Unit 3 Corporate Restructuring Valuation PDF

Unit III: Deal Valuation and Evaluation 1  Methods of valuation; cash flow approaches,  Economic value added (EVA) (with numerical)  Sensitivity analysis (with numerical)  Valuation for slump sale  Valuation of synergy (with numerical)  Cost-benefit analysis and  Swap ratio determination (wi...

Unit III: Deal Valuation and Evaluation 1  Methods of valuation; cash flow approaches,  Economic value added (EVA) (with numerical)  Sensitivity analysis (with numerical)  Valuation for slump sale  Valuation of synergy (with numerical)  Cost-benefit analysis and  Swap ratio determination (with numerical) 05-11-2024  Situation requiring Valuation 2 Following are some of the usual circumstances when valuation of shares or enterprise becomes essential: 1. When issuing shares to public either through an initial public offer or by offer for sale of shares of promoters or for further issue of shares to public. 2. When promoters want to invite strategic investors or for pricing a first issue or a further issue, whether a preferential allotment or rights issue. 3. In making investment in a joint venture by subscription or acquisition of shares or other securities convertible into shares. 4. For making an ‘open offer’ for acquisition of shares. 5. When company intends to introduce a ‘buy back’ or ‘delisting of shares’. 6. In schemes involving mergers/demergers, share valuation is resorted to in order to determine the consideration for the purpose of issue of shares or any other consideration to shareholders of transferor or demerged companies. 7. On directions of Tribunal or Authority or Arbitration Tribunals. 05-11-2024  Situation requiring Valuation 3 Following are some of the usual circumstances when valuation of shares or enterprise becomes essential: 8. For determining fair price for effecting sale or transfer of shares as per Articles of Association of the company. 9. As required by the agreements between two parties. 10. To determine purchase price of a ‘block of shares’, which may or may not give the holder thereof a controlling interest in the company. 11. To value the interest of dissenting shareholders under a scheme of amalgamation, merger or reconstruction. 12. Conversion of debt instruments into shares. 13. Advancing a loan against the security of shares of the company by the Bank/Financial Institution. 14. As required by provisions of law such as the Companies Act, 2013 or Foreign Exchange Management Act, 1999 or Income Tax Act, 1961 or the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 [the Takeover Code] or SEBI (Share Based Employee Benefits) Regulations, 2014 or SEBI (Buy Back of Securities) Regulations, 2018 or Delisting Guidelines. 05-11-2024  Factors Affecting Valuation Basics 4  The key to valuation is finding a common ground between all of the companies for the purpose of a fair evaluation.  Determining the value of a business is a complicated and intricate process. Valuing a business requires the determination of its future earnings potential, the risks inherent in those future earnings. A company’s fair market value is the price at which the business would change hands between a willing buyer and a willing seller when neither are under any compulsion to buy or sell, and both parties have knowledge or relevant facts. 05-11-2024  Factors Influencing Valuation 5 The process of arriving at this value includes a detailed analysis of its mix of physical and intangible assets, and the general economic and industry conditions. The other salient factors include: 1) The stock exchange price of the shares of the two companies before the commencement of negotiations or the announcement of the bid. 2) Dividends paid on the shares. 3) Relative growth prospects of the two companies. 05-11-2024  Factors Influencing Valuation contd. 6 The other salient factors include: 4) In case of equity shares, the relative gearing of the shares of the two companies. (‘gearing’ means ratio of the amount of issued preference share capital and debenture stock to the amount of issued ordinary share capital.) 5) Net assets of the two companies. 6) Voting strength in the merged (amalgamated) enterprise of the shareholders of the two companies. 7) Past history of the prices of shares of the two companies. 8) Merger and amalgamation deals can take a number of months to complete during which time valuations can fluctuate substantially. Hence provisions must be made to protect against such swings. 05-11-2024  Preliminary steps in Valuation 7 A business valuation involves analytical and logical application/analysis of historical/future tangible and intangible attributes of business. The preliminary study to valuation involves the following aspects: 1) Purpose of valuation. 2) Goodwill/Brand name in the market. 3) Business environment of the entity to be valued. 4) Estimation/forecast of future cash flows as accurately as possible. 5) Is company listed on any stock exchange? 6) If listed, whether shares of the company are traded frequently? 7) The industry in which the entity is part of 8) The industry P/E ratio, past and future growth rate. 9) Who are the competitors locally, internationally? 10) Whether any similar valuation has been done recently? 11) The technology concerning the enterprise and its probability of obsolescence. 12) The accepted discounting rate. 13) Study of market capitalization aspects. 14) Identification of hidden liabilities through analysis of material contracts. 05-11-2024  Valuation for M&A 8 The value of a business is a function of the business logic driving the M&A and is based on bargaining powers of buyers and sellers. Thorough due diligence has to be exercised in deciding the valuation parameters since these parameters would differ from sector to sector and company to company. Some most popular methods of valuation amongst other are: A. Assets based valuation B. Earnings based valuation C. Market based valuation D. Others 05-11-2024  Valuation Based on Assets 9 This valuation method is based on the simple assumption that adding the value of all the assets of the company and subtracting the liabilities, leaving a net asset valuation, can best determine the value of a business. However, for the purposes of the amalgamation the amount of the consideration for the acquisition of a business may be arrived at either by valuing its individual assets and goodwill or by valuing the business as a whole by reference to its earning capacity. If this method is employed, the fixed assets of all the amalgamating companies should preferably be valued on a going concern basis. The term ‘going concern’ means that a business is being operated at not less than normal or reasonable profit and valuer will assume that the business is earning reasonable profits when appraising the assets. 05-11-2024  Valuation Based on Assets Contd. 10  Balance sheet usually gives an accurate indication of short-term assets and liabilities. This is not the case of long-term ones as they may be hidden by techniques such as “off balance sheet financing”.  Moreover, a balance sheet is a historical record of previous expenditure and existing liabilities.  As valuation is a forward looking exercise, acquisition purchase prices generally do not bear any relation to published balance sheet. 05-11-2024  Valuation Based on Assets Contd. 11 An asset-based valuation can be further separated into four approaches: 1. Book value  The tangible book value of a company is obtained from the balance sheet by taking the adjusted historical cost of the company’s assets and subtracting the liabilities; intangible assets (like goodwill) are excluded in the calculation.  Statutes like the Gift Tax Act etc., have in fact adopted book value method for valuation of unquoted equity shares for companies other than an investment company. Book value of assets does help the valuer in determining the useful employment of such assets and their state of efficiency. In turn, this leads the valuer to the determination of rehabilitation requirements with reference to current replacement values.  