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Valuation in M&A

FM-II, Term III


IIFT
When can an M&A create
value?
When CASH FLOWS When RISK When GROWTH is
improve reduces enhanced
Economies of scale Less Greater pricing power
Tax benefits cyclicality Functional synergies
Management change leading to comprehensive
Diversificatio Cash availability, debt
improvements n?? capacity
Important: Timing of these benefits +
Probability of occurrence
WHAT ABOUT PURCHASE OF AN UNDERVALUED
TARGET?
Operating Financial
synergies synergies

Corporate
control
Valuing an acquisition

Step 1: Value the target on a standalone


basis = Vt
Step 2: Value the target with effects of
control change built in = V(t+m)
Step 3: Value the combined entity with
effects of synergy built in = V(C)
Step 4: V(t+m) V(t) = value of
management control
V(C) V (t+m) = value of synergies
When does an acquisition create
value?
Deal cost = Deal cost =
How much Value of $5m $5m
synergies Acquirers
of this value gain =
should be = $25m
$10m
given away
Value of
as control

Goodwill
control =
premium to
$25m Walkaway
target
company offer price = Negotiated
Current market Target firm $145m
SHs? offer price =
valuation = standalone $135m
$85m
Current book equity
value/ FMV = value =
$65m $100m

Important: What is the target firms equity currently valued


at? Greater than, equal to or less than $100m?
Who brings in the additional value of $50m? Target or
acquirer?
Factors impacting purchase
consideration
Current market valuation of target
Indispensability of target for bidder
vs. indispensability of bidder for
target factor of
unique advantages brought in by each,
availability of more targets/ bidders
Deciding on form of payment
EPS dilution in stock payments

Assuming market has priced bidders and


targets stocks correctly,
Exchange ratio (ER) = Value of target share
(VT)/ Value of bidder share (VB)
e.g. Bidders share price = Rs.200
And, Targets share price = Rs.150
ER = 0.75, i.e. every share of target firm gets
0.75 shares of bidder firm.
If 300 shares of bidder were outstanding prior to
acquisition, post deal shares outstanding will be
300 * 1.75 = 525 shares
EPS dilution in stock payments
Compa PAT No. of EPS Share PE M.Cap
ny (Rs.cr.) shares (Rs.) Price ratio (Rs. Cr.)
(Cr.) (Rs.)
Bidder 2 20 0.1 2 20 40
Target 2 20 0.1 1 10 20
What should be the ER if the shares are correctly valued by the
market?
What should be the combined P/E ratio if this is a deal purely for
ER Co Post acquisition value of B & T at Bootstrappi
diversification? ng
. different P/E (Rs. Cr.) assuming
combined firms PAT = Rs.4 cr.
P/E = 10 X P/E = 15 X P/E = 20 X
B 26.6 40.0 53.3
0.5
T 13.4 20.0 26.7
B 20.0 30.0 40.0
1.0
T 20.0 30.0 40.0
B 16.0 24.0 32.0
1.5
Stock price movements around a
merger
Typical movement in share price of acquirer
and target firm
What prices should be taken to arrive at ER?
Assume our example
has synergy gains of
Rs.10 cr.
Value of combined
entity = Rs.70cr.
At ER of 0.5shares,
value of target
shareholding =
1/3*70 = Rs.23.33cr
Implies gain of
Rs.3.33cr. Out of
Accounting for M&A
Pooling of interests vs. Purchase method
Book value vs. FMV (scope for goodwill)
Treatment as combination vs. investment in
subsidiary
IFRS allows only Purchase method for M or A.
In acquisitions, Acquirer acquires Targets
assets at fair market value, assumes its
liabilities and Target is dissolved
In mergers, a new company acquires the
participating companies assets at fair
market values and only the new company
exists. According to Ind-AS, one of the
companies still has to be identified as the
acquirer.
LBO & MBO

Leveraged buyout basically involves buying out a


target using significant portion of debt.
Debt is loaded on the combined firms balance
sheet
Works only when target firm is very low on
leverage and hence, has immense debt capacity.
Mostly assumed that significant debt will need to
be repaid in the initial years in order to manage
risk profile of the firm
Cost of equity and hence, cost of capital will
significantly reduce with time, as debt gets paid
off.