Valuation and Accounting Issues:

 Valuation and the term Value are highly subjective.

 It varies from person to persons and changes in externalities and internalities
over a period of time.
 It is difficult to assign value to an entity to a corporate as corporate can be
controlled even by partially owning them.
 In M&A the financial value is very important and hence valuation is an important
concept which has to be understood in proper perspective.
 Valuation is an exercise based on certain assumptions and may lead to
overestimation and payment of more value and on the other may lead to
underestimation and loose a important opportunity of acquisition or merger.

Concept of Valuation:
 Valuation is based on the true worth of an asset.
 Valuation is driven by not only financial considerations but also by aesthetic and
emotional considerations.
 The value of a target company is determined by a function of business logic that
drives the decision merger and acquisition and takeover that is, cash flows
expected after the deal is over and also the bargaining power of the acquirer and
the target company.
 Since business is based on dynamic considerations, valuation also becomes a
dynamic process.
 Due to this, the same deal would be valued differently by the same player at
different times or by different players at the same time.
 Valuation of a business entity centre’s around three fundamental concepts
namely:
1. Going concern Value,
2. Liquidation value,
3. Market value.

Going Concern Value:

 Going concern value assumes that a business entity has infinite life and shall
continue to exist irrespective of the life of the promoter.
 Every business is an entity and separate from its owner/promoters and in the
eyes of law has it will survive for a continuous period and will keep generating
earnings or revenues for ever.
 This concept it is argued will increase the value of the business, with time and
finally becomes a perpetual annuity.

Liquidation Value:
  In this concept, the value that the entity shall realize on liquidation after
incurring all incidental costs once it ceases to exist.
 The liquidation value moves along with the replacement cost of the assets.
 The Value of a business according to the liquidation concept depends more
on realizable or replacement value of its underlying assets rather than the
earning potential of the business.

Market Value:
 This concept is more relevant to listed companies and that is the market price
of the shares of the entity.
 It represents the price at which the corporate ownership or the resources are
available.
 Here the fundamentals are not more important but is governed by market
sentiments and the forces of demand and supply.
 Under this method of valuation, the value of the company largely depends
upon non quantitative personal and strategic considerations.

Conclusion:
 From the above broad methods of valuation, it can be understood that the
valuation exercise is a complex interaction of quantitative and non-
quantitative considerations.
 As very many issues or elements are involved during the valuation exercise,
the process of valuation becomes a highly complex, time consuming and
lengthy task.
 For M&A professionals, models and tools of valuation are applied which may
result only in an “arithmetic price”, which may not always give the true picture.

Factors to be considered for valuation:

As valuation is a very complex process, the company has to keep in mind the
needs the purpose of valuation in mind.
The main factors are:
1. Valuation process to sell the business,
2. To determine objectively a fair market value,
3. Fair market value to be suitably adjusted, for the expected synergies and
fit that the target may generate for the acquirer.
4. The nature of the business and its operating history.
5. The industry and sector dynamics.
6. The economic outlook and market sentiments.
7. The book value and financials of the entity.
8. The stage of evolution of the target company.
9. The entity earnings and dividend paying capacity.
10. Market value of other entities engaged in similar business.
 11. Potential liabilities of the company, such as environmental claims, tax
demands, and off balance sheet liabilities.

These factors provide an insight into elements that may not necessarily feature
the balance sheet of the company but have the potential to create or destroy the
future value of the business.
Methods of Valuation:
 There are several methods that professionals use to value business.
 Each method has its own relevance, merits and demerits.
 The final valuation of the target is arrived at by using the appropriate blend
of the results available using more than one method.
 They are all based on the assumption that analysis regarding strategic fit,
financial logic and industry and economy analysis have already been
carried out and have been found to be favorable
 Broadly there would be two major estimates of values:
 Standalone value and restructured value.
 In standalone method, the value of the target is determined on a
standalone basis without considering any internal, external or financial
restructuring improvements.
 In restructured valuation method, all improvements and estimates
pertaining to the company’s restructured value are incorporated.

