Mergers and Acquisitions Unit 4

Unit 4 Valuation
Structure
4.1 Introduction
Objectives
4.2 Meaning and Valuation Approaches
4.3 Basis of valuation
Self Assessment Questions
4.4 Valuation Methods
Relative Valuation
Discounted cash flow valuation
Market Multiple Analysis
Self Assessment Questions
Earning Analysis
Self Assessment Questions
Valuing Operating and Financial Synergy
Valuing corporate control
Valuing LBO
4.5 Summary
4.6 Terminal Questions
4.7 Answers to SAQs and TQs

4.1 Introduction
This unit presents a comprehensive approach to corporate valuation. It
provides a unique combination of practical valuation techniques with the
most current thinking to provide an up-to-date synthesis of valuation theory,
as it applies to mergers, buyouts and restructuring. The unit will provide the
understanding and the answers to the problems encountered in valuation
practice, including detailed treatments of free cash flow valuation; financial
and valuation of leveraged buyouts.

Objectives
After studying this unit, you should be able to:
 Define the concept of Valuation of corporate merger and acquisition
 Discuss the valuation in relation to merger and acquisition activity
 Discuss the valuation of operation and financial synergy
 Discuss the valuation of LBO
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4.2 Meaning and Valuation Approaches

Once a firm has an acquisition motive, there are two key questions that
need to be answered.
 The first relates to how to best identify a potential target firm for an
acquisition
 The second is the more concrete question how to value a target firm
Valuation is the process of estimating the market value of a financial asset
or liability. Valuations can be done on assets or on liabilities. Valuations are
required in many contexts including merger and acquisition transactions.
Valuation is the starting point of any merger, buyout or restructuring
decision.
Before any mergers & acquisitions take place, a valuation of the intended
firm must be conducted in order to determine the true financial worth of the
company in question. Valuation is the device to assess the worth of the
enterprise. Valuation of both companies is necessary for fixing the
consideration amount to be paid in the form of exchange of shares.
Such valuation helps in determining the value of shares of the acquired
company as well as the acquiring company to safeguard the interest of the
share holders of both the companies. Valuation is necessary for the decision
making by shareholders to sell their interest in the company in the form of
shares.
To enable shareholders of both the companies, to take decision in favour of
amalgamation, valuation of shares is needed. The valuation should give
answer to the following basic questions:
 What is the maximum price that should be paid to the shareholder of the
merged company?
 How is the price justified with reference to the value of assets, earnings,
cash flows, balance sheet implications of the amalgamation?
 What should be the strength of the surviving company reflected in
market price or enhanced earning, capacity with reference to the
acquired strategies to justify the consideration of the merged company?
The above questions find answers in valuation and fixation of exchange
ratios. There are two final points worth making here, before we move on to
valuation. The first is that firms often choose a target firm and a motive for

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the acquisition simultaneously, rather than sequentially. That does not

change any of the analysis in these sections. The other point is that firms
often have more than one motive in an acquisition, say, control and synergy.
If this is the case, the search for a target firm should be guided by the
dominant motive.

4.3 Basis of Valuation

Valuation of business is done using one or more of these types of models:
1. Relative value models determine the value based on the market prices
of similar business.
2. Absolute value models determine the value by estimating the expected
future earnings from owning the business discounted to their present
value
An accurate valuation of companies largely depends on the reliability of the
company's financial information. Inaccurate financial information can lead to
over and undervaluation. In an acquisition, due diligence is commonly
performed by the buyer to validate the representations made by the seller.
The financial analysis required to be made in the case of merger or takeover
is comprised of valuation of the assets and stocks of the target company in
which the acquirer contemplates to invest large amount of capital. The
financial evaluation of a merger is needed to determine the earnings and
cash flows, areas of risk, the maximum price payable to the target company
and the best way to finance the merger. In M & A, the acquiring firm must
pay a fair consideration to the target firm. But, sometimes, the actual
consideration may be more than or less than the fair consideration. A
merger is said to be at a premium when the offer price is higher than the
target firm’s pre-merger market value. It may have to pay premium as an
incentive to the target firm’s shareholders to induce them to sell their shares.
The value of the firm depends not only upon its earnings but also upon the
operating and financial characteristics of the acquiring firm. It is therefore,
not possible to place a single value for the acquired firm. Instead, a range of
values is determined, which would be economically justifiable to the
prospective acquirer. To determine an acceptable price for a firm, a number
of factors, qualitative (managerial talent, strong sales staff, excellent
production department etc) as well as quantitative (value of an asset,

