How Items on the Financial Statement Affect the Post-Merger Value of a Company - Case Study Example

Task: Company evaluation Introduction The major task in this paper is to evaluate the value of the company using the market approach, the discounted cash flow and the asset approach. However, the company’s operating income is negative. This situation presents a challenge to the company’s estimation using the discounted cash flow methods (the net present value, the internal rate of return, the payback period and the profitability index). Therefore, an explanation to that effect has been provided. Secondly, some items in the company’s statement will not affect the ultimate value. The items have been identified and underlying explanations provided. Lastly, some items in the company’s financial statement play a key role in the value determination. They have been identified and the effect of their inclusion determined. The company’s financial statement items According to the available financial statements of the company, the below computations are some guide to the value determination. The company’s current assets consist of the inventory for $ 150,000, finished goods for $ 30,000 and available cash for $ 100. Therefore, the company’s total current assets are (150,000 + 100 + 30,000) = $ 180,100. The company’s total fixed assets are estimated to be (75,000 – 40,000) = $ 35,000. Therefore, the value of the company’s total assets would be (180,100 + 35,000) = $ 215,100. Other items that could be used in estimating the total value of the company are the cost of goods sold, the operating expenses, and the add backs. The cost of goods sold = $ 661,894; the operating expenses = $ 332,551; the add backs = $ 193,643. Other expenses such as engineering, overheads and selling are in the amount of, engineering = $ 49,614; overheads = 162,315; and selling expense = $ 261,560. The value of the benefits allocation is also considered it = $ 44,511. The reason for taking these figures is that they have been contributed by the company’s initial capital outlay. The discounted cash flow techniques The methods used under this technique are the payback period, the net present value, the internal rate of return and the profitability index. Payback period method- according to this method, the feasibility of a company is measured by dividing the initial capital outlay by the periodic cash inflows. For this reason, the payback period is defined as the period a company takes to generate cash that is equivalent, in value, to the initial cost of investment. The traditional financial managers mostly practice this approach because it helps to identify the time a company would take to return the cost of investment. Payback period method is considered a screening tool for viable investment opportunities. (Howard 21-87). The decision rule based on this method is that, if the payback period of an investment lies within investors required range of duration, the investment is considered. With reference to ME DIV’S case, the total initial outlay to be used is the estimated cost of $ 1,921,188. On the other hand, the cash inflow considered is the 2011 net sales worth $ 972,632. Therefore, the company’s payback period would be approximately two years. That is in the first year, 972,632 of 1,921,188 would be paid. The remaining amount of (1,921,188 – 972,632) = 948,556 would be cleared in the second year- assuming a consistent level of cash inflows. Concerning the potential buyer, it is upon him to decide whether the payback period is preferable. (Howard 21-87). Net present value- in this method, both the cash inflows and outflows are discounted. The discounted outflow is subtracted from the sum of discounted cash inflows to obtain the net present value. The discounting rate is selected based on the cost of finance. According to this method, an investment should be accepted if the net present value is greater or equal to zero. Therefore, a company with a positive net present value is considered more valuable than that with a negative net present value. Concisely, companies with positive net present values generate a higher capital gain than those with negative net present value. With reference to ME DIV’S case, the net sales have been assumed as the total cash inflow. On the other hand, the value of the total assets is the initial outlay. Assuming a cost of finance of 12%, the company’s net present value would be (972,632 – 215,100) = $ 757,532. This is the value of the company at the end of the financial year ended December 2011. To recognize the time value of money, the current value of the company is (757,532) 1.12^3 = $ 1,064,278. From the estimation, it is clear that the company’s net present value is positive. The interpretation of this is that the company’s value is high and it is suitable for investment. The company’s high value would increase the overall value of the post-merger company (Howard 56-87). The proponents of this method assert that it is advantageous because it takes into account the time value of money. Secondly, it conforms to the objective of shareholder wealth maximization. Lastly, it takes into account all the cash flows. Therefore, it is realistic concerning the estimation of return on investment. On the other hand, opponents of the method assert that it is disadvantageous because it ignores the element of risk. Secondly, it ignores the concept of payback period and lastly, it uses the cost of finance whose estimation is a challenge (Howard 56-87). The internal rate of return- IRR is the cost of capital of a company when the net present value equals zero. IRR of an investment can be obtained using trial and error, interpolation and extrapolation method. The fair value of a company is considered high if the IRR is higher or equal to the cost of finance. In the case of the ME DIV Company, the 2011 gross profit has been considered as the cash inflow ($ 310,738). On the other hand, the initial outlay used is the value of total assets ($ 215,100). The company’s IRR has been determined using the trial and error method. Therefore, the NPV when the cost of finance is 12% is (310,738/1.12) – 215,100 = $ 62,345. In order to get a negative NPV a higher