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CHAPTERS 15 & 25

Corporate Valuation and Merger Analysis

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Justifications for Mergers

Valid justifications: Break-up value exceeds value as

going concern Synergy

Questionable justifications: Diversification Increase firm size

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Types of Mergers

Friendly vs. Hostile merger Cash vs. stock swap

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Analysis of mergers

Discounted cash flow approach to merger valuation requires: Estimation of cash flows Determine the discount rate

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Analysis of mergers

The correct cash flows and discount rate depend on the evaluation technique used.

We will use the “Corporate Valuation Model” (from Chapter 15) based on Free Cash Flows, discounted at the WACC

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Corporate Valuation Model: Discount Rate

To use the corporate valuation model to value a merger target, we must estimate the post-merger WACC of the target firm.

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Free Cash Flow Valuation

The FCF approach estimates the total firm value, rather than the value of equity or per share value directly.

The value of equity (& per share value) can be obtained from the total value of assets by netting out other claims.

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Corporate Valuation: A company owns two types of assets.

Operating assets Nonoperating assets (securities)

NOWC

Operating assets include Net Fixed Assets and Net Operating Working Capital (NOWC).

NOWC = Operating CA – Operating CL

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Operating current assets

Operating current assets are the CA used to produce and sell the firm’s products. Op CA include cash, receivables,

inventory Op CA exclude securities (interest

earning current assets)

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Operating current liabilities Operating current liabilities are the

CL resulting as a normal part of operations. Op CL: accounts payable and accruals

(current liabilities that do not charge interest)

Op CL excludes notes payable because this is a source of financing, not a part of operations.

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Applying the Corporate Valuation Model Free cash flow is the cash flow

available for distribution to investors after all necessary additions to operating assets:

FCF = NOPAT – net investment in operating

assets

Calculating FCF

NOPAT is what a firm’s profit would be if it had no debt and no financial assets:

NOPAT = EBIT (1 – tax rate)

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Calculating FCF

The net investment in operating assets includes additions to operating assets in excess of depreciation expense.

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Corporate value

The PV of their expected future free cash flows, discounted at the WACC, is the value of operations (VOP).

Total corporate value is sum of:Value of operationsValue of nonoperating assets

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Data for Valuation

FCF0 = $20 million WACC = 10% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million

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Constant Growth Formula

If FCFs are expected to grow at a constant rate:

Vop = FCF1

(WACC - g)

= FCF0(1+g)

(WACC - g)

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Find Value of Operations

Vop = FCF0 (1 + g)(WACC - g)

Vop = 20(1+0.05)(0.10 – 0.05)

= 420

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Value of Equity

Sources of Corporate Value Value of operations = $420 Value of non-operating assets = $100

Claims on Corporate Value Value of Debt = $200 Value of Preferred Stock = $50 Value of Equity = ?

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Value of Equity

Total corporate value = Vop + Mkt. Sec.

= $420 + $100

= $520 million

Value of equity = Total - Debt - Pref. = $520 - $200 - $50

= $270 million

Valuation if growth is not constant

Often FCFs will be forecast for an initial planning period of N years, after which they are assumed to grow at a constant rate.

In this case, we must calculate the horizon (or “terminal”) value at the end of the planning period.

(Cont.)

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Valuation if growth is not constant (Cont.)

With nonconstant grown the value of operations is the present value of FCFs for years 1 through N plus the present value of the horizon value.

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Alternative valuation techniques

Another method of estimating firm value is based valuation multiples. Examples include value as a multiple of: Earnings (P/E) Book value Sales revenue

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Merger winners & losers

Target firm shareholders receive an average premium of:Friendly merger 20%Hostile takeover 30%

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Merger winners & losers

Long-run (five year) stock performance of acquiring firms:

Abnormal returnsCash acquisitions 18.5%Stock swaps -24.2%

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