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earnings of the firm etc) are relevant. Therefore, the focus of determining
the firm’s value is on several quantitative variables. There are several
bases of valuation as listed below:
 Asset Value
The business is taken as going concern and realizable value of assets is
considered which include both tangible and intangible assets. The value of
goodwill is added to the value of the tangible assets which gives value of the
company as a going concern. Goodwill represents the company’s excess
earning power capitalized on the basis of certain number of year’s
purchases.
 Capitalized earnings
This is the predetermined rate of return expected by an investor. In other
words, this is simple rate of return on capital employed. Under this method,
the expected profit will be divided by the expected rate of return to calculate
the value of the acquisition.
 Market Value of listed stocks
Market value is the value quoted for the stocks of listed company at stock
exchanges. The market price reflects investor’s anticipation of future
earnings, dividend payout ratio, confidence in management of company,
operational efficiency etc. The temporary factors causing volatility are
eliminated by averaging the quotations over a period of time to arrive at a
fair market value. The acquirer pays only market value in hostile takeover.
The market value approach is one of the most widely used in determining
value, especially of large listed firms. The market value provides a close
approximation of the true value of a firm.
 Earnings Per Share
The value of a prospective acquisition is considered to be a function of the
impact of the merger on the earnings per share. The analysis could focus
on whether the acquisition will have a positive impact on the EPS after the
merger or if it will have the effect of diluting the EPS. The future EPS will
affect the firm’s share prices, which is the function of price-earning (P/E)
ratio and EPS.

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 Investment value
Investment value is the cost incurred (original investment plus the interest
accrued thereon) to establish an enterprise. This determines the sale price
of the target company which the acquirer may be asked to pay for the
negotiated merger.
 Book Value
Book value represents the total worth of the assets after depreciation but
with revaluation. Book value is the audited written down money worth of the
total net tangible assets owned by a company. The total net assets are
composed of gross working capital plus fixed assets minus outside liabilities.
The book value, as the basis of determining a firm’s value, suffers from a
serious limitation as it is based on the historical costs of the assets of the
firm. Historical costs do not bear a relationship either to the value of the firm
or to its ability to generate earnings. However, it is relevant to the
determination of a firm’s value for the following reasons:
i) It can be used as a starting point to be compared and complemented by
other analyses.
ii) The ability to generate earnings requires large investments in fixed
assets and working capital and study of these factors is particularly
appropriate and necessary in mergers
 Cost basis valuation
Cost of the assets less depreciation becomes the basis under this method.
This method ignores intangible assets like goodwill. It does not give weight
to changes in price level.
 Reproduction Cost
Reproduction cost method is based on assessing the current cost of
duplicating the properties or constructing similar enterprise in design and
material. It does not take into account the intangible assets for valuation
purpose.
 Substitution cost
Substitution cost is the estimate of the cost of construction of the
undertaking or enterprise in the same utility and capacity.
Out of the above nine methods of valuation, the important methods are:
assets based valuation, earning based valuation and market price valuation.

