1 Chapter 5b Global mergers and acquisitions

2 Valuation methods Adjusted net assets Comparables Value based on the net realizable value of the assets and liabilities on a going concern basis. The net present value of the projected free cash flows discounted at an appropriate discount rate (risk adjusted cost of capital). Valuation benchmarks based on the target industry/country’s previous recent deals or market valuation of comparable business. Use of earnings multiples or sales multiples. Valuation methodologies Discounted cash flow

3 Tangible Land and property Equipment Inventories Receivables Securities Cash Intangible Patents Brands Customer base Market value Replacement value Market value minus obsolete items Face value minus unrecoverable Market value Face value ?????? Industry norms ? Minus Long term Short term Suppliers Hidden liabilities ASSETS LIABILITIES Adjusted net assets Views the value of the business as the excess of assets over liabilities in adjusted book value terms.

4 Commonly used when: the company being valued is predominantly an investment-holding entity which does not carry on any business operations of a commercial nature; or the company businesses is tangible asset intensive; or the company carries on a business which incurs losses or generates insufficient return on the assets employed; or the future prospects of a company are extremely doubtful and/or liquidation is being contemplated; or the sale of a company is required. Replacement value “Fire sale” or its assets Orderly realization of its assets Adjusted net assets cont. Three potential assumptions:

5 Standalone: Business as a going concern Synergies: Value added resulting from the combination of operations Discounted cash flow (“DCF”) Two kinds of cash flow

6 DCF approach requires: - Estimation of forecast net “free cash flows” for the company for its outlook period (approx. 5 years), based on revenues and costs projection - Estimation of key industry risks, growth prospects and the general economic outlook, etc. - Estimation of a terminal value for the company at the end of its outlook period - Determination of discount rates, given the optimum mix of financing between equity and debt given the company rating and the estimated costs of these forms of financing (weighted average cost of capital) - Calculation of the value of the company based on the sum of the net present values of the forecast net cash flows and the terminal value DCF cont.

7 Earnings before interest, depreciation, amortization & tax (EBITDA) - Tax on EBITDA 1 = Net operating profit before depreciation, amortization and after tax + Depreciation tax shield 2 -Increase in working capital requirement (Δ inventories+ Δ receivables -Δ payables) - Net capital expenditures = Cash flow from assets (free cash flow) Estimating standalone free cash flows from accounting data 1 Tax rate × EBITDA 2 Depreciation expenses × tax rate

8 Forecasting the standalone cash flow 1.Forecast sales: market share * size of the target market 2.Examine the historical relationship between sales and the components of cash flow (EBITDA/sales, working capital/sales, fixed assets/sales) 3.Check how reasonable the forecast is: compare growth, profit, economic value added with past performances and competitors’ performance

9 The relevant cash flows  Ignore all financing cash flows. All these cash flows are taken into account by the cost of capital. Estimate only pre-financing cash flows.  Only CASH matters!  For valuation purposes we need to discount cash expenditures as they occur - NOT the accounting measures of earnings.  The relevant cash flow includes the sales of non productives assets.

10 Forecasting the standalone cash flow terminal value The business is considered as continuing after the end of the cash flow calculation period (except in special cases, e.g. mining, oil)  The business usual methods are: to calculate the terminal value as a perpetual value equal to last cash flow/WACC (weighted average cost of capital) or if on considering that the business is still growing equal to last cash flow * 1+ growth rate)/ WACC – growth rate another method is to calculate the liquidation value at the end (net assets)

11 Standalone value Equals : - NPV of free cash flows - Plus disposals - Minus debts Adjusted with: - Cash flows resulting from post mergers - Operational improvements (without synergies)

12 Revenues enhancement Cost reduction Process improvement Financial Synergies Transfer of best practices Information sharing = higher cash flow stream Synergies cash flow 1=either cash flow or WACC Extension of distribution Product complementarity System integration Geographical extension Market power Economies of scale pooling Resources e.g. procurement Economies of scope Consolidation Risk reduction 1 Cost of debts reduction 1 Tax shield

13 R&DProcurementManufacturingMarketing General COMPETENCES ASSETS R&DProcurementManufacturingMarketing General Synergies RESOURCES How much can we gain from common sourcing, access to contacts, financial clout, etc.? Do we have access to better people thanks to the combination of industry? How much can we gain from grouping factories, sharing distribution and sales forces, computer systems, etc.? What know-how can we transfer? Can we learn from the other industry? How much is the technology of this diversification worth?

