Stock Market Driven Acquisitions - Essay Example

Assignment: Corporate Finance Table of Content Overview 2 Motives 2 Economics of Scale 3 Increased revenue/increased market share 4 Cross selling 4 Synergy 4 Taxes 4 Geographical or other diversification 4 Assets acquisition 5 Method of Valuation 5 Discounted cash flow method 6 Net present value 6 Financing 8 Equity 8 Debt Financing 9 Cross-border investment 9 Dividends 11 Summary 12 Recommendations 13 Financial provision 14 Legal provision 14 Value Added tax on M & A fixed assets 14 Recruitment of well qualified staff 14 References 16 Overview This report attempt to minutely establish the appropriate theoretical bases of corporate finance with practicable and life example on proposed take over of UCB. We carried a research in the following aspect: Motive, Method of Valuation, Financing the project and finally we give adequate recommendation. Motives In economics, merger is a combination of two companies into one larger company such actions are commonly voluntary and involved stock swap or cash payment to the target stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name or combining the names of the original companies. (http://en.wikipedia.org) Shleifer and vishny (2003) proposed a market timing model of acquisition. They assumed that acquirers are overvalued, and the motive for acquisition is not to gain synergies, but to reserve some of their temporary overvaluation for long-run shareholder. Specifically, by acquiring less-overvalued target with overpriced stock (or less interestingly, undervalued target with cash) overvalued acquirers can cushion the fall for their shareholders by leaving them with more hard assets per share or, if the deals value proposition. Our company can engage in merger and acquisition when synergetic benefits are observed and consideration to add shareholder value. The motivation for the USB acquisition should match the following motives: Economies of scale: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the cost of the company relative to theoretically the same revenue stream thus, increasing profit. Increased revenue /increased market share: This motive assumes that the company will be absorbing a major competitor and increasing its power (by capturing increased market share) to set prices. Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock's customers while the broker can sign up the banks customers for brokerage account. Or a manufacturer can acquire and sell complimentary products. Synergy: There would be better use of complimentary resources. Taxes: A profitable company can buy a lost marker to use the targets tax write-off. Geographical or other diversification: This is the sign to smoothen the earning result of a company, which over the long-term smoothes a stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (http://en.wikipedia.org) From datamonitor analyses, UCB has an inorganic expansion into lucrative AIID and oncology market. The acquisition of the Biotechnology Company, Celltech offered UCB technology platforms and experience for the development of biological drugs. And the new regulations allows our company to create motive for us to merge and acquire, which is an opportunity for us to have a strong R & D pipeline and new expertise in the pharmaceutical sectors. So all of this would be achieved rapidly if acquisition decision is taken. Asset acquisition UCB is a multinational company, operating in more than one hundred and forty countries, also it is one of the largest pharmaceutical and chemical companies in Belgium. The present structure of the company reflects its global market. This can give our company a global coverage and a broader market share which may lead to a drastic change in our sales i.e. rapid growth and more profit would be made. Method of valuation Under method of valuation we will see to the issue of UCB Company's value in our case of merger and acquisition. We will also review briefly and analyze all methods of evaluation, most importantly the discounted cash flow method. Discounted cash flow method The most popular approach to estimate the value of a project is to estimate future cash flow discount then to a present value. The discounted cash flow (CDCF) model value the equity of a company as the value of its operation. The discount cash flow method attempts to determine the value of UCB by calculating the present value of free cash flow over the life of the company. Free cash flow reflects the amount of cash that the company actually generates in a period of usually one year. Free cash flow in one period is calculated as: FCF = NOPAT + depreciation +/ - changes in networking capital NWC - investments. Assuming that all the cash outflows are made in the initial year, the present value can be calculated on the basis of the following equation: PV= CF1 + CF2 + + CF + S + Wn (1+k)1 (1+k)2 (1+k)n (1+k)n (1+kn)n = CFn + Sn + Wn (1+k)t (1+k)n (1+k)n The discount cash flow method attempts to determine the value of UCB by computing the present value of free cash flows over the life of this company. Since a corporation is assumed to have infinite life, our analysis. In our analysis we will take a forecast period of 4 years. We use of trial and error approach. Assuming investment required a minimum return of 20% and UCB has the following cash flow yr 0 (4000), yr 1 1200, yr 2 1410, yr 3 1875, yr 4 1150, then if we to find the internal rate of return (IRR). From the above, the total receipts are 5635 giving a total profit of 1635 and average profit of 409. The average investment =4000/2 = 2000. 