Mergers and Acquisitions

OBJECTIVES

Provide a rationale for mergers and acquisitions. Provide an overview of valuation approaches in an acquisition. Introduce valuation of brands. Summarize the empirical findings on mergers.

Define MergerMergers are defined as the combining of two or more companies into one, usually with only one company retaining its identity. Typically, the larger firm is the one whose identity is maintained.The term merger is generally used to indicate friendly joining of companies, while the term acquisition is used for unfriendly takeovers or combinations where one company is much larger than the other.

Types of MergersMergers can be classified as horizontal, vertical, or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business. A vertical merger is one in which the buyer expands toward the source of raw material or forwards toward the end customer. A conglomerate merger is one in which companies in unrelated lines of business merge.

WHY DO COMPANIES MERGE?The most commonly cited reasons are economies of scale and synergy.Economies of scale are enjoyed when the average unit cost of production decreases as production increases. The fixed costs are spread over a larger volume of production when companies merge.

WHY DO COMPANIES MERGE?The combined entity might become so large that the complicated organisation structure that usually follows a merger may increase costs due to bureaucratization.At times the acquired company may have potential tax shields but cannot avail them as the profits are not adequate. The company with tax loss carry forwards can merge with a profitable entity so that the tax shields may be availed.

WHY DO COMPANIES MERGE?Synergy could be expected in production, marketing, finance and operations due to sharing of R&D know-how, transferring of technology, more efficient usage of machinery, selling of complementary products through a common distribution channel, lower borrowing costs due to scale economies in borrowing, etc.

WHY DO COMPANIES MERGE?Some cash rich companies prefer to use cash for acquisitions under the premise that diversification reducesunsystematic corporate risk.That is, downturn in one companys fortune will be offset by upturn in another companys earnings. Modern finance theory hypothesizes that unsystematic risk is not priced in markets and hence irrelevant. So, a diversifying company can create value only by providing a better riskreturn tradeoff that is unavailable through simple portfolio diversification. There are six ways in which diversification can create value

Diversification can create valueInvesting in markets closely related to current fields of operation thereby reducing the long-run average cost.Reducing systematic risk by diversifying into related product markets.By lowering cost of debt and weighted average cost of capital due to risk pooling.

Gains from Merger

Combined value > (value of acquirer + stand-alone value of target)

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.

Target ValuationStep 1: Determine Free Cash Flow

Step 2: Estimate a Suitable Discount Rate for the AcquisitionThe acquiring company can use its weighted average cost of capital based on its target capital structure only if the acquisition will not affect the riskiness of the acquirer

Step 3: Calculate the Present Value of Cash FlowsSince the life of a going concern, by definition, is infinite, the value of the company= PV of cash flows during the forecast period + Terminal valueWe can set the forecast period in such a way that the company reaches a stable phase after that. In other words, we are assuming that the company will grow at a constant rate after the forecast period.

Step 4: Estimate the Terminal ValueThe terminal value is the present value of cash flows occurring after the forecast period. If we assume that cash flows grow at a constant rate after the forecast period, the terminal value

Step 5Add present value of terminal value.Step 6Deduct the value of debt and other obligations assumed by the acquirer

An Example

Clariant is a manufacturer of dyes and chemicals. Analysts expect the company to grow at 15 percent, perannum. The analyst forecast of free cash flow is shown in Exhibit 33.4. The cost of capital for the companyis 14.62 percent. The present value of cash flows amounts to Rs 39.09 crore. We are assuming that thecompany acquiring Clariant will not make any operating improvements or change the capital structure.

Since we are interested in buying only the shares of the firm, the value of outstanding debt should bededucted from the firm value to arrive at the value of equity. Clariant has debt amounting to Rs 7.92 crore.Value of equity = 103.52 7.92 = Rs 95.60 crore

Approach 2: Terminal Value is a Stable PerpetuityIf the total capital does not grow anymore, cash flow equals profit after tax

Approach 4: Terminal Value as a Multiple of EarningsThe terminal value under this method is established by multiplying the forecasted terminal year profits by an appropriate priceearning multipleAs usual, the current P/E multiple can be used as proxy for the future

To illustrate, if the current market value is Rs 57.62 crore and profit after tax is Rs 8.23 crore,P/E = 57.62/8.23 = 7Terminal value = Last year profits P/E multiple= 20.11 7 = Rs 140.8 crore

ConclusionObviously, the method adopted by the analyst affects the final value placed on the companys equity.These four methods might give four different answers. The DCF approach can capture the value of assets in place. Some components of the acquisition are hard to quantify. Consequently, the final price paid by theacquirer might be much higher than the DCF value obtained. But the premium paid for the so-called synergy should not be out of proportion. We could think of the target companys value as: