-

Merger & Acquisition

Valuation Techniques

- Harsh
- F - 3
- R. No. 19
 TABLE OF COTENTS

INTRODUCTION 3
INCOME APPROACH 6
DISCOUNTED CASH FLOW TECHNIQUE 7
FREE CASH FLOW FROM EQUITY TECHNIQUE 9
MARKET APPROACH 10
ASSET APPROACH 11
NET ASSET VALUE TECHNIQUE 12
ECONOMIC VALUE ADDED TECHNIQUE 14
MARKET VALUE ADDED TECHNIQUE 15
CONCLUSION 17

2
A merger is said to occur when two or more business
combine into one. This can happen through absorption of an
existing company by another. In a consolidation, which is a
form of merger, a new company is formed to takeover
existing business of two or more companies. In India,
mergers are called amalgamations in legal parlance.

The acquisition refers to the acquisition of controlling

interest in an existing company. A takeover is same as
acquisition, except that a takeover has a flavor of hostility in
majority of cases. For this reason, the company taken over
is usually called the target company and the acquirer is
called the predator. The mergers are different from
acquisitions in the sense that acquisitions generally do not
involve liquidation of the target company.

Why Mergers and Acquisitions take place?

The common objective of both the parties in a M&A
transaction is to seek synergy in operating economies by
combining their resources and efforts. Now we shall see the
reasons for M&A from the perspective of both, the buyer
company as well as the seller company.

Objectives in a M&A transaction?

 An opportunity for achieving faster growth

3
  Obtaining tax concessions
 Eliminating competition
 Achieving diversification with minimum cost
 Improving corporate image and business value
 Gaining access to management or technical talent

Objective for Companies to offer themselves for sale?

 Declining earnings and profitability
 To raise funds for more promising lines of business
 Desire to maximize growth
 Give itself the benefit of image of larger company
 Lack of adequate management or technical skills

M&A under the Companies Act, 1956

The procedure for putting through a M&A transaction under
the Companies Act, 1956 is very tedious and a lot of time is
consumed in completion of the process. Sections 391 to 396
deal with the procedure, powers of the court and allied
matters.
“The basic difference between a merger and an acquisition is
that the transferor company will be dissolved in case of a
merger, whereas in case of acquisition the transferor
company continues to exist.”

M&A under the Income Tax Act, 1961

Tax implications can be understood from the following three
perspectives:
a) Tax concessions to the Amalgamated (Buyer) Company
b) Tax concessions to the Amalgamating (Seller) Company
c) Tax concessions to the shareholders of an Amalgamating
Company

Valuation of Target Company

4
The principal incentive for a merger is that the business
value of the combined business is expected to be greater
than the sum of the independent business values of the
merging entities. The difference between the combined
value and the sum of the values of individual companies is
the synergy gain attributable to the M&A transaction. Hence,

Value of acquirer + Stand alone value of Target + Value of

Synergy = Combined Value.

There is also a cost attached to an acquisition. The cost of

acquisition is the price premium paid over the market value
plus other costs of integration. Therefore, the net gain is the
value of synergy minus premium paid.

Suppose
VA = Rs. 200 (Merging Company, or Acquirer)
VB = Rs. 50 (Merging Company, or Target)
VAB = Rs. 300 (Merged or Amalgamated Entity)
Therefore,
Synergy = VAB – ( VA + VB ) = Rs. 50.
If the premium paid for this merger is Rs. 20,
Net gain from merger of A and B will be Rs. 30 (i.e. Rs. 50 –
Rs. 20). It is this 30, because of which companies merge or
acquire.
One of the essential steps in M&A is the valuation of the
Target Company. Analysts use a wide range of models in
practice for measuring the value of the Target firm. These
models often make very different assumptions about pricing,
but they do share some common characteristics and can be
classified in broader terms. There are several advantages to
such a classification: it is easier to understand where
individual models fit into the bigger picture, why they
provide different results and where they have fundamental
errors in logic.
There are only three approaches to value a business or
business interest. However, there are numerous techniques
within each one of the approaches that the analysts may

5
consider in performing a valuation. The Approaches and
Techniques are as follows: -

Income Approach
The Income Approach is one of three major groups of
methodologies, called valuation approaches, used by appraisers. It is
particularly common in commercial real estate appraisal and in
business appraisal. The fundamental math is similar to the methods
used for financial valuation, securities analysis, or bond pricing.
However, there are some significant and important modifications
when used in real estate or business valuation.

