Acquisition Analysis - Essay Example

Acquisition Analysis Executive summary Present day economic situation is favorable for IAP Company Limited to invest into international company Adobe. Economic conditions and political situation in the USA is stable, which minimize the risk of failure. Adobe company is a market leader in its industry, which also creates favorable conditions for investment decisions. Such factors as internal and external market environment as well as Adobe priorities were examined, and it was found that acquisition is profitable for both companies. The three templates were designed to analyze broad, specific and other issues necessary to evaluate the risk and profitability of the project. It was supposed that the company IAP will invest about $ 1000000 from internal cash funds. Financial analysis proves that fact that the rate of return will be high if IAP invests $ 1,000000. Such calculations as WACC, risk assessment, CAPM, foreign currency translation effect, cash flow analysis have been made. ---------- The initial assessment of markets conditions involves screening foreign markets to discover the potential of different countries. This process includes consideration of rates of growth of economies, new developments such as opening up of markets in developing and emergent economies, technical changes that are creating new opportunities to sell and identification of long-term economic and demographic factors that are altering demand patterns. With the globalization of the world economy, companies like IAP Company Limited are growing by merger and acquisition in a bid to expand operations and remain competitive. The complexity of such transactions often makes it difficult to assess all risk exposures and liabilities, and requires the skills of a specialist advisor. Four main types of assessment for companies considering acquisition beyond their national borders should be undertaken: political and legal conditions, economic conditions, cultural conditions, competitive conditions. USA-based company Adobe operates in the stable political situation, which has high rates of economic growth. Acquisition policy is undoubtedly the most radical growth strategy open to management in that it represents a deliberate attempt to change the nature of the business. Acquisition policy can be classified into backward, forward and horizontal integration. Acquisition policy occurs when the new business is related in some way to the old one. (Zolkiewski, 1994). Template 1: IAP Company Limited will be reluctant to enter countries that have high political risks unless the potential returns are high or when countries with high political risk are providers of raw material that are in short supply. When the overall market is growing or can be induced to grow, it may be relatively easy for companies with a small market share, or even new entrants, to gain share. This is because the absolute level of sales of the established companies may still be growing; and indeed, in some instances, those companies may be unable or unwilling to meet the new demand. Import penetration into some industries can be traced back to the early 1990s, when companies were unable to supply the peak demand occurring during booms and their customers had to seek alternative sources overseas (Benito, Gripsrund, 1992). Once established with overseas suppliers, many UK users were reluctant to revert to UK sourcing. When the boom was over, the importers held on to their market share. The size of the investment required by a business wishing to enter industry will be an important determinant of the extent new entrants. Acquisition with Adobe allows IAP Company Limited to subject to a complex regulate framework whereas others are less so. Still, even if it is possible to predict the needs of customer there are some threats and new opportunities, which should be taken into consideration. American administrative and legal environment is very favourable for acquisition with Adobe. There are no specific regulations governing the goals and structures of the industry, there is no constitutional restrictions or legislative mandate that restricts acquisition. The social environment includes general forces that do not directly touch on the short-run activities of the organization but that can, and often do, influence its long-run decisions. Economic forces regulate the exchange of materials, money, energy, and information. Political-legal forces allocate power and provide constraining and protecting laws and regulations. Socio-cultural forces regulate the values, mores, and customs of society. It is possible to conclude that strategy is the determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals (Austin, 2000). Template 2. The economic health of Adobe Company also should be assessed to