Valuation of Merger Candidates - Financial Management

In principle, the valuation of merger candidates is an application of the capital budgeting techniques described in. The purchase price of a proposed acquisition is compared to the present value of the expected future cash inflows from the merger candidate. If the present value of the cash inflows exceeds the purchase price, the merger project has a positive net present value and is acceptable.

In the case of an acquisition candidate whose common stock is actively traded, the market value of the stock is a key factor in the valuation process. To induce the stockholders of the acquisition candidate to give up their shares for the cash and/or securities of the acquiring firm, they have to be offered a premium over the market value of the stock prior to the merger announcement. Generally, a 10 to 20 percent premium is considered a minimum offer. Even then, in many situations, stockholders may hold out for much better offers— either from the company making the initial offer or from other interested companies.

Valuation Techniques

Three major methods are typically used to value merger candidates: the comparative price–earnings ratio method, the adjusted book value method, and the discounted cash flow method.

The comparative price–earnings ratio method examines the recent prices and price–earnings (P/E) ratios paid for other merger candidates that are comparable to the company being valued. For example, if two companies in a specific industry were recently acquired at P/E ratios of 10, the comparative P/E ratio method suggests that a P/E ratio of 10 may be reasonable for other, similar companies. Financial analysts who use this method should exercise caution and determine whether the companies being compared really are similar. This method, which focuses on the current income statement, may not be useful if the P/E ratios of recent, similar mergers vary widely.

The adjusted book value method involves determining the market value of the company’s underlying assets. For example, suppose a company has equipment fully depreciated on its books but still in use. The market value of this equipment is determined, and the company’s shareholders’ equity (book value) is adjusted by the difference between the assets’ book value and its market value. Financial analysts who use this method should exercise caution because the determination of the market value of the merger candidate’s assets may be difficult. The discounted cash flow method for valuing merger candidates calculates the present value of the company’s expected future free cash flows and compares this figure to the proposed purchase price to determine the proposed acquisition’s net present value.

The free cash flow (FCF) concept is particularly important in long-range corporate financial planning and when evaluating the acquisition of a firm or a portion of a firm. FCF recognizes that part of the funds generated by an ongoing enterprise must be set aside for reinvestment in the firm. Therefore, these funds are not available for distribution to the firm’s owners. Free cash flow can be computed as

FCF = CF – I (1 – T) – Dp – Pf – B Y

where CF is the after-tax operating cash flow, I is the before-tax interest payments, Dp is the preferred stock dividend payments, Pf is the required redemption of preferred stock, B is the required redemption of debt, and Y is the investment in property, plant, and equipment required to maintain cash flows at their current levels. (If a firm has interest income, this is netted out against interest expense. If interest income exceeds interest expense, FCF will increase by the amount of the net after-tax interest income.) FCF represents the portion of a firm’s total cash flow available to service additional debt, to make dividend payments to common stockholders, and to invest in other projects.

When valuing a takeover prospect, it is important to recognize that explicit cash outlays are normally required to sustain or increase the current cash flows of the firm. For example, in considering the acquisition of an oil production company, it is not correct to project current cash flows into an indefinite future without explicitly recognizing that crude oil reserves are a depleting resource that require continual, significant investment to ensure future cash flow streams. Also, the free cash flows from a merger should include any effects of synergy because the marginal impact of the merger on the acquiring firm is of interest to us. Consider the following example.

Suppose the annual after-tax free cash flow from a merger candidate is calculated to be $2 million and is expected to continue for 15 years, at which time the business can be sold for $10 million. If the appropriate risk-adjusted discount rate is 14 percent, for example, the present value of the expected cash inflows is as follows:

Present value of an annuity of $2 million for 15 years at 14% + Present value of $10 million in 15 years at

Therefore, if the merger candidate’s purchase price is less than $13,684,000, the proposed merger has a positive net present value and is an acceptable “project.” In principle, the discounted cash flow method is the most correct of the three methods discussed in this section, because this method compares the present value of the cash flow benefits from the merger with the present value of the merger costs. However, in practice, the future cash inflows from a merger can be quite difficult to estimate. Most financial analysts who work on proposed mergers use all of these methods to attempt to value merger candidates. In addition, they consider a large number of other factors in valuing merger candidates. These factors include the merger candidate’s management, products, markets, distribution channels, production costs, expected growth rate, debt capacity, and reputation.