In all cases of valuation on assets basis, except book value basis, it is important to arrive at current replacement and realization value. It is more so in case of assets like patents, trademarks, know-how, etc. which may posses value, substantially more or less than those shown in the books.  Using book value does not provide a true indication of a company’s value, nor does it take into account the cash flow that can be generated by the company’s assets. 05-11-2024  Valuation Based on Assets Contd. 12 2. Excess earnings  In order to obtain a value of the business using the excess earnings method, a premium is added to the appraised value of net assets. This premium is calculated by comparing the earnings of a business before a sale and the earnings after the sale, with the difference referred to as excess earnings.  In this approach, it is assumed that the business is run more efficiently after a sale; the total amount of excess earnings is capitalized (e.g., the difference in earnings is divided by some expected rate of return) and this result is then added to the appraised value of net assets to derive the value of the business. 05-11-2024  Valuation Based on Assets Contd. 13 3. Replacement cost  Replacement cost reflects the expenditures required to replicate the operations of the company. Estimating replacement cost is essentially a make or buy decision. 05-11-2024  Valuation Based on Assets Contd. 14 4. Liquidation Value / Realizable Value:  Value of asset is based on the presumption that they have to be sold now. In theory, this should be equal to the value obtained from DCF valuations of individual assets, but the urgency associated with liquidating assets quickly may result in a discount on the value. How large the discount will be depend on the number of potential buyers for the assets, the asset characteristics, and the state of the economy.  This method may look simple on the face of it as long as the assets can be valued based on similar assets available in the market. However, if the entity has some intangible assets such as brand, technical know-how, designs, trademark, etc., it gets more complicated because there may not be readily available market value for such intangible assets. The valuation methods for intangible assets are totally different. 05-11-2024  Valuation Based on Assets Contd. 15 4. Liquidation Value / Realizable Value Contd.:  This approach is likely to be used when the business is non-operating such as under corporate insolvency resolution or under liquidation. Under the Insolvency and Bankruptcy Code, 2016, liquidation value is defined as realizable value. This is determined by appointing two independent valuers. The average value given by the valuers based on International Valuation Standards is taken as the liquidation value. 05-11-2024  Valuation Based on Assets Contd. 16 The asset based approach is useful in combination with the other methods such as cash flow methods. For example company-A has net assets of Rs. 15,00,000 whereas company-B has net assets of Rs. 5,00,000. The cash flows of the two companies are same. It is very easy to say that company-B is more valuable than company-A based on the comparison. However in the worst case scenario of insolvency or liquidation the risk in company-A is less, as it has more assets that can be liquidated. 05-11-2024  Question 17 ABC Ltd. has the following values in its books: Particulars (Rs. in thousand) Land and building 300 Plant and machinery 200 Inventory 200 Investment 100 Receivables 300 Cash 100 Current liabilities 300 Term loans 200 Land and buildings will fetch 500 more. Plant and machinery will fetch 100 less. Inventory will fetch 50 less. Receivables will fetch 50 less. Current liabilities of 50 will not be payable. Calculate the net realizable value of this business. 05-11-2024  Solution 18 Book Value Appreciation Realizable Value Assets Land & Buildings 300 +500 800 Plant & Machinery 200 -100 100 Investments 100 100 Inventory 200 -50 150 Receivables 300 -50 250 300 -50 250 Cash 100 100 100 100 TOTAL 1200 300 1500 1200 300 1500 Liabilities Bank Borrowings 200 200 200 200 Current Liabilities 300 -50 250 Net Realisable value 1050 05-11-2024  Valuation for M&A 19 Some most popular methods of valuation amongst other are: A. Assets based valuation B. Earnings based valuation C. Market based valuation D. Others 05-11-2024  Valuation Based on Earnings 20 The normal purpose of the contemplated purchase is to provide for the buyer the annuity for his outlay. He will expect yearly income, return great or small, stable or fluctuating but nevertheless some return which is commensurate with the price paid therefore. Valuation based on earnings, based on the rate of return on capital employed is a more modern method. From the last earnings declared by a company, items such as tax, preference dividend, if any, are deducted and net earnings are taken. An alternate to this method is the use of the price-earning (P/E) ratio instead of the rate of return. The P/E ratio of a listed company can be calculated by dividing the current price of the share by earning per share (EPS). Therefore, the reciprocal of P/E ratio is called earnings - price ratio or earning yield. Thus P/E = P/EPS Where P is the current price of the shares The share price can thus be determined as P = EPS x P/E ratio 05-11-2024  Valuation Based on Earnings Contd. 21 1) Discounted Cash Flow / Free Cash Flow: Being the most common technique takes into consideration the future earnings of the business and hence the appropriate value depends on projected revenues and costs in future, expected capital outflows, number of years of projection, discounting rate and terminal value of business. 2) Cost to Create Approach: In this approach the cost for building up the business from scratch is taken into consideration and the purchase price is typically the cost plus a margin. 3) Capitalised Earning Method: The value of a business is estimated in the capitalised earnings method by capitalising the net profits of the business, the current year or average of three years or a projected year at required rate of return. 05-11-2024  Discounted Cash Flow Method (DCF) 22 Discounted Cash Flow Method involves discounting future cash flow projections, from the newly formed company, to its present value. If the present value is higher than the actual cost of merger, then the merger is viable. The present value is calculated using the weighted average cost of capital. In this method as the name suggests, it involves discounting the cash flows of the entity to be valued. The value of the entity is arrived at by adding the discounted free cash flows. Requirements of this method are: Forecast of the free cash flows. Estimate the discount rate which will be the weighted average cost of capital. 05-11-2024  Discounted Cash Flow Method (DCF) 23 Cost of capital is calculated based on the cost of debt and cost of equity and taking a weighted average. The present value of future cash flows is calculated using the standard formula:  PV = CF1 / (1+r) + CF2 / (1+r)2 + … [TCF / (r - g)] / (1+r)n-1 Where, PV = present value CF1= cash flow in year 1 r = discount rate TCF = the terminal year cash flow g = growth rate assumption in perpetuity beyond terminal year n = the number of periods in the valuation model including the terminal year 05-11-2024  Discounted Cash Flow Method (DCF) 24 The formula for calculating free cash flows is: Free cash flows = operating profit + depreciation + amortization of goodwill – capital expenditures – cash taxes – change in working capital. 05-11-2024  Question 25 The free cash flows of Company A are forecasted as shown below: Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Year Free Cash 100,000 100,000 150,000 180,000 200,000 300,000 Flows Other information is as below: The cost of debt is = 12% The cost of equity = 16% Debt/Equity ratio = 1:1 Calculate the value of the business. 