Fall 2022 Acquisition Analysis Class Test Solutions – Columbia University
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What Is the Significance of Net Asset Value in Acquisition Valuation?
The approach to assessing a company's net asset value should be adapted to the strategy to realize significant sums in cash over a short period, it is necessary to be sure that assets earmarked for disposal are valued on a quick sale basis. The market may be aware that asset sales are likely after the acquisition. This will affect the vendor's bargaining position and the price realized. Different views may be taken of a stake in an associate company. A purchaser who is in a position to control the company (perhaps because of an existing stake) may attribute a higher value than would a passive investor.
Explain the Quality of Earnings in Acquisition Analysis
The quality of earnings of an acquisition target should be scrutinized by reference to the factors discussed in Part 1. However, the acquiror may be able to identify areas of cost savings should the acquisition be completed. Some upward revisions in earnings estimates may be legitimate as part of analyzing the consequences of the acquisition.
The purchaser of a company that is available for sale should be wary that the company may have reached a cyclical peak in earnings. Many purchasers assume that the price earnings multiple on which an acquisition is valued will decline as future growth comes through. However, in cyclical industries, the price earnings multiple at the purchase price may well increase. Similarly, if an acquiror is striking at an opportunist time of depressed earnings, it must obviously not be too surprised if its own analysis shows the purchase to be on a rather high immediate multiple.
How Do You Valuate an Acquisition on Cash Flow Basis?
Calculating the return on the purchase of a company by discounting an expected stream of cash flows can involve the assumption that cash generated is reinvested at the same rate of return. This may not be the case if the acquisition target is a business where the proceeds are unlikely to be reinvested, for example, a mine or a quarry that is being worked out or a 'cash cow', ie a business that generates cash and does not require significant funds to be reinvested. It may be necessary to modify the normal internal rate of return methods so that funds reinvested are assumed only to earn the average return on capital of the acquiring group.
This may well be lower than the return expected on the acquisition, especially if the acquisition is attractive principally for financial reasons. In evaluating cash flow, it may be that cash generated by the acquisition will include other elements besides operating cash flow, such as sales of fixed assets. A company that has been run by inactive management is likely to have some fat in working capital. For example, stocks and debtors may have been kept at higher levels than necessary. If such funds can be released, they can be regarded as a legitimate part of the cash generated from the acquisition. In conglomerate groups, likely, a valuation that looks at each part of the business separately may be higher than a valuation simply based on group
Is Composite Valuation the Best Approach for Conglomerate Groups?
In conglomerate groups, it is likely that a valuation that looks at each part of the business separately may be higher than a valuation simply based on group earnings or consolidated net assets. Some parts of the group may generate substantial profits but have a low book value. Some assets with a high book value may for the moment be generating little or no income. A simple valuation of the consolidated group may gloss over this aspect.
If this basis of acquisition is to be accepted, the seller must be prepared to adopt an approach equivalent to a controlled liquidation or at least a partial break-up of the group. If the purchaser is not willing to accept this, he may be better advised to let the existing management handle the asset sales and buy only the parts of the business which interest him.
Explain How the Share Price Plays a Role in Acquisition Valuation
If a company is quoted, it is of course possible to base the valuation on the market price. Indeed, this is the most natural starting point in many ways. However, it must be accepted by a purchaser that the share price is a price for a small number of shares and may have little relevance, depending on the circumstances, to the price which is necessary to achieve control of the whole company. The simple force of inertia will require the offeror to pay a premium over the market price. If a shareholder can buy and sell in the market at a certain price there is no need for him to take the trouble to consider the terms of an offer. A premium over the market is therefore necessary simply to get shareholders' attention.
The level of premium will vary with circumstances, but, as a rule of thumb, might be considered to be in the region of 20% to 40%. Attention must also be paid to the target company's price history. While negotiations are in progress or investigations are being made, leaks or rumors may occur which are likely to cause a rise in the share price. This 'froth' may result in a price that settles at a small discount to the market's guess of where a bidder might eventually pitch his offer. In these circumstances, the purchaser may assess the price which may have to be paid on the basis of the share price prevailing before the rumors started. If the rumors prove false, the price is likely to fall back to the previous level.
It may also be useful to look at the price history over a number of years. particularly the peaks and the levels of turnover in the shares at those peaks. The offer price may look attractive compared with current values. Shareholders have a habit of remembering the price they originally paid. If that price was higher than the offer, they may be reluctant to take what they would still consider a loss. The share price lows may be useful for calculations to show the attractions of the offer. On the negative side, they may indicate substantial possible tax liabilities for shareholders deemed to have made disposal under the offer.
The general techniques of company valuation apply to valuing an acquisition but with a sharpened focus. An assessment should also be made on a strictly practical basis of the price it is thought necessary to secure control of the company. If this price is significantly above an objective valuation, strong warning signs should be registered against proceeding.
Especially in a situation that is likely to be contested, it is useful to set an upper limit before negotiations begin and while cold logic and rationality still prevail. In the heat of a contested battle when victory becomes more important than price, it is easy to lose sight of the objective value. A maximum price formula established in advance is the best safeguard against living to regret an expensive acquisition. It is legitimate to allow some flexibility, as during a contested takeover, the target company will frequently release new and more favorable financial information, on which the acquiror may be able to justify a higher valuation.
Give An Example of Tailoring the Terms of An Offer to Avoid Dilution
An example of how this type of package works is set out below. The example below demonstrates that even if (as often happens in a bid) it is necessary to pay a premium over market price so that the acquisition is not necessarily made on an advantageous price-earnings ratio, nevertheless by introducing other elements into the terms an increase in earnings per share can be achieved.
- An offer by the acquiror for 100% of the shares of the target company, partly in shares, partly in loan stock.
- The terms are based on a total value for the target company of 500.
- The acquiror's shares are issued at market value.
- The convertible loan stock is convertible at a 10% premium to the current market value of the acquiror's shares.
|Latest pre-tax profits||133||67|
|Tax at 25%||(33)||(17)|
|Number of shares in issue||1000||1000|
|Earnings per share||0.10||0.05|
|Multiple on which shares are rated||10 times||10 times (at the offers price)|
|40% in shares||200|
|40% in 7% Convertible Loan Stock (CLS)||200|
|20% in 10% Unsecured Loan Stock/cash (ULS)||100|
|Effect on earnings per share|
|Pre-tax profits of target||67||67|
|Less: interest on CLS||(14)|
|interest on ULS||(10)||(10)|
|Less: tax at 25%||(11)||(14)|
|Earnings from target||32||43|
|Earnings from acquiror||100||100|
|Shares of acquiror in issue||1000||1000|
|Shares issued for acquisition||200||200|
|Shares issued on conversion to CLS||180|
|Net earnings per share||0.110||0.104|
In the above example, the cost of debt at 10% is in nominal terms the same as the assumed earnings yield on the acquiror's shares which is also 10%. However, because interest payments are allowable for tax, an improvement in earnings per share from 0.10 to 0.11 is achieved. An equally important factor is the assumption that the coupon on convertible loan stock will be 7%, significantly lower than on the straight loan stock. After conversion, an improvement in earnings per share is still registered. This is partly because of the tax relief on the interest payment on the straight loan stock and partly because it is assumed that the conversion price for the convertible loan stock can be set at a premium to the current market price of the shares. This results in the issue of fewer shares than if shares have been issued at the outset.