Valuation for

Mergers &
Acquisitions

Introduction
No rational buyer would pay more for an asset than its true

worth
Value driven by not just financial considerations but also be

aesthetic and emotional considerations

Value of a target should be determined by a function of

business logic that drives the decision of merger and

acquisition.
Logic one is referring to is the cash flows one expects

from the business post the deal but then a lot also depends
on the bargaining power of the acquirer and the target

Why companies value themselves?

Impending sale of the entity
Completing relevant legal proceedings
Undertaking estate planning
Settling shareholders disputes
Raising additional capital

Factors considered for Valuation

The nature of the business and its operating history
The stage of evolution of the target company i.e. whether the target is a profitable

company or is in the early stage of technology development, etc.

The industry / sector dynamics
The economic outlook and market sentiments
The book value and financials of the entity
The entitys earnings and dividend paying capacity
The value of the entitys intangible assets such as quality of management,

especially in knowledge based or intellectual property based business

Market value of other entities engaged in similar business
Identifying whether the target is healthy or is financially troubled
Potential liabilities of the company such as environmental claims, tax demands and

off - balance sheet liabilities

Sources of bias in valuation

Enterprise Value and Equity Value

Enterprise value is the intrinsic value of a company as

a whole.
In other words, it is the sum of the value of the stakes of all

the stakeholders whose funds have been deployed by the

company in business.
Thus, enterprise value includes value of equity shares,
preference shares & secured and unsecured debt in the
books of the company.

Equity value means intrinsic value of the equity shares

of the company alone.

While

investing in any company or acquiring in any

company, we are concerned with the valuation of equity
shares of the target company and not with the valuation of
its debt or preference shares.

M&A: Cost Benefit Analysis

M&A deals create synergy for both the merging

and the merged firms.

V(A) + V(B) < V(AB)
Where, V(A) = Value of A Ltd
V(B) = Value of B Ltd
V(AB) = Value of merged company

Merger is successful if it creates a positive NPV

for all the firms that are involved.

Benefit = (PVAB) (PVA + PVB)

Computation of cost depends on whether the

purchase consideration for merger is paid in cash

or by issue of shares.
If it is paid in cash by the merged entity, the cost
of the merger from the view point of the acquiring
firm is calculated as:
Cost = Purchase Consideration PV(B)
Thus, NPV for A = Benefit Cost
= [PVAB (PVA + PVB)] (Cash Purchase
consideration PVB)
NPV for acquired firm (B) = Cost of the
merger (A)
NPV (B) = Cash Purchase Consideration PV(B)

If the purchase consideration is paid by

issuing shares in the merged company to the

shareholders of merging company, then the NPV
computation requires an estimation of the
proportion of shareholding of the shares in
merged company by the shareholders of merging
company.

Question:
Firm S acquires Firm T. Following are the pre-

merger statistics of the 2 firms:

Firm S

Firm T

Market price per share

(Rs.)

60

20

No. of outstanding shares

5,00,000

3,00,000

Market value of the firm

(Rs.)

3,00,00,000

60,00,000

Firm S offers to the shareholders of Firm T one

share in exchange for every three shares held by
them in Firm T. The merger is expected to bring
gains that have a present value of Rs. 60 lacs.
Should Firm S acquire Firm T?

Solution:
Cost of acquired/merged firm:
Cost = PV (AB) PV (B)
Where represents the fraction of the shares in the combined entity received by
shareholders of Firm T
The share of T in the combined entity denoted by is computed as:
= 1,00,000/ (5,00,000 + 1,00,000) = 0.167
If we assume that the market value of the combined entity will be equal to the sum of PV of
separate firms & benefit accruing to the combined firm on account of merger.
PV (AB) = PV (S) + PV (T) + benefit on account of merger
= 3,00,00,000 + 60,00,000 + 60,00,000
= 4,20,00,000
Cost = PV (AB) - PV (T)
= 0.167 *4,20,00,000 60,00,000
= 10,14,000

Thus, NPV to Firm S is Benefit Cost = 60,00,000 10,14,000

= 49,86,000
NPV of Firm T = Cost to Firm S = Rs. 10,14,000
Since NPV for both the firms is positive, both are the net gainers.