05-11-2024  Solution 26  Weighted average cost of capital = (12% +16%)/2 = 14%  PV of Year 1 cash flows = 100 / (1+14%) = 87.7  PV of Year 2 Cash flows = 100/ (1+14%)^2 = 76.95  PV of Year 3 Cash flows = 100/ (1+14%)^3 = 101.2  PV of Year 4 Cash flows = 100/ (1+14%)^4 = 106.5  PV of Year 5 Cash flows = 100/ (1+14%)^5 = 103.8  PV of terminal value = 300/ (1+14%)^5 = 155.8 Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Year Free Cash 100,000 100,000 150,000 180,000 200,000 300,000 Flows PV 87700 76950 101200 106500 103800 155800 05-11-2024  Solution 27  Total of all PVs = 87.7 + 76.95 +101.2 + 106.5 +103.8 +155.8 = 631.95  The value of the business = `6,31,950 05-11-2024  Valuation for M&A 28 Some most popular methods of valuation amongst other are: A. Assets based valuation B. Earnings based valuation C. Market based valuation D. Others 05-11-2024  Market Based Valuation 29 Market based methods help the strategic buyer estimate the business value by comparison to similar businesses. Where the company is listed, market price method helps in evaluating on the price on the secondary market. Average of quoted price is considered as indicative of the value perception of the company by investors operating under free market conditions. To avoid chances of speculative pressures, it is suggested to adopt the average quotations of sufficiently longer period. The valuer will have to consider the effect of issue of bonus shares or rights shares during the period chosen for average. 05-11-2024  Market Based Valuation Contd. 30 I. Market Price Method is not relevant in the following cases:  Valuation of a division of a company  Where the shares are not listed or are thinly traded  In the case of a merger, where the shares of one of the companies under consideration are not listed on any stock exchange  In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds. II. In case of significant and unusual fluctuations in market price the market price may not be indicative of the true value of the share. At times, the valuer may also want to ignore this value, if according to the valuer, the market price is not a fair reflection of the company’s underlying assets or profitability status. The Market Price Method may also be used as a back up for supporting the value arrived at by using the other methods. 05-11-2024  Market Based Valuation Contd. 31 III. It is important to note that regulatory bodies have often considered market value as one of the very important basis for preferential allotment, buyback, open offer price calculation under the Takeover Code. IV. In earlier days due to non-availability of data, while calculating the value under the market price method, high and low of monthly share prices were considered. Now with the support of technology, detailed data is available for stock prices. It is now a usual practice to consider weighted average market price considering volume and value of each transaction reported at the stock exchange. V. If the period for which prices are considered also has impact on account of bonus shares, rights issue etc., the valuer needs to adjust the market prices for such corporate events. 05-11-2024  Methods for Market Based Valuation 32 Following methods are used for valuation under this approach: I. Comparable companies multiple approach – Market multiples of comparable listed companies are computed and applied to the company being valued to arrive at a multiple based valuation. II. Comparable transaction multiples method – This technique is mostly used for valuing a company for M&A, the transaction that have taken place in the industry which are similar to the transaction under consideration are taken into account. III. Market value approach – The market value method is generally the most preferred method in case of frequently traded shares of companies listed on stock exchanges having nationwide trading as it is perceived that the market value takes into account the inherent potential of the company. 05-11-2024  Market Comparables 33 This method is generally, applied in case of unlisted entities. This method estimates value by relating the same to underlying elements of similar companies for past years. It is based on market multiples of ‘comparable companies’. For example  Earnings / Revenue Multiples (Valuation of Pharmaceutical Brands)  Book Value Multiples (Valuation of Financial Institution or Banks)  Industry Specific Multiples (Valuation of cement companies based on Production capacities)  Multiples from recent M&A Transactions. Though this method is easy to understand and quick to compute, it may not capture the intrinsic value and may give a distorted picture in case of short term volatility in the markets. There may often be difficulty in identifying the comparable companies. 05-11-2024  Market Comparables 34  This method estimates value by relating the same to underlying elements of similar companies for past years. It is based on market multiples of ‘comparable companies’. Philosophical basis behind the method is that there is a comparable asset in the market which is already valued, which can form basis of valuation of an asset. This method of valuation is also known as relative valuation.  Following steps are involved in this method of valuation : Comparable assets are identified and their market values are obtained Market values are converted into standardized values, since the absolute price cannot be compared Standardized value or multiple for the asset being analyzed are compared with the standardized value of the comparable asset, controlling for any difference between the firms that might affect the multiple, to judge whether the asset is under or over valued. 05-11-2024  Market Comparables 35 The following metric can be used as a basis for relative valuation: o Sales – EV/Sales o EBITDA – EV/EBITDA o EBIT – EV/EBIT o Earnings/Net Profit – Price-to-Earnings Ratio o Book Value – Price to Book o Cash Flow – EV/Cash Flow  Enterprise Value = Market Value Debt + Market Value Equity– Cash & Investments.  The other option is to use Equity Multiples, such as: o Price / Cash Flow per share o Price / Sales per share o Price / Earnings per share o Price / Book Value per share  Industry Specific variable (Price per ton capacity of steel, per store value in the days of retail boom, price per click in e- commerce). 05-11-2024  Market Comparables 36 Which multiple should one use? While a range of values can be obtained from a number of multiples, the best estimate value is obtained using one multiple. Multiple that seems to make the most sense for that sector should be used. For example:  In retailing: The focus is usually on same store sales and profit margins and so the revenue multiple is the most common in this sector.  In financial services: The emphasis is usually on return on equity. Book Equity is often viewed as a scarce resource, since capital ratios are based upon it. Price to book ratios dominate.  In technology: Growth is usually the dominant theme. PEG ratios (Price / Earnings to growth ratio) were invented in this sector. PEG = PE ratio / EPS growth rate 05-11-2024  Valuation for M&A 37 Some most popular methods of valuation amongst other are: A. Assets based valuation B. Earnings based valuation C. Market based valuation D. Others 05-11-2024  Valuation for M&A 38 Other methods:  Super Profit Method: This approach is based on the concept of the company as a going concern. The value of the net tangible assets is taken into consideration and it is assumed that the business, if sold, will in addition to the net asset value, fetch a premium. The super profits are calculated as the difference between maintainable future profits and the return on net assets. In examining the recent profit and loss accounts of the target, the acquirer must carefully consider the accounting policies underlying those accounts. Particular attention must be paid to areas such as deferred tax provision, treatment of extraordinary items, interest capitalisation, depreciation and amortisation, pension fund contribution and foreign currency translation policies. Where necessary, adjustments for the target’s reported profits must be made, so as to bring those policies into line with the acquirer’s policies. For example, the acquirer may write off all R&D expenditure, whereas the target might have capitalised the development expenditure, thus overstating the reported profits. 