determine whether the macroeconomic conditions are conducive to stable economic conditions. In general, inflation rates, balance of payments, exchange rate stability, government budgets and the record of growth will be considered to evaluate the prospects for economic instability or crisis. Demographic factors will also be taken into account together with measures such as disposable income per head (Amin, Thrift, 1994). These considerations enable appraisal of the strength of general demand. Microeconomic data, such as size and development of particular markets and price movements in these markets, are also needed (Krugman, 1998). The lessons of the experience curve stress that it is much easy to consider acquisitions in mature markets, since the advantageous cost structure of market leaders should not prevent the incursion of competitors with lower market share. However, the complacency of market leaders may allow smaller-share competition (Ciborra, 1991). According to the recent data, Adobe grows substantially during the last three years. Adobe is a market leader in the USA, so acquisition with it is considered as the most desirable one. Costs, revenues, inflation and interest rates, taxation and numerous other factors; the alternatives available in which to invest. This is the stage at which the various techniques used to appraise the competing investments would be used (Anderson, Gatignon, 1986,) Template 3 A special attention should be paid to the problems of rates of return and investment decision making. This is because of the scale and long-term nature of the consequences of such decisions. The task of both companies is to gather the essential data from various sources, consider the financing and taxation implications, analyse the data using one or more of the appraisal techniques and present the decision maker with the results of the exercise so that the decision maker may make more informed and hopefully better decisions. Because investment decisions are often on a large scale, analysis of the investor's attitude to risk and the project uncertainty are critical factors in an investment decision (Blake, Amat, 1993). The rate of return and the payback period are also important in planning a strategy of investment decisions. Sometimes, however, cashflows may not be available and so profit might be used as a surrogate. If this is the case, the profit figure must be before depreciation, otherwise there will be double counting. Depreciation is merely an allocation of cost and the purpose of the exercise is to determine how long it takes for funds to be generated to meet that cost. The result will be a revised profit figure comprising revenue from sales less all of the expenses directly relating to the investment other than depreciation (Doz, Hamel, 1998). The important aspect of investment decision-making is the rates of return. This is the ratio of average annual profits, after depreciation, to the capital invested. This is a basic definition only and variations exist, for example, profits may be before or after tax, capital may or may not include working capital, capital invested may mean the initial capital investment or the average of the capital invested over the life of the project (Krugman, 1998). That is why the strategic investment planning process is a series of logical steps that have to be worked through in order to arrive at a logical 'common format' for the implementation of strategy, or marketing plan. It is the systemization of this process that is distinctive, and that lies at the heart of the theory of strategic marketing planning (Stijn Jansen, 2000). The source of finance may be internal to the company. One advantage of having a product which is a cash cow is that it provides funding for the development of other products which will hopefully become stars. Sometimes, however, it will be necessary to raise funds from other sources. If IAP Company Limited has a stock exchange quotation, it is possible to raise additional funds by either issuing additional equity or additional debt in the form of loans or debentures (Rugman, Brewer, 2001). b) For a shareholder, the required return will be based on three factors: market interest rates, the financial risk of the company, and its operating risk. Market interest rates will set the minimum desired return and can be approximated by the interest payable on short-dated government stock. This is probably the nearest to a risk-free possible, although it is not totally free of risk. Despite holders being guaranteed both the interest and repayment, there is still an element of risk from inflation by being repaid in a depreciated currency. Analysis shows that acquisition with Adobe will be successful if the following data is taken into account. The appraisal of almost any investment project