Question:
Company Y intends to acquire ABC Ltd. The balance sheet of
ABC Ltd. are entitled to get 1 share in company Y for every 3
shares. The shares of company Y will be issued at a market
price of INR 20. The expected benefits from acquisition will
amount to INR 180000 per annum for next 5 years. If the
firms cost of capital is 12%, do you think the merger will
create synergy?
ABC Ltd. Balance Sheet

Liabilities

Amount

Assets

Amount

Equity (33000
shares @INR 10)

3,30,000

Cash

20,000

Retained Earnings

1,60,000

Debtors

30,000

Creditors and
others

2,50,000

Inventories

90,000

Plant & equipment

6,00,00
0

Solution:
Cost of the merger (cash outflows):

Equity (11,000*INR 20)

INR 2,20,000
Payment of creditors and other liabilities
INR 2,50,000
Less: Cash balance of ABC Ltd.
INR 20,000
Total
INR 4,50,000
Computation of the NPV for
INR 180000 for 1-5 years at PV of 12%
6,48,900
Less: the cost of acquisition
4,50,000
Net Present Value
1,98,900
Since Y Ltd has positive NPV, the merger should take place.

Exchange Ratio
The relative number of new shares that will be

given to existing shareholders of a company

that has been acquired or merged with
another.
After their old company shares have been
delivered, the exchange ratio is used to give
shareholders the samerelative valuein new
shares of the merged entity.

Question
K Ltd. Is considering acquiring N Ltd., the following
information is available:
Company

Profit after
tax

No. of equity Market value

shares
per share

K Ltd.

50,00,000

10,00,000

200.00

N Ltd.

15,00,000

2,50,000

160.00

Exchange of equity shares for acquisition is based on

current market value provided above. There is no synergy
advantage available.
Find the earning per share for Co. K after merger.
Find the exchange ratio so that the shareholders of N Ltd.
would not be at loss.

Solution:
a) Exchange ratio = 160: 200 = 4:5
That is for 4 shares of K Ltd. for every 5 shares of N Ltd.
Total no. of shares to be issued = 4/5* 250000
= 200000 shares
Total no. of shares of K and N Ltd. combined are
10,00,000 + 2,00,000 = 12,00,000 shares
Total profit after tax = 50,00,000+15,00,000
= 65,00,000
EPS after the merger = 65,00,000/12,00,000
Rs. 5.42 per share

b) To find the exchange ratio so that shareholders of N Ltd.

would not be at loss.
Present EPS of K Ltd.: 50,00,000/10,00,000
= Rs. 5
Present EPS of N Ltd.: 15,00,000/2,50,000
= Rs. 6
Exchange ratio should be 6 shares of K Ltd. for every 5
shares of N Ltd.
In such a case, shares issued to N Ltd. = 2,50,000*6/5
= 3,00,000
So, Total no. of shares with K Ltd. after merger =
10,00,000+ 3,00,000 = 13,00,000
EPS after merger = 65,00,000/13,00,000 = Rs. 5 per share
Hence, total earnings available to shareholders of N Ltd. =
3,00,000*5 = 15,00,000

Methods of Valuation
Asset Based Valuation
Involves estimation of the value of corporate assets, as if they have been

with the bidder.

Assets

valued include: the net fixed assets, intangible

investments, current assets, and all third party liabilities.

assets,

Assets Side:
While valuing the fixed assets, each sub class is considered and the value of all the
individual assets under each sub class is estimated. For example: Real estate,
Plant and machinery, Furniture and fixtures, Buildings, Vehicles, etc.
Investment are estimated either at their realizable value or its current yield.
Investments are valued under the categories of listed securities, unlisted

securities, inter-corporate deposits, and other investments.

Current assets such as stocks and receivables are also estimated at their

realizable values.