14 Innovation   Technology transfer - License - Know-how leading to:  Process improvement  Product improvement  New products  Rationalization of R&D  Estimate of additional cash flow coming from:  Cost reductions; speed  Increase in sales  New sales  Overheads; headcount Procurement  Purchasing power  Time delivery  Rationalization of procurement process and supply chain, and sources of supplies  Lower supplies cost  Increase in sales and lower inventories  Overheads, headcount  Higher quality, lower costs Valuation of synergies Value chain elementSource of synergiesHow is it measured?

15 Manufacturing/ operations  Economies of scale  Time delivery  Rationalization of operations (plant closure, reorganization)  Lower unit costs  Increase in sales and lower inventories  Overheads; headcount Marketing  Economies of scale in distribution logistics  Extended distribution  Rationalization of sales force  Joint advertising  Joint market research  Joint product management  Solution selling  Lower unit costs and lower inventories  Increased sales  Overheads; headcount  Lower costs  Higher revenues Value chain elementSource of synergiesHow is it measured? Valuation of synergies cont.

16 Administration  Rationalization of IT and other infrastructures  Legal, accounting and consulting fees  Rationalization of offices  Net saving (total potential saving minus migration costs)  Overheads; headcount Financial  Debts capacities  Tax shield  Lower cost of debts  Tax savings Value chain elementSource of synergiesHow is it measured? Valuation of synergies cont.

17 Valuation of synergies: summary Revenues increase Cost decrease Source of synergies Effect of cash flow  Innovation  Procurement  Manufacturing/Operations  Marketing  Administration  Financial  Others NET EFFECT over cash flow period Exceptional items: Sales of duplicated assets (indicate year) Cost of integration (indicate year) + - Cash flow effects over the years 1, 2, 3, 4, ….

18 Selecting a discount rate WACC (Weighted average cost of capital) = (Cost of debts *% of debts financing) + (Cost of equity * % of equity financing) Cost of debt= interest rate Cost of equity = risk free rate + (market risk premium * company risk premium) Premium? Which risk premium ? Acquirer or Acquiree? Adjusted cash flows How do we assess RISK?

19 How to incorporate country risk in cash flow valuation? Adjust cost of capital (equity and debts) Adjust cash flow

20 1.Calculate the risk premium due to market risk (off-shore project beta) to be included in the cost of equity 1.Off-shore project beta = beta of comparable project in home country * country beta 2.Where country beta = volatility of the host country stock market (correlation of changes with home country) (or GDP)/ to the home country 2.Add a political risk premium 1.Bond risk premium 3.Adjust WACC accordingly 4.Cost of equity in a foreign investment: 1.= risk-free home country + country risk ( bond risk premium ) + market risk premium* 2.( company beta * country market beta ) Adjusting the cost of equity (Donald Lessard - MIT)

21 1. Identify the elements of cash flow subject to country risk variation (revenues, costs) 2. Assign a probability of occurrence to those elements 3. Take the expected value [likely cashflow * (1-probability of adverse event)] 4. Possibility to run a Monte Carlo simulation if various probabilities affect various elements 5. Calculate NPV with global cost of capital Adjusting the cash flows (Hawawini & Viallet - INSEAD)

22 Has a strong theoretical basis and is most commonly used for: businesses with reasonable predictable revenue and cash flows start up projects businesses with diverse capital expenditure requirements over time businesses that are subject to cyclical factors limited life projects Source: Ernst & Young Discounted cash flow (“DCF”)

23 Comparison of similar transactions in similar industries: Price/earnings ratio or price/ EBITDA or in some cases price/ sales Appropriate valuation when comparable transactions are available This method involves: Selection of the earnings, EBITDA, sales level based on historical and forecasted operating results, non-recurring items of income and expenditure and known factors likely to impact on operating performance; and Determination of an appropriate capitalization multiple taking into consideration the market rating of comparable companies, the extent and nature of competition, quality of earnings, growth prospects and relative business risks. Source: Ernst & Young Comparable values

24 The appropriate multiple is usually assessed: Comparing the multiples of companies that are in the same or similar industries And where possible, purchase and sale transactions involving comparable companies Some of the issues to be considered: Individual characteristics (growth, size, gearing, etc.) Time period consistency (e.g. Historical earnings with historical multiples) Obtaining market evidence of comparable company multiple (from Bloomberg…) Source: Ernst & Young Comparable values cont.

25 The value capture decomposition Stand- alone value Implement- tation costs Employees Suppliers Customers Compensations Competitors’ gains Value captured Total value potential Synergies } Premium Price?