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These methods are frequently used in the corporate mergers and

acquisition.
I. Self Assessment Questions
1. Why valuation is necessary in mergers and acquisitions?
_________________________________________________________
_________________________________________________________
2. What are the basic questions taken into consideration in valuation?
_________________________________________________________
_________________________________________________________
3. What are the two basic models in valuation of business?
_________________________________________________________
_________________________________________________________
4. List the various basis of valuation.
_________________________________________________________
_________________________________________________________
5. How do you value using EPS and Book Value as basis in valuation?
_________________________________________________________
_________________________________________________________

4.4 Valuation Methods

The financial consideration generally is the form of exchange of shares.
This requires that relative value of each firm’s share and based on this value
a particular exchange ratio is determined. The determination of the
exchange ratio is therefore, based on the value of the shares of the
company involved in the merger.
The valuation of an acquisition is not fundamentally different from the
valuation of any firm, although the existence of control and synergy
premiums introduces some complexity into the valuation process. Given the
inter-relationship between synergy and control, the safest way to value a
target firm is in steps, starting with a relative and discounted cash flow
valuation (status quo valuation of the firm), and following up with a value for
control and a value for synergy.

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4.4.1 Relative Valuation

If the motive for acquisitions is under valuation, the target firm must be
under valued. How such a firm will be identified depends upon the valuation
approach and model used.
o With relative valuation, an under valued stock is one that trades at a
multiple (of earnings, book value or sales) well below that of the rest of
the industry, after controlling for significant differences on fundamentals.
For instance, a bank with a price to book value ratio of 1.2 would be an
undervalued bank, if other banks have similar fundamentals (return on
equity, growth, and risk) but trade at much higher price to book value
ratios.
o In discounted cash flow valuation approaches, an under valued stock is
one that trades at a price well below the estimated discounted cash flow
value.
4.4.2 Discounted Cash Flow (DCF) Methods
It may be started with the valuation of the target firm by estimating the firm
value with existing investing, financing and dividend policies. This valuation
provides a base from which the control and synergy premiums can be
estimated. The value of the firm is a function of its cash flows from existing
assets, the expected growth in these cash flows during a high growth
period, the length of the high growth period, and the firm’s cost of capital.
In a merger or acquisition, the acquiring firm is buying the business of the
target company rather than a specific asset. Thus, merger is special type of
capital budgeting decision. The acquiring firm incurs a cost (in buying the
business of the target firm) in the expectation of a stream of benefits (in the
form of cash flows) in the future. The merger will be advantageous to the
acquiring company, if the present value of the target merger is greater than
the cost of acquisition. In order to apply DCF techniques, the following
information is required.
 Estimation of cash flows
 Timing of cash flows
 Discount rate
The appropriate discount rate depends on the risk of the cash flows.

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Discounted cash flow is a method for determining the current value of a

company using future cash flows adjusted for time value. The future cash
flow set is made up of cash flows within the determined forecast period and
a continuing value that represents a steady state cash flow stream after the
forecast period, known as the Terminal Value. In conducting a valuation of
a firm, cash flow is usually the main consideration. There is a five-step
process for evaluating a company's cash flow:
i) Analyze operating activities
ii) Analyze the investments necessary to buy new property or business
iii) Analyze the capital requirements of the firm
iv) Project the annual operating flows and terminal value of the firm
v) Calculate the Net Present Value of those cash flows to calculate the
firm's value
In nutshell, the following steps are involved in the financial evaluation of a
merger:
 Identify growth and profitability assumptions and scenarios
 Project cash flows magnitudes and their timing
 Estimate the cost of capital
 Compute NPV for each scenario
 Decide if the acquisition is attractive on the basis of NPV
 Decide if the acquisition should be financed through cash or exchange
of shares
 Evaluate the impact of the merger on EPS and P/E Ratio
1. Estimating Free Cash Flows
The steps in the estimation of the cash flow are as follows:
 The first step in the estimation of cash flow is the projection of sales.
 The second step is to estimate expenses.
 The third step is to estimate the additional capital expenditure and
depreciation.
 Final step is to estimate changes in net working capital due to change in
sales.

