Module 6: Introduction to Valuation of Corporations

Transcription

1 Module 6: Introduction to Valuation of Corporations

2 Reading 6.2: Stages of Growth and Financing

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6 Reading : Mergers and Acquisitions

7 Mergers & acquisitions (M&A) Merger Shareholders of two companies approve the combination of their companies into a single company under a statutory amalgamation. Existing shares are exchanged for new shares in the merged entity. Acquisition One company acquires voting control of another company by buying the company s common shares either for cash, shares, or a combination of the two.

8 Types of mergers Horizontal merger Companies are direct competitors in the same product lines & markets. The end goal is larger market share ( possibly expansion into different markets). Scrutinized the most from a regulatory perspective. Vertical merger When a company acquires a supplier secure reliable supply of materials and components, improve product development, etc. Congeneric merger Companies who sell different but related products. It has been a series of congeneric acquisitions that have shaped Canada s major banks. Conglomerate merger combination of companies that operate in entirely unrelated markets/industries.

9 Motives for mergers Operating economies of scale/scope Larger market share/production = lower unit production costs. Biggest benefit is usually stated in terms of cost synergies. Strategic motives Company may acquire a supplier (vertical merger) to secure a key component. Market power and control Company uses increase size and power in one part of business to its advantage in another part. Financial economies of scale Better and cheaper access to funds in the capital markets. Greater exposure to sell side analysts/institutional investors. Increase in management capabilities A company may acquire a smaller company whose best asset is a couple of key employees/executives.

10 Fast growth Often easier to buy growth/expansion in new geographic markets or different lines of business. Diversification Primary motive for a conglomerate to expand. Main belief is that the company s earnings will be more stable the more it diversifies, and thus reduce the company s risk. Investment opportunity A company may view another company as being cheap, and thus a worthwhile investment. This may be due to the state of the global economy, or company specific issues.

11 Vertical mergers Vertical mergers make sense if/when: The threat of production failures are serious enough to warrant bringing production in house. If firm s activities are complex and difficult to control. There are a few outside suppliers and they tend to behave in an opportunistic manner. If there is a realistic possibility of achieving economies of integration (more cost effective for one company doing what two companies can do).

12 Vertical mergers Vertical mergers don t make sense if/when: Can achieve economies of scale, but not worth it because of low production volume. There is the potential for unknown costs associated with entering new business. Friendly vs hostile takeover

13 Strategies designed to inhibit takeover attempts 1. Keep voting power in hand of current shareholders (or a small group of shareholders) Dual class shares certain group of shareholders have class of share with far greater voting privileges (10 votes for one class A share, v.s 1 vote for each class B share). Employee stock option plans (ESOPs) management may vote the shares allocated to ESOP. Gives management a little more voting power. Changing majority vote company s charter could be changed to require significant majority vote by shareholders to approve takeover. Staggered board of directors small number of directors are elected per year. This makes it hard for a company looking to takeover the company to elect its own directors.

14 Strategies designed to inhibit takeover attempts 2. Golden parachutes - Design executive compensation so key executives will receive large benefits if contracts terminated. 3. Poison pills Rights/warrants are issued that become valuable when an unfriendly bidder controls certain percentage of company s vote.

15 Fighting a declared takeover attempt Find a white knight a third company that will agree to a friendly acquisition. Negotiate with the bidder to stop the takeover process for a period of time so that the two companies can negotiate a friendly merger. Make sure shares owned by bidder will not exceed those of management or management friendly shareholders: Buyback shares of bidder at a premium (white mail) Use cash or borrow to buy back shares Sell shares to friendly third parties Management could take measures to make company less desirable: Buy assets that could create anti-trust issues or bidder may find undesirable Sell attractive assets Load up the company with debt Make your own takeover attempt for bidder

16 Reading &6.4: Leveraged Buyouts

17 LBO is where an acquisition is financed with a significant amount of debt. If the investors include employees of the company, it is considered a management buyout (MBO). Most of the time, the company acquired is publicly traded, and is proceeded to be taken private (i.e no longer publicly traded). Once the company has improved its operations/profitability, the company is then usually taken public again at a huge profit for the owners. Generally not the case for a MBO: under a MBO the company may be run just as it always has been.

18 Good targets for an LBO Company is stable with a consistent history of profitability (i.e low business risk), and generates strong cash flows (it s the cash flows that will pay off the debt). Company operates in a stable industry and generally has an asset base that deteriorates slowly (i.e doesn t need a major reinvestment in assets anytime soon), and is quite tangible (offers good collateral value). Company currently has relatively low amount of debt.

19 Is leasing an option? Can the company use the tax shield that interest payments offer? With lease financing of assets, reduces initial cash outlays. Difficulty with lease financing: Leasing companies may prefer to wait until the LBO goes through, which may be too late from the perspective of the LBO sponsors. Lease financing may not be large enough for the needs of the LBO. LBO deal may be too complex and occurring too quickly for leasing companies.

20 Evaluating a merger/lbo The evaluation of a potential merger is very much a capital budgeting problem. The present value of the cash flows generated must be greater than the purchase price. The key is the premium being offered to acquire the company. Study after study has concluded that the majority of mergers fail this is normally due to the high premium that must be paid to acquire the company and/or anticipated synergies that never materialize.

21 Reading 6.5: Basic Valuation Using Discounted Cash Flows

22 Basics of discounted cash flow valuation Basic discounted valuation model: Equation 6-4 Forecasted cash flows Terminal value There are 3 key inputs: cash flows (C), discount rate (r), and growth rate (g). The different models are based on different methods of determining which cash flows to value. Remember, are you valuing the firm in its entirety, or just the equity of the firm?

23 Reading 6.6: Valuation Using Operating Cash Flows and the WACC

24 Operating cash flows (OCF) Equation 6-5 Forecasted cash flows Terminal value OCF = operating cash flows after tax, including cash flows from non-cash items. WACC = Weighted average cost of capital g = perpetual growth rate

25 Calculating operating cash flows

26 Determining NPV of acquisition Equation 6-6 Equation 6-7

27 Reading 6.7: Valuation Using Free Cash Flows to the Firm

28 Free cash flows to firm (FCFF) Equation 6-8 A/tax operating cash flows Net capital investments Terminal value

29 FCFF using APV Using APV at the unlevered cost of equity to the operating and investing cash flows. Adjust for financial side effects discounted at cost of debt. Equation 6-9

30 Reading 6.8: Valuation Using Free Cash Flows to Equity

31 Free cash flows to equity (FCFE) Value the equity portion of the company by considering cash flows that flow directly to shareholders.

32 Equation 6-10

33 From June 2011 exam ABL Corp. is one of the industry leaders looking for target companies to acquire on the market. One such target, AIM Inc., is being pursued by ABL s main rival, LAB Inc. LAB has made a bid valuing AIM at $100,000. ABL is seeking your advice on whether they should also bid on AIM.

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42 From June 2012 exam Big Nickel Inc. (BN) has found a target company to take over: Small Nickel Corp. (SN), a smaller mining company.

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46 Reading 6.9: Valuation Using Dividend Growth Models

47 Dividend growth models Variation of FCFE where we use dividends as a substitute for cash flows. If you dividends are specified for the forecast periods:

48 If the forecast period is characterized as a period of high growth, then the following model is used:

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52 Reading 6.11: Valuation Using Price-Multiple Ratios

53 Using price-multiples Instead of discounting cash flows, using multiples is easier and based on the notion that the current transaction should be priced similar to previous transactions.

54 From June 2014:

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