Damodaran
Damodaran
Damodaran
Aswath Damodaran
Aswath Damodaran
Acquisition valuations are complex, because the valuation often involved issues like synergy and control, which go beyond just valuing a target firm. It is important on the right sequence, including
When should you consider synergy? Where does the method of payment enter the process.
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Can synergy be valued, and if so, how? What is the value of control? How can you estimate the value?
Aswath Damodaran
Step 1: Establish a motive for the acquisition Step 2: Choose a target Step 3: Value the target with the acquisition motive built in. Step 4: Decide on the mode of payment - cash or stock, and if cash, arrange for financing - debt or equity. Step 5: Choose the accounting method for the merger/acquisition purchase or pooling.
Aswath Damodaran
(4) Poorly managed firms are taken over and restructured by the new owners, who lay claim to the additional value. (5) Managerial self-interest and hubris are the primary, though unstated, reasons for many takeovers.
Aswath Damodaran
Aswath Damodaran
Aswath Damodaran
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Valuation Guidelines Value the combined firm with synergy built in . This may include a. a higher growth rate in revenues: growth synergy b. higher margins, because of economies of scale c. lower taxes, because of tax benefits: tax synergy d. lower cost of debt: financing synergy e. higher debt ratio because of lower risk: debt capacity Subtract the value of the target firm (with control premium) + value of the bidding firm (pre-acquisition). This is the value of the synergy. Value the company as if optimally managed. This will usually mean that investment, financing and dividend policy will be altered: Investment Policy: Higher returns on projects and divesting unproductive projects. Financing Policy: Move to a better financing structure; eg. optimal capital structure Dividend Policy: Return unused cash Practically, 1. Look at industry averages for optimal (if lazy) 2. Do a full-fledged corporate financial analysis
Should you pay? Which firm is indispensable for the synergy? If it is the target, you should be willing to pay up to the synergy. If it is the bidder, you should not.
Synergy
Control Premium
If motive is control or in a stand-alone valuation, this is the maximium you should pay.
Value the company as is, with existing inputs for investment, financing and dividend policy.
Aswath Damodaran
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Valuation Guidelines Value the combined firm with synergy built in . This may include a. a higher growth rate in revenues: growth synergy b. higher margins, because of economies of scale c. lower taxes, because of tax benefits: tax synergy d. lower cost of debt: financing synergy e. higher debt ratio because of lower risk: debt capacity Subtract the value of the target firm (with control premium) + value of the bidding firm (pre-acquisition). This is the value of the synergy. Value the company as if optimally managed. This will usually mean that investment, financing and dividend policy will be altered: Investment Policy: Higher returns on projects and divesting unproductive projects. Financing Policy: Move to a better financing structure; eg. optimal capital structure Dividend Policy: Return unused cash Practically, 1. Look at industry averages for optimal (if lazy) 2. Do a full-fledged corporate financial analysis
Synergy
Control Premium
Value the company as is, with existing inputs for investment, financing and dividend policy.
$ 5,949 million
Aswath Damodaran
Generally speaking, firms which believe that their stock is under valued will not use stock to do acquisitions. Conversely, firms which believe that their stock is over or correctly valued will use stock to do acquisitions. Not surprisingly, the premium paid is larger when an acquisition is financed with stock rather than cash. There might be an accounting rationale for using stock as opposed to cash. You are allowed to use pooling instead of purchase. There might also be a tax rationale for using stock. Cash acquisitions create tax liabilities to the selling firms stockholders.
Aswath Damodaran
Correct Exchange Ratio to use in a Valuation = Value per Share of Target Firm (with control premium and target-controlled synergies) / Value per Share of Bidding Firm If the exchange ratio is set too high, there will be a transfer of wealth from the bidding firms stockholders to the target firms stockholders. If the exchange ratio is set too low, there will be transfer of wealth from the target firm to the bidding firms stockholders.
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Purchase Method:
The acquiring firm records the assets and liabilities of the acquired firm at market value, with goodwill capturing the difference between market value and the value of the assets acquired. This goodwill will then be amortized , though the amortizationis not tax deductible. If a firm pays cash on an acquisition, it has to use the purchase method to record the transaction.
Pooling of Interests:
The book values of the assets and liabilities of the merging firms are added to arrive at values for the combined firm. Since the market value of the transaction is not recognized, no goodwill is created or amortized. This approach is allowed only if the acquiring firm exchanges its common stock for common stock of the acquired firm. Since earnings are not affected by the amortization of goodwill, the reported earnings per share under this approach will be greater than the reported earnings per share in the purchase approach.