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The above mentioned steps can be presented in the form of below

mentioned model.
Net Sales
Less: Cost of goods sold
Selling & Admn. Exp
Depreciation
Total Exp
PBT
Tax @ %
PAT
(+) Depreciation
Funds from operation
(-) Increase in NWC
Cash from operation
(-) Capital Expenditure
Free Cash Flow
+ Salvage Value
(at the end of the year)
P.V. Factor
Present Value
The above steps can be presented in a mathematical equation as below to
calculate cash flows:

NCF = EBIT
1  T )  DEP  NWC  CAPEX 
Where,
 NCF means net cash flows;
 EBIT means earnings before interest and tax;
 T means Tax Rate;
 DEP means depreciation;
 Delta NWC means changes in working capital; and
 Delta CAPEX means changes in capital expenditure.
Here it should be noted that the discount rate should be average cost of
capital.
2. Terminal Value
Terminal value is the value of cash flows after the horizon period. It is
difficult to estimate the terminal value of the firm as the firm is normally
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acquired as going concern. The terminal value is the present value of free
cash flow after the forecast period. Its value can be determined under three
different situations as below:
 When terminal value is likely to be constant till infinity:
TV = FCFt-1 / Ko
 When terminal value is likely to grow at a constant rate
TV = FCFt-1 (1+g)/(Ko-g)
 When terminal value is likely to decline at a constant rate
TV = FCFt-1(1-g)/(Ko+g)
Where, FCFt-1 refers to the expected cash flow in first year after the horizon
period, Ko refers average cost of capital.
Example
ABC Company Limited targeted to acquire XYZ Company Ltd. The
Projected Post Merger Cash Flow Statements for the XYZ Company Ltd is
given below:
(Rs. in millions)
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales Rs. 105 Rs. 126 Rs. 151 Rs. 174 Rs. 191
Cost of goods sold 80 94 111 127 136
Selling and administration
Expenses 10 12 13 15 16
Depreciation 8 8 9 9 10
EBIT 7 12 18 23 29
Interest* 3 4 5 6 7
EBT 4 8 13 17 22
Taxes (40%) $ 1.6 3.2 5.2 6.8 8.8
Net Income 2.4 4.8 7.8 10.2 13.2
Add Depreciation 8 8 9 9 10
Free Cash Flows 10.4 12.8 16.8 19.2 23.2
Less retention needed for growth
# 4 4 7 9 12
Add Terminal Value @ 126.3
Net Cash Flows** 6.4 8.8 9.8 10.2 137.5

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* Interest payments are estimated based on XYZ Co’s existing debt, plus
additional debt required to finance growth
$ The taxes are the full corporate taxes attributable to XYZ’s operation
# Some of the cash flows generated by the XYZ after the merger must be
retained to finance asset replacements and growth, while some will be
transferred to ABC to pay dividends on its stock or for redeployment within the
company. These retentions are net of any additional debt used to help finance
growth.
@ XYZ’s available cash flows are expected to grow at a constant 6% rate after
Year 5.

The value of all post- Year 5 cash flows as on December 31, Year 5 is
estimated by use of the constant growth model to be Rs. 126.3 million:
TV(Year 5) = FCF(Year 6)/(k-g)
= {Rs.23.2 – Rs.12.0)(1.06)}/(0.154 -0.06)
= Rs. 126.3 million
The Rs. 126.3 million is the present value at the end of Year 5 of the stream
of cash flows for Year 6 and thereafter. Here, it estimated 15.4 per cent as
cost of capital.
** These are the net cash flows projected to be available to ABC by virtue of
the acquisition. The cash flows could be used for dividend payments to
ABC share holders, finance asset expansion in ABC’s other divisions and
subsidiaries and so on.
The current value of XYZ to ABC’s shareholders is the present value of the
cash flows expected from XYZ discounted at 15.4% :

