Of Mergers & Acquisitions - Assignment Example

Discuss, and compare, (i) the CAPM, (ii) the ICAPM, and (iii) the Multifactor Model, as the different techniques in estimating the cost of equity(Ke) in the context of cross border mergers and acquisitions. Mergers and acquisitions is a very important aspect of corporate finance which is mainly done to strengthen corporate strategies. Mergers and acquisition is a very popular corporate accounting aspect and is rapidly practiced in the new era in order to create new business entities as well as to strengthen the existing business entities. Mergers and acquisitions is a part of corporate restructuring. According to Zabihollah Rezaee in the book Financial Institutions, valuations, mergers and acquisitions: …. The author states that for mergers or acquisitions it is necessary to find the economic value of the asset that is being brought or sold. By the economic value of the asset it means the “total economic environment associated with the asset, the potential use of the asset, timing of the value estimate, location of the asset, extent of ownership involved.” (2001). Financial Institutions, valuations, mergers and acquisitions: the fair…. By Zabihollah Rezaee, p 165. The CAPM, the ICAPM, and the Multifactor Model are the three different model used to estimate the cost of equity in the circumstance of merger and acquisitions. There are various factors which affect the merger and acquisitions of the companies. Capital Asset Pricing Model: All investment has a there own risk constituent in every industry. The amount of risk in the one industry is defers from another industry and also from organization to organization. The Capital Asset Pricing method is a financial model for assessing stock, derivative, security and assets by concerning risk and anticipated rate of return. Capital Asset pricing method is based on the thought that depositors demand extra anticipated return. Business organization countenance various risk at their day to day affairs. To recognize these risks is the one of the most significant jobs that the financial manager required to perform. To recognize the various kinds of risk, their computing, the methods to reduce or recompense risk and risk-return affiliation elucidated by the CAPM three terms have to be described. These three terms are risk aversion, risk-return affiliation and risk. The relationship between risk-return describes the relationship among risk and anticipated rate of return. “The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk.” (Capital Asset Pricing Model: CAPM, 2011). Capital assets pricing has been various functions. One of the main functions of this model to create the comparative study of the risk and return of the particular market. And also the model is also made on the basis of various assumptions. There is difference between the Capital Asset Pricing model, Intertemporal Capital Asset Pricing Model and The Multifactor Model. Intertemporal Capital Asset Pricing Model: The Intertemporal Capital Asset Pricing Model (ICAPM) is used to decide estimated asset returns. The main dissimilarity among the CAPM and ICAPM the extra state variable that recognized the fact the depositor’s hedge in opposition to deficits in consumption or in opposition to alterations in the future investment chance set. Intertemporal Capital Asset Pricing Model takes probable risks issues into consideration and also it exposes all the risk so that depositors identify the all the risks. In stock market depositor is mainly accumulate financial earning by numerous ways. “In contrast to the CAPM, the ICAPM allows multi-period portfolio choice and time variation in investment opportunities. In this context, the additional risks factors are requiring to capture the investors special hedging concerns since the market portfolio is no-longer mean-variance-efficient, as in the CAPM, but multifactor efficient” (Michel, 2009, p. 24). One of the biggest parts in the profitability assessment criteria is the Return on Equity Return on Equity reveals all the stage of profits that a business brings in, apart to the whole quantity of depositor equity created on the balance sheet. The stock assessment is a constructive procedure in designing the values of the companies and the stocks. The technique is much useful in predicting the future of the business and about the stocks, the various kinds of the pricing movements that will affect the firm, the value of the stocks that are different at different times and the stocks which are under valued that can be overvalued and sold. The Multifactor Model: The multi-factor model (MFM) is used to explain either a portfolio of securities or individual security such as risk, or to way indexes. It is used to evaluate dealings between the security’s and variables resulting performance. When building a multi-factor model, it is difficult to choose which and how many factors to include. One instance, the Fama and French model, included three aspects: book-to-market, values excess return on the market and size of industries. Furthermore, models will be judged on historical numbers, which might not correctly forecast future standards. This model can be divided into three groups: fundamental, statistical and macroeconomic models. Fundamental models examine the connection between a security's return and its fundamental financials. Statistical models are used to assess the incomes of different securities founded on the statistical performance of each safety in and of itself. Macroeconomic models evaluate a security’s return to such