Valuation of Firms in Mergers and Acquisitions - Case Study Example

Valuation of Firms in mergers and acquisitions Abstract Mergers and acquisitions form one of the most common corporate strategies in modern organisations. The reasons pushing the intriguing corporate revolutions are many and varied. Many firms hope to reap the benefits of economies of scale, expand their markets, and benefit from benefits of synergy. However, the process of acquitting a target company is usually challenging and exacting for many corporates. Many times, the merger and acquisition may lead the two companies to perform worse than they initially did. To avoid such situations, it is necessary to perform careful valuations before the acquisition is completed successfully. In addition, the process of transition immediately following the merger and acquisition process should be performed delicately so that the goals of the merger and acquisition are brought to fruition. This paper seeks to demonstrate the different aspects of mergers and acquisition using a case of two companies: Triumph and Rustic. Introduction Background to the Case Triumph is of the opinion that acquisition of Rustic, a competitor in the same industry but with a radically different market share, would significantly boost its market penetration, enhance quality in production, and give it immense benefits with regard to economies of scale. As of present, Triumph has a predominantly southern customer base while Rustic has a chiefly northern customer base. The premise for this presumption is the view by Triumph’s CEO that Rustic is underperforming and its shares are undervalued. Hopes regarding the merger and acquisition soar high, with the expectations that the deal will grow the combined business establishment by up to 10%. However, the operating costs will rise by an estimated 5% in the first year. The financing option under consideration involves issuance of long-term bonds to buy out shareholders at Rustic. The bonds will be issued at the current borrowing rate of the two companies. This report analyses the merger and acquisition case for Triumph and Rustic Plc. Value of the combined company Divided Valuation Model Assuming a dividend cover of 2, a constant dividend in perpetuity, and a cost of capital of 20%: Constant dividend DVM Vo = {D(1 + g)/(k – g)} = D/(k - g) g = growth rate of the dividends Vo = value of the firm Di = Dividend in year i k = discount rate, cost of capital Value of Triumph ={5,520,000/0.2) = 27,600,000 Value of Rustic = {2,700,000/0.2) = 13,500,000 Combined Value of the business is = 41,100,000 Divided Valuation Model A dividend covers of 2 Growth in dividend of 10% per year in perpetuity A cost of capital of 20% Constant growth DVM Vo = {(Do(1 + g)/(1 + k)} + {Do(1 + g)/(1 + k)2} + … = {Do(1 + g)/(k – g)} Value of Triumph = {5,520,000(1 + 0.1)/(0.2 – 0.1)} = 60,720,000 Value of Rustic = {2,700,000(1 + 0.1)/(0.2 – 0.1)} = 29,700,000 Combined Value of the new company is = 60,720 + 29,700 = 90,420,000 Shareholder Value Added Approach Shareholder value added approach to valuation of cash flows for the first 5 years with the assumption of growth of dividends in year 6 onwards at an annual rate of 4% in perpetuity, and a cost of capital of 20%. The formula for shareholder value added is Shareholder Value Added = Net Operating Profit after Taxes (NOPAT) – (Capital x WACC) Where WACC is Weighted Average Cost of Capital = 20% NOPAT = Operating Income x (1 – Tax Rate) WACC = (E/V) * Re + (D/V) * Rd * (1 – T) Re = cost of equity = 20% Rd = cost of debt = 5% E = Market value of firm’s equity = 26,000 D = Market value of firm’s debt = 24,960 V = E + D =50,960 E/V = percentage of financing that is equity = 26,000/50,960 = 0.51 D/V = percentage of financing that is debt = 24,960/50960 = 0.49 T = Corporate tax rate = 20% WACC = (0.51)*0.2 + (0.49)*0.05(1-0.20) = 0.102 + 0.0196 = 0.1216 = 12.16% The figures are in ‘000 of GBP Year 1 Year 2 Year 3 Year 4 Year 5 Sales 119,108 131,018.8 144,120.68 158,532.748 174,386.02 Operating Costs -91,770 -104,815.04 -115,296.544 -126,826.1984 -139,508.82 Net Profit BIT 27,338 26,203.76 28,824.136 31,706.5496 34,877.205 Interest Cost -1248 -1248 -1248 -1248 -1248 Depreciation Costs -4,000 -4,000 -4,000 -4,000 -4,000 Maintenance Costs -4,000 -4,000 -4,000 -4,000 -4,000 Net Profit Before Tax 18,090 16,956 19,576 22,459 25,629 NOPAT (Tax Rate 20%) 14,472 13,564.608 15,660.909 17,966.839 20,503.364 Change in sales 0 11910.8 13101.88 14412.068 15853.275 Working capital 8,000 8,833.756 9,750.8876 10,759.73236 11,869.462 Capital 48,000 48,834 49,751 50,760 51,869 Capital charge (Capital * WACC) 5,836.8 5,938.185 6,049.708 6,172.383 6,307.327 SVA (NOPAT – Capital Charge) 8,635.2 7,626.423 9,611.201 11,794.456 14,196.037 Vo = {(Do(1 + g)/(1 + k)} + {Do(1 + g)/(1 + k)2} + … = {Do(1 + g)/(k – g)} Value of Triumph = {5,520,000(1 + 0.04)/(0.2 – 0.04)} = 35,880,000 Value of Rustic = {2,700,000(1 + 0.04)/(0.2 – 0.04)} = 17,550,000 Total value of Triumph and Rustic = 53,430,000 SVA + Value of Combined = 14,196,037 + 53,196,037 = 67,626,037 A Comparison of the Valuation Methods The first two valuation cases are highly similar, with the only difference being that the first method assumes a constant dividend in perpetuity while the other DVM option assumes a constant dividend growth in perpetuity. The slight difference, however, makes a considerable difference in the estimate value of the resultant business, 41,000,000 and 90,420,000 respectively. The use of DVM in valuation model is most relevant in cases where the dividend pattern for a company is predictable and highly estimable (Bayrak, 2010). The management at both companies can make use of the method since both companies are currently paying dividends to their shareholders. Another additional element in the DVM approach is the dividend cover, which is an indicator of the number of times that a company’s dividend could be paid out if all the after tax profits were paid off as tax. A dividend cover is a good decision making tool for the management. Usually a dividend cover of over 2 implies that a company is faring well financially. However a dividend cover of less than two is considered risky. Finally, a dividend cover of less than 1 means that the company is paying its dividend from capital, and is failing financially. Shareholder value added is a measure of the revenue a company generates well and above the minimum requirements by the shareholders. The valuation approach appreciates the need to recognise the risk compensation creditors and shareholders in the organisation. The method of valuation relies on the profitability levels and WACC figure to calculate the value of a company at a particular point in time. The WACC weights the value of different sources of each capital component (Investopedia, 2012). In addition, the WACC uncovers how much interest a company will have to pay for each dollar of financing. The WACC value is the overall discount rate required by a firm to determine its expansionary opportunities, and hence is a comprehensive measure of the level of risk a company should be willing to take in an acquisition. According to SVA approach, the combined business made up of Triumph and Rustic is worth 67,626,037, a value that falls below the two previous amount obtained by DVM approach. Discounted cash flow method Discounted cash flow method tries to estimate the value of a corporate entity by use of the approximate values of cash flows over the life of the company. Discounted cash flow method is a robust valuation technique which takes into consideration multiple factors that indicate the suitability of a company as an acquisition target. Book Value Method Book value method of valuation is overly simplistic for most corporations. Therefore, the method has a wider applicability in situations where the company in question has a large proportion of intangible assets. For the case of Triumph and Rustic the method would not be very accurate in valuing the combined business. For instance, the method would ignore the relevance of depreciation, a major factor in the value of any company. Additional costs in valuation of companies Although the major costs involved in the valuation activity relate to the cost of acquiring the new enterprise, a number of factors affect the amounts a company will spend for the entire acquisition process. Some of these costs include the costs relating to securing of funds for acquisitions in form of interest on loans. In addition, the company may have to hire professionals to help in valuing and negotiating the