409/2000 = 20%. Two thirds of the ARR is approximately 14%.therefore we shall start our try and error with 14%. Period cashflow DF (14%) present value 0 (4000) 1.00 (4000) 1 1200 0.877 1052 2 1410 0.769 1084 3 1875 0.675 1266 4 1150 0.592 681 NPV =83 Since the NPV at 14% is positive, the IRR must be higher than 14%.Assume 16%. Period cashflow DF (16%) present value 0 (4000) 1.00 (4000) 1 1200 0.862 1034 2 1410 0.743 1048 3 1875 0.641 1202 4 1150 0.552 635 NPV (81) Therefore, IRR would be between 14% and 16% We can solve for the IRR by interpolation. IRR = RL + (NPVp) * (Rh - Rl) NPVn + NPVp = 14% + 83 * (16% - 14%) = 15.01% 83 * 81s IRR = approximately 15% As we see from the figures above, the rate of return is still above average 20% expected meaning M & A can still take place. Net Present Value Method (NPV) A variation of the present value decision criterion is the NPV. The difference between the two is that the NPV deducts the present value of original outlay (C) from the present value of the future CFAT. Thus, NPV may be defined as the summation of the present values of the cash proceeds (CFAT) in each year minus the summation of present values of he net cash outflows in each year. Symbolically, the NPV for project having conventional cash flows would be: NPV= CF1 + CF2 + + CF + S + Wn (1+k)1 (1+k)2 (1+k)n (1+k)n (1+kn)n Sn + Wn (1+k)n = CFtn + Sn + Wn - c (1+k)t (1+k)n (1+k)n where = k = cost of capital CF = cash inflows t = 1 = the first period in the sum n = the last period in the sum Sn = salvage value Wn = working capital We can always apply NPV formula for UCB M & A. NPV explicitly recognizes the time value of money and it also fulfils the second attribute of a sound method of appraisal in that it considers the total benefits arising out of the proposal over it life-time. This method is an instrument in achieving the objective of financial management, the maximization of the shareholders' wealth. Financing The simple theoretical framework suggests the long horizon managers may reduce the overall cost of capital paid by their ongoing investors (shareholders) by issuing overpriced securities and repurchasing underpriced securities. Financing our acquisition, we will either use external financing by issuing debt or equity or cutting shareholders dividends. Equity Several lines of evidence suggest that overvaluation is a motive for equity issuance. Graham and Harvey (2001) anonymous survey of CFD's of public corporations, two-third of the corporation surveyed stated that the amount by which undervaluation and overvaluation was an important or very important valuation in issuing equity (P216). Pagano, Panetta, and Zingales (1998) examine the determinants of Italian private firms decision to undertake an IPO between 1982 and 1992 and find that the most important is the market-to-book ratio of seasoned firms in the same industry. Lerner (1994) find that IPO volume in the Biotech sector is highly correlated with Biotech stock indexes. Loughram, Ritter, and Rydgvist (1994) find that aggregate IPO volume and stock market valuations are highly correlated in most major stock markets around the world. Due to several threats facing UCB and its acquisition the financial distress costs are high in R & D intensive industries and R & D expenditures generates non-interest tax shields, thus the level of debt is expected to be low in our R & D intensive industries. The threats facing UCB are as follows: The threat of a new drug substitution by the competitors. Lack of U.S sale force. The threat of non-successful acquisition. Moreover the equity can increase the cost of our capital and eliminate the tax benefit generated by debt financing and our gain may be much larger. Debt financing Match (1982) in a sample of U.K firm finds that the choice between debt and equity does appear to be swayed by the level of interest rate. And Guedes and opler examine and largely confirm the survey responses regarding the effect of the yield curve. In a sample of seven thousand three hundred and sixty six U.S debt issues between 1982 and 1993 defined that maturity is strongly negatively related to the term spread (The difference between long and short term bond yields) which was fluctuating considerably during this period. Is debt market timing successful in any sense In aggregate data Baker, Greenwood, and Wurglar in the analysis of debt issues, connects the maturity of new issues to subsequent bond market returns. Speiss and Affeck Graves (1999) examine 392 straight debt issues and 400 convertible issues between 1975 and 1989 the shares of straight debt issuers under perform a size and book to market benchmark by an insignificant 14% over five years (The median under performance is significant) while convertible issuers under performed by a significant 37%.There is also a suggestion that the riskiest firms may be timing their idiosyncrasy credit quality despite the survey answers on this point the share of unrated issuers have a median five years under performance of 54%. If the equity did so poorly the debt issues presumably also did poorly. There are several potential explanations for this pattern. Certainly, equity overvaluation will be expected to lower the cost of debt directly. Credit risk models routinely include stock market. Capitalization as an input, soothe relationship with subsequent stock return may reflect debt market timing per se. Cross-border Investment The evidence in Froot and Dabora (1999) suggests that relative mispricings across International securities markets are possible, even between particularly liquid markets such as the US and the UK. This raises the possibility of international market timing. Along these lines, Graham and Harvey (2001) find that among US CFOs who have considered raising debt abroad, 44% implicitly dismissed covered interest parity in replying that lower foreign interest rates were an important or very important consideration in their decision. In practice, most international stock and bond issues are made