05-11-2024  Valuation for M&A 39 Other methods:  Contingent Claim Method: Contingent Claim valuation uses option pricing models to measure the value of assets that have share option characteristics. Some of these assets are traded financial assets like warrants, and some of these options are not traded and are based on real assets. Projects, patents and oil reserves are examples. The latter are often called real options.  Accounting Professionals Experts: The accounting professionals use the various accounting ratios which are beneficial in deriving the swap ratios. These accounting ratios may be: Dividend Payout Ratio (DP Ratio), Price Earnings Ratio (PE Ratio), Debt Equity Ratio, Net Assets Value (NAV). 05-11-2024  Sensitivity Analysis 40  The profitability of an enterprise may be sensitive to different factors. If we take these factors as independent variables, then given a change in one or more of the variables, how the profitability will change? This technique is known as “Sensitivity Analysis”.  In business valuation, there are variables such as discount rate, future growth rate, market share, beta value, required rate of return, etc. Each of these factors can be varied to test the business valuation model. 05-11-2024  Sensitivity Analysis contd. 41 Eg 1: The variables are Sales and EBT%. How sensitive is the EBT% to decrease or increase in sales. Current 10% decline 10% 20% decline 32% in sales increase in in sales increase in sales sales Sales 100000 90000 110000 88000 132000 Cost of Sales 70% 70000 63000 77000 61600 92400 Gross Profit 30000 27000 33000 26400 39600 Fixed Cost 15000 15000 15000 15000 15000 Interest 10% 5000 5000 5000 5000 5000 Earnings before 10000 7000 13000 6400 19600 tax EBT % 10% 8% 12% 7% 15% 05-11-2024  Sensitivity Analysis contd. 42 As can be seen the sensitivity analysis is: Variable = Sales Variable = EBT% 0% change from current 10% 10% decrease Decrease by 8% 10% increase increase to 12% 20% decrease decrease to 7% 32% increase increase to 15% 05-11-2024  Sensitivity Analysis contd. 43 Example 2:  Business valuation of an enterprise which has 2 crore shares issued and paid-up, has current earnings of Rs.10 per share. Current Earnings Earnings P/E ratio P/E ratio decrease increase by increase by decrease by 10% 10% 20% by 20% P/E ratio of industry 25 25 25 30 20 Earnings per share 10 9 11 10 10 (Rs.) Market price of share 250 225 275 300 200 (Rs.) Value of the 500 450 550 600 400 enterprise (Rs. in cr.) 05-11-2024  Swap Ratio 44  A swap ratio is an exchange rate of the shares of the companies that would undergo a merger. This is calculated by the valuation of various assets and liabilities of the merging companies.  The swap ratio determines the control that each group of shareholders of the companies shall have over the combined firm. It is an indicator of relative values of financial and strategic results of the company.  In a merger or acquisition between two companies, the ratio at which the acquiring company offers its own shares in exchange for the target company’s shares, is known as the swap ratio. 05-11-2024  Exchange Ratio / Swap Ratio 45  Exchange ratio is defined as the number of shares the acquiring firm is willing to give in exchange for one share of the target firm.  An exchange ratio of 0.5 means that the acquiring firm is willing to give half a share for every share of the target firm.  Swap Ratio : Parameter of the target company Parameter of the acquiring company 05-11-2024  Exchange Ratio / Swap Ratio 46 Example:  In October 2017, Indusind Bank acquired a micro finance company Bharat Financial Inclusion Ltd. The swap ratio had been decided at 639 shares of IndusInd Bank for every 1,000 shares of Bharat Financial. This means that the value of one share of Bharat Financial is equal to 0.639 share of Indusind Bank, swap ratio of 1:0.639.  In 2018, IDFC Bank and Capital First announced merger between the two to form a combined entity with assets under management of `88,000 crore, branch network of 194 and customer base of over 5 million. As per the agreement, IDFC Bank will issue 139 shares for every 10 shares of Capital First. So the swap ratio here is 1:13.9. 05-11-2024  Bases for Determining the Exchange ratio 47  Book value per share  Earnings per share  Market price per share  Dividend discount value per share  Discounted cash flow value per share 05-11-2024  Bases for Determining the Exchange ratio 48  Book value per share Do not reflect changes in purchasing power of money. Often different from true economic values.  Earnings per share Difference in the growth rate of earnings of the two companies. Gains in earnings arising out of merger. Differential risks associated with the earnings of the two companies. Negative earning per share. Wind fall profit, large tax relief. 05-11-2024  Bases for Determining the Exchange ratio 49  Market price per share Less reliable for stocks which are less traded Does not exists for stocks which are less traded Can be manipulated  Dividend discount value per share The dividend discounted value per share is the present value of the expected stream of dividends. Can be used when dividends can be predicted  Discounted cash flow value per share DCF value per share = Firm value using the DCF method – Debt value Number of equity shares Cash flow projections are available for a long period. 05-11-2024  Bases for Determining the Exchange ratio 50  Book value per share  Earnings per share  Market price per share  Dividend discount value per share  Discounted cash flow value per share 05-11-2024  Boundaries for exchange rate determination 51 Larson & Gonedes Conn & Nielson  ER = Exchange Ratio  P1 = Price per share for acquiring company  P12 = Price per share for combined company  PE12 = Price earnings multiple for combined company  EPS12 = Earnings per share for combined company  E1 = Earnings for acquiring company  E2 = Earnings for acquired company  S1 = Number of outstanding equity shares for acquiring company  S2 = Number of outstanding equity shares for acquired company 05-11-2024  Boundaries for exchange rate determination 52 contd. P12 ≥ P1 P12 = P1 P12=(PE12) (EPS12) = P1 𝐸1+𝐸2 EPS12= 𝑆1+𝑆2 (𝐸𝑅1) (𝑃𝐸12) (𝐸1+𝐸2) P1 = 𝑆1+𝑆2 (𝐸𝑅1) −𝐒𝟏 𝑬𝟏+𝑬𝟐 𝑷𝑬𝟏𝟐 ER1 = + 𝑺𝟐 𝑷 𝟏𝑺 𝟐 05-11-2024  Boundaries for exchange rate determination 53 contd. P12 (ER2) ≥ P2 (PE12) (EPS12) ER2 = P2 𝐸1+𝐸2 PE12 𝑥 𝑥 𝐸𝑅2 = 𝑃2 𝑆1+𝑆2 (𝐸𝑅2) 𝐸1 + 𝐸2 𝑃2 𝑥 𝐸𝑅2 = 𝑆1 + 𝑆2 (𝐸𝑅2) 𝑃𝐸12 𝑃2 𝐸1 + 𝐸2 𝑥 𝐸𝑅2 = 𝑥 (𝑆1 + 𝑆2 𝑥 𝐸𝑅2) 𝑃𝐸12 𝑃2𝑆1 𝑃2𝑆2 𝑥 𝐸𝑅2 𝐸1 + 𝐸2 𝑥 𝐸𝑅2 = + 𝑃𝐸12 𝑃𝐸12 05-11-2024  Boundaries for exchange rate determination 54 contd. 𝑃2𝑆1 𝑃2𝑆2 𝑥 𝐸𝑅2 𝐸1 + 𝐸2 𝑥 𝐸𝑅2 = + 𝑃𝐸12 𝑃𝐸12 𝑃2𝑆2 𝑥 𝐸𝑅2 𝑃2𝑆1 𝐸1 + 𝐸2 𝑥 𝐸𝑅2 − = 𝑃𝐸12 𝑃𝐸12 (𝑃2𝑆2 ) 𝑃2𝑆1 (𝐸1 + 𝐸2) 𝑥 𝐸𝑅2 − 𝐸𝑅2 = 𝑃𝐸12 𝑃𝐸12 (𝑃2𝑆2 ) 𝑃2𝑆1 (𝐸1 + 𝐸2 − )𝑥 𝐸𝑅2 = 𝑃𝐸12 𝑃𝐸12 𝑷𝟐𝑺𝟏 ER2 = 𝑷𝑬𝟏𝟐 𝑬𝟏+𝑬𝟐 −𝑷𝟐𝑺𝟐 05-11-2024  Boundaries for exchange rate determination 55 contd. 