in the real world will involve the making of a great number of estimates. For example, the outlay required to undertake the project, its life, the annual cash inflows and outflows it will generate, the scrap value it will have, and even the correct rate of discount to reduce the cash flows to present values. Estimates will be made for all these factors and the project will then be appraised by calculating an expected net present value (Glautier, Underdown, 1999). Sensitivity analysis for $250,000 (Griffithes, 1987) Element to be varied Alteration from Basic Revised NPV Increase + Decrease - Percentage Change Sensitivity Factor $ $ E+B Sales +15% 460,000 +210,000 84 5.6 Volume +10% 330,000 + 80,000 32 3.2 (Basic Value -10% 107,000 - 80,000 32 3.2 8000 units in Period 1, -15% 140,000 -110,000 44 2.9 8500 in Period 2 etc) -20% 90,000 -160,000 64 3.2 Sales +20% 420,000 + 170,000 68 3.4 Price +10% 310,000 + 60,000 24 2.4 (Basic Value -10% 170,000 - 80,000 32 3.2 $6 unit in Period 1, -15% 110,000 -140,000 56 3.73 $6.25 in Period 2 etc) -20% 20,000 -230,000 92 4.6 Cost/Unit +25% -120,000 -370,000 148 5.9 (Basic Value +10% 60,000 -190,000 76 7.6 $2.50 in Period 1 -5% 340,000 + 90,000 36 7.2 $2.60 in Period 2 etc) -10% 470,000 +220,000 88 8.8 If this NPV is positive then the appraisal is in favour of acceptance. But, in terms of down-side risk, the decision maker is also interested in how sensitive the advice is to changes in the estimates made about the project. In other words, it is likely to be interested in the margin of error that there can be in the estimates made about the individual components of the project (i.e., outlay, life, etc.) before the advice that the appraisal gives (in this case to accept) becomes incorrect. The advice to management is that the decision given by the NPV calculation is insensitive to changes in most of the estimated variables. However, if the revenues were the fall by 10% of their estimated value the original decision advice would turn out to be incorrect, Hence it may be worthwhile to re-examine the estimates of annual revenues to see if the company's confidence in their accuracy can be improved (Pijper, 1993). Accounting Rate of Return (Glossary of auditing terms - Reporting materiality, 2000). IAP Company Limited is considering two scenarios each with an initial investment of $1000000 and a life of 5 years. The profits generated by the projects are estimated to be as follows. After tax and depreciation profits. Year Scenario 1 Scenario 2 1 200000 150000 2 200000 150000 3 200000 150000 4 200000 200000 5 200000 350000 Total $1000000 $1000000 ARR on Initial Capital for scenario 1 (Whittington, Pany, 1998): Average Profits 1000000/5 = $200 000 p.a. ARR 200000 /1000000=20% ARR on Initial Capital for scenario 2: Average Profits 1000000/5 = $200 000 p.a. ARR 200000 /1000000=20% ARR on Average Capital is calculated on the bases of the following formula: Average Capital = Initial Investment / 2. So, Average Capital for scenario 1 is: 1000000/2= $500000 p.a., ARR 200000/500000=40%,; and Average Capital for scenario 2 is 1000000/2=$500000 p.a., ARR 200000/500000=40%. Average of the capital invested can be calculated by using the following method: Average lifetime investment = $1,000 000/2= $500,000, or graphically, $1,000 000 $500,000 Payback is the number of periods cash flows required to recoup the original investment. Apart from its use an accept criterion, payback can be used as a measure of risk, often in conjunction with NPV (Pijper, 1993). If two projects had approximately the same NPV and A had the shorter payback period then 1 would be preferred. The extra percentage is known as the risk premium. Such an inflated discounted rate raise the acceptance hurdle for IAP and can be shown to treat risk as a function of time by more heavily discounting later cash flows as demonstrated in the following example. If we assume the there are two possible scenarios for IAP Company to acquire Adobe, it can calculate the shortest payback period. 1st scenario 2nd scenario Cash Flow Calculative cash flow Cash Flow Calculative cash flow 0 -150000 -150000 -150000 -150000 1 + 60000 -90000 + 30000 -120000 2 + 50000 -40000 + 50000 -70000 3 + 40000 NIL + 40000 -30000 4 - + 30000 NIL 5 - + 30000 +30000 The results show that the payback period of the 1st scenario is three years while the payback period of the second scenario is 4 years. The NPV method involves calculating the present values of expected cash inflows and outflows and establishing whether in total the present value of cash inflows is greater than i.e. present value of cash outflows. The formula for NPV is: = the net cash flow in the period, i = the period number = discount rate (Pijper, 1993). An investment is being considered for which the net cash flows have been estimated as