on the US and UK markets. Henderson, Jegadeesh, and Weisbach (2005) find that when total foreign issues in the US or the UK are high, relative to respective GDP, subsequent returns on those markets tend to be low, particularly in comparison to the returns on issuers' own markets. In a similar vein, and consistent with the survey evidence mentioned above, foreign firms tend to issue more debt in the US and the UK when rates there are low relative to domestic rates. Dividends The catering idea has been applied to dividend policy. Long (1978) provides some early motivation for this application. He finds that shareholders of Citizens Utilities put different prices on its cash dividend share class than its stock dividend share class, even though the value of the shares' payouts are equal by charter. In addition, this relative price fluctuates. The unique experiment suggests that investors may view cash dividends per se as a salient characteristic, and in turn raises the possibility of a catering motive for paying them. Baker and Wurgler (2004) outline and test a theory of dividends in aggregate US data between 1963 and 2000. They find that firms initiate dividends when the shares of existing payers are trading at a premium to those of nonpayer, and dividends are omitted when payers are at a discount. To measure the relative price of payers and nonpayer, they use an ex ante measure of mispricing they call the "dividend premium." This is just the difference between the average market-to-book ratios of payers and non-payers. They also use ex post returns, and find that when the rate of dividend initiation increases, the future stock returns of payers (as a portfolio) are lower than those of nonpayer. This is consistent with the idea that firms initiate dividends when existing payers are relatively overpriced. Li and Lie (2005) find similar results for dividend changes. On the one hand, Myers and Majluf (1984) argue that a firm should not pay dividends (pecking order theory) if the other methods to get cash for financing acquisition come from selling stock or other risky securities. They argue that a change in dividend is highly correlated with the managers' estimate of assets. Summary From what is written above equity financing will be the last choice in financing M & A financing a deal entirely by debt may create an underinvestment in future opportunities in a sector with high pace of growth. The best strategy you can adopt is: By cutting the percentage of dividends of the shareholders. Cross border investment can be applied it can convey the signal of optimism to the market. It is also an avenue to finance the M & A of UCB. You can pay UCB a mix of cash from taking a debt issue. Recommendation Psychological experiments and intuition suggest that people value changes in economic status such as wealth or performance, not just levels in consideration various problems we suggest that the acquisition be carried out for the following reason To maximize stock price or stockholder wealth. To maximize profit or profitability. To maximize market share. To maximize revenue. To maximize social good. Financial provision Adequate provision must be made M & A in UCB for take-off of the project. Financing acquisition we will either use external financing by issuing debt or equity or cutting shareholders dividends. For valuation project DCF, NPV can be use to future or time value of money while going into investment. UCB will also need a way of recruiting staff and there must be legal provision on the merger and acquisition program. Legal provision Legal advice and support must be sought in the M & A in other to avoid some unforeseen contingencies in nearest future. Value Added Tax on M & A Fixed Assets Value added tax incurred on acquisition of fixed assets should be reported as an input value added tax rather that be capitalized as part of the acquired fixed assets. Recruitment of well Qualified Staff Employment of well qualified staff at all levels will distant the value added tax administration from the bureaucratic bottlenecks in UCB and the activities of dubious unqualified personnel due to the low level of income. The Qualified staff will be able to monitor the structure of intelligent network, the audit and special investigation, so that we can achieve stipulated results in UCB merger and acquisition. References Baker, Malcolm, Robin, Greenwood and Jeffrey Wurgler, 2003, the maturity of debt issues and predictable variation in bond returns, journal of financial Economic 70,261-291 Danzon, P.Eplem A and Nicholson S (2003) "Merger and acquisitions in the pharmaceutical and Biotech industries Nation Bureau of economy research June 2004. Datamonitor 2005, "Global Biotechnology" Datamonitor October 2005. Datamonitor UCB SA Datamonitor 2006. Graham, John R, Campbell R. Harvey, and Shiva Rajgopal, 2005 the economic implication of corporate financial report Journal of Accounting and Economics, forthcoming. http://www..giddy.org/byblos/ http://en.wikipedia.org/wiki/merger_and_acquisition http://corp.buppuaribas.com/merger_and_acquisiton Lerner, Joshua, 1994, venture Capitalists and the decision to go public, journal of financial Economics 35,293-316. Loughram, Tim and Jay Ritter, 1995 The new issues Puzzle, Journal of Finance 50,23-31. Loughram, Tim and Jay Ritter and Kristian Rydgvist, 1994, initial public offering: international insight Pacific-Basin finance Journal 2, 165-199. Marsh, Paul 1982 the choice between equity and debt: An empirical study, Journal of finance, 37 121-144. Pagano, Marco, Fabio Panetto and Luigi Zingalas, 1998, why do companies go public Empirical analyses, Journal of finance 53, 27-64. Shleifer, Andre, and Robert W. Vishny, 2003, Stock market driven acquisitions, Journal of financial Economics 70, 295-312. Read More