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The value of control should be inversely proportional to the perceived quality of that management and its capacity to maximize firm value. Value of control will be much greater for a poorly managed firm that operates at below optimum capacity than it is for a well managed firm. Value of Control = Value of firm, with restructuring - Value of firm, without restructuring Negligible or firms which are operating at or close to their optimal value
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Many of the hostile takeovers were followed by an increase in leverage, which resulted in a downgrading of the debt. The leverage was quickly reduced, however, with proceeds from sale of assets. There was no significantchange in the amount of capital investment in these firms, but investment was more focused on core business. Almost 60% of the takeovers were followed by significant divestitures, where half or more of the firm was divested. The overwhelming majority of the divestitures were of units which were in business areas unrelated to the company's core business, i.e., they constituted reversal of earlier corporate diversification. There were significant management changes in 17 of the 19 hostile takeovers, with the entire corporate management team replaced in 7 of the takeovers.
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Digital had earning before interest and taxes of $391.38 million in 1997, which translated into a
A pre-tax operating margin of 3% on its revenues of $13,046 million An after-tax return on capital of 8.51%
Based upon its beta of 1.15, an after-tax cost of borrowing of 5% and a debt ratio of approximately 10%, the cost of capital for Digital in 1997 was
Cost of Equity = 6% + 1.15 (5.5%) = 12.33% Cost of Capital = 12.33% (.9) + 5% (.1) = 11.59%
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Digital had capital expenditures of $475 million, depreciation of $ 461 million and working capital was 15% of revenues. Operating income, net cap ex and revenues are expected to grow 6% a year for the next 5 years, and 5% thereafter.
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Digital will raise its debt ratio to 20%. The beta will increase, but the cost of capital will decrease.
New Beta = 1.25 (Unlevered Beta = 1.07; Debt/Equity Ratio = 25%) Cost of Equity = 6% + 1.25 (5.5%) = 12.88% New After-tax Cost of Debt = 5.25% Cost of Capital = 12.88% (0.8) + 5.25% (0.2) = 11.35%
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Digital will raise its return on capital to 11.35%, which is its cost of capital. (Pre-tax Operating margin will go up to 4%) The reinvestment rate remains unchanged, but the increase in the return on capital will increase the expected growth rate in the next 5 years to 10%. After year 5, the beta will drop to 1, and the after-tax cost of debt will decline to 4%.
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Valuing Synergy
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The key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable if combined with the bidding firm's resources. The specialized resource will vary depending upon the merger:
In horizontal mergers: economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales. (Examples: Bank of America and Security Pacific, Chase and Chemical) In vertical integration: Primary source of synergy here comes from controlling the chain of production much more completely. In functional integration: When a firm with strengths in one functional area acquires another firm with strengths in a different functional area, the potential synergy gains arise from exploiting the strengths in these areas.
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In 1997, Compaq acquired Digital for $ 30 per share + 0.945 Compaq shares for every Digital share. ($ 53-60 per share) The acquisition was motivated by the belief that the combined firm would be able to find investment opportunitiesand compete better than the firms individually could.
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Background Data
Compaq $ 2,987 million $25,484 mil $ 184 million 10% 5% 10% 5% 1.25 1.00 15% Digital: Opt Mgd $ 522 million $13,046 mil $ 14 (offset) 10% 5% 20% 5.25% 1.25 1.0 15%
Current EBIT Current Revenues Capital Expenditures - Depreciation Expected growth rate -next 5 years Expected growth rate after year 5 Debt /(Debt + Equity) After-tax cost of debt Beta for equity - next 5 years Beta for equity - after year 5 Working Capital/Revenues Tax rate is 36% for both companies
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Valuing Compaq
Year FCFF Terminal Value PV 1 $1,518.19 $1,354.47 2 $1,670.01 $1,329.24 3 $1,837.01 $1,304.49 4 $2,020.71 $1,280.19 5 $2,222.78 $56,654.81 $33,278.53 Terminal Year $2,832.74 $38,546.91 n Value of Compaq = $ 38,547 million n After year 5, capital expenditures will be 110% of depreciation.
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The Combined firm will have some economies of scale, allowing it to increase its current after-tax operating margin slightly. The dollar savings will be approximately $ 100 million.
Current Operating Margin = (2987+522)/(25484+13046) = 9.11% New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%
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The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years, because of operating synergies. The beta of the combined firm is computed in two steps:
Digitals Unlevered Beta = 1.07; Compaqs Unlevered Beta=1.17 Digitals Firm Value = 4.5; Compaqs Firm Value = 38.6 Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16 Combined Firms Debt/Equity Ratio = 13.64% New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26 Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98%
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Value of Combined Firm wit Synergy Value of Compaq + Value of Digital = 38,547 + 4532 Total Value of Synergy
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There are 146.789 million Digital shares outstanding, and Digital had $1,006 million in debt outstanding. Estimate that maximum price you would be willing to offer on this deal.
Assume that Compaq wanted to do an exchange offer, where it would exchange its shares for Digital shares. Assuming that Compaq stock is valued at $27 per share, what would be the exchange ratio?
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Citicorp + Travelers = ?