Value (Year 0) = (Rs.6.4)/(1.154)1 + (Rs. 8.8) / (1.154)2 + (Rs.9.8) / (1.154)3

+
(Rs. 10.2) / (1.154)4 + (Rs.137.5)/(1.154)5 = Rs. 91.5 million
Thus, the value of Target Company to ABC shareholders is Rs. 91.5 million.
It should be noted that in a merger analysis, the value of the target consists
of the target’s pre merger value plus any value created by operating or
financial synergies. In this example, it is assumed that target company’s
capital structure and tax rate constant. Therefore, the only synergies were
operating synergies, and these effects were incorporated into the forecasted
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cash flows. If there had been financial synergies, the analysis would have
to be modified to reflect this added value.
4.4.3 Market Multiple Analysis
The another method of valuing a target company is market multiple analysis,
which applies a market-determined multiple to net income, earnings per
share, sales, and book value or number of subscribers (in case of cable TV
or cellular telephone systems). While DCF method applies valuation concept
in a precise manner, focusing on expected cash flows, market multiple
analysis is more judgmental.
This method uses sample ratios from comparable peer groups for
determining the current value of a company. The specific ratio to be used
depends on the objective of the valuation. The valuation could be designed
to estimate the value of the operation of the business or the value of the
equity of the business.
To explain the concept, note that XYZ company’s projected net income is
Rs. 2.4 million in Year 1 and it rises to Rs. 13.2 million in Year 5, for an
average of Rs.7.7 million over five year projected period. The average P/E
ratio for publicly traded companies similar to XYZ is 12. To estimate XYZ’s
value using the market P/E multiple approach, simply multiply its Rs. 7.7
million average net income by market multiple of 12 to obtain the value
(Rs.7.7 x 12) Rs. 92.4 million. This is the equity or the ownership value of
the firm. It can be noted here that we used the average net income over the
coming five years to value XYZ. The market P/E multiple of 12 is based on
the current year’s income of comparable companies, but XYZ’s current
income does not reflect synergistic effects or managerial changes that will
be made. By averaging future net income, we are attempting to capture the
value added by ABC to XYZ’s operations.
EBITDA is another commonly used measure in the market multiple
approach. When calculating the value of the operation, the most commonly
used ratio is the EBITDA multiple, which is the ratio of EBITDA (Earnings
before Interest Taxes Depreciation and Amortization) to the Enterprise
Value (Equity Value plus Debt Value). This multiple is based on total value,
since EBITDA measures the entire firm’s performance. Multiplying the
Target Company’s EBITDA by the market multiple gives an estimate of the

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targets’ total value. To find the target’s estimated stock price per share,
subtract debt from total and then divide by the number of equity shares.
II. Self Assessment Questions
1. What are the basic pieces of information required for DCF technique?
_________________________________________________________
_________________________________________________________
2. List the five-step process for evaluating a company's cash flow.
_________________________________________________________
_________________________________________________________
_________________________________________________________
3. What is terminal value?
_________________________________________________________
_________________________________________________________
4.4.4 Earnings Analysis
When valuing the equity of a company, the most widely used multiple is the
Price Earnings Ratio (P/E Ratio) of stocks in a similar industry, which is the
ratio of Stock price to Earnings per Share of any public company. Earning
per share (EPS) is the earning attributable to share holders which are
reflected in the market price of the shares. Using the sum of multiple P/E
Ratio’s improves reliability but it can still be necessary to correct the P/E
Ratio for current market conditions. A reciprocal of this ratio (EPS/P)
depicts yield. Share price (P) can be determined as P = EPS x P/E Ratio.
While planning for takeover, P/E ratio plays significant role in decision
making for the acquirer in the following ways:
 Target Company’s P/E ratio is exit ratio and higher the ratio means the
acquirer has to pay more. In such cases, merger will lead to dilution in
EPS and adversely affect share prices. If the exit ratio of Target
Company is less than the acquirer, then shareholders of both companies
benefit.
 A company can increase its EPS by acquiring another company with a
P/E ratio lower than its own, if business is acquired by exchange of
shares.