Under this approach two primary used methods to value a

business interest include:
a) Discounted Cash flow method
b) Capitalized Cash flow method
Each of these methods depends on the present value of an
enterprise’s future cash flows.

6
 Discounted Cash flow Technique

The Discounted Cash flow valuation is based upon the notion

that the value of an asset is the present value of the
expected cash flows on that asset, discounted at a rate that
reflects the riskiness of those cash flows. The nature of the
cash flows will depend upon the asset, dividends for an
equity share, coupons and redemption value for bonds and
the post tax cash flows for a project. The Steps involved in
valuation under this method are as under:

Step I: Estimate free cash flows available to all the

suppliers of the capital viz. equity holders, preference
investors and the providers of debt.
Free Cash Flow = EBIT (1- T) + Depreciation – CAPEX -
ΔNWC,
where:

• EBIT is earnings before interest and taxes.

• T is the marginal cash (not average) tax rate, which should
be inclusive of federal,
State and local, and foreign jurisdictional taxes.
• Depreciation is noncash operating charges including
depreciation, depletion, and
Amortization recognized for tax purposes.
• CAPEX is capital expenditures for fixed assets.
• ΔNWC is the change in net working capital.

Step II: Estimate a suitable Discount Rate for

acquisition, which is normally represented by weighted
average of the costs of all sources of capital, which are
based on the market value of each of the components of the
capital.

7
WACC = Wd*kd*(1-T) + We*ke , where:

• k d is the interest rate on new debt.

• ke is the cost of equity capital (see below).
• Wd, We are target percentages of debt and equity (using
market values of debt and equity.)
T is the marginal tax rate.

Step III: Cash flows computed in Step I are discounted at

the rate arrived at in Step II.
Step IV: Estimate the Terminal Value of the business, which
is the present value of cash flows occurring after the
forecast period.
TV = CFt (1+ g) ,
k-g
where, CFt is the cash flow in last year,
g is constant growth rate and
k is the discount rate
Step V: Add the present value of free cash flows as arrived
at in Step III and the Terminal Value as arrived at in Step
IV. This will give the value of firm.
Step VI: Subtract the value of debt and other obligations
assumed by the acquirer to arrive at the value of equity.

So, in all Terminal Value is,

8
FCFE Technique (Free Cash Flow From Equity)

The Capitalized Cash flow technique of income approach is

the abbreviated version of Discounted Cash flow technique
where the growth rate (g) and the discount rate (k) are
assumed to remain constant in perpetuity. This model is
represented as under:
Value of Firm = Net Cash flow in year one
(k–g)

9
 Market Approach

The origin of market approach of business valuation is

established in the economic rationale of competition. It
states that in case of a free market, the demand and supply
effects direct the value of business properties to a particular
balance. The purchasers are not ready to pay higher
amounts for the business and the vendors are not ready to
receive any amount, which is lower in comparison to the
value of a corresponding commercial entity.

It the value of a firm by performing a comparison between

the firms concerned with organizations in the similar
location, of equal volume or operating in the similar sector.
It has a large number of resemblances with the comparable
sales technique, which is generally utilized in case of real
estate estimation. The market value of shares of companies
that are traded publicly and are involved in identical
commercial activities may be a logical signal of the value of
commercial operation. In this case the company shares are
bought and sold in an open and free market. This process
allows purposeful comparison of the market value of shares.

The problem exists in distinguishing public companies, which

are adequately corresponding to the company concerned for
this intention. In addition, in case of a private company, the
liquidity of the equity is lower (put differently, its shares are
difficult to trade) in comparison to a public company. The
value is regarded as somewhat lesser in comparison to that
a market-based valuation will render.

E.g. - Suppose a company operating in the same industry as

ABC with comparable size and other situations has been sold
at Rs. 500 crores in last week provides a good measurement
for valuation of business. Considering the circumstances,

10
value of the business of ABC should be around Rs. 500
crores under market approach.

Assets Approach

The first step in using the assets approach is to obtain a

Balance Sheet as close as possible to the valuation date.
Each recorded asset including intangible assets must be
identified, examined and adjusted to fair market value. Now
all liabilities are to be subtracted, again at fair market value,
from the value of assets derived as above to reach at the
fair market value of equity of the business. It is important to
note here that any unrecorded assets or liabilities should
also be considered while arriving at the value of business by
the assets approach.

