costs of the acquisition would be an additional $2.5 million in Year 0, with tax

relief on all these costs in Year 1. The issue costs would be financed from retained

profits.

By acquiring the share capital of Little Company, Big Company will increase the

post-tax operating profits by $2 million per year in perpetuity. Assume that the debt

capital will be repaid in full at the end of ten years.

An APV valuation can be made as follows.

(1) The ungeared beta can be calculated as follows:

= 1.10 × 75/[75 + 25(1 – 0.30)] = 0.81

(2) Cost of equity = 6% + 0.81(9.5 – 6.0)% = 8.8%, say 9%.

(3) Base case NPV = $2 million/0.09 = $22.2 million. The acquisition cost f $15

million must be deducted, giving a net base case NPV of $7.2 million.

(4) Tax relief on interest = (6% × $15 million) × 30% = $270,000.

PV on tax relief (in perpetuity) = $270,000/0.06 = $4.5 million.

(5) PV of acquisition costs = $2.5 million + ($2.5 million × 30% × 0.943) = $1.80

million.

(6) APV:

Base case NPV 7.2

PV of other costs (1.8)

PV of tax relief on interest

4.5

APV 9.9

The APV is positive, indicating that the acquisition is worthwhile at a

purchase cost of $15 million.

Chapter 9: Mergers and acquisitions

6.5 The iterative method of equity valuation

Another approach to obtaining a valuation for the equity of a company can be used

where the target company is in a different industry sector and it is not certain what

the cost of equity and cost of capital should be used for the valuation. The valuation

method is independent of how the acquisition will be financed.

The method is ‘iterative’, which means that the same method is used to make a large

number of repeated valuations until a ‘steady state’ is reached, and each successive

valuation produces the same total equity value.

Each repetition of the calculation process uses a cost of equity that is calculated from

an ungeared equity beta for the industry.

Initial assumptions and estimates

The starting point is to decide a value of debt for the company. This value does not

change in any of the iterative calculations. Next, an arbitrary valuation for equity

should be selected: any valuation is acceptable as a starting point. If in doubt, the

book value of equity should be used, but any other reasonable starting point is just

as good.

The expected cash flows from the acquisition should be estimated next. These cash

flows should be the earnings before interest and tax, or a cash flow equivalent

(which is even better). Tax should then be deducted to arrive at future estimates for

earnings or cash flow before interest but after tax (EBIBAT).

The iterative process

The iterative process starts with a calculation of the geared equity beta, using the

ungeared equity beta for the industry and the initial assumptions about capital

structure.

For example, suppose the valuation for the debt capital in the company is taken as

$1,000,000 and the starting point for the valuation of equity is the book value of

equity, which is $800,000. The rate of tax is 30% and the ungeared industry beta is

0.85. The re-geared beta for the company would then be calculated as follows:

0.85 = Geared beta × 800/[800 + (1,000 × 0.7)]

Geared beta = 1.5937.

The re-geared beta can be used to calculate a cost of equity, using the CAPM.

This cost of equity should then be used to obtain a present value of the estimated

future EBIBAT cash flows from the acquisition.

This first iteration gives a new value for equity, different from the starting

valuation. The same calculation process should now be repeated using the new

equity valuation but the same debt value and the same ungeared industry beta as

before. This gives a new re-geared equity beta, a new cost of equity and a new

equity valuation.

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The process should be repeated, often many times, before the valuation of equity is

the same with each repeated calculation. This ‘steady state’ valuation provides a

valuation for equity in the company, given a valuation of the debt.

Example

Large Company is considering a bid for the equity in Small Company. Small

Company is in a different industry where the ungeared equity beta is 0.90.

The value of Small Company’s debt is $600,000 and the book value of its equity is

$800,000.

The following cash flows would be expected, before interest and taxation, if the

takeover is successful:

Year $

1 200,000

2 500,000

3 550,000

4 onwards 600,000 per year

The rate of tax is 30%. The risk-free rate of interest is 5% and the market risk

premium is 3%.

Using the iterative method of valuation, it can be assumed that for the first iteration,

the value of equity should be $800,000. The re-geared beta for the company would

then be calculated as follows:

0.90 = Geared beta × 800/[800 + (600 × 0.7)]

Geared beta = 1.3725.

The cost of equity = 5% + 1.3725 × 3% = 9.1%, say 9%.

