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Truth -!2. The direction and magnitude of the #ias in your valuation directly proportional to ho pays you and ho much you are paid! Truth 2!-. There are no precise valuations
Myth 2!. A good valuation provides a precise estimate of value 1 1 1 1 Truth 2!2. The payoff to valuation is greatest hen valuation is least precise! Truth 3!-. One$s understanding of a valuation model is inversely proportional to the num#er of inputs required for the model! Truth 3!2. 4impler valuation models do much #etter than comple+ ones! 55!As ath 6amodaran
(n an efficient mar&et, the mar&et price is the #est estimate of value! The purpose of any valuation model is then the ,ustification of this value!
(ncome Approach
(ncome Approach
Valuation of the target company may #e done on the #asis of its earning capacity! This is, theoretically, more appropriate as the investment is done in the company ith the o#,ective of getting earnings from the company There are t o methods under this approach 1 'apitali9ation of earnings method 1 6iscounted cash flo method!
'apitali9ation Method
;nder this method, the value of the target company is computed on the #asis of the multiple of its accounting earnings! Generally, e estimate the average annual earning ta&ing into accounting the current year$s earning and the estimated earnings for ne+t t o years! The average of these three years is ta&en as average annual earning for the company under valuation! The multiple for capitali9ation purposes is computed on the #asis of cost of capital for a company ith the given gro th rates in sales, earnings and or dividend payouts Value H Average Annual :arning I 'ost of capital here Average Annual :arning H J?resent earningK ne+t 2 years pro,ected earningLI3 Ma,or limitation of this method is that it is #ased on accounting profit hich su#,ect to a num#er of limitations! Another limitation is that it loo&s at the profits in the short run! Further, it is difficult to estimate accurately the cost of capital required for capitali9ation!
7usiness ?ro,ection
6efine time hori9on = M"-@ years> for pro,ection :stimate gro th rates in sales, income, etc! :stimate changes in pro,ected gro th :stimate changes requirements in or&ing capital in vie capital e+penditure of the =cape+>
:stimation of cost of each of the sources of finance :stimation of WA'' #ased on proposed capital structure!
Mode of Financing
The shareholders of the target company need to #e paid for surrendering their o nership to the #idder company! Three elements can #e ,udiciously mi+ed to determine the mode of financing the acquisition These are. 'ash, :quity shares in Acquiring company and 6e#t!
(nternal Accruals
For most domestic acquisitions in (ndia, primary = and most of the times, entire> source of funding is internal accruals! /Acquisition is a game that is normally played #y cash"rich companies0 4ince (ndian #an&s are still not very enthusiastic a#out lending for acquisitions, internal accruals remain the primary source of funding for acquisition! :+amples of entire funding through internal accruals. %indalco acquired (ndal =2@@2>N M&M acquired ?un,a# Tractors = 2@@A>N 6a#ur (ndia acquired Fem 'are ?harma = 2@@E>N Oet acquired 4ahara = 2@@A>
8ight (ssue
8ight issue is an effective post acquisition route to mo#ili9e funds for repayment of #ridge loans ta&en from #an&s and financial institutions for acquisition! (t is used quite often! For e+ample Tata Motors, in 2@@E, came out ith right issue of 8s! B-BM crores for repayment of part of the short term #ridge loan ta&en for acquisition of Oaguar <and 8over <td! %indalco ith 8s! M@BE crores right issue for part repayment of #ridge loan for acquisition of *ovelis, *etherlands!
4hare :+change
:quity share e+change is one of the commonly used financing option for funding acquisition of target company! (n this method, a #idder company issues its shares to the shareholders of the target company in e+change of shares of the target company in a specified ratio &no as a s ap ratio and hence this method is commonly &no n as share s ap method! This mode ena#les sharing of the ris& and #enefits in reali9ation of #enefits of synergies This mode also serves the ta+ management o#,ectives of shareholders of target company as they may have to pay capital gain ta+ only hen they sell the shares of #idder company and not immediately! (n case, the acquiring company is an unlisted company, this method may not useful as the pricing of the acquiring company$s shares #ecomes difficult to determine! Moreover, 4:7($s Ta&eover code also permits share e+change only in case the acquiring company is listed company
:+change 8atio
4 ap ratio or e+change ratio is simply the ratio of the price offered for acquiring one equity share of the target company divided #y the valuation of one equity share of the acquirer company :+change ratioH Offer ?rice per shareI4hare ?rice of #idder company For e+ample, A7' <td has made an open offer to acquire 2@P of the equity capital QCR <td! at 8s! 2@@ per share! A7' <td! shares have #een valued at 8s! -@@ per share! The s ap ratio ill #e 2.-, i!e! 2 shares A7' <td ould #e issued to the shareholders of QCR for every one share of QCR <td tendered #y them and accepted #y A7' <td!