aspects as inflation, interest and employment. The multi-factor models are using the following formula: “Ri = ai + ?i(m) Rm + ?i(1)F1 + ?i(2)F2 +…+?i(N)FN + ei.” (Multi Factor Model, 2011). Where: Ri = the income of security. Rm = the market return. F =the factors used (1, 2, 3…N) ? = the beta with respect to each factor including the market (m). e =the error phrase. a= is the intercept. In the multi-factor model the cost of equity is calculated as the risk-free price plus the industries compassion to numerous factors for example country-specific factors, global factors, company-specific factors or macroeconomic factors. The multi-factor model’s advantages are that it permits shareholders to tailor the model to match their particular risk exposure, and the enclosure of multiple risk factors may develop the model’s descriptive power. However, the MFM does not specify the suitable risk issues, may not be economical, and may not considerably develop upon the CAPM’s cost of equity. Further, the MFM is computationally troublesome and does not determine existing troubles estimating beta, risk-free rates of return or market returns. So, the multifactor model may not be a considerable development on the CAPM. Comparison between these CAPM, ICAPM, and the Multifactor Model: CAPM. ICAPM. Multifactor Model. The Capital Asset Pricing Model (CAPM) theory mainly describes the relationship between the risks in the stock market and the required returns of a particular stock in the market. The ICAPM considered various features other than CAPM use. The ICAPM thinks that depositors utilize their assets for above than merely reduce the variance in returns. The multi-factor model (MFM) is used to explain either a individual security or portfolio of securities such as risk, or to way indexes. The Capital Asset Pricing Model considered tome value of money and risk. Intertemporal Capital Asset Pricing Model takes probable risks issues into consideration. The multi-factor model computed the cost of equity as the risk-free price plus the industries compassion to various factors. Capital Asset Pricing Model not constantly exposes the entire risk. Intertemporal Capital Asset Pricing Model is the one of the reliable method. It exposes all the risk so that depositors identify the all the risks. MFM does not identify the suitable risk issues, may not be inexpensive, and may not greatly develop upon the CAPM’s cost of equity. “The Capital Asset Pricing Model (CAPM) theory mainly describes the relationship between the risks in the stock market and the required returns of a particular stock in the market” (Tavakoli, n.d.). “The main purpose of using CAPM is to make a comparative analysis regarding the risks and the returns associated with a particular stock in the stock market. While using the CAPM model, there are certain assumptions like the stockholders who are not ready to take risks and in case they are ready; they need to be compensated with high returns” (Kapil, 2011 p. 168). The other assumption in the CAPM model is that the stockholders or the investors do not influence the price of the stocks i.e. to say that they have an independent identity apart from the stock market in the influence of stock prices. “The other assumption is that there are no transactional expenses like commission, processing charges etc. Also, it is assumed that there are no taxation expenses in the stock market. The CAPM is the most popular model used in determining the cost of equity” (Taylor, 2005). According to the capital asset pricing model a stock’s beta alone should explain its average return. “Since a stock’s beta measures its contribution to the risk of a portfolio, beta is the theoretically correct measure of the stock’s risk” (Brigham & Daves, 2010, p. 52). In the book Mergers & Acquisitions from A to Z by Andrew J. Sherman and Milledge A. Hart the author’s state that the motive behind mergers and acquisitions is large in number and it is simply not only for monetary benefits but also for other benefits. The authors state that corporate restructuring is also done because it is strategically motivated. “One key trend in mergers and acquisitions is to acquire a company to access today’s knowledge worker and top obtain the intellectual property” (Sherman & Hart, 2006). 2. Discuss the extent to which these techniques may be properly applied in light of the recent crisis in financial markets. In the light of the recent financial crisis it is necessary to inspect the global markets appropriately before cross border mergers and acquisitions take place. In cross border mergers and acquisitions the most important factor that needs to analysis is the degree of integration of capital markets. There is a need for the creation of a global beta and global equity premium in the cross border mergers and acquisitions. Valuation is the most important factor in cross border mergers and acquisitions. When a stock’s book value is high the stock is less considerate and of little concern. When its book value is high then its prospect income is doubtful. When the stock is fully of a capital nature then the stock will be generating very less income especially during the times of economic recession. According to the CAPM model “the book value of the stock is the measurement of the stock’s risk. The main reason behind this idea which they suggest is that when a stock’s book value is high then it implies that the stock is of little concern and its prospect income is a little doubtful. It can also be viewed that the stock is fully of a capital nature and therefore will be generating