There are three basic method of valuation:

1. Asset based valuation.
2. Earning based valuation.
3. Market based valuation.

In addition to the above other variants of these methods:

1. Book value approach.
2. Stock and debt approach.
3. Direct comparison approach.
4. Discounted cash flow method.
5. Cash flow forecast during the explicit forecast period.
6. Cost of capital.
7. Continuing value.

Asset Based Valuation:

 Asset based valuation involves estimation of the value of the corporate
assets, as if they have been with the bidder.
 The assets that are included are fixed assets, intangible assets,
investments, current assets and third party liabilities.
  In this valuation, each sub-class is considered and the value of all the
individual assets like, real estate property, plant and machinery, furniture
and fixtures etc.
 Current assets like stock and receivables are estimated at their realizable
values.
 Finally, third party liabilities are valued and deducted from the total assets
to arrive at the value of the target.
 Liabilities’ include, short term borrowings, creditors, contingent liabilities,
etc.
 The entire valuation exercise is carried out by valuing all the assets and
liabilities at their realizable value or current yield.

Calculation of net assets value means:

 Net fixed assets + current assets+investments+intangibles
 Minus
 long term debts + short term debts+ contingent liabilities+ accumulated
losses and misc expenditure,
 = Net assets
 Minus
 Preference share capital= Net assets for equity shareholders.
 Divided by No of equity shares= Net assets value per share (NAV).

Earning based valuation:

 In this method, the future maintainable earnings (FME) of the target
company is estimated after adjusting the extraordinary items such as
seasonal fluctuations , contingent payments or receipts, concessions or
penalty in past years or any recurring items such as profit/ loss on sale of
assets etc.
 This method assumes:
 That FME will continue till its survival based on going concern principle.
 The value of the target is determined using the formula- FME/r
 R is an appropriate discount rate which represents the opportunity cost of
funds used by the acquiring entity, which depends based on the
company’s experience and its growth rate over a period of time.
 g is the growth rate of the Future maintainable earnings
 the equation is FME/r-g.
 This formula has two elements- value of entity under consideration and
capitalization rate which is normally the shareholders expected rate of
return for their investments in the company. Which is (I-tax).
  This method focuses on the value of the company a determined in the
market based on the earnings of the company.
 It also focuses on profit earning capacity value of the share as the returns
are valued after taxes are deducted from PBIT.
 Market based earnings:
 This method of valuation involves comparison of the target company’s
market variables and other comparables with that of the industry.
 The value thus arrived is called as market based valuation.
 Most commonly used variables in this valuation are:
 Price/earrings.
 Price/sales.
 Price/assets
 Any other quantifiable variable in relation with market price per share,
 Variables are selected for different periods of times and fundamental
factors such as earnings, assets, or capital employed is selected
appropriately.
 Under this method, once the variables have been calculated, appropriate
weightage is assigned to each variable to arrive at the weighted average
multiplier, for calculating the market capitalization of the target company.
 The resultant figure is divided by the number of shares outstanding to
arrive at the value per share.

Book value approach:

 In this method, the values of all assets are estimated at book values and
arrived at the value of the target company. However if the difference
between the book value and market value is wide, then the value of the
company becomes unrealistic and vice versa.
 Some of the factors that result in the difference are:
 Inflation- becomes important since book value is calculated using the
historical cost of the asset less depreciation. However, the market value
has impact of inflation on the value of the asset.
 Technological changes- may render certain assets obsolete and worthless
well before they are fully depreciated in the books of the accounts. There
may be value in the books of accounts but the asset may be worthless
and useless.
 Organizational capital- this is never gets reflected in the balance sheet,
but this value get created as the stakeholders like employees, customers,
suppliers and managers have become mutually beneficial and productive
relationship and collective contribute towards the attainment of corporate
objectives.
  It is to be noted that the assets earning power is not always related to its
book value.

Stock and debt approach:

 This method is followed when the securities of the company are listed and
publicly traded.
 The value is obtained by adding the market value of all its outstanding
securities.
 This method is straight forward based on a price on a date.
 In cases where is volatility in prices ascertaining the date becomes difficult, then
average of particular selected period becomes the starting factor.
 Direct comparison approach:
 This method is based on the assumption that similar assets sell at similar
prices.
 The value of the asset is determined by checking the price of a
comparable asset in the market.
 This principle is commonly applied while dealing with assets such as land
and building.