Present Earnings Shares Outstanding Earning Per Share 10 5 Pri e Per Share 150 50 +he !%%er is .0/ *re-iu- a0!#e Pri e Earning 15 the *re1-erger -arket 10 *ri e !% & Ltd. S!' the agreed *ri e is 502 5030..04 )5. +he Rati! e( hange rati!4 )5 515040.6. !r 6. shares !% 7 Ltd %!r
RICHA KUMAR
Earning Per Share 6 2.50 Pri e Per Share )6 .0 E( hange Rati!4 .55)640.569. +hus' 10:.950;0.569320 $akhs< shares= +!ta$
Earnings4 250 Lakhs' >!. !% shares in1) -erged !-*an8 )0':.'950 Pri e Earning 12 ;50$akhs210:.950<' +hus' EPS4 250 Lakhs5)0.:.950 $akhs4 Rs. 6.10 *er Rati! share
Future :arnings
The highest price computed earlier is valid only if it is assumed that current level of earnings of the t o #usinesses ill remain unchanged! That is to say that 2K-H3! 7ut the rationale #ehind most mergers is that it ill result in synergies and that 2K-U 3! (n the short run, one or the other company e+periences dilution in :?4, depending upon the relative #argaining po er of the companies and the agreed value of the target company! (f the com#ined earning of the t o companies after merger does not gro faster then dilution in the :?4 of the acquirer may not #e recovered and merger ill reduce value for the #idder company! Thus, the future earnings, rather than the immediate dilution in :?4 should determine hether or not the acquisition is orth hile! %o much, then should the acquiring company should #e illing to pay for the target companyV (t should also #e determined #y the e+pected gro th in the earnings of the acquiring company after the acquisition!
Current Assets ?i(ed Assets +!ta$ Assets Current Lia0i$ities "!nds EAuit8 Shares Ca*ita$ Retained Earnings +!ta$ Lia0i$ities and Ca*ita$ >!. !% !utstanding Shares Esti-ated >et In !-e EPS PE Rati! Share *ri e ;EPS 7 PE<
2'00'000 @'00'00 10'00'000 90'000 50'000 5'00'000 .'@0'000 10'00'000 50'000 1'00'000 Rs. 2 Rs. 25 50
1'50'000 10'00'000 11'50'000 )0'000 50'000 @'00'000 2'60'000 11'50'000 @0'000 @0'000 Rs. 1 Rs. 20 20
4olution
Assume that earnings of company A as gro ing at 2P per year #efore the merger and e+pected to gro at FP ith merger! (f this co! agrees to pay 8s! 2E per share for company 7, the e+change ratio ould #e 2EIM@ or @!MF share of company A for each share of company 7! Total no! of ne share of company A required to pay the value of company 7 H BB,E@@ = E@@@@ Q @!MF>! :?4 immediately after the merger ould #e 8s! -!T@ = -E@@@@I=M@@@@KBBE@@> The shareholders of company A ould e+perience an immediate dilution in :?4, hereas shareholders of 7 ould e+perience increase in :?4! %o ever, the impact may #e quite different two years after the merger!
Particulars o# A ltd
A#ter Merger
$it%out Merger
7ootstrapping :?4
A #ootstrap is a small strap or loop at the #ac& of a leather #oot that ena#les you to pull the entire #oot on!, Wpulling yourself up #y your o n #ootstraps,W means to leverage yourself to success from a small #eginning!
7ootstrapping :?4 is practice here an acquirer #uys a company ith a lo :?4 ratio through a stoc& s ap in order to #oost the post"acquisition :?4 of the ne ly formed group and create a rise in the stoc& price! 4uch strategy may or& hen mar&ets are not efficient! <arge company ith high ?: ratio may acquire a company ith lo er ?: ratio, and o#tain immediate increase in :?4 of com#ined entity! This can happen even hen the #idder company agreed price of target company is higher than the mar&et value of the company!
Assu-e A !%%ers t! *a8 Rs. 60 *er share t! shareh!$ders !% "' ,hi h is ...../ ;*re-iu- 8!u *a8ing5-arket *ri e< ;10 5.0< higher than the -arket *ri e' it an sti$$ in rease it EPS. +he e( hange rati! ,i$$ 0e 605)040.))9. +his ,!u$d -ean that 20 $akhs 7 0.))94 1.'..'... shares ,i$$ 0e issued t! shareh!$ders !% ".
+here are t,! !nditi!ns %!r 0!!tstra**ing EPS a. PE rati! -ust n!t de $ine a%ter -erger. +his ,!u$d genera$$8 ha**en ,hen -arket d!es n!t rea t negati#e$8 t! the !#er1#a$uati!n !% target !-*an8 RICHA KUMAR
(t is primarily due to the fact that in most cases the potential impact of synergy and management enhancement are not enough to fully offset the premium paid to shareholders of target company! (n some #idding ars, the premiums paid are unreasona#ly high!