Introduction
Takeover involves one company acquiring another company. A takeover may be friendly or hostile. Whichever the case, the value of the firm to be acquired must be determined. Also of importance is the value of the combined firm to measure the economic rationale of acquisition.
Valuation of the Combined Company
The value of a firm can be estimated using various methods. One of the methods is the dividend valuation model which can assume a constant growth in perpetuity or a constant dividend in perpetuity.
Constant Dividends in Perpetuity
Assuming a dividend cover of 2, a constant dividend in perpetuity, and a cost of capital of 20%,
P=D1/k for constant growth where D1 is the dividend paid in the period, P is the price of the share and k is the cost of capital.
P= D1/k
D1=2, k=20%
P= 2/0.2=10
Constant Growth in Perpetuity
Assuming a dividend cover of 2, growth in dividend of 10% per year in perpetuity and assuming a cost of capital of 20%,
P=D0 (1+g)/(k-g)
P= 2 (1+0.1)/ (0.2-0.1)
=2(1.1)/0.1 =22
As an alternative Shareholders, Value Added Approach can also be used Shareholder Value Added approach to the estimation of cash flows for the first 5 years with an assumption of growth of dividends in year 6 onwards at an annual rate of 4% in perpetuity. The cost of capital is estimated at 20%
SVA = Net Operating Profit After Taxes (NOPAT) – (Capital x WACC)
Step 1: Calculate Net Operating Profit after Taxes
Step 2: Calculate capital employed
Step3: calculate capital charge:
Step4: calculate SVA
Comparison of Valuation Methods Used
The dividend valuation approach has several advantages as a valuation model. It is flexible in the estimation of the dividends stream expected in the future. It can also lead to an approximation of value from highly oversimplified inputs. The dividend valuation model also allows the use of the prevailing market price of stocks to calculate the expected market growth and return. The method also allows for analyzing the reaction of the market to the changing conditions. It also helps investors to understand the relationship that exists between growth, returns, value, and dividend payout ratio.
However, this method suffers from several shortcomings such as oversimplified inputs which can lead to wrong models and poor results. The method is also highly sensitive to changes in assumptions and inputs. The method is also not applicable to non-dividend-paying companies.
On the other hand, the shareholder’s value-added method recognizes economic cost in the equity component of capital. The accounting measure’s main focus is on the profit after taxes as a ratio of total assets. However, the shareholder’s value-added method mainly focuses on the performance of the operation by the firm. This is done by adjusting the net operating profit after taxes by taking into account the capital charge which reflects the economic operations of a going concern.
This method also combines both income statements and balance sheets to determine the available return for the shareholders. It also addresses the risk issues and the expectations of the shareholders.
Alternative Valuation Methods
The Discounted Cash Flow Approach
This process is aimed at finding the value of the company by finding the present value of its cash flows over its lifetime. The life of the company is however assumed to be perpetual. Therefore, to calculate its value one has to break its life into periods. These periods may be forecast and terminal periods. The forecast period may last between five years to ten years. It must take into account the economic benefit of the company and the costs involved in running the company.
Terminal value is calculated at the end of the forecast period and takes into account the cash flows generated during the forecast period. It also takes into account the future cash flows based on the assumption of constant growth. Finally, the Weighted Average Cost of Capital is used to discount the cash flows which give the value of the company.
The Free Cash Flow
This equals the summation earning after-tax, depreciation, and other non-cash charges fewer investments in capitals.
Free Cash Flow= EBIT (1-T) +D-C-N
Where
- EBIT is earnings before interest and taxes
- T is taxed on earnings
- D is the depreciation charges and other non-cash charges.
- C is the capital investments on fixed charges
- N is the investment in working capital.
Terminal Value
This takes into account the long-term prospect of the company. It assumes constant growth. Terminal value is arrived at by the following formula:
Terminal Valuet=FCF (1+g)/WACC-g)
Where FCF is the expected future cash flows over period t,
g is the estimated growth of the company and
WACC is the waited average cost of capital,
The Discount Rate
This represents the opportunity cost of investment in a given company by the investors. WACC should include this rate.
WACC=Wd.Kd+ We.Ke
Where Kd is the after-tax cost of debt and. Ke is the cost of capital. Wd. and We are the percentage composition of debt and equity on the total cost.
Ke=Rt+ β (Rt-Rm)
Where Rt is the risk-free returns expected from the market over period t,
Î’ is the measure of systematic risk faced by the company by investing in the common stock, while Rt-Rm is the historic risk premium of the market.
Adjusted Present Value Approach (APV)
In this method, initially, the firm is assumed to be fully financed by equity. The net effect of adding debt is considered by taking into account both benefits and costs of debt. The tax benefit is considered the most significant and the major cost is considered to be the added risk that the company may go into bankruptcy.
The three-step process of valuation involves the estimation of an unlevered firm. The next step takes into account the leverage by considering the present value of the interest tax-saving obtained by borrowing a given amount of money. The final stage involves the evaluation of the probability of the firm going into bankruptcy and the cost of bankruptcy should it occur.
Unlevered Firm
To obtain the value, the free cash flow of the firm should be discounted at the cost of equity.
The value of the firm in this case is given by the following:
Value of the firm=FCFF (1+g)
Pu-g
Where FCFF represents the after-tax operating cash flow of the company, Pu is the cost of equity of the unlevered company and g is the growth rate expected by the firm.
Levered Company
The expected tax benefit from acquired debt is calculated. The tax benefit is calculated and then discounted at the cost of debt.
At perpetuity, the tax benefit is obtained by the product of tax rate and debt.