cost of finance is necessary. Therefore, using 45% as the new cost of finance, the new NPV is (310,738/1.45) – 215,100 = - 798. To get the IRR, 12+ (45-12)62,345/ {798 + 62,345} = 44.6% (Howard 56-87). According to this method, a company is suitable for investment if the internal rate of return is greater or equal to the cost of finance. From this statement, it is appropriate to assert that the ME DIV Company is suitable for investment. This is because it has an IRR of 44.6%, which is higher than the cost of finance (12%). The proponents of this method assert that it is advantageous because it takes into account the concept of time value of money. Secondly, it considers the cash flows over the entire life of a venture. Lastly, it is compatible with the maximization of the owner’s wealth. On the other hand, its opponents argue that it is difficult to use (Howard 56-87). Profitability index- it is the ratio obtained after dividing the sum of the present value of cash inflows by the initial cost of investment. A company whose PI > 1 is considered of high fair value and is suitable for investment. Investment is discouraged in companies whose PI < 1. With reference to ME DIV’S case, the value of net sales is assumed as the cash inflow. On the other hand, the value of the total assets is considered as the initial investment cost. As a result, the value of the company’s net sales for the year 2011 is $ 972,632 and the estimated value of the total asset according to the financial statements is $ 215, 1000. Therefore, the profitability index of the company is (972,632/215,100) = 4.52. According to the computations, the profitability index of the company is greater than one. This means that the company has a high fair value and therefore, is suitable for investment. If the acquisition takes place, the company’s high value would be a boost to the merged company because it will pull up the post-merger value of the company (Howard 21-87). The asset approach The book value- this method involves the use of the par value of capital as indicated on the balance sheet. The value of a company, using this method, equals the value of assets as indicated on the balance sheet. According to the definition, the company’s value concerning the items on the financial statement would be the sum of the following: the current assets, the fixed assets, the cost of goods sold, the operating expense, the add backs and the expenses such as engineering, overhead, selling and the benefits allocation. Therefore the company’s value according to this method would be (193,643 + 332,551 + 661,894 + 49,614 + 162,315 + 261,560 + 44,511 + 180,100 + 35,000) = $ 1,921,188. This value is identified with the financial year ended December. According to the time value of money, the purchasing power of money reduces with time owing to increase in interest rates. The phenomenon also affects the values of companies. Consequently, the value of the ME DIV Company should be adjusted for inflation as follows (1,921,188) 1.12^3 = $ 2,772,076 (Howard 56-112). The market approach The market value- is the market price of an asset. Using this method, the fair value of a company is the product of the share price and the total number of shares. This method is limited because the share prices keep on changing thus the market value can only be computed at one point in time. The market value of the company’s fixed asset would be (75,000 – 40,000) = $ 35,000 (Howard 56-112) How do items on the financial statement affect the post-merger value of a company? The company’s earnings after tax would influence the post-merger value of the company. The influence would be brought about in the following way: if two companies merge, their earnings after tax are added in order to obtain the total earnings after tax of the merged company. The post merger earnings after tax would be therefore used together with the post-merger number of shares to obtain the post-merger earnings per share. The obtained post-merger EPS would then be used to determine the post-merger Market price per share. The post-merger value of the company would therefore be the product of the post-merger market price per share and the number of ordinary shares. The negative value of ME DIV’S operating income would reduce the total earnings after tax of the merged company. This would reduce the value of earnings per share of the merged firm. The reduced earnings per share, assuming a constant rate of the price earnings ratio, would reduce the market price per share of the post-merger company. Since the value of a company is the product of market price per share and the number of ordinary shares, a lower market price per share would lower the company’s post-merger value (Business valuation reports par. 1-8). Under the asset approach, all the assets in the balance sheet of a company are included while determining the company’s value. The assets would increase the value of the company. Liabilities, particularly current liabilities would also be included while determining the company’s value. The liabilities would reduce the value of a company since they reduce the value of the total assets (Business valuation reports par. 1-8). The total capital of the company is another item that would be included while determining the value. Capital is the initial outlay that is used to determine a company’s value under the net present value method, the profitability index method, and the internal rate of return method. Large amounts of capital would reduce the company’s fair value under profitability index method (Business valuation reports par. 1-8). The other expenses such as the company overheads, engineering, selling, benefits and tax expenses are not included while evaluating the value of a company. The reason is the named expenses have a direct influence on the company’s income. Therefore, they are adjusted prior to the merger process (Business valuation reports par. 1-8). Works Cited Howard, Malcolm K. Accounting and Business Valuation Methods: [how to Interpret Ifrs Accounts], Amsterdam: Elsevier/Cima Pub, 2008. Internet resource. Business valuation reports 2013. Web. 2 Dec. 2013 http://www.bizquest.com/business-valuation-report/#topTop>. Read More