Year Cash flow

before interest

and tax

After tax Discount factor at

$ $ $

1 200,000 140,000 0.917 128,380

2 500,000 350,000 0.842 294,700

3 550,000 385,000 0.772 297,220

4 onwards 600,000 420,000 (1/0.09) × 0.772 3,602,667

4,322,967

This calculation process is repeated using an equity valuation of $4,322,967 rather

than $800,000, to obtain another equity valuation.

The process is repeated until each successive repetition of the calculation process

produces the same valuation for equity.

Chapter 9: Mergers and acquisitions

6.6 Valuation of high-growth start-up companies

The techniques already described in this chapter can be used for any sort of

company valuation. However, a particular problem arises in the case of high-

growth companies that are being set up, or have recently been set up. Valuations

might be needed by venture capital organisations that have been asked to invest

capital in the business.

The special features of high-growth start-up companies are as follows:

 The risk of failure of the business is high. Venture capital investors might allow

for a high failure rate when they make their investment decisions.

 Estimates of cash flows will be subject to enormous uncertainty, and might be

little better than a guess.

 The company’s equity will have no value for a venture capitalist until an ‘exit

route’ is available, and the venture capitalist is able to sell the shares, either in a

stock market flotation or in a trade sale of the company to another more

established company in the industry.

A venture capitalist might therefore be more interested in the exit valuation at the

end of the investment period, rather than estimates of cash flows in the intervening

years. An estimated exit valuation might be discounted to a present value, so that

the venture capitalist can assess how much it might be willing to invest in the

company.

The company’s management need to prepare a robust business plan, to give a

venture capitalist some reassurance that the business risks with the start-up

business can be managed successfully.

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Financing acquisitions and mergers

 Purchase consideration

 All-share consideration

 Cash or debt finance in the purchase consideration

7 Financing acquisitions and mergers

7.1 Purchase consideration

In a merger, one company might acquire the other company by issuing new shares.

The shareholders in the other company exchange their shares for the new shares in

the first company. For example, if company A and company B merge, company A

might issue new shares in exchange for the shares in company B. The company B

shareholders therefore become shareholders in the enlarged company A.

Similarly, a takeover might be paid for by issuing new shares to the shareholders in

the target company, who will then become shareholders in the buying company

after the takeover.

Example

Company X makes a successful bid to acquire the shares in company Y. Company Y

consists of 500,000 shares of $1 each. Company X offers 3 new shares for every 2

shares in company Y. Company X therefore issues 750,000 new shares to purchase

the shares in company Y and the company Y shareholders become shareholders of

company X. If the shares of company X are valued at $4 each before and after the

takeover, the takeover price is $3,000,000 (750,000 shares × $4).

Instead of making an acquisition by exchanging shares, a company might pay for

some or all of the acquisition:

 in cash (which it might obtain by borrowing)

 by issuing debt securities in exchange for some of the shares in the target company

In the example above for example, company X might have acquired the shares in

company Y for $3 million by paying $2 million in cash and $2 of redeemable loan

stock for every 1 share in company Y.

Cash to finance a takeover bid might be obtained from existing cash resources, or by

issuing new shares to other investors, or by borrowing.

The purchase consideration – both the total purchase price for a takeover and the

nature of the purchase consideration (shares, cash or debt securities) – are usually

subject to negotiation in a friendly takeover.

Chapter 9: Mergers and acquisitions

 In a friendly takeover, the directors of the target company negotiate terms that

they then recommend to their shareholders for acceptance.

 In a hostile takeover, the bidding company makes an offer to the shareholders in

the target company, without the co-operation of the board of directors of the

target company. With a hostile takeover bid, the bid is much more likely to

succeed if it is an all-cash offer, because the shareholders in the target company

might not want to retain any investment in the acquiring company.

7.2 All-share consideration

When a takeover is financed by issuing new shares as the purchase consideration,

either the shareholders in the buying company or the shareholders in the target

company will gain value at the expense of the shareholders in the other company.

Example

Company A and company B are companies whose shares are traded on a stock

market. Company A makes profits after tax of $800,000 each year and company B

makes after-tax profits of $400,000. Both companies have 1 million shares in issue.

Company A shares are valued on a price/earnings multiple of 10 and company B

shares are valued on a P/E multiple of 9 ($3.60 per share).

Suppose that company A makes an offer of $4.40 per share for company B, valuing

company B at $4.4 million. This values the company on a P/E ratio of 11.