Citicorp Net Income BV of Equity ROE Dividends Payout Ratio Retention Ratio Expected growth Growth Period Beta Risk Premium MV of Equity (bil) Cost of Equity Beta - stable Growth-stable Payout-stable DDM DDM/share Aswath Damodaran $ 3,591 $ 20,722 17.33% $ 1,104 30.74% 69.26% 12.00% 5 1.25 4.00% 81 11.00% 1.00 6.00% 65.38% $ 70,743 155.84 Travelers $ 3,104 $ 20,736 14.97% $ 587 18.91% 81.09% 12.14% 5 1.40 4.00% 84 11.60% 1.00 6.00% 59.92% $ 53,464 46.38 32 Citigroup $ 6,695 $ 41,458 16.15% $ 1,691 25.27% 74.73% 12.07% 5 1.33 4.00% 165.00 11.31% 1.00 6.00% 62.85% $ 124,009
Based upon these numbers, what exchange ratio would you agree to as a Citicorp stockholder?
The actual exchange ratio was 2.5 shares of Travelers for every share of Citicorp. As a Citicorp stockholder, do you think that this is a reasonable exchange ratio?
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25000 20000 15000 10000 5000 0 Increase by1% Increase by 2% Increase by 3% Change in ROE of combined firm
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Financial Synergy
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A takeover, motivated only by diversification considerations, has no effect on the combined value of the two firms involved in the takeover. The value of the combined firms will always be the sum of the values of the independent firms. In the case of private firms or closely held firms, where the owners may not be diversified personally, there might be a potential value gain from diversification.
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Managers may reject profitable investment opportunities if they have to raise new capital to finance them. It may therefore make sense for a company with excess cash and no investment opportunities to take over a cash-poor firm with good investment opportunities, or vice versa. The additional value of combining these two firms lies in the present value of the projects that would not have been taken if they had stayed apart, but can now be taken because of the availability of cash.
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Assume that Netscape has a severe capital rationing problem, that results in approximately$500 million of investments,with a cumulative net present value of $100 million, being rejected. IBM has far more cash than promising projects, and has accumulated $4 billion in cash that it is trying to invest. It is under pressure to return the cash to the owners. If IBM takes over Netscape Inc, it can be argued that the value of the combined firm will increase by the synergy benefit of $100 million, which is the net present value of the projects possessed by the latter that can now be taken with the excess cash from the former.
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Assume that you are Best Buys, the electronics retailer, and that you would like to enter the hardware component of the market. You have been approached by investment bankers for Zenith, which while still a recognized brand name, is on its last legs financially. The firm has net operating losses of $ 2 billion. If your tax rate is 36%, estimate the tax benefits from this acquisition. If Best Buys had only $500 million in taxable income, how would you compute the tax benefits? If the market value of Zenith is $800 million, would you pay this tax benefit as a premium on the market value?
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One of the earliest leveraged buyouts was done on Congoleum Inc., a diversified firm in ship building, flooring and automotive accessories, in 1979 by the firm's own management.
After the takeover, estimated to cost $400 million, the firm would be allowed to write up its assets to reflect their new market values, and claim depreciation on the new values. The estimated change in depreciation and the present value effect of this depreciation, discounted at the firm's cost of capital of 14.5% is shown below:
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Diversification will lead to an increase in debt capacity and an increase in the value of the firm. Has to be weighed against the immediate transfer of wealth that occurs to existing bondholders in both firms from the stockholders.
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When two firms in different businesses merge, the combined firm will have less variable earnings, and may be able to borrow more (have a higher debt ratio) than the individual firms. In the following example, we will combine two firms, with optimal debt ratios of 30% each, and end up with a firm with an optimal debt ratio of 40%.
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If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and target firms, operating independently. V(AB) > V(A) + V(B) Bradley, Desai and Kim (1988) use a sample of 236 inter-firm tender offers between 1963 and 1984 and report that the combined value of the target and bidder firms increases 7.48% ($117 million in 1984 dollars), on average, on the announcement of the merger. Operating synergy was the primary motive in one-third of hostile takeovers. (Bhide)
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A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth), relative to their competitors, after takeovers.
McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for evidence on two questions Did the return on the amount invested in the acquisitions exceed the cost of capital? Did the acquisitions help the parent companies outperform the competition?
They concluded that 28 of the 58 programs failed both tests, and 6 failed at least one test.
Large number of acquisitions that are reversed within fairly short time periods. About 20.2% of the acquisitions made between 1982 and 1986 were divested by 1988. In studies that have tracked acquisitions for longer time periods (ten years or more) the divestiture rate of acquisitions rises to almost 50%.
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The sharing of the benefits of synergy among the two players will depend in large part on whether the bidding firm's contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the target firm. It is unique, the sharing of benefits will be much more equitable. Bradley, Desai and Kim (1988) conclude that the benefits of synergy accrue primarily to the target firms when there are multiple bidders involved in the takeover. They estimate that the market-adjusted stock returns around the announcement of the takeover for the successful bidder to be 2%, in single bidder takeovers, and -1.33%, in contested takeovers.
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