follows: Year $ 1 -95,000 2 +30,000 3 +47,000 4 +48,000 5 +32,000 The first scenario is more preferable because payback period is less (3 years instead of 4 years needed for the second scenario). If the NPV of the first scenario is positive this can be interpreted as the potential increase in consumption made possible by the project valued in present day terms (Griffithes, 1987). For IAP Company the results shows that if $95000 is borrowed at 20% p.a. to finance the project on overdraft terms where intense is paid on the balance outstanding at the end of each year. The discount factors are 0.833, 0.694, 0.579 and 0.482. NPV = 95000 + (0.833 x 30000) + (0.694 x 47000) + (0.579 x 48000) + (0.482 x 32000) i.e. NPV = + $5820. Year Amount Owing Year's interest Year's Cash flow Balance o/sc/fwd 1 95,000 20,000 15,000 100,000 2 100,000 16,000 13,000 112,000 3 112,000 10,000 7,000 115,000 4 115,000 9,000 5,000 119,000 5 119,000 7,000 4,000 122,000 This shows that if $95000 is borrowed at 20% the principal and interest could be repaid from the project flows leaving a cash balance at the end of Year 5 of $122,000. This balance is known as the Net Terminal Value and has a present value of $58804 ($122,000 x 0.482) The cost of capital is 10% and as the project is considered will be risky, a risk premium of 5% is to be added to the basic rate. The effects of the two discount rates are shown. Year 0 1 2 3 4 5 NPV Estimated Cash Flows -100,000 +20,000 +30,000 +25000 +30,000 +35000 10% Discount Factors 10.000 0.909 0.826 0.751 0.683 0.621 P.V. @ 10% -100,000 18180 24780 18770 20490 21730 +3950 15% Discount Factors 10.000 0.870 0.756 0.658 0.572 0.495 P.V. @ 15% -100,000 17400 22680 16450 17160 17320 -8990 Percentage reduction of P.V.s caused by risk premium 4% 8% 12% 16% 20% The WACC is found by calculating the average of the cost of each component of the firm's finance (equity, preference, debentures) weighted according to its proportionate share of the total pool of capital available (Glautier, Underdown. 1999). The weighting normally used is the current market valuation of the shares and loan stock, not the nominal book values. The individual component costs have been estimated at 16%, 12% and 8% respectively. Calculate the WACC using market value weighting. Component Market Value Proportion Individual Cost Weighted Cost% Ord. Shares 10m x $1.4 = $14m 62% 16% 0.62 x 16% = 9.92 Pref. Shares 2m x 0.925 = $1.85m 8% 12% 0.08 x 12% = 0.96 Debentures 7.5m x 0.9 = $6. 75m 30% 8% 0.3 x 8% = Total = 2.4 $22.6m total 13.28% Weighted average cost of capital = 13.28%. The CAPM is an alternative approach to the problem of measuring the cost of capital(Glautier, Underdown. 1999). Two parts of this process are a risk free rate of interest to which is added a premium to cater for the particular level of risk in a given security. Where the risk is greater so is the additional premium. The premium is calculated by using what is known as the P (Beta) coefficient. Three possible beta values have been shown which result in three estimates of the required rate of return: Beta value 1.4 - higher than average return and risk; Beta value 1.0 - security with an average return and risk; Beta value 0.5 - lower than average return and risk.The formula is Ra=Rf + (Rm-Rf)p, where Ra = the expected return on the security; Rf = the risk free interest rate; Rm = the expected return on a market portfolio; P = the beta coefficient which measures the volatility of the security's return relative to market return (Glautier, Underdown. 1999). Accounting for foreign subsidiaries is not the same as accounting for cross border individual transactions. Individual transactions involve currency conversion, the exchange of one currency for another as a result of a transaction. No such transaction nor exchange of currency takes place when group accounts are consolidated. Instead the subsidiary's accounts are merely re-expressed in terms of the group's currency, allowing consolidation to take place. This process is known as currency translation (Rickett, 2000). If IAP Company's balance sheet comprised fixed assets of $80,000 and cash of $120,000 which was financed by ordinary share capital of $160,000 and reserves of $40,000. It formed an acquisition with Abode by investing $100,000 of its cash balance. The acquisition was formed with a share capital of $200,000 which it is used to acquire $180,000 of fixed assets, leaving the balance as cash. At the end of the year the subsidiary's financial data can be translated using the original exchange rate, the year end or closing rate or a mixture of both. Using the original exchange rate to translate the accounts into their USA equivalent shows the real resources given up by the IAP Company when making the investment. This is known as the historic rate method. It