deal, which results in considerable extra costs for the company. Risks that Bidding Companies face when Undertaking Acquisitions Risks in mergers and acquisitions may stand in the way of companies realising their goals for making the acquisition deals. One of the most common challenges merging companies face is misalignments in management strategies between the two organisations (Hubbard, 2001). The management of the acquiring company may aggressively push reforms in management style, which may inspire resistance to change. The overarching impact of such scenarios is the erosion of synergetic benefits of acquisition. Many mergers have caved into bankruptcy over management conflicts. Therefore, to overcome this challenge, the companies involved needs to invest in technical and professional advice to oversee the transition process until the companies can work as one corporate entity. Cultural conflicts between the merging companies are a major challenge for many firms engaging in mergers and acquisitions. A merger and acquisition seek to join two companies with very divergent cultures (Domadaran, 2001). Usually the process is characterised by suspicion and animosity. Employees, especially of the target company, may feel alienated and threatened by the changes in the corporate structure of the new corporate entity. Consequently, the disgruntled employees may lack the motivation necessary to realise the goals of the newly formed corporate entity. Therefore, to overcome this challenge, the companies should put in place elaborate measures to help the employees see the new strategic goal, and how they form part of it. Another issue that could pose risk to the success of a merger and acquisition is the technical issues relating to the merger of two different corporate establishments. Management of the respective companies may express reluctance to share information and technologies with the other company (Raghavendra & Vermaelen, 1998). The exchange of technologies forms a basis for the successful attainment of acquisition synergies of the merging companies. Such actions may put in jeopardy the efforts by the combined enterprise to forge its combined corporate goal. In addition, initial misjudgements about the worth of the target company may jeopardise the state of the new corporate entity (Dong et al., 2006). Conclusion Mergers and acquisitions present numerous opportunities to corporations. However they also involve numerous risks, self-evidenced by the high failure rate of mergers and acquisitions. Some of the problems facing mergers and acquisitions stem from misconceptions in the acquisition rationale adopted by the management of the acquiring companies. For instance, a company may assume that acquiring a new business entity would result in broader market presence (Moeller et al. 2005). However, the reality may prove to be radically different, resulting in loss of profitability and failure to realise pre-acquisition goals. The problems facing mergers and acquisitions can be avoided through sound valuation processes and handling of transition stage in the merger and acquisition. References Bayrak, O, 2010, Valuation of Firms in mergers and acquisitions, Penn University, Pp.1-27 Dong M., Hirshleifer D., Richardson S., and Teoh S., 2006, Does Investor Misvaluation Drive the Takeover Market? The Journal of Finance 61(2) 725–762, Domadaran, A, 2001, Acquisition Valuation, New York University, Pp 1-40 Hubbard, N, 2001, Acquisition: strategy and implementation Basingstoke, Palgrave. Investopedia, 2012, WACC, Investopedia.com Limmack R.J. 1990, Takeover activity and differential returns to shareholders of bidding companies. Edinburgh: David Hume Institute, Moeller S.B., Schlingemann F. P. and Stulz R, 2005, Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, Journal of Finance 41(2) 757 Raghavendra R, and Vermaelen T., 1998, Glamour, value and the post-acquisition performance of acquiring firms, Journal of Financial Economics 49(2) 223–253 Rankine D. and Howson P., 2006, Acquisition essentials: a step-by-step guide to smarter deals. Financial Times/Prentice Hall, Harlow, England Song M. H. and Walkling R. A., 1993 The Impact of Managerial Ownership on Acquisition Attempts and Target Shareholder Wealth. 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