Liabilities Side:
All 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, and contingent /

deferred liabilities
Are pegged at an appropriate level to arrive at estimated value of

total liabilities of the business

Contingent liabilities also included in the valuation for their value

sometimes becomes so significant that it may turn an acceptable

proposal into a non-viable one.
Such liabilities need to be suitably factored in
Take the form of pending litigations related to business, guarantees

provided by the company, etc.

Net Asset Valuation

Entire valuation exercise is carried out by valuing all the assets and liabilities at

their revised value or at their current yield

While assets and liabilities are all generally taken over but the parties to the deal

may also decide to knock them off at the time of agreement. Here their value
becomes irrelevant and immaterial.
The calculation of Net Assets value done as under:

Net Fixed Assets

(+) Current Assets
(+) Investment
(+) Intangibles
(-) Long term debts
(-) Short Term debts
(-) Contingent liabilities
(-) Accumulated losses and miscellaneous expenditure not written off, if any
= Net Assets of the Company
(-) Preference Share Capital, if any
Net Assets for Equity Shareholders

When Net Assets for Equity Shareholders are divided by the number of equity

shares, one arrives at the net assets value (NAV) per share

However, the asset valuation method is

not relevant in determining the intrinsic

value of the target company.

Cash-Flow based
Approach/Discounted Cash Flow
Method
Represents present value of the expected cash flows generated

through an asset that are discounted at a discount rate reflecting the

risk involved in earning the cash flows
Most preferred

and acceptable method of valuation as based on

fundamentals of time value of money i.e. the value of money changes
over time and gives weightage to the future prospects of the business
rather than on its historical performance

Equation used would be:

FCF1
FCF2
FCF3
FCFn
= --------- + ---------- + --------- + ---------(1 + r) (1 + r)2 (1 + r)3 (1 + r)n

Where,
FCF1, FCF2.FCFn represent expected free cash flows over a period of n years
r represents the discount rate that incorporates the risk involved in the investment.
n represents the useful life on the investment i.e. the time frame during which the investment

would generate cash flows

Investment bankers compute Free Cash Flow

using the following formula:

FCFF = After tax operating income + Interest*(1-t)
+ Non-cash charges (such as D&A) - Capex Working capital expenditures = Free Cash Flows
to the Firm (FCFF)
FCFE = Net income + Non-cash charges (such as
D&A) - Capex - Change in Non Cash Working
Capital + Net Borrowing = Free Cash Flows to the
equity (FCFE)
Or simply:
FCFE = FCFF + Net borrowing - Interest*(1-t)

Find out the PVs of projected net annual cash flows

accruing to the stakeholders put together using WACC.

Find out the Continuing Value (CV)/Terminal value (TV) at the

end of the projection horizon of the cash flows beyond

projection horizon. Further, find out the PV of the continuing
value using WACC.
The sum total of PV of projected cash flows and PV of

the
continuing value provides the Enterprise Value of the
company.

After deducting the value of debt and preference shares, if any,

from the enterprise value, we would get the equity value of

the company.
This divided by the outstanding number of equity shares would

give the Intrinsic Value of one equity share.

 Terminal value computed using Perpetuity Growth method:

This approach calculates the value of the business on the

assumption that it will operate into perpetuity.

Terminal Value using No Growth Perpetuity Model: assumes

that a company earns its cost of capital on all new

investments into perpetuity. As such, the level of investment
growth is irrelevant because such growth does not affect the
value (i.e. the growth rate is zero and Capital Expenditure is
equal to depreciation and amortization).

Question:
The cost of capital in high growth period is 10%.
The cost of capital for terminal year (Year 5) is 8%.
The economic growth rate of the economy in which the firm is operating is 5%.

Free Cash Flows (in crores)

20 30 40

50

60

Find the value of the firm under the following scenario:

(a) Terminal value with growing perpetuity
(b) Terminal value with no growth/stable perpetuity

Advantages of using the DCF method:

The model allows for changes in cash flows in the future.
The cash flows and estimated value are based on forecasted
fundamentals.
The model can be adapted for different situations.
Disadvantages of using the DCF method:
For a rapidly growing company, the FCF and net income may be
misaligned (e.g., higher-than-normal capital expenditure).
Estimating future cash flows is difficult because of the uncertainty.
Estimating discount rates is difficult, and these rates may change over
time.
The terminal value estimate is sensitive to the assumptions and model
used.

Market Based Valuation/Relative Valuation

Involves comparison of the target companys market variables and

other comparables with that of the industry

Commonly used variables are:
Price/Earnings
Price/Sales
Price/Assets
Price/Book value
Any other quantifiable variable in relation to market price per share

(like price/cash earning per share, price/operating profit per share

and so on)
Variables for different periods (such as highest, lowest, and current)
Fundamentals factors (like earnings, assets, or capital employed,
whichever is found appropriate)
Relative valuation methods relies on use of multiples.
Appropriate weightages are assigned to the variables in order to arrive

at the weighted average multiplier

Comparable company analysis

Select
Select Comparable
Comparable Companies
Companies

Publicly
Publicly traded
traded companies
companies that
that are
are similar
similar to
to the
the subject
subject company
company
Same
or
similar
industry
Same or similar industry

Calculate
Calculate Relative
Relative Value
Value Measures
Measures
Enterprise
Enterprise value
value multiples
multiples
Price
multiples
Price multiples

Apply
Apply Metrics
Metrics to
to Target
Target
Judgment
Judgment needed
needed to
to select
select appropriate
appropriate metric
metric

Estimate
Estimate Takeover
Takeover Price
Price
Takeover
Takeover premium
premium added
added

Advantages
Provides reasonable estimate of the target companys value
Readily available inputs
Estimates based on markets value of company attributes

Disadvantages
Sensitive to market mispricing
Sensitive to estimate of the takeover premium, and historical

premiums may not be accurate to apply to subsequent

mergers
Does not consider specific changes that may be made in the
target post-merger

Comparable Transaction Analysis

Advantages
Does not require specific estimation of a takeover

premium
Based on recent market transactions, so information is
current and observed
Reduces litigation risk

Disadvantages
Depends on takeover transactions being correct

valuations
There may not be sufficient transactions to observe the
valuations
Does not include value of changes to be made in target

Real Option Valuation

This is another method that relies on cash

flows based on option-pricing models than

DCF models.
This valuation method proves to be useful

when
a
company
has
investment
opportunities that have option-like features.
For example: A company might have rights

(but not obligations) to delay investments,

expand into new markets, redeploy resources
between projects or exit investments.

Valuation of Control Premium

Control premium is the excess of price paid

for acquisition over the current market price of

the company.
By current market price, it does not mean any

single days market price but it means the

average price in a sufficiently large (but not
too large) period before the acquisition block
deal was signed or the public announcement
was made.

For example:

Closing price of equity shares of XYZ Ltd on 30 May,

2010 was Rs. 437. on June 1, 2010 an acquirer entered

into an agreement with the promoters to acquire their
stake of 30% at a price of Rs. 500. Thereafter, on June
4, 2010, the acquirer made an open offer for acquiring
another 30 per cent from the public at Rs. 550 per
share. XYZ Ltd. share price had been hovering
between Rs. 380 and Rs. 460 during March 2010 to
May 2010 and the average of the daily closing prices
during these 3-month period was Rs. 407.

Solution:

Price paid in the Block deal for 30% stake: Rs. 500
Price paid in the open offer for 30% stake: Rs. 550
Hence average price paid for acquisition: Rs. 525
Average price for 3 months prior to acquisition: Rs.

407
Control premium = Rs. 525 Rs. 407 = Rs. 118

The control premium is paid by the acquirer

since he is confident that after he acquires the

company, due to the new operational,
management, investment, financing and
dividend policies that he would introduce, the
valuation of the target company will
significantly go up.