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Chapter 5bGlobal mergers and acquisitions
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Valuation methods
Adjusted net assets
Comparables
Value based on the net realizable value of the assets and liabilities on a going concern basis.
The net present value of the projected free cash flows discounted at an appropriate discount rate (risk adjustedcost of capital).
Valuation benchmarks based on the targetindustry/country’s previous recent deals or market valuation of comparable business. Use of earnings multiples or sales multiples.
Valuationmethodologies
Discountedcash flow
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TangibleLand and propertyEquipmentInventoriesReceivablesSecuritiesCashIntangiblePatentsBrandsCustomer base
Market valueReplacement valueMarket value minus obsolete itemsFace value minus unrecoverableMarket valueFace value
???
Industry norms?
Minus Long term Short termSuppliersHidden liabilities
ASSETS
LIABILITIES
Adjusted net assetsViews the value of the business as the excess of assets over liabilities in adjusted book value terms.
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Commonly used when:• the company being valued is predominantly an investment-holding entity
which does not carry on any business operations of a commercial nature;
• or the company businesses is tangible asset intensive;
• or the company carries on a business which incurs losses or generates insufficient return on the assets employed;
• or the future prospects of a company are extremely doubtful and/or liquidation is being contemplated;
• or the sale of a company is required.
• Replacement value• “Fire sale” or its assets• Orderly realization of its assets
Adjusted net assets cont.
Three potential assumptions:
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Standalone: Business as a going concern
Synergies: Value added resulting from the combination of operations
Discounted cash flow (“DCF”)Two kinds
of cash flow
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DCF approach requires:
- Estimation of forecast net “free cash flows” for the company for its outlook period (approx. 5 years), based on revenues and costs projection
- Estimation of key industry risks, growth prospects and the general economic outlook, etc.
- Estimation of a terminal value for the company at the end of its outlook period
- Determination of discount rates, given the optimum mix of financing between equity and debt given the company rating and the estimated costs of these forms of financing (weighted average cost of capital)
- Calculation of the value of the company based on the sum of the net present values of the forecast net cash flows and the terminal value
DCF cont.
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Earnings before interest, depreciation, amortization & tax (EBITDA)- Tax on EBITDA1
= Net operating profit before depreciation, amortization and after tax
+ Depreciation tax shield2
- Increase in working capital requirement (Δ inventories+ Δ receivables -Δ payables)
- Net capital expenditures
= Cash flow from assets (free cash flow)
Estimating standalone free cash flows from accounting data
1 Tax rate × EBITDA2 Depreciation expenses × tax rate
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Forecasting the standalone cash flow
1. Forecast sales: market share * size of the target market
2. Examine the historical relationship between sales and the components of cash flow (EBITDA/sales, working capital/sales, fixed assets/sales)
3. Check how reasonable the forecast is: compare growth, profit, economic value added with past performances and competitors’ performance
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The relevant cash flows
Ignore all financing cash flows. All these cash flows are takeninto account by the cost of capital. Estimate only pre-financing cash flows.
Only CASH matters!
For valuation purposes we need to discount cash expenditures as they occur - NOT the accounting measures of earnings.
The relevant cash flow includes the sales of non productives assets.
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Forecasting the standalone cash flow terminal value
The business is considered as continuing after the end of the cash flow calculation period (except in special cases, e.g. mining, oil)
The business usual methods are:• to calculate the terminal value as a perpetual value equal to last cash
flow/WACC (weighted average cost of capital)
• or if on considering that the business is still growing equal to last cash flow * 1+ growth rate)/ WACC – growth rate
• another method is to calculate the liquidation value at the end (net assets)
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Standalone valueEquals:
- NPV of free cash flows- Plus disposals- Minus debts
Adjusted with:
- Cash flows resulting from post mergers- Operational improvements (without synergies)
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Revenuesenhancement
Cost reduction
Processimprovement
Financial
Synergies
Transfer of best practices
Information sharing
= higher cash flow stream
Synergies cash flow
1=either cash flow or WACC
Extension of distribution
Product complementarity
System integration
Geographical extension
Market power
Economies of scale poolingResources e.g. procurement
Economies of scope
Consolidation
Risk reduction1
Cost of debts reduction1
Tax shield
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R&D Procurement Manufacturing Marketing General
COMPETENCES
ASSETS
R&D Procurement Manufacturing Marketing General
Synergies
RESOURCES How much can we gain from common sourcing, access to contacts, financial clout, etc.?Do we have access to better people thanks to the combination of industry?
How much can we gain from grouping factories, sharing distribution and sales forces,computer systems, etc.?
What know-how can we transfer? Can we learn from the other industry? How much isthe technology of this diversification worth?