05-11-2024  Class Exercise on Exchange Ratio 56 Firm 1 Firm 2 Total earnings Rs. 18 mn Rs. 6 mn No. of Outstanding shares 9 mn 6 mn EPS Rs. 2 Re. 1 PE ratio 12 8 MPS Rs. 24 Rs. 8 Maximum exchange ratio acceptable to shareholders of firm 1 PE 12 9 10 11 12 15 20 Max ER1 Minimum exchange ratio acceptable to shareholders of firm 2 PE 12 3 9 10 11 12 15 20 Min ER2 05-11-2024  Class Exercise on Exchange Ratio 57 Firm 1 Firm 2 Total earnings Rs. 18 mn Rs. 6 mn No. of Outstanding shares 9 mn 6 mn EPS Rs. 2 Re. 1 PE ratio 12 8 MPS Rs. 24 Rs. 8 Maximum exchange ratio acceptable to shareholders of firm 1 PE 12 9 10 11 12 15 20 Max ER1 0 0.17 0.33 0.50 1.0 1.83 Minimum exchange ratio acceptable to shareholders of firm 2 PE 12 3 9 10 11 12 15 20 Min ER2 3 0.43 0.38 0.33 0.30 0.23 0.17 05-11-2024  Class Exercise on Exchange Ratio 58 BBA(FIA) Limited is keen on reporting an earnings per share of Rs. 6 after acquiring BMS Limited. The following financial data are given. BBA(FIA) Limited BMS Limited Earnings per share Rs. 5 Rs. 5 Market price per share Rs. 60 Rs. 50 No. of share 10 Lakh 8 Lakh There is an expected synergy gain of 5%. What exchange ratio will result in a post-merger earnings per share of Rs. 6 for BBA(FIA) Limited? 05-11-2024  Solution 59  Total earnings of BBA(FIA) limited = Rs. 50,00,000  Total earnings of BMS limited = Rs. 40,00,000  Synergy Gain = 5%  Total earnings of the combined limited = 90,00,000X1.05= 94,50,000 Rs.  EPS = 6 = 94,50,000 10,00,000 + (ER x 8,00,000) ER = 0.71875 05-11-2024  Question on Exchange Ratio 60 Alpha Corporation plans to acquire Beta Corporation. The following information is available: Alpha Corporation Beta Corporation Total current earnings, E Rs. 50 million Rs. 20 million Number of outstanding shares, S 20 million 10 million Market price per share, P Rs. 30 Rs. 20 a) What is the maximum exchange ratio acceptable to the shareholders of Alpha Corporation if the PE ratio of the combined entity is 12 and there is no synergy gain? b) What is the minimum exchange ratio acceptable to the shareholders of Beta Corporation if the PE ratio of the combined entity is 11 and there is a synergy benefit of 5%? c) Assuming that there is no synergy gain, at what level of PE multiple will the lines ER1 and ER2 intersect? 05-11-2024  Solution 61 a) Maximum exchange ratio acceptable to the shareholders of Alpha Corporation −𝑆1 𝐸1 + 𝐸2 𝑃𝐸12 𝐸𝑅1 = + 𝑆2 𝑃1𝑆2 −20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 50+20 12 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝐸𝑅1 = 10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 30 𝑥10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 0.80 05-11-2024  Solution 62 b) minimum exchange ratio acceptable to the shareholders of Beta Corporation 𝑃2 𝑆 1 𝐸𝑅2 = 𝑃𝐸12 𝐸1 + 𝐸2 − 𝑃2𝑆2 20 𝑥 20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝐸𝑅2 = 11 𝑥 70 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑥 1.05 −20 𝑥 10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 0.657 05-11-2024  Solution 63 c) Level of PE multiple: The lines ER1 and ER2 will intersect at the weighted average of the two PE multiples, wherein the weights correspond to the respective earnings of the two firms. 𝐸1 E2 𝑃𝐸12 = 𝑃𝐸1 + PE2 𝐸1 + 𝐸2 𝐸1 + 𝐸2 (𝑃𝐸1 & 𝑃𝐸2 = MPS/EPS) 50 20 𝑃𝐸12 = PE1 + PE2 70 70 50 20 𝑃𝐸12 = x 12 + x 10 = 11.43 70 70 05-11-2024  Class Exercise on Exchange Ratio 64 The following information is provided relating to the acquiring company BBB(FIA) Ltd. and the target company BMS Ltd. BBA(FIA) Ltd. BMS Ltd. No. of shares (F.V. Rs. 10 each) 10.00 lakhs 7.5 lakhs Market capitalisation 500 lakhs 750 lakhs P/E ratio 10 5 Reserve and Surplus 300 lakhs 165 lakhs Promoter’s Holding (No. of shares) 4.75 lakhs 5 lakhs Board of Directors of both the companies have decided to give a fair deal to the shareholders and accordingly for swap ratio the weights are decided as 40%, 25% and 35% respectively for Earning, Book value, Market price of share of each company: 1. Calculate the swap ratio and also calculate Promoter’s holding % after acquisition. 2. What is the EPS of BBA(FIA) Ltd. after acquisition of BMS Ltd.? 3. What is the expected market price per share and market capitalisation of BBA(FIA) Ltd. after acquisition, assuming P/E ratio of firm BBA(FIA) Ltd. remains unchanged. 4. Calculate free float market capitalisation of the merged firm. 05-11-2024  Solution 65 Particulars BBA(FIA) Ltd. BMS Ltd. Market capitalisation No. of shares Market price per share P/E ratio EPS Profit / Earnings Share capital Reserves and surplus Total Book value per share 05-11-2024  Solution 66 Particulars BBA(FIA) Ltd. BMS Ltd. Market capitalisation 500 lakhs 750 lakhs No. of shares 10 lakhs 7.5 lakhs Market price per share Rs. 50 Rs. 100 P/E ratio 10 5 EPS Rs. 5 Rs. 20 Profit / Earnings Rs. 50 lakhs Rs. 150 lakhs Share capital Rs. 100 lakhs Rs. 75 lakhs Reserves and surplus Rs. 300 lakhs Rs. 165 lakhs Total Rs. 400 lakhs Rs. 240 lakhs Book value per share Rs. 40 Rs. 32 05-11-2024  Solution 67 1. Calculation of swap ratio EPS 4 :1 4 x 40% = 1.6 Book Value 0.8:1.8x 25% = 0.2 Market Price 2 :1 2 x 35% = 0.7 Total = 2.5 Swap ratio is for every 1 share of BMS Ltd. to issue 2.5 shares of BFIA Ltd. Total no. of shares to be issued: 7.5 lakh x 2.5 = 18.75 lakh shares. Promoters holding= 4.75 lakh shares + (2.5 x 5 lakh shares) = 4.75 + 12.5 = 17.25 lakh Promoters holding % = 17.25 lakh / (18.75 + 10 lakh) x 100 = 60% 05-11-2024  Solution 68 2. EPS of BBA(FIA) Ltd. after acquisition of BMS Ltd. Total no of shares 10 lakh + 18.75 lakh = 28.75 lakh EPS Total profit / No. of shares = 50 L + 150 L / 28.75 L = 200 / 28.75 = Rs. 6.956 3. Expected market price per share and market capitalisation of BBA(FIA) Ltd. after acquisition, assuming P/E ratio of firm BBA(FIA) Ltd. remains unchanged. Expected market price = EPS 6.956 x P/E 10 = Rs. 69.56 Market Capitalisation = 69.56 per share x 28.75 Lakh shares = Rs. 1999.85 Lakh 05-11-2024  Solution 69 4. Free float market capitalisation of the merged firm Free float of market cap. = MPS x (Total shares – Promoters holding) = 69.56 x (28.75L – 17.25L) = 69.56 x (11.5L) = Rs. 799.94 Lakh 05-11-2024  Economic Value Added 70  Concept of EVA was developed by Joel Stern and Bennett Stewart.  EVA is the after tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. EVA= NOPAT - (k0 x TCE) 05-11-2024  EVA 71  Sales – Total cost (Except interest) = operating Profit  Operating Profit – tax = NOPAT NOPAT - Total funds * WACC = EVA Capitalised value = EVA/ WACC 05-11-2024  EVA 72 Approach 1 Approach 2 Sales Amount Sales Amount Total Cost Less Total Cost less (excluding interest) (including interest) Operating Profit (EBIT) Balance EBT Balance Tax Less Tax Less NOPAT Balance EAT / PAT Balance (E+R+P+D) Less E+R * KE Less total funds * WACC P*Kp Less EVA Balance EVA Balance 05-11-2024  Class Exercise (EVA) 73 A company generates before tax profit of Rs. 2 million (No interest has been deducted). By deploying a capital expenditure of 0.75 million, it incurs a cost of 10% after tax (cost of debt is 5%, cost of equity is 15% weighted equally). What is EVA generated by the company? (Assume tax rate @ 35%) 05-11-2024  Economic Value Added Solution 74 NOPAT = Rs. 2 x (1-35%) = Rs. 1.3 million Cost of capital = 10% x 0.75 = Rs. 0.075 million EVA of the investment is Rs. 1.3 m – Rs. 0.075 m = Rs. 1.225 million Cost of debt 5% Cost of equity 15% Debt / Equity ratio 50% WACC 10% EBIT 2000000 Tax rate 35% EBIT (1-T) 1300000 WACC 10% Total Capital employed 750000.0 WACC x TCE 75000.0 EVA 1225000 Value of investment 1225000 05-11-2024  Class Exercise (EVA) 75 A firm generates Rs. 1 million in profits expected to grow at 10% for the next five years and perpetually @ 9%. The cost of capital is 10%, tax rate is 35% and total capital employed is Rs. 0.5 million. The capital expenditure increases at 7.5% per annum. Determine the EVA value of the firm. 05-11-2024  Solution (EVA) 76 Year EBIT Tax EBIT(1-T) WACC Total Capital WACC EVA PV of rate NOPAT Employed x TCE EVA 0 1000 500.00 1 1100 35% 715 10% 537.5 53.75 661.25 601.14 2 1210 35% 786.5 10% 577.81 57.78 728.72 602.25 3 1331 35% 865.15 10% 621.15 62.11 803.03 603.33 4 1464 35% 951.665 10% 667.73 66.77 884.89 604.39 5 1611 35% 1046.8315 10% 717.81 71.78 975.05 605.43 TY 1756 35% 1141.4 10% 771.65 77.17 1064.23 Total 3016.54 TV 106423 66080.31 Value 69096.85 of Firm 05-11-2024  Class Exercise (EVA) 77 The capital structure of BBA(FIA) Ltd. is as under: 80,00,000 Equity shares of Rs. 10 each 1,00,000, 12% Preference shares of Rs. 250 each 1,00,000, 10% Debenture of Rs. 500 each Terms loan from bank @ 10%, Rs. 450 lakhs The company’s statement of Profit and Loss for the year showed PAT of Rs. 100 lakhs, after appropriating Equity Dividend @ 20%. The company is in the 40% tax bracket. Treasury bonds carry 6.5% interest and beta factor for the company may be taken as 1.5. The long run market rate of return may be taken as 16.5%. Calculate Economic Value Added. 