Step on which this method is based:

1. Economy analysis- involves assessing the prospects of various industries or
sectors in an economy and aims at ascertaining the GDP, annual industrial
production, annual agricultural output, inflation rate interest rates, balance of
payments, exchange rates etc.
2. Industry analysis- focuses on elements such as the relationship of the industry
with the economy as a whole, life cycle, profit potential of the industry,
regulations on the industry, competition, procurement of raw materials,
production costs, marketing and distribution etc.
3. Company analysis-this focuses on all aspects of the company and its business
such as its product portfolio and market segments, availability and cost of inputs
etc. The analysis serves the purpose only when efforts are made to look carefully
at 15-20 companies in the same industry and select finally 1-2 companies
closely.
4. Apply ratios or multiples- this provides a very reliable and sound basis for
decision making. The ratios commonly used are firms value to sales, firm value
to book value of assets, firm value to profit before interest, depreciation and tax
(PBIDT), equity value to net worth etc.
5. Select comparable companies- involve deciding where the target company fits
in relation to the comparable companies.
6. Value the company- applies the appropriate multiples to the financial numbers
of the company so that the value of the target company is determined.
 This approach is popular because it relies on multiples that are easy to
relate to and can be obtained quickly and without any difficulty and is
 useful when several comparable companies are traded and the market
prices them correctly.
 The biggest drawback of this approach is that it relies on multiples that are
subjective and hence can be easily misused and manipulated, and same gets
reflected through valuation errors, in terms of overvaluation and undervaluation
of the market.

Discounted cash flow method (DCF):

 This method represents the present value of the expected cash flows
generated through an asset, which are discounted at a discount rate® that
reflects the risk involved n earning these cash flows.
 It is most preferred and accepted method of valuation at present.
 It is based on fundamentals of time value of money and gives weight age
to future prospects of the business rather than on it historical performance.
 It considers two important aspects like- the predictability of cash flows,
and the quantum of cash flows.
 This means that “assets with more predictable and higher cash flows
would command a higher value and vice versa”
 The equation for this DCF technique is
 Value of an asset or entity=𝐸𝐶𝐹1 ÷ (1 + 𝑅) + 𝐸𝐶𝐹2 ÷ (1 + 𝑅)2+ECF3÷
(1 + 𝑟)3.
 Where ECF1 ECF2, ECF3 represent expected cash flows over a period of
n years,
 r represents the discount rate that incorporates the risk involved in the
investment,
 And n represents the useful life of the investment which the investment
would generate cash flows.
 Thus DCF valuation involves three basic components- expected cash
flows, discount rate, and ascertaining the DCF.
 Excepted cash flows may be:
 Free cash flows to the firm- means after tax-earnings of the company,
represent cash flows generated for all claim holders in the firm and are the
pre-debt cash flows.
 Free cash flows to equity- are ascertained after deducting the cash flows o
account of all types of debt are termed as free cash flow to equity, means
that cash flows available for distribution among equity holders of the
company.
 Nominal cash flows- that incorporate expected inflation in the economy.
 Real cash flows- cash flows that do not incorporate the inflation
component.
  Pre-tax cash flows- are cash flows that are pre tax payable by the
investors.
 Post-tax cash flows- are arrived at after deducting the tax payable by the
investors. This is because all types of investors have to pay tax on their
income which includes the aforesaid taxes.

Discount rate:
 This rate is based on risks associated with earning that year’s cash flow
including cyclical movements, inflations, exchange rates and market
trends.
 All the above affect the discount rate that keeps changing.
 The changing variable creates problems and complexities.
 Firms as a substitute choose a discount rate that is higher than the normal
discounting rate as a standard rate for the entire analysis.
 The rate of discount rate is ascertained on the following basis:
 The discount rate is generally used which is equivalent to the cost of
equity, which represent the expected rate of returns by the investors.
 Another way is cost of equity applied to historical returns and risk premium
based on degree of volatility of stock returns with risk premium.
 Another method, the discount rate is taken as the weighted average cost
of capital and weighted yield to market.