is therefore consistent with the stewardship basis of accounting. It also shows clearly that no goodwill has been paid on the acquisition, allowing the assets to be simply substituted for the investment in the parent's books on consolidation. The translation, however, is using an exchange rate which no longer exists (Sterman, 2000). Another method is also possible to use. Using the closing rate overcomes this and, superficially at least, is consistent with intuitive logic by showing at the year end the 200,000 in yen being equivalent to $50,000 in the USA. A further advantage is that it shows the real value of the cash held in Erehwon has fallen in terms of pounds sterling because of the exchange rate differences. To calculate the return of investor the Adobe needs to follow some steps: First, it lays out the cash flows as a series of numbers and use negative numbers for cash it receives from the investors. Than, it uses positive numbers for cash the investors receive. Each number should represent the same time period. Na than it should use IRR function to calculate the return of investors: R= C-D / I; where R -the accounting rate of return, C- average yearly net inflows, D- depreciation, I -net outlays(Rickett, 2000). IRR cannot be found directly, but a graphical representation can help to draw a present value profile. NPV is $5820. NPV, $ 6000 5000 4000 3000 2000 1000 0 1000 5% 10% 15% 20% 25% 30% 40% 2000 3000 Bear in mind the financial data it is possible to say that IAP Company will be profitable and will receive high revenue a year acquiring Adobe. When appraising the past performance of a business, it is normal to relate profitability to some form of capital base to derive the return on capital employed. Distorting the data is possible by using the average profit. There is a general objection to the rate of return method when evaluating the capital budgeting decisions. Profit is a nebulous term, which is influenced by accounting conventions. Proposals will only be undertaken if the organization is better off as a result of making the investment and this begs the question as to what is meant by the term "Better off". Ignoring intristic factors such as image and "feel good" factor, an organization will be better off if it has more resources after undertaking the investment than before (Welford, Gouldson, 1993). It is possible to conclude that with the changing economic environment, factors such as globalization of markets, international economic integration, removal of barriers to business and trade and increased competition have enhanced the need of transportation. It is one of the most important infrastructure requirements, which is essential for the expansion of opportunities and plays an important role in making or breaking the competitive positioning (Todeva, Knoke, 2001). Furthermore, acquisition tends to suffer more serious commercial and organizational consequences when environmental and competitive conditions become hostile and unstable. In international acquisitions, firms seek to acquire new strengths based on the leverage' of technological, marketing or organizational knowledge. Many coalitions of this nature involve firms based in different geographic regions and consequently operate outside of the artificially developed economic world unions. This helps to spread technologies between major trading blocs which has important ramifications for world technological development. The problem in committing resources to new modes of distribution is the time it can take to change consumer behaviour and engender acceptance of new means of purchase. Some forms of distribution may be withdrawn before they have time to take effect. References 1. Anderson, E. 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Rickett, D. 2000 Building Strategic Relationships: A Practical Guide to Partnering with Non-Western Missions. Pleasant Hill , CA : Klein Graphics 14. Rugman, A., Brewer T., 2001, handbook of International Business, Oxford. Oxford University Press. 15. Stijn Claessens and Marion Jansen, eds 2000, The Internationalization of Financial Services: Issues and Lessons for Developing Countries. Boston, Mass.: Kluwer Academic Press. 16. Sterman, J. D. 2000, Business Dynamics: Systems Thinking and Modeling for a Complex World, Irwin McGraw-Hill, New York. 17. Todeva, E., Knoke, D. 2001. Starategic Allience and Corporate Social Capital. May. Available from: www.soc.umn.edu/knoke/pages/Todeva&Knoke.pdf [Accessed 20 Aug 2005] 18. Welford, H. Gouldson, K., Environmental Management and Business Strategy, Pitman, 1993. 19. Whittington, O. Ray, and Kurt Pany, Principles of Auditing, 12th edition, Irwin/McGraw-Hill, 1998. 20. Zolkiewski, Judith M. 1994, "Marketing of Large Contracts: Selling Costs and Profitability" MSc Dissertation, UMIST, UK. Read More