11
 Net Asset Value Approach

Net asset value (NAV) is a term used to describe the value of an

entity's assets less the value of its liabilities. The term is most
commonly used in relation to open-ended or mutual funds due to the
fact that shares of such funds are redeemed at their net asset value.
The NAV will usually be below the market price for the
following reasons:
 The NAV describes the company's current asset and
liability position. Investors might believe that the
company has significant growth prospects, in which
case they would be prepared to pay more for the
company than its NAV.
 The current value of a company's assets may be higher
than the historical financial statements used in the NAV
calculation.
 Certain assets, such as goodwill (which broadly
represents a company's ability to make future profits),
are not necessarily included on a balance sheet and so
will not appear in an NAV calculation.

For valuation purposes it is common to divide net assets by

the number of shares in issue to give the net assets per
share. This is the value of the assets that belong to each
share, in much the same way that PE Ratio measures profit
per share.

E.g. - One way to calculate NAV is to divide the net worth of

the company by the total number of outstanding shares.
Say, a company’s share capital is Rs. 100 crores (10 crores
shares of Rs. 10 each) and its reserves and surplus is
another Rs. 100 crores. Net worth of the company would be
Rs. 200 crores (equity and reserves) and NAV would be Rs.

12
20 per share (Rs. 200 crores divided by 10 crores
outstanding shares).

NAV can also be calculated by adding all the assets, and

then subtracting all the outside liabilities from them. This will
again boil down to net worth only. One can use any of the
two methods to find out NAV.

One can compare the NAV with the going market price while
taking investment decisions.

13
 Economic Value Added (EVA) Approach

Economic Value Added or EVA is an estimate of economic

profit, which can be determined, among other ways, by
making corrective adjustments to GAAP accounting,
including deducting the opportunity cost of equity capital.
The concept of EVA is in a sense nothing more than the
traditional, commonsense idea of "profit," however, the
utility of having a separate and more precisely defined term
such as EVA or Residual Cash Flow is that it makes a clear
separation from dubious accounting adjustments that have
enabled businesses such as Enron to report profits while in
fact being in the final approach to becoming insolvent. EVA
can be measured as Net Operating Profit After Taxes(or
NOPAT) less the money cost of capital. EVA is similar to
Residual Income (RI), although under some definitions there
may be minor technical differences between EVA and RI (for
example, adjustments that might be made to NOPAT before
it is suitable for the formula below). Another, much older
term for economic value added is Residual Cash Flow. In all
three cases, money cost of capital refers to the amount of
money rather than the proportional cost (% cost of capital).
The amortization of goodwill or capitalization of brand
advertising and other similar adjustments are the
translations that can be made to Economic Profit to make it
EVA.

14
 MARKET VALUE ADDED APPROACH (MVA)

Market Value Added (MVA) is the difference between the

current market value of a firm and the capital contributed by
investors. If MVA is positive, the firm has added value. If it
is negative, the firm has destroyed value. The amount of
value added needs to be greater than the firm's investors
could have achieved investing in the market portfolio,
adjusted for the leverage (beta coefficient) of the firm
relative to the market.
The formula for MVA is:
MVA = V - K

Where:
MVA is market value added
V is the market value of the firm, including the value of the
firm's equity and debt
K is the capital invested in the firm

The higher the MVA the better it is. A high MVA indicates the
company has created substantial wealth for the
shareholders. A negative MVA means that the value of
management's actions and investments are less than the
value of the capital contributed to the company by the

15
capital market (or that wealth and value have been
destroyed).

MVA is the present value of a series of EVA values. MVA is

economically equivalent to the traditional NPV measure of
worth for evaluating an after-tax cash flow profile of a
project if the cost of capital is used for discounting.
None of the above methods is the best or none of them is
the worst but each one has its own advantages and
viewpoints different from others. All these methods should
be used in combinations to arrive at proper valuation of the
business.

16
 CONCLUSION

These aspects, which we talked about in this article, will

justify the exchange process in a Merger & Acquisition
transaction if they are duly considered and their impact is
properly arrived at. Hence their review becomes a prime and
critical stage before proceeding with the big deal.

These assumptions might not, and probably do not, reflect

the actual conditions of the market in which the subject
business might be sold. However, these conditions are
assumed because they yield a uniform standard of value,
after applying generally accepted valuation techniques,
which allows meaningful comparison between businesses
that are similarly situated.

I would also say that no method is Perfect. Every situation

demands different approaches to be applied, and quite often
more than one approach would be used.

17