B.V.Raghunandan,SVS College,

Bantwal.Karnataka-India

Valuation of a Firm in case of Mergers & Acqusitions

Valuation of a Firm

Most important aspectCrucial for the success of M&ASelecting a suitable method of Valuation

Determining the Price payableMode of PaymentForecasting future income is a vital element of any method of valuation

Valuation Approaches

Discounted Cash Flow determines the value of the firm by ascertaining the present value of future cash flows

Comparable Firm determines the value of the firm at the value of a similar firm in the same industry

Adjusted Book Value estimates the value of the firm at the sum of market value of assets and liabilities as a going concern

Option Pricing Model regards the equity of a taken over company as an option and values it like an option

Merger as a Capital Budgeting Decision

Capital Budgeting involves acquiring fixed or long-term assets

Discounted Cash Flow Approach is used determine the profitability of an asset or viability of a Project

M&A involves acquiring the target firm comprising a large number of assets and liabilities

It is a very long-term investmentValuation of the target firm is done in the

light of additional cash flows generated additionally by the acquisition

Steps in Evaluating M & A DecisionA. Determine the Cost of AcquisitionB. Forecast the Incremental Cash flows for the

future periodC. Calculate the cost of capital which can be used

as the rate of discountD. Obtain the present value of future free cash

flowsE. Estimate the Terminal ValueF. Compute the present value of the terminal

value by using the rate of discountG. Add up the present value of future free cash

flows and the present value of Terminal Value

A. Determining Cost of AcquisitionMarket Price of Equity Shares Allotted (+) Payment to Preference Shareholders

(+) Payment to Debenture holders (+) Payment of other Liabilities (+) Unrecorded Liabilities (+) Dissolution Expenses (-) Sale of Assets

B. Forecasting Cash Flows of Future

Cash Flow

Free Cash Flow (FCF)

Operating Free Cash Flow (OFCF)

Free Cash Flow to the Firm (FCFF)

Free Cash Flow to Equity (FCFE)

Cash FlowIt is the net profit arrived at after removing non-

cash items like depreciation and amortisation of intangible assets and expenses shown in the Balance Sheet

Cash Flow has become more reliable as manipulation becomes difficult with cash. As it is said, cash is a fact while profit is an opinion

It is calculated by adding back depreciation and amortisation of expenses to the Profit after Tax…

Profit after Tax ………… (+) Depreciation ………… (+) Amortisation of Expenses …………

-------------------- Cash Flow ………

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Free Cash Flow

It is a cash flow that is arrived at after providing for capital expenditure and the net working capital

It is a better measure since it considers the operating expenses and also the capital expenditure

It is also more realistic in that it takes care of the net working capital requirements

It is also a good measure because it shows the profitability that is relevant to both the equity shareholders and the lenders

Calculation of Free Cash Flows (FCF)

Profit after Tax ………… (+) Depreciation ………… (+) Amortisation of Expenses ………… -------------------- Cash Flow ………… (-) Purchase of Fixed Assets ………… (-) Increase in Net Working Capital ………… -------------------- Free Cash Flow ………… --------------------

Operating Free Cash Flows (OFCF)

It is the cash flow that takes into account only the operating income and operating expenses

Other items like interest, other income etc are ignored

It is a measure that shows the profitability of the main operation and is not affected by the investment activities and financing activities

This is used when only the manufacturing facilities are taken over through M&A

Calculation of OFCF

Profit after Tax ………… (+) Depreciation ………… (+) Amortisation of Expenses ………… -------------------- Cash Flow ………… (-) Purchase of Fixed Assets ………… (-) Increase in Net Working Capital ………… -------------------- Free Cash Flow ………… (+) Interest Paid ………… (-) Interest Received ………… (-) Other Income ………… -------------------- Operating Free Cash Flow …………. --------------------

Free Cash Flow to the Firm (FCFF)It takes into consideration all the cash items

including interest, items arising out of capital expenditure and also investment in marketable securities

The decision on M&A takes FCFF and its discounted values for the purpose of determining the value of the firm

There are many firms where investment, capital expenditure and capital receipts and other incomes are as regular as any other operating item

Thus, FCFF is the right cash flow for the purpose of valuation of the firm

Computation of FCFF Profit after Tax ………… (+) Depreciation ………… (+) Amortisation of Expenses …………

-------------------- Cash Flow …………

(-) Purchase of Fixed Assets ………… (-) Increase in Net Working Capital …………

-------------------- Free Cash Flow …………

(+) Non-Operating Income …………. (+) Decrease in Marketable Securities …………

-------------------- FCFF …………

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