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Example
ABC Company Ltd takes over XYZ Company Ltd. The merger is not
expected to yield in economies of scale and operating synergy. The
relevant data for two companies are as follows:

ABC Ltd XYZ Ltd

No. of Shares 10,000 5,000
Total Earnings 1,00,000 50,000
EPS 10 10
P/E Ratio 2 1.5

ABC Ltd acquires XYZ at share-for-share exchange. The exchange ratio

has been calculated as under:
Assume that XYZ Ltd is going to exchange its share with ABC Ltd at its
market price. The exchange ratio will be: 15/20 = 0.75. That is for every
one share of XYZ Ltd., 0.75 share of ABC Ltd will be issued. In total 3750
(0.75x5000) shares of ABC Ltd will need to be issued in order to acquire
XYZ Ltd. Hence, the total number of shares in combined company will be
13,750 (10000 + 3750).
Impact of merger on ABC Ltd shareholders:
EPS on merger = (100000 + 50000) / 13750 = Rs. 10.91
Net gain in EPS = Rs. 10.91 – Rs. 10.00 = Re. 0.91
Market Price of share (after merger) = EPS x P/E Ratio = Rs. 10.91 x 2
= 21.82
Net gain in Market Price = Rs. 21.82 – Rs. 20.00 = Rs. 1.82
Impact of Merger on XYZ Ltd shareholders:
New EPS = 0.75 x 10.91 = Rs. 8.18
EPS dilution (Net Loss) = Rs. 10.00 – Rs. 8.182 = Rs. 1.82
ABC Ltd shareholders have gained in the combined company from the
merger because the P/E ratio of target company (XYZ) is less than that of
the acquirer.

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III. Self Assessment Questions

Analyze the impact of merger on ABC Ltd and XYZ Ltd if Target Company
demands a price of Rs. 22 per share instead of Rs. 15 per share.
1. Exchange Ratio
_________________________________________________________
2. Total No. of shares in combined company
_________________________________________________________
3. EPS after merger
_________________________________________________________
4. EPS dilution for XYZ Ltd
_________________________________________________________
5. Market Price of share of ABC Ltd (after merger)
_________________________________________________________
It is very important to note that valuation is more an art than a science
because it requires judgment:
1) There are very different situations and purposes in which you value an
asset. In turn this requires different methods or a different interpretation
of the same method each time.
2) All valuation models and methods have their limitations (e.g.,
mathematical, complexity, simplicity, comparability) and could be widely
criticized. As a general rule the valuation models are most useful when
you use the same valuation method as the "partner" you are interacting
with. Mostly the method used is industry or purpose specific;
3) The quality of some of the input data may vary widely
4) In all valuation models there are a great number of assumptions that
need to be made and things might not turn out the way you expect. Your
best way out of that is to be able to explain and stand for each
assumption you make;
4.4.5 Valuing Operating and Financial Synergy
The third reason to explain the significant premiums paid in most
acquisitions is synergy. Synergy is the potential additional value from
combining two firms. It is probably the most widely used and misused
rationale for mergers and acquisitions.

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1. Sources of Operating Synergy

Operating synergies are those synergies that allow firms to increase their
operating income, increase growth or both. It can be categorized operating
synergies into four types:
a) Economies of scale that may arise from the merger, allowing the
combined firm to become more cost-efficient and profitable.
b) Greater pricing power from reduced competition and higher market
share, which should result in higher margins and operating income.
c) Combination of different functional strengths, as would be the case
when a firm with strong marketing skills acquires a firm with a good
product line.
d) Higher growth in new or existing markets, arising from the combination
of the two firms. This would be the case, when a multinational consumer
products firm acquires an emerging market firm, with an established
distribution network and brand name recognition, and uses these
strengths to increase sales of its products.
Operating synergies can affect margins and growth, and through these the
value of the firms involved in the merger or acquisition.
2. Sources of Financial Synergy
Synergy can also be created from purely financial factors. With financial
synergies, the payoff can take the form of either higher cash flows or a lower
cost of capital. Included are the following:
1. A combination of a firm with excess cash, or cash slack, (and limited
project opportunities) and a firm with high-return projects (and limited
cash) can yield a payoff in terms of higher value for the combined firm.
The increase in value comes from the projects that were taken with the
excess cash that otherwise would not have been taken. This synergy is
likely to show up most often when large firms acquire smaller firms, or
when publicly traded firms acquire private businesses.
2. Debt capacity can increase, because when two firms combine, their
earnings and cash flows may become more stable and predictable. This,
in turn, allows them to borrow more than they could have as individual
entities, which creates a tax benefit for the combined firm. This tax
benefit can either be shown as higher cash flows, or take the form of a
lower cost of capital for the combined firm.

