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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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