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Innovation Technology transfer - License - Know-howleading to: Process improvement Product improvement New products Rationalization of R&D
Estimate of additional cash flow coming from:
Cost reductions; speed Increase in sales New sales Overheads; headcount
Procurement Purchasing power Time delivery Rationalization ofprocurement process and supply chain, and sources of supplies
Lower supplies cost Increase in sales and lower inventories Overheads, headcount Higher quality, lower costs
Valuation of synergies
Value chain element Source of synergies How is it measured?
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Manufacturing/operations
Economies of scale Time delivery Rationalization of operations(plant closure, reorganization)
Lower unit costs Increase in sales and lower inventories Overheads; headcount
Marketing Economies of scale in distribution logistics Extended distribution Rationalizationof sales force Joint advertising Joint market research Joint product management Solution selling
Lower unit costs and lower inventories Increased salesOverheads; headcount Lower costs Lower costs Lower costs Higher revenues
Value chain element Source of synergies How is it measured?
Valuation of synergies cont.
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Administration Rationalization of IT and other infrastructures Legal, accounting and consulting fees Rationalization of offices
Net saving (total potential saving minus migration costs) Overheads; headcount
Financial Debts capacities Tax shield
Lower cost of debts Tax savings
Value chain element Source of synergies How is it measured?
Valuation of synergies cont.
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Valuation of synergies: summary
Revenues increase
Cost decreaseSource of synergies
Effect of cash flow
Innovation Procurement Manufacturing/Operations Marketing Administration Financial Others
+++++++
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NET EFFECT over cash flow periodExceptional items:
Sales of duplicated assets (indicate year)Cost of integration (indicate year)
+ -
Cash flow effects over the years 1, 2, 3, 4, ….
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Selecting a discount rate
WACC (Weighted average cost of capital) =
(Cost of debts *% of debts financing)+ (Cost of equity * % of equity financing)
Cost of debt= interest rateCost of equity = risk free rate + (market risk premium * company risk premium)
• Premium? Which risk premium ? Acquirer or Acquiree?• Adjusted cash flows
How do we assess RISK?
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How to incorporate country risk in cash flow
valuation?
Adjust cost of capital(equity and debts)
Adjust cash flow
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1. Calculate the risk premium due to market risk (off-shore project beta) to be included in the cost of equity
1. Off-shore project beta = beta of comparable project in home country * country beta2. Where country beta = volatility of the host country stock market (correlation of changes
with home country) (or GDP)/ to the home country
2. Add a political risk premium1. Bond risk premium
3. Adjust WACC accordingly
4. Cost of equity in a foreign investment:
1. = risk-free home country + country risk (bond risk premium) + market risk premium*2. (company beta * country market beta)
Adjusting the cost of equity (Donald Lessard - MIT)
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1. Identify the elements of cash flow subject to country risk variation (revenues, costs)
2. Assign a probability of occurrence to those elements
3. Take the expected value [likely cashflow * (1-probability of adverse event)]
4. Possibility to run a Monte Carlo simulation if various probabilities affect various elements
5. Calculate NPV with global cost of capital
Adjusting the cash flows (Hawawini & Viallet - INSEAD)
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Has a strong theoretical basis and is most commonly used for:
• businesses with reasonable predictable revenue and cash flows
• start up projects
• businesses with diverse capital expenditure requirements over time
• businesses that are subject to cyclical factors
• limited life projects
Source: Ernst & Young
Discounted cash flow (“DCF”)
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Comparison of similar transactions in similar industries:• Price/earnings ratio • or price/ EBITDA• or in some cases price/ sales
Appropriate valuation when comparable transactions are available
This method involves:
• Selection of the earnings, EBITDA, sales level based on historical and forecasted operating results, non-recurring items of income and expenditure and known factors likely to impact on operating performance; and
• Determination of an appropriate capitalization multiple taking into consideration the market rating of comparable companies, the extent and nature of competition, quality of earnings, growth prospects and relative business risks.
Source: Ernst & Young
Comparable values
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The appropriate multiple is usually assessed:• Comparing the multiples of companies that are in the same
or similar industries• And where possible, purchase and sale transactions
involving comparable companies
Some of the issues to be considered:• Individual characteristics (growth, size, gearing, etc.)• Time period consistency (e.g. Historical earnings with
historical multiples) • Obtaining market evidence of comparable company multiple
(from Bloomberg…)
Source: Ernst & Young
Comparable values cont.
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The value capture decomposition
Stand-alonevalue
Implement-tationcosts
EmployeesSuppliersCustomersCompensations
Competitors’gains
Valuecaptured
Total valuepotential
Synergies
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