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3. Tax benefits can arise either from the acquisition taking advantage of tax
laws or from the use of net operating losses to shelter income. Thus, a
profitable firm that acquires a money-losing firm may be able to use the
net operating losses of the latter to reduce its tax burden. Alternatively, a
firm that is able to increase its depreciation charges after an acquisition
will save in taxes, and increase its value.
Clearly, there is potential for synergy in many mergers. The more important
issues are whether that synergy can be valued and, if so, how to value it.
3. Valuing Operating Synergy
There is a potential for operating synergy, in one form or the other, in many
takeovers. Synergy can be valued by answering two fundamental questions:
1. What form is the synergy expected to take?
 Will it reduce costs as a percentage of sales and increase profit
margins (e.g., when there are economies of scale)?
 Will it increase future growth (e.g., when there is increased market
power) or the length of the growth period?
 Synergy, to have an effect on value, has to influence one of the four
inputs into the valuation process:
o cash flows from existing assets,
o higher expected growth rates (market power, higher growth
potential)
o a longer growth period (from increased competitive advantages)
o a lower cost of capital (higher debt capacity)
2. When will the synergy start affecting cash flows?
 Synergies can show up instantaneously, but they are more likely to
show up over the time. Since the value of synergy is the present
value of the cash flows created by it, the longer it takes for it to show
up, the lesser its value.
Once we answer these questions, we can estimate the value of synergy
using an extension of discounted cash flow techniques.
 First, we value the firms involved in the merger independently, by
discounting expected cash flows to each firm at the weighted average
cost of capital for that firm.
 Second, we estimate the value of the combined firm, with no synergy, by
adding the values obtained for each firm in the first step.

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 Third, we build in the effects of synergy into expected growth rates and
cash flows, and we value the combined firm with synergy.
 The difference between the value of the combined firm with synergy and
the value of the combined firm without synergy provides a value for
synergy.
4.4.6 Value Creation through Synergy
Synergy is a stated motive in many mergers and acquisitions. If synergy is
perceived to exist in a takeover, the value of the combined firm should be
greater than the sum of the values of the bidding and target firms, operating
independently.
V(PQ) > V(P) + V(Q)
Where,
 V(PQ) = Value of a firm created by combining P and Q (Synergy)
 V(P) = Value of firm P, operating independently
 V(Q) = Value of firm Q, operating independently
Merger will create an economic advantage (EA) through synergy when the
combined present value of the merger firms is greater than the sum of their
individual present values as separate entities. If firm P and firm Q merge,
and they are separately worth VP and VQ respectively, and worth VPQ in
combination then the economic advantage will occur if:
VPQ  VP  VQ 

The economic advantage is equal to:

EA =
VPQ  VP  VQ 

Merger and acquisition involves costs. The Cost of merging to P in the

above example is:
Cash Paid - VQ
The net economic advantage of merger (NEA) is positive if the economic
advantage exceeds the cost of merging. Thus,
Net Economic Advantage = Economic Advantage – Cost of Merging

NEA =
V PQ  VP  VQ   CashPaid  VQ 

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VPQ  VP  VQ  represent the benefit results from operating efficiency and
synergy when two firms merge. If the acquiring firm pays cash equal to the
value of the acquired firm, then the entire advantage of merger will accrue to
the shareholders of acquired firm. In practice, the acquiring and the acquired
firm may share the economic advantage between themselves.
4.4.7 Valuing Corporate Control
If the motive for the merger is control, the target firm will be a poorly
managed firm in an industry where there is potential for excess returns. In
addition, its stock holdings will be widely dispersed (making it easier to carry
out the hostile acquisition) and the current market price will be based on the
presumption that incumbent management will continue to run the firm.
Many hostile takeovers are justified on the basis of the existence of a
market for corporate control. Investors and firms are willing to pay large
premiums over the market price to control the management of firms,
especially those that they perceive to be poorly run.
The value of wresting control of a firm from incumbent management is
inversely proportional to the perceived quality of that management and its
capacity to maximize firm value. In general, the value of control will be much
greater for a poorly managed firm that operates at below optimum capacity
than for a well managed firm. The value of controlling a firm comes from
changes made to existing management policy that can increase the firm
value. Assets can be acquired or liquidated, the financing mix can be
changed and the dividend policy re-evaluated, and the firm can be
restructured to maximize value. If we can identify the changes that we
would make to the target firm, we can value control. The value of control can
then be written as:
Value of Control = Value of firm,
Optimally managed - Value of firm with current management
The value of control is negligible for firms that are operating at or close to
their optimal value, since a restructuring will yield little additional value. It
can be substantial for firms operating at well below optimal, since a
restructuring can lead to a significant increase in value.