Its own shares are valued at $8 each (EPS $0.80 × P/E ratio 10). If company A makes

an all-share offer, it would therefore propose to issue 550,000 new shares to the

shareholders in company B ($4.4 million/$8 per share). The terms of its offer would

therefore be 11 new shares in company A for every 20 shares in company B.

If the offer is accepted by the shareholders of company B, company A would consist

of 1,550,000 shares after the takeover. The combined after-tax profits of the company

might be $1.2 million ($800,000 + $400,000), which is the sum of the profits of the

individual companies before the takeover.

Does the takeover create wealth for the shareholders of company A?

The answer depends on what happens to the share price of company X after the

takeover. Unless there is an increase in the P/E ratio, or an increase in the profits of

the combined companies, a takeover will destroy value for the shareholders of the

company making the takeover when all of the following conditions apply:

 The purchase consideration is all shares.

 The purchase price is on a higher P/E multiple than the P/E ratio of the

company making the takeover.

 There is no increase in the combined profits of the two companies after the

takeover.

Paper P4: Advanced Financial Management

In this example, if the P/E ratio of the company after the takeover is 10, the total

value of the company will be $12 million ($1.2 million × 10), which is $7.74 per share

($12 million/1,550,000 shares).

The former shareholders in the two separate companies will therefore lose or gain

value in their investment, as follows:

Shares owned by

Number of

Value at

$7.74

Investment

value before

the takeover

(Loss)/gain

in value

$m $m

Original shareholders in A 1,000,000 7.74

8.00 (0.26)

Former shareholders of B 550,000 4.26

3.60 0.66

12.00

11.60

There has been some increase in value in the combined company, because the

earnings of company B are now valued on a higher P/E multiple. However, all the

benefits are enjoyed by the former shareholders in company B. The original

shareholders in company A have suffered a loss in value due to the takeover.

All-share consideration: the effect of synergy

If there is synergy, and total annual earnings and cash profits increase, the total

value of the businesses should be expected to increase, adding value for the

shareholders.

In the example above, suppose that after the acquisition of company B by company

A, there are benefits from economies of scale and total annual earnings increase by

$200,000 to $1,400,000. Suppose also that the P/E ratio of the enlarged company A is

10. The total value of company A will now be $1.4 million × 10 = $14 million. The

price per share will be $9.03.

The former shareholders in the two separate companies will therefore gain value in

their investment, as follows:

Shares owned by

Number

of shares

Value at

$9.03

Value

before

takeover

Gain

in value

$m $m

Original shareholders in A 1,000,000

9.03

8.00 1.03

Former shareholders of B 550,000

4.97

3.60 1.37

14.00

11.60

Because of the synergy and growth in combined earnings (or cash profits),

shareholders in both companies benefit from the takeover.

7.2 Cash or debt finance in the purchase consideration

Another way of providing extra value for shareholders in a takeover might be to

pay for the acquisition in whole or in part with either cash (financed by borrowing)

or debt securities. The benefit of paying in these ways is that there is tax relief on the

interest cost.

Chapter 9: Mergers and acquisitions

The target company’s shareholders might want to be paid in cash; therefore offering

to buy the target company’s shares for cash (financed by new debt) could be

attractive to those shareholders, who will be cashing in their investment by

accepting the takeover offer.

Example

Returning to the previous example, suppose that a takeover price of $4,400,000 is

agreed for company B, and that this purchase price is paid all in cash, with the

money obtained from a bank loan at 8% interest.

The rate of tax is 25%, and after the takeover there is no synergy. The company’s

shares continue to be valued on a P/E multiple of 10.

The company’s earnings and value after the takeover can be calculated as follows:

Profits of ‘old’ company A 800,000

Profits of ‘old’ company B

400,000

1,200,000

Interest on debt ($4.4 million × 8%)

(352,000)

Less tax relief at 25% 88,000

Net cost of interest

(264,000)

Annual earnings after the takeover

936,000

Value of company A shares $

After the takeover ($936,000 × 10) 9,360,000

Before the takeover 8,000,000

Gain to company A shareholders

1,360,000

Company A will now be geared, and its cost of capital might therefore change. If so,

the P/E ratio would no longer be 10. Even so, financing a takeover with debt capital

can add to the wealth of the shareholders because of the tax relief on debt interest.

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

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