Ascertaining the DCF:

 Discounted cash flows involve calculating the free cash flows to the equity.
 The process involves a detailed analysis of future cash flows of the
company for n of year.
 The analysis includes the industry and its prospects, projected growth,
existing and expected market share, analysis of operations of business
and their sensitivity to value, scanning the external environment including
regulatory framework, competition, etc.
 Factors like expected rate of inflation, exchange rate fluctuations and
movement of interest rates.

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VALUATION OF SYNERGIES IN MERGERS AND ACQUISTIONS:

Introduction:
o Synergy is the increase in value that is generated by combining two
entities to create a new and more valuable entity,
 o Synergy is the additional value that is generated by combining two firms,
creating
o Opportunities that would not been available to these firms operating
independently.

The potential sources of synergy can be categorized into two groups.

1. Operating synergies affect the operations of the combined firm and include
economies of scale, increasing pricing power and higher growth potential.
They generally show up as higher expected cash flows.

2. Financial synergies, on the other hand, are more focused and include tax
benefits, diversification, a higher debt capacity and uses for excess cash.
They sometimes show up as higher cash flows and sometimes take the form
of lower discount rates.

Operating Synergy:

Operating synergies are those synergies that allow firms to increase their operating
income from existing assets, increase growth or both.

It is categorized into four types.

1. Economies of scale that may arise from the merger, allowing the combined firm to
become more cost-efficient and profitable. In general, we would expect to see
economies of scales in mergers of firms in the same business (horizontal mergers) –
two banks coming together to create a larger bank or two steel companies combining
to create a bigger steel company.

2. Greater pricing power from reduced competition and higher market share, which
should result in higher margins and operating income. This synergy is also more
likely to show up in mergers of firms in the same business and should be more likely
to yield benefits when there are relatively few firms in the business to begin with.
Thus, combining two firms is far more likely to create an oligopoly with pricing power.
3.Combination of different functional strengths, as would be the case when a firm with
strong marketing skills acquires a firm with a good product line. This can apply to
wide variety of mergers since functional strengths can be transferable across
businesses.

4. Higher growth in new or existing markets, arising from the combination of the two
firms. This would be case, for instance, when a US consumer products firm acquires
an emerging market firm, with an established distribution network and brand name
recognition, and uses these strengths to increase sales of its products.
Operating synergies can affect margins, returns and growth, and through these the
value of the firms involved in the merger or acquisition.

Financial Synergy:
With financial synergies, the payoff can take the form of either higher cash flows
or a lower cost of capital (discount rate) or both. Included in financial synergies
are the following:

1. A combination of a firm with excess cash, or cash slack, (and limited project
opportunities) and a firm with high-return projects (and limited cash) can yield a
payoff in terms of higher value for the combined firm. The increase in value comes
from the projects that can be taken with the excess cash that otherwise would not
have been taken. This synergy is likely to show up most often when large firms
acquire smaller firms, or when publicly traded firms acquire private businesses.

Debt capacity can increase, because when two firms combine, their earnings and
cash flows may become more stable and predictable. This, in turn, allows them to
borrow more than they could have as individual entities, which creates a tax benefit for
the combined firm. This tax benefit usually manifests itself as a lower cost of capital for
the combined firm.

Tax benefits can arise either from the acquisition taking advantage of tax laws to write
up the target company’s assets or from the use of net operating losses to shelter
income. Thus, a profitable firm that acquires a money-losing firm may be able to use
the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that
is able to increase its depreciation charges after an acquisition will save in taxes and
increase its value.

Diversification is the most controversial source of financial synergy. In most publicly

traded firms, investors can diversify at far lower cost and with more ease than the
firm itself. For private businesses or closely held firms, there can be potential benefits
from diversification.

Clearly, there is potential for synergy in many mergers. The more important issues
relate to valuing this synergy and determining how much to pay for the synergy.