05-11-2024  Solution (EVA) 78 Calculation of Profit before tax Particulars Computation Rs. In lakhs Profit before Interest and Taxes Less: Interest on Debentures 500 x 10% Interest on bank term loan 450 x 10% Profit before tax Less: Tax @ 40% Profit after Tax Less: Preference Dividend 250 x 12% Profit available for equity SH Less: Equity Dividend 800 x 20% Net balance in P & L Account 05-11-2024  Solution (EVA) 79 Calculation of Profit before tax Particulars Computation Rs. In lakhs Profit before Interest and Taxes 578.33 Less: Interest on Debentures 500 x 10% (50.00) Interest on bank term loan 450 x 10% (45.00) Profit before tax 483.33 Less: Tax @ 40% (193.33) Profit after Tax 290.00 Less: Preference Dividend 250 x 12% (30.00) Profit available for equity SH 260.00 Less: Equity Dividend 800 x 20% (160.00) Net balance in P & L Account 100.00 05-11-2024  Solution Contd. (EVA) 80 Computation of Cost of equity = Rf + β x (MR - Rf) = 6.5% + 1.5 (16.5% - 6.5%) = 21.5% Computation of Cost of debt Interest 45 L +50 L Less: Tax @40% (18 L)+ (20 L) Interest after tax 27L+ 30L 57/950*100= 6% Cost of debt = I (1-t) = 10% (1- 40%) = 6% 05-11-2024  Solution Contd. (EVA) 81 Computation of weighted average cost of capital Component Amount Ratio Individual cost WACC Rs. Lakhs Equity 800 800/ 2000 = 0.40 Ke = 21.5 8.6 Preference 250 250/2000 = 0.125 Kp= 12 1.5 Debt 950 950/ 2000 = 0.475 Kd= 6 2.85 Total 2000 12.95% 05-11-2024  Solution Contd. (EVA) 82 Particulars Rs. In Lakhs Profit before interest and taxes 578.33 Less: Interest (50+45) (95.00) Profit before tax 483.33 Less: Taxes (193.33) Profit after tax 290.00 Add: Interest (net of tax) [95 x (1- 0.40)] 57.00 Net operating profit after taxes 347.00 Less: Cost of capital (259.00) (WACC x Capital Employed) (12.95% x 2000) EVA 88.00 05-11-2024  Solution Contd. (EVA) 83 Particulars Approach 1 Rs. In Particulars Approach 2 Rs. In Particulars Approach 3 Rs. In Lakhs Lakhs Lakhs Profit before interest and 578.33 Profit before interest and 578.33 Profit before interest and 578.33 taxes taxes taxes Less: Interest (50+45) (95.00) Less: Interest (50+45) (95.00) Profit before tax 483.33 Profit before tax 483.33 Less: Taxes (231.33) Less: Taxes (193.33) Less: Taxes (193.33) Profit before interest but 347.00 Profit after tax 290.00 Profit after tax 290.00 after tax Less: Cost of (202.00) Add: Interest (net of tax) 57.00 Kp 12 = 30 [95 x (1- 0.40)] Ke 21.5 = 172.0 Net operating profit after 347.00 Net operating profit after 347.00 taxes taxes Less: Cost of capital (259.00) Less: Cost of capital (259.00) (WACC x Capital (WACC x Capital Employed) Employed) (12.95% x 2000) (12.95% x 2000) EVA 88.00 EVA 88.00 EVA 88.00 05-11-2024  Class Exercise (EVA) 84 Compute EVA of A Ltd. from the information given. Particulars Year 1 Average Capital Employed 4,000.00 Operating Profit before Interest and Tax 1600.00 Corporate Income Taxes 120.00 Average Debt (In %) 13.00 Beta Variant 1.30 Risk Free Rate (%) 12.50 Equity Risk Premium (%) 10.00 Cost of Debt (Post Tax) (%) 20.00 05-11-2024  Solution Contd. (EVA) 85 EVA Statement of Sarin Ltd. Particulars Year 1 Cost of Equity (Ke) = Risk Free Rate+ (Beta x Equity Risk Premium) 12.5 +(1.3 x 10) = 25.50% Cost of Debt (Kd) (given) 20.00% Debt – Equity Ratio (Debt = given; Equity is bal. fig) 13% & 87% WACC = [(Kd) x Debt % + (Ke) x Equity%] 24.79% (25.50 x 87% + 20 x 13%) Average Capital Employed (given) 4,000.00 Capital Charge (Fair Return to Providers of Capital i.e. Average Capital 4,000 x 24.79% = 991.60 Employed x WACC) Operating Profit before Taxes & Interest 1,600.00 Less: Taxes Paid 120.00 Operating Profit after Taxes 1,480.00 (This is the return to the Providers of Capital i.e. Debt and Equity) Capital Charge 991.60 Economic Value Added 488.40 EVA as a % of Average Capital Employed 12.21% 05-11-2024  Class Exercise (EVA) 86 From the following information, compute EVA of A Ltd. Equity Share Capital 1,000 Lakhs PE Ratio 5 times Financial Leverage 1.5 times 12% Debentures 500 Lakhs Deb Tax rate 35% PBT Rs. 120.00 Lakhs 05-11-2024  Solution Contd. (EVA) 87 Profit and Loss Statement Particulars % Rs. Lakhs Profit before Interest and Taxes 150% 180.00 Less: Interest on Debentures Rs. 500 x 12% 50% 60.00 Profit before Tax 100% 120.00 Less: Tax at 35% 35% 42.00 Profit after tax 65% 78.00 Financial Leverage = PBIT / PBT = 1.5. (Let PBT = 100%), then PBIT = 150% hence, Interest = 50%. 05-11-2024  Solution Contd. (EVA) 88 Computation of WACC Component Amount Ratio Individual Cost WACC Equity Rs. 1,000 Lakhs 2/3 Ke = 1 ÷ PE Ratio = 20% 13.33% Kd = I (1 - T) Debt Rs. 500 Lakhs 1/3 2.60% = 12% x (1 - 35)= 7.8% Total Rs. 1,500 Lakhs Ko = Ke x We + Kd x Wd 15.93% 05-11-2024  Solution Contd. (EVA) 89 Computation of EVA Particulars Rs. Lakhs Profit before Interest and Taxes 180.00 Less: Taxes 42.00 Net Operating Profit After Taxes 138.00 Less: Capital Charge 238.95 = WACC x Cap. Emp = 1,500 x 15.93% Economic Value Added Nil 05-11-2024  Class Exercise (EVA) 90 With the help of the following information of BBA(FIA) Limited compute the Economic Value Added: Capital Structure Equity capital Rs. 160 Lakhs Reserves and Surplus Rs. 140 lakhs 10% Debentures Rs. 400 lakhs Cost of equity 14% Financial Leverage 1.5 times Income Tax Rate 30% 05-11-2024  Solution Contd. (EVA) 91 Financial Leverage = PBIT/PBT 1.5 = PBIT / (PBIT – Interest) 1.5 = PBIT / (PBIT – 40) 1.5 (PBIT – 40) = PBIT 1.5 PBIT – 60 = PBIT 1.5 PBIT – PBIT = 60 0.5 PBIT = 60 or PBIT = 60 = Rs. 120 lakhs 0.5 NOPAT = PBIT – Tax = Rs. 120 lakhs (1 – 0.30) = Rs. 84 lakhs. Weighted Average Cost of Capital (WACC) =14%×(300/700)+(1–0.30)×(10%)×(400/700) =10% EVA = NOPAT – (WACC × Total Capital) EVA = Rs. 84 lakhs – (0.10 × Rs. 700 lakhs) EVA = Rs. 14 lakhs 05-11-2024  Class Exercise (EVA) 92 RST Ltd.’s current financial year's income statement reported its net income as Rs. 25,00,000. The applicable corporate income tax rate is 30%. Following is the capital structure of RST Ltd. at the end of current financial year: Rs. Debt (Coupon rate = 11%) 40 lakhs Equity (Share Capital + Reserves & Surplus) 125 lakhs Invested Capital 165 lakhs Following data is given to estimate cost of equity capital: Beta of RST Ltd. 1.36 Risk –free rate i.e. current yield on Govt. bonds 8.5% Average market risk premium 9% Required: (i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and (ii) Estimate Economic Value Added (EVA) of RST Ltd. 05-11-2024  Solution (EVA) 93 Cost of Equity ke = Rf + β x Market Risk Premium = 8.5% + 1.36 x 9% = 8.5% + 12.24% = 20.74% Cost of Debt kd = 11%(1 – 0.30) = 7.70% WACC (ko) = ke x We + kd x Wd = 20.74 x 125 + 7.70 x 40 165 165 = 15.71 + 1.87 = 17.58% 05-11-2024  Solution (EVA) 94 Taxable Income = Rs. 25,00,000 / (1 - 0.30) = Rs. 35,71,429 or Rs. 35.71 lakhs Operating Income = Taxable Income + Interest = Rs. 35,71,429 + Rs. 4,40,000 = Rs. 40,11,429 or Rs. 40.11 lacs EVA  = EBIT (1-Tax Rate) – WACC x Invested Capital = Rs. 40,11,429 (1 – 0.30) – 17.58% x Rs. 1,65,00,000  = Rs. 28,08,000 – Rs. 29,00,700 = - Rs. 92,700 05-11-2024  Class Exercise 95 BBA(FIA)A Ltd. Wants to acquire BBA(FIA)B Ltd. at a swap ratio of 0.5. BFIA_A Ltd. BFIA_B Ltd. PAT 18 Lakh 3.6 Lakh Outstanding Shares 6 Lakh 1.80 Lakh EPS Rs. 3 per share Rs. 2 per share PE 10 times 7 times MPS 30 per share 14 per share 1. Calculate the No. of equity shares to be issued by BBA(FIA)A Ltd. For acquisition of BBA(FIA)B Ltd. 2. What is the EPS of BBA(FIA)A Ltd. After acquisition? 3. Determine the equivalent EPS of BBA(FIA)B Ltd. 4. What is the expected market price per share of A Ltd. After the acquisition, assuming that its PE multiple remains unchanged? 