Analysis of a Merger

The following merger examples illustrate some of the steps and considerations involved in typical mergers. Diversified Industries, Inc., is considering acquiring either High-Tech Products, Inc., or Stable Products, Inc.High-Tech Products has a high expected growth rate and sells at a higher P/E ratio than Diversified. Stable Products, on the other hand, has a low expected growth rate and sells at a lower P/E ratio than Diversified. contains financial statistics on Diversified and the two merger candidates.

The possible merger of Diversified with Stable Products is considered first. To entice Stable Products’ present stockholders to tender their shares, Diversified would probably have to offer them a premium of at least 10 to 20 percent over Stable Products’ present stock price. Suppose Diversified decides to offer a price of $24 per share and Stable Products accepts. The exchange is on a stock-for-stock basis. As a result, because Diversified’s stock price is $30 a share, Stable Products’ shareholders receive 0.8 share of Diversified common stock for every share of Stable Products stock they hold; in other words, the exchange ratio is 0.8.

The exchange ratio, ER, is the number of acquiring company shares received per share of acquired company stock owned. Next, the possible merger of Diversified with High-Tech Products is considered. If Diversified decides to offer $60 a share and High-Tech Products accepts, the High-Tech Products’ shareholders would receive two shares of Diversified common stock for every share of High-Tech Products stock they hold; in other words, the exchange ratio would be 2.0.on page 778 shows the pro forma financial statement summary for Diversified, assuming separate mergers with each of the merger candidates. The following equation is used to calculate the postmerger earnings per share for the combined companies, EPSc:

EPSc = EAT1 + EAT2 + EAT1,2/NS1 + NS2(ER)

where EAT1 and EAT2 are the earnings after taxes of the acquiring and acquired companies, respectively, EAT1, 2 is the immediate synergistic earnings from the merger, and NS1 and NS2 are the number of shares outstanding of the acquiring and acquired companies, respectively. For the acquisition of Stable Products by Diversified, EPSc is calculated as follows:

EPSc = $120 million + $12 million + 0/ 40 million + [(4 million) (0.8)] = $3.06

As a result of a merger with Stable Products, Diversified has earnings per share of $3.06, as compared with $3.00 without the merger. In other words, the merger transaction can cause Diversified’s earnings to change, due to P/E differences between merging companies.

Selected Financial Data: Diversified Industries and Two Merger Candidates

Diversified Industries: Pro Forma Financial Statement Summary

Specifically, if the exchange ratio is based on current stock market prices and no synergy exists, the acquisition of a company with a lower P/E ratio causes the earnings per share figure of the acquiring company to increase. Similarly, the acquisition of a company with a higher P/E ratio causes the earnings per share figure to decrease. This short-term earnings per share change is caused solely by the merger transaction, and a rational stock market does not perceive this change to be real growth or real decline.

A more important question remains:What will happen to the price and the P/E ratio of Diversified’s stock after a merger has been accomplished? Obviously, it can go up, stay the same, or go down. Normally, the stock market seems to view mergers rationally, recognizing that the postmerger P/E ratio is a weighted average of the two premerger P/E ratios. As a result, the postmerger share price of the acquiring company is usually in the same range as prior to the merger, unless significant economies of scale or synergistic benefits are achieved in the merger.

With regard to a possible merger with Stable Products, suppose Diversified’s management is not willing to incur an initial dilution in its earnings per share.What is the maximum price and exchange ratio Diversified should agree to under this criterion? The maximum price iscalculated using the following equation:

Pmax = (P/E)1(EPS2)

where Pmax is the maximum offering price without incurring an initial EPS dilution, (P/E)1 is the price-to-earnings ratio of the acquiring company, and EPS2 is the earnings per share for the to-be-acquired company. Diversified can offer up to $30 a share for Stable Products without diluting its EPS:

Pmax = (10)($3.00) = $30

A price of $30 a share in this example results in an exchange ratio of 1.0, because Diversified’s stock is also selling at $30 a share. Suppose Diversified Industries merges with High-Tech Products and initially dilutes its EPS to $2.83 from its present $3.00 level, assuming no immediate synergy. Diversified’s managers may want to know how long it will take the expected EPS of the combined companies to equal the expected EPS of Diversified without the acquisition. To answer this question, we have to consider the expected growth rates of the individual companies given in. Without a merger, Diversified’s earnings, dividends, and assets are expected to grow at an annual rate of 7 percent, and High-Tech Products’ earnings are expected to grow at 14 percent a year. Assume that the combined companies grow at 9 percent a year. The expected EPS growth for Diversified with and without merger is shown in. Based on expected growth rates, the EPS of Diversified with the merger will be equal to its EPS without the merger in about three years.11 This information will be used by the Diversified management in its decision whether to acquire High-Tech Products.

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