very less income in the times of economic recession” (Meyers, 2011, p. 361). Cross border mergers and acquisitions are strategic alliances. The targeted enterprise should be valued on the basis of the projected performance of the capital asset in the stock market. The CAPM theory states the relationship between the risk associated with a stock and the expected return on the stock which counters the risk associated with the stock. The Intertemporal Capital Asset pricing model (ICAPM) is an international extension of the capital asset pricing model. While the CAPM focuses on a single currency area and single financial, the ICAPM focuses on multiple currency area and multiple financial markets. In cross border mergers and acquisitions also the risk of a corporate restructuring is measured by the risk involved which is refereed to as beta in the investment. In the normal ways it is considered that a project with a lower beta has a lower risk as well as lower returns. Using the ICAPM model investment in multicurrency and multiple financial markets is possible. While in the CAPM “The measurable relationship between risk and expected return in the CAPM is summarized by the following expression: Rt = Rf + ?i [ Rm – Rf ], Where Ri is the expected return on security or portfolio i, Rf is the return on a risk-free security like a U.S. Treasury bond, ?i is the beta of security or portfolio I and Rm is the expected return on a broad index of equity market performance like the Standard & Poor.s Composite 500 Index” (Capital Asset Pricing Model Analysis of the Cost of Equity Capital, n.d., pp. 1). The risk free factor in the ICAPM is the risk free rate in the currency in which on the whole proceeds are being calculated. In finance, the CAPM is used to decide in a theoretic manner a suitable rate of return on an asset. If the asset is a well diversified portfolio then the asset’s non diversifiable risk also needs to be calculated. The CAPM obtains into account the asset’s sensitivity to non-diversifiable risk, often represented by the amount beta (?) in the fiscal business, as well as the probable proceeds of the market and the estimated return of a academic risk-free asset. “The CAPM tells us that only systematic risk (market risk), as measured by beta, is rewarded, and that the relationship between expected return and beta is linear. Even though the CAPM has proven to be a useful instrument for describing stock returns, the current consensus is that the single risk factor is not quite adequate for describing the cross-section of stock returns” (Gobbi, 2005). Intertemporal CAPM identifies a multivariate linear substitute for marginal utility. This Model has been broadly designed for finding an appropriate necessary rate of return of a share. However, the supposition of using a main share market index as the yardstick becomes a problem. The shareholders in the stock market put on income generally from mainly two ways there are, it is from trading shares and dividend payment. The stock estimation is a helpful method in planning the principles of the stocks and the companies “As in the stock market, models can be broken down into two classes: One-Factor- and Multi-Factor models. A One-Factor model assumes that all bonds are influenced by the same source of uncertainty. This would make all bonds be perfectly correlated so that a combination of two bonds can serve as a perfect substitute for any other bond. By incorporating multiple factors, different types of shifts in the shape and location of the term structure can be captured, delivering more realistic term structure shapes” (Gobbi, 2005). Thus to conclude all the techniques can be properly employed but the most important technique which can be better employed is the CAPM model. Reference List Brigham, EF., Daves, PR. 2010, Intermediate Financial Management,10th edn, Cenage Learning Inc, USA. Capital Asset Pricing Model Analysis of the Cost of Equity Capital, n.d. BellSouth Telecommunications, pp. 1- 4, Available at: http://www.psc.state.al.us/29054/bellsouth_directii/billingsley/040120_29054_exhibit_rsb-4.pdf [Accessed 18 April 2011]. Capital Asset Pricing Model: CAPM, 2011. [Online] Investopedia. Available at: http://www.investopedia.com/terms/c/capm.asp [Accessed 18 April 2011]. Gobbi, S. 2005, Interdependencies Between Stock and Bond Market Returns. Swiss Banking Institute University of Zurich. Available at: http://www.bf.uzh.ch/publikationen/pdf/publ_1165.pdf [Accessed 18 April 2011]. Kapil, S. 2011. Financial Management, Dorling Kindersley (India) Pvt Ltd, Mumbai. p.164 Meyers, RA. 2011, Complex Systems in Finance and Econometrics, SpringerScience+Business Media, LLC, USA. Multi Factor Model, 2011. [Online] Answers.com. Available at: http://www.answers.com/topic/multi-factor-model [Accessed 18 April 2011]. Michel, G. 2009, Real Estate Risk in Equity Returns: Empirical Evidence from U.S. Stock Markets, 1st edn, Gabler Edition Wissenschaft, Oestrich-Winkel. Rezaee, Z. 2001, Financial Institutions, Valuations, Mergers, and Acquisitions: the fair.., Wiley e Book. Canada. Tavakoli, MR. n.d. Application of CAPM in Measuring Risk and Return for Selected Markets of Iran’s Econmy. [Online] Wbiconpro.com. Available at: http://www.wbiconpro.com/15-Mohammad.pdf [Accessed 09 June 2011]. Sherman, AJ., Hart, MA. 2006, Mergers & Acquisitions from A to Z, 2nd edn, USA. Taylor, B. 2005. An Empirical Evaluation of the Capital Asset Pricing Model. [Online] Economics.fundamentalfinance.com. Available at: http://economics.fundamentalfinance.com/capm.php [Accessed 09 June 2011]. Read More