Bankruptcy Cost and Net Effect
This step evaluates the default risk of the firm and the probability that the firm will go into bankruptcy.
Present Value of Expected Bankruptcy = probability that the firm will go into bankruptcy * present value of bankruptcy cost.
Excess Return Models
Return on capital must exceed the cost of capital for the growth to be realized. The excess return model tries to calculate the value of the firm from the excess return expected from equity. Economic value added a version of the excess return model, looks at the value created by investments. It is determined as the product of returns above the cost of capital.
The Cost of Capital Model
In this approach, one obtains the value of the firm through discounting the expected free cash flows by the weighted average cost of capital (Jensen and Ruback, 1986). The model takes into account the tax benefit of debt capital and the additional risks involved in employment leverage. This model assumes that the cost of capital includes both benefits of tax deduction and increased risks expected from using debt capital. The version begins by valuing the value of the firm various versions of the model exist.
The stable growth model gives the value of the firm as follows:
Value of the firm=FCFF/ (WACC-gn)
Where FCFF is the future free cash flow expected next year
WACC is the weighted average cost of capital and is the annual growth rate of cash flow which is expected to last forever.
The model assumes a growth rate less than the economic growth rate. Also, all conditions of the firm must be stable.
Risks Faced By the Bidding Firm in Undertaking Acquisition
Various studies have indicated that mergers and acquisitions, in general, provide better performance than individual companies. However, various risks are also associated with acquisitions. According to a study by Jensen and Ruback (1986), the acquiring firms’ stock price tends to perform below expectations. This was also confirmed by studies by Ravenscraft, (1987) that showed most acquisitions produced negative returns in the long run. According to a study conducted by Hill Samuel Bank Limited, (1992), it concluded that the profitability of the acquiring firm reduced drastically in the long run, sometimes by about 50%.
Another risk involved in the acquisition is the overconfidence of the management which often results in consequences that may be disastrous to the firm. This overconfidence may lead to unnecessary expansion that in the long run stretch the resources owned by the business. This can severely affect the returns in the long run (Limmack, 1990). In a study conducted by Straub (2007) problems in administration and inefficiencies are common and tend to cancel out the advantages foreseen. The problems may arise from cultural differences between the acquired and the acquiring firm. Different firms have different cultures, ethics, and traditions. This may be a hindrance to flexibility and adaptability in the acquiring firm.
Most managers acquire other firms for different motives. Some do so for fame, to build empires, and also with the expectations of higher compensations. These motives may result in a loss of focus on the mission and visions of the firm. As a result, most acquisitions fail to achieve the intended results (Dong, Hirshleifer, Richardson, and Teoh, 2006).
Another risk that may face a bidding firm is the choice of a long target. The risk is often high especially if the management lacks interest in the whole arrangement. A long target adds costs to the acquiring firm without any substantial contribution to the growth or economic advantage of the acquiring firm (Panel on Takeovers and Mergers, 2006).
The main motivation behind acquisition should be to gain strategic benefits. However, this is often sidelined by the management. As a result, there is always the risk of poor planning of the strategic plan consequently leading to the poor implementation of the plan. There is also the risk of unrealistic expectation of benefits from strategic reasons of acquisitions (Schuler, Jackson and Luo, 2004).
The bidding firm also faces the risk of low motivation by the employees of the acquired firm. This may result from the fear of losing their jobs and uncertainties that surround the acquisition process. There is also the risk of a lack of communication between the employees of the acquired firm and the acquiring firm. This adversely affects performance in the short run leading to returns below the expectations (Hubbard and Nancy, 2001).
The acquiring firm also faces the risk of legal challenges in the circumstances in which it is deemed to break the antitrust laws. Most acquisitions are carried out to gain a competitive advantage over competitors. This may involve acquiring a firm that holds in possession, strategic resources, or acquiring a firm to command a larger market share. This can be challenged in court to curb monopolistic characteristics that may arise after acquisition (Rankine and Howson, 2006).
Conclusion
Substantial benefits can be gained from the acquisition. These benefits may include high returns, large market share, and possession of strategic resources. However, each acquisition should be economically justifiable. This will help to avoid the risk of overstretching resources of the firm and the probability of a drastic reduction of returns in the long run.
References List
Dong, M., Hirshleifer, D., Richardson, S., and Teoh, S., H. 2006. Does Investor Misvaluation Drive the Takeover Market? The Journal of Finance. 61(2). Pp 725–762.
Hill Samuel Bank Limited. 1992. Mergers and Acquisitions and Alternative Corporate Strategies. New York: W. H. Allen and Co plc.
Hubbard, N. 2001. Acquisition: strategy and implementation Basingstoke, Palgrave.
Jensen, M., C. 1986. Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers. The American Economic Review. 76 (920), pp.323-329.
Limmack, R., J. 1990. Takeover activity and differential return to shareholders of bidding companies. Edinburgh: David Hume Institute.
Panel on Takeovers and Mergers. 2006. The City Code on takeovers and mergers. London: Panel on Takeovers and Mergers.
Rankine, D. and Howson, P., 2006. Acquisition essentials: a step-by-step guide to smarter deals. Prentice-Hall: England.
Ravenscraft, D., J. and Scherer, F., M. 1987. Mergers, Sell-offs, and Economic Efficiency, Washington, D.C.: Brookings Institution.
Schuler, R., S., Jackson, S., E. and Luo, Y. 2004. Managing Human Resource in Cross-Border Alliances. London: Routledge.
Straub, T., 2007. Reasons for frequent failure in mergers and acquisitions. A comprehensive analysis. Upper Saddle River: Cengage.