5. Determine the market value of the merged firm. 05-11-2024  Class Exercise Solution 96 1. 90,0000 2. New EPS = Total Net Profit / Total no. of Equity shares = 18 L +3.6 L / 6 L + 90000 = 21.6 L / 6.9 L = 3.13 Rs. per share 3. 0.5 ER :1 ? : 3.13 Rs. 1.57 per share 4. New MPS = 10 x 3.13 = Rs. 31.30 5. Market value= 6,90,000 x 31.30 = Rs. 2,15,97,000 05-11-2024  Class Exercise 97 BBAFIA Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its expected high growth in earnings and dividends is reflected in its PE ratio of 17. The Board of Directors of BBAFIA Ltd. has been advised that if it were to take over firms with a lower PE ratio than its own, using a share for share exchange, then it could increase its reported earnings per share. BMS Ltd. has been suggested as a possible target for a takeover, which has a PE ratio of 10 and 1,00,000 shares in issue with a share price of Rs. 15. BBAFIA Ltd. has 5,00,000 shares in issue with a share price of Rs. 12. Calculate the change in earnings per share of BBAFIA Ltd. if it acquires the whole of BMS Ltd. by issuing shares at its market price of Rs. 12. Assume the price of BMS Ltd. shares remains constant. 05-11-2024  Class Exercise Solution 98 Total market value of BMS Ltd. PE ratio Earnings Total market value of BBAFIA Ltd. PE ratio Earnings The number of shares to be issued by BBAFIA Ltd. Total number of shares of BBAFIA Ltd. EPS of new firm Present EPS of BBAFIA Ltd. Change in EPS 05-11-2024  Class Exercise Solution 99 Total market value of BMS Ltd. 1,00,000 X Rs. 15 = 15,00,000 Rs. PE ratio 10 Earnings 15,00,000 / 10 = 1,50,000 Rs. Total market value of BBAFIA Ltd. 5,00,000 X Rs. 12 = 60,00,000 Rs. PE ratio 17 Earnings 60,00,000 / 17 = 3,52,941 Rs. The number of shares to be issued by Rs. 15,00,000 / 12 = 1,25,000 BBAFIA Ltd. Total number of shares of BBAFIA Ltd. 5,00,000 + 1,25,000 = 6,25,000 EPS of new firm (3,52,941 + 1,50,000) / 6,25,000 = Rs. 0.80 Present EPS of BBAFIA Ltd. 3,52,941 / 5,00,000 = Rs. 0.71 Change in EPS 0.80 - 0.71 = 0.09 05-11-2024  Valuation for Slump Sale under Income-tax 100 Act, 1961  As per section 2(42C) of Income-tax Act 1961, ‘slump sale’ means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.  Section 50B of the Income-tax Act, 1961 provides the mechanism for computation of capital gains arising on slump sale. Section 50B reads as ‘Special provision for computation of capital gains in case of slump sale’.  As per section 50B(1), any profits or gains arising from the slump sale effected in the previous year shall be chargeable to income-tax as capital gains arising from the transfer of long-term capital assets and shall be deemed to be the income of the previous year in which the transfer took place. The salient features of these provisions are:  The capital asset was held for more than 36 months preceding the date of transfer  The cost of acquisition will be the net worth of the undertaking or division  A certificate of Chartered Accountant certifying the net worth will be required to be obtained  For the purpose of this ‘slump sale’ the net worth is calculated as shown below: Net worth = WDV of assets – liabilities as per books (Where the entire value of the asset has been depreciated, its value will be taken as Nil) 05-11-2024  Synergy 101 Synergy is the additional value that is generated by combining two firms, creating opportunities that would not been available to these firms operating independently. 05-11-2024  Operating Synergy 102 Allow firms to increase their operating income from existing assets, increase growth or both. 1. Economies of scale 2. Economies of scope 3. Greater pricing power 4. Combination of different functional strengths 5. Higher growth in new or existing markets Operating synergies can affect margins, returns and growth, and through these the value of the firms involved in the merger or acquisition. 05-11-2024  Financial Synergy 103 With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate) or both. 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. 2. Debt capacity can increase 3. Tax benefits can arise 4. Diversification 05-11-2024  Value of Synergy 104 Value the combined firm with synergy built in. This may include i. a higher growth rate in revenues: growth synergy ii. higher margins, because of economies of scale iii. lower taxes, because of tax benefits: tax synergy iv. lower cost of debt: financing synergy v. higher debt ratio because of lower risk: debt capacity (Subtract) the value of the target firm (with control premium) + value of the bidding firm (pre-acquisition). = value of the synergy 05-11-2024  Breaking down the Acquisition Price 105 Acquisition Premium Acquisition Price of target firm Goodwill Market Price of target firm prior to acquisition Book Value of Equity Book Value of Equity of Target firm  Valuing Operating Synergy 106 in a DCF Framework Categorizing operating synergies into cost synergies and growth synergies 1. Cost synergies: 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. 05-11-2024  Steps in Valuing Operating Synergy 107  Value the firms involved in the merger independently  Value of the combined firm, with no synergy  Revalue of the combined firm with synergy  Difference between the value of the combined firm with synergy and the value of the combined firm without synergy 05-11-2024  Valuing Cost Synergy 108 Acquiring Firm Target Firm Beta 0.9 0.9 Pre-tax cost of debt 5% 5% Corporate tax rate 30% 30% Debt to capital ratio 10% 10% Revenue Rs. 1,000 Rs. 500 EBIT Rs. 50 Rs. 25 Pre-tax return on Capital 15% 15% Reinvestment Rate 70% 70% Risk free rate 4.25% 4.25% Length of Growth period 5 years 5 years Risk Premium 4% 4% 05-11-2024  Valuing Cost Synergy - Solution 109 Acquiring Target Combined Firm Firm Firm Value Cost of Equity = (Rf+ Bx Risk premium) After tax cost of debt Cost of Capital = Ke x We + Kd x Wd After tax return on capital Reinvestment Rate Expected Growth rate (high growth period) (return on capital x reinvestment rate) 05-11-2024  Valuing Cost Synergy - Solution 110 Acquiring Target Combined Firm Firm Firm Value Cost of Equity = (Rf+ Bx Risk premium) (4.25% + 0.9 x 4%) = 4.25+ 3.60 7.85% 7.85% 7.85% After tax cost of debt = Kd= 5% x 0.7 3.5% 3.5% 3.5% Cost of Capital = Ke x We + Kd x Wd [7.85x.9 + 3.5 x.1] = 7.42% 7.42% 7.42% 7.42% After tax return on capital= 15% x 0.7 10.50% 10.50% 10.50% Reinvestment Rate 70% 70% 70% Expected Growth rate (high growth period) (return on capital x reinvestment rate) 7.35% 7.35% 7.35% 05-11-2024  Valuation of Acquiring Firm 111 Year EBIT EBIT (1-t) Reinvestm Reinvestment FCFF PV of FCFF T=@30% ent Rate 0 50.0000 1 53.67500 37.57250 70% 26.30075 11.27175 10.49316 2 57.62011 40.33408 70% 28.23386 12.10022 10.48546 3 61.85519 43.29863 70% 30.30904 12.98959 10.47548 4 66.40155 46.48108 70% 32.53676 13.94432 10.47658 5 71.28206 49.89744 70% 34.92821 14.96923 10.46799 Terminal ? Year Total 52.39745 05-11-2024  Valuing Cost Synergy 112 Reinvestment rate for perpetuity Reinvestment Rate = Expected growth Rate in perpetuity/ Return on capital = 4.25% / 7.42% = 57.28% We assume that both firms will be in stable growth after year 5, growing 4.25% a year in perpetuity and earning no excess returns (i.e., return on capital = cost of capital). 