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4.4.8 Valuing Leveraged Buyouts

Leveraged buyouts are financed disproportionately with debt. This high
leverage is justified in several ways as pointed below:
 First, if the target firm initially has too little debt relative to its optimal debt
ratio, the increase in debt can be explained partially by the increase in
value moving to the optimal ratio provides. The debt level in most
leveraged buyouts exceeds the optimal debt ratio, however, which
means that some of the debt will have to be paid off quickly in order for
the firm to reduce its cost of capital and its default risk.
 A second explanation is provided by Michael Jensen, who proposes that
managers cannot be trusted to invest free cash flows wisely for their
stockholders; they need the discipline of debt payments to maximize
cash flows on projects and firm value.
 A third rationale is that the high debt ratio is temporary and will
disappear once the firm liquidates assets and pays off a significant
portion of the debt.
The extremely high leverage associated with leveraged buyouts creates two
problems in valuation.
 First, it significantly increases the risk of the cash flows to equity
investors in the firm by increasing the fixed payments to debt holders in
the firm. Thus, the cost of equity has to be adjusted to reflect the higher
financial risk the firm will face after the leveraged buyout.
 Second, the expected decrease in this debt over time, as the firm
liquidates assets and pays off debt, implies that the cost of equity will
also decrease over time.
Since the cost of debt and debt ratio will change over time as well, the cost
of capital will also change in each period. In valuing a leveraged buyout,
then, we begin with the estimates of free cash flow to the firm, just as we did
in traditional valuation. The DCF approach is used to value an LBO.
However, instead of discounting these cash flows back at a fixed cost of
capital, we discount them back at a cost of capital that will vary from year to
year. Once we value the firm, we then can compare the value to the total
amount paid for the firm. As LBO transactions are heavily financed by debt,
the risk of lender is very high. Therefore, in most deals they require a stake
in the ownership of the acquired firm.

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4.5 Summary
Merger should be undertaken when the acquiring company’s gain exceeds
the cost. The cost is the premium that the acquiring company pays for the
target company over its value as a separate entity. Merger benefits may
result from economies of scale, increased efficiency, tax shield or shared
resources. Discounted cash flow technique can be used to determine the
value of the target company to the acquiring company. This unit described
different techniques for the valuation of target companies on the basis of
various parameters.

4.6 Terminal Questions

1. Explain how terminal value can be determined under three different
situations
2. Explain the market multiple model of valuation
3. What are the sources of Operating Synergy?
4. What are the sources of Financial Synergy?
5. Explain the process of valuing LBO.

4.7 Answers to SAQs & TQs

SAQs I
1. Refer to Section 4.2
2. Refer to Section 4.2
3. Refer to Section 4.3
4. Refer to Section 4.3
5. Refer to Section 4.3
SAQs II
1. Refer to Section 4.4.2
2. Refer to Section 4.4.2
3. Refer to Section 4.4.2-2
SAQs III
1. 1.1
2. 15500
3. Rs. 9.67
4. Re. 0.33
5. Rs. 19.34

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TQs
1. Refer to Section 4.4.2-2
2. Refer to Section 4.4.3
3. Refer to Section 4.4.5-1
4. Refer to Section 4.4.5-2
5. Refer to Section 4.4.7

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