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Valuing Synergy:

The key question about synergy is not whether it can be valued but how it should
be valued. After all, firms that are willing to pay billions in dollars for synergy have to be
able to estimate a value for that synergy. In this section, we will consider how best to
value different types of synergy and the sensitivity of this value to various assumptions

Valuing Operating Synergies:

There is a potential for operating synergy, in one form or the other, in many
takeovers. Some disagreement exists, however, over whether synergy can be valued
and, if so, what that value should be. One school of thought argues that synergy is too
nebulous to be valued and that any systematic attempt to do so requires so many
assumptions that it is pointless. If this is true, a firm should not be willing to pay large
premiums for synergy if it cannot attach a value to it. The other school of thought is that
we have to make our best estimate of how much value synergy will create in any
acquisition before we decide how much to pay for it, even though it requires
assumptions about an uncertain future. We come down firmly on the side of the second
school.

While valuing synergy requires us to make assumptions about future cash flows
and growth, the lack of precision in the process does not mean, we cannot obtain an
unbiased estimate of value.

Thus we maintain that synergy can be valued by answering two fundamental questions.

(1) What form is the synergy expected to take? Will it reduce costs as a percentage of
sales and increase profit margins (e.g., when there are economies of scale)?

Will it increase future growth (e.g., when there is increased market power) or the length
of the growth period?

Synergy, to have an effect on value, has to influence one of the four inputs into the
valuation process – higher cash flows from existing assets (cost savings and economies
of scale), higher expected growth rates (market power, higher growth potential), a
longer growth period (from increased competitive advantages), or a lower cost of capital
(higher debt capacity).

When will the synergy start affecting cash flows? ––

Synergies seldom show up instantaneously, but they are more likely to show up over
time. Since the value of synergy is the present value of the cash flows created by it, the
longer it takes for it to show up, the lesser its value.

Steps in Valuing Operating Synergy:

Once we answer these questions, we can estimate the value of synergy in three
steps:
First, we value the firms involved in the merger independently, by discounting
expected cash flows to each firm at the weighted average cost of capital for that
firm.

Second, we estimate the value of the combined firm, with no synergy, by adding
the values obtained for each firm in the first step.

Third, we build in the effects of synergy into expected growth rates and cash
flows and we revalue the combined firm with synergy. The difference between
the value of the combined firm with synergy and the value of the combined firm
without synergy provides a value for synergy.

It is important at this stage, that we keep the value of synergy apart from the value of
control, which is the other widely cited reason for acquisitions. The value of control is
the incremental value that an acquirer believes can be created by running a target firm
more efficiently. To value control, we just revalue the target firm with a different and
presumably better management in place and compare this value to the one we obtain
with the status quo – existing management in place.

Operating synergies can be categorized into

1. Cost synergies
2. Growth synergies.

Cost synergies are the operating synergies that are easiest to model.

One-time cost savings will increase the cash flow in the period of the savings, and thus
increase the firm value by the present value of the savings. Continuing cost savings will
have a much bigger impact on value by affecting operating margins (and income) over
the long term. The value will increase by the present value of the resulting higher
income (and cash flows) over time.

Growth synergies are more complicated because, they can manifest themselves in so
many different ways.
There are at least three different types of growth synergies:
a) The combined firm may be able to earn higher returns on its investments than
the firms were able to generate independently, thus increasing the growth rate.
b) The combined firm may be able to find more investments than the firms were
able to invest in independently. The resulting higher reinvestment rates will increase the
growth rate.
c) The combined firm may be in a much more powerful competitive position
than the individual firms were, relative to their peer group. The payoff will be
that the combined firm will be able to maintain excess returns and growth for
a longer time period.

Both cost and growth synergies manifest themselves as higher expected cash flows in
the future.
Cost synergies, by their very nature, tend to be bounded – there is after all only so
much cost that you can cut.
Growth synergies, on the other hand, are often unbounded and are constrained only by
your skepticism about their being delivered.

Valuing Financial Synergies

Synergy can also be created from purely financial factors. We will consider three
legitimate sources of financial synergy - a greater “tax benefit” from accumulated losses
or higher tax deductions, an increase in debt capacity and therefore firm value and
better use for “excess” cash or cash slack. We will begin the discussion, however, with
diversification, which though a widely used rationale for mergers, is not a source of
increased value by itself, at least for publicly traded firms with diversified investors.

Diversification
A takeover motivated only by diversification considerations should, but by itself,
have no effect on the combined value of the two firms involved in the takeover, when
the two firms are both publicly traded and when the investors in the firms can diversify
on their own.

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