05-11-2024  Valuation of Acquiring Firm 113 Year EBIT EBIT (1-t) Reinvestm Reinvestment FCFF PV of FCFF T=@30% ent Rate 0 50.0000 1 53.67500 37.57250 70% 26.30075 11.27175 10.49316 2 57.62011 40.33408 70% 28.23386 12.10022 10.48546 3 61.85519 43.29863 70% 30.30904 12.98959 10.47548 4 66.40155 46.48108 70% 32.53676 13.94432 10.47658 5 71.28206 49.89744 70% 34.92821 14.96923 10.46799 Terminal 74.31155 52.01808 57.28% 29.79596 22.22213 Year Total 52.39745 05-11-2024  Valuation of Acquiring Firm 114 Acquiring Target Combined Firm Firm Firm Value Value of the firm Terminal Value PV of FCFF Rs. 52.40 PV of Terminal Value Value of the firm 05-11-2024  Valuation of Acquiring Firm 115  Terminal Value = FCFF6 / ( Cost of capital in stable growth - growth rate in perpetuity) = 22.22213 / (7.42% - 4.25%) = 22.22213 / 3.17% = 701.0134  PV of Terminal Value = 701.0134 / 1.430295 = 490.1179  Value of Firm = PV of FCFF + PV of Terminal Value = 52.39745 + 490.1179 = 542.5154 05-11-2024  Valuation of Acquiring Firm 116 Acquiring Firm Target Firm Combined Firm Value Value of the firm Terminal Value Rs.701.53 PV of FCFF Rs. 52.400 PV of Terminal Value Rs. 490.117 Value of the firm Rs. 542.517 05-11-2024  Valuation of Target Firm 117 Year EBIT EBIT (1-t) Reinvest- Reinvest- FCFF PV of FCFF @30% ment Rate ment 0 25 1 5.2468 2 5.2436 3 5.2404 4 5.2373 5 5.2341 Terminal 245.29 Year Total 05-11-2024  Valuation of Target Firm 118 Year EBIT EBIT (1-t) Reinvest- Reinvest- FCFF PV of FCFF @30% ment Rate ment 0 25 1 26.8375 18.78625 70% 13.15038 5.635875 5.246579 2 28.81006 20.16704 70% 14.11693 6.050112 5.243160 3 30.9276 21.64932 70% 15.15452 6.494795 5.239743 4 33.20077 23.24054 70% 16.26838 6.972162 5.236329 5 35.64103 24.94872 70% 17.4641 7.484616 5.232917 Terminal 37.15577 26.00904 57.28% 14.89798 11.11106 Year Total 26.19873 05-11-2024  Valuing Cost Synergy 119 Reinvestment rate for perpetuity Reinvestment Rate = Expected growth Rate in perpetuity/ Return on capital = 4.25% / 7.42% = 57.28% We assume that both firms will be in stable growth after year 5, growing 4.25% a year in perpetuity and earning no excess returns (i.e., return on capital = cost of capital). 05-11-2024  Valuation of Target Firm 120  Terminal Value = FCFF6 / ( Cost of capital in stable growth - growth rate)  PV of Terminal Value =  Value of Firm = 05-11-2024  Valuation of Target Firm 121  Terminal Value = FCFF6 / ( Cost of capital in stable growth - growth rate) = 11.11106 / (7.42% - 4.25%) = 11.11106 / 3.17% = 350.5067  PV of Terminal Value = 350.5067 / 1.430295 = 245.059  Value of Firm = PV of FCFF + PV of Terminal Value = 26.19873 + 245.059 = 271.2577 05-11-2024  Summarizing the Valuations 122 Acquiring Firm Target Firm Combined Firm Value Value of the firm Terminal Value Rs.701.53 Rs. 350.76 PV of FCFF Rs. 52.400 Rs. 26.198 Rs. 78.598 PV of Terminal Value Rs. 490.117 Rs. 245.059 Rs. 735.176 Value of the firm Rs. 542.517 Rs.271.257 Rs.813.774 05-11-2024  Incorporating the Synergy effect 123 To value synergy, assume that the combined firm will save Rs. 15 million in pre-tax operating expenses each year, pushing up the combined firm’s pre-tax operating income by that same amount. 05-11-2024  Combined Firm Valuation with Synergy 124 Combined Firm Value of Firm Value with Synergy Cost of Equity 7.85% 7.85% After tax cost of debt 3.5% 3.5% Cost of Capital 7.42% 7.42% After tax return on capital 10.35% 10.35% Reinvestment Rate 70% 70% Pre-tax operating income = EBIT Rs. 75 Rs. 90 Expected Growth rate 7.35% 7.35% 05-11-2024  Combined Firm Valuation with Synergy 125 EBIT (1-t) Reinvest- Reinvest- Year EBIT FCFF PV of FCFF @30% ment Rate ment 0 90 1 2 3 4 5 Terminal Year Total 05-11-2024  Combined Firm Valuation with Synergy 126 EBIT (1-t) Reinvest- Reinvest- Year EBIT FCFF PV of FCFF @30% ment Rate ment 0 90 1 96.615 67.6305 70% 47.34135 20.28915 18.88768 2 103.7162 72.60134 70% 50.82094 21.7804 18.87538 3 111.3393 77.93754 70% 54.55628 23.38126 18.86308 4 119.5228 83.66595 70% 58.56616 25.09978 18.85078 5 128.3077 89.8154 70% 62.87078 26.94462 18.8385 Terminal 133.7608 93.63255 57.28% 53.63273 39.99983 Year Total 94.31542 05-11-2024  Valuation of Combined Firm with Synergy 127  Terminal Value = FCFF6 / ( Cost of capital in stable growth - growth rate in perpetuity) = 39.99983 / (7.42% - 4.25%) = 39.99983 / 3.17% = 1261.824 Rs.  PV of Terminal Value = 1261.824 / 1.430295 = 882.212 Rs.  Value of Firm = PV of FCFF + PV of Terminal Value = 94.31542 + 882.212 = 976.527 Rs. 05-11-2024  Value of Synergy 128 Combined Firm Combined Firm Value of Value Value with Synergy Synergy Value of the firm Terminal Value Rs.1052.29 Rs. 1261.824 PV of FCFF Rs. 78.598 Rs. 94.315 PV of Terminal Value Rs. 735.176 Rs. 882.212 Value of the firm Rs.813.774 Rs. 976.527 Rs. 162.753 05-11-2024  Valuing Growth Synergy 129 Categorizing operating synergies into cost synergies and growth synergies There are at least three different types of growth synergies:  The combined firm may be able to earn higher returns on its investments, thus increasing the growth rate.  The combined firm may be able to find more investments. The resulting higher reinvestment rates will increase the growth rate.  The combined firm may be in a much more powerful competitive position, 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. 05-11-2024  Valuing Synergy from Higher Growth: 130 Better Projects (Higher ROC) Combined Combined Firm Value of Firm Value Value with Synergy Synergy Cost of Equity 7.85% 7.85% After tax cost of debt 3.50% 3.50% Cost of Capital 7.42% 7.42% After tax return on capital 10.50% 12.60% Reinvestment Rate 70% 70% Pre-tax operating income =EBIT Rs. 75 Rs. 75 Expected Growth rate 7.35% 8.82% Length of growth period 5 years 5 years Value of the firm: PV of FCFF Rs. 78.61 Rs. 81.89 Terminal Value Rs.1052.29 Rs. 1126.34 Value of the firm Rs.814.49 Rs. 869.56 Rs. 55.07 05-11-2024  Valuing Synergy from Higher Growth: 131 More Projects (Higher Reinvestment Rate) Combined Combined Firm Value of Firm Value Value with Synergy Synergy Cost of Equity 7.85% 7.85% After tax cost of debt 3.50% 3.50% Cost of Capital 7.42% 7.42% After tax return on capital 10.50% 10.50% Reinvestment Rate 70% 90% Pre-tax operating income = EBIT Rs. 75 Rs. 75 Expected Growth rate 7.35% 9.45% Length of growth period 5 years 5 years Value of the firm: PV of FCFF Rs. 78.61 Rs. 27.78 Terminal Value Rs.1052.59 Rs. 1159.32 Value of the firm Rs.814.49 Rs. 838.51 Rs. 24.02 05-11-2024  Valuing Synergy from Higher Growth: 132 Longer growth period Combined Combined Firm Value of Firm Value Value with Synergy Synergy Cost of Equity 7.85% 7.85% After tax cost of debt 3.5% 3.5% Cost of Capital 7.42% 7.42% After tax return on capital 10.50% 10.50% Reinvestment Rate 70% 70% Pre-tax operating income = EBIT Rs. 75 Rs. 75 Expected Growth rate 7.35% 7.35% Length of growth period 5 years 10 years Value of the firm: PV of FCFF Rs. 78.61 Rs. 125.66 Terminal Value Rs.1052.29 Rs. 1301.79 Value of the firm Rs.814.49 Rs. 860.21 Rs. 45.72 05-11-2024  Valuing Synergy - Question 133 Acquiring Firm Target Firm Beta 0.8 0.9 Pre-tax cost of debt 5% 5% Corporate tax rate 35% 35% Debt to capital ratio 10% 10% Revenue Rs. 56,741 Rs. 10477 EBIT Rs. 10,927 Rs. 2645 Capital Invested Rs. 38,119 - Pre-tax return on Capital - 25% Reinvestment Rate 40% 50% Risk free rate 4.25% 4.25% Length of Growth period 5 years 5 years Risk Premium 4% 4% 05-11-2024  Valuing Cost Synergy - Solution 134 Acquiring Firm Target Firm Beta 0.8 0.9 Pre-tax cost of debt 5% 5% Corporate tax rate 35% 35% Debt to capital ratio 10% 10% Revenue Rs. 56,741 Rs. 10477 EBIT Rs. 10,927 Rs. 2645 Capital Invested Rs. 38,119 Rs. 10,580 Pre-tax return on Capital 28.67% 25% Reinvestment Rate 40% 50% Risk free rate 4.25% 4.25% Length of Growth period 5 years 5 years Risk Premium 4% 4% 05-11-2024  Valuing Synergy 135 Acquiring Firm Target Firm Combined Firm Beta 0.8 0.9 ? Pre-tax cost of debt 5% 5% 5% Corporate tax rate 35% 35% 35% Debt to capital ratio 10% 10% 10% Revenue Rs. 56,741 Rs. 10,477 Rs. 67,218 EBIT Rs. 10,927 Rs. 2645 Rs. 13,572 Capital Invested Rs. 38,119 Rs. 10,580 Rs. 48,699 Pre-tax return on Capital 28.67% 25% ? Reinvestment Rate 40% 50% ? Risk free rate 4.25% 4.25% 4.25% Length of Growth period 5 years 5 years 5 years Risk Premium 4% 4% 4% 05-11-2024  Valuing Cost Synergy - Solution 136 Acquiring Target Combined Firm Firm Firm Value Cost of Equity = (Rf+ Bx Risk premium) After tax cost of debt Cost of Capital = Ke x We + Kd x Wd After tax return on capital Reinvestment Rate Expected Growth rate (high growth period) (return on capital x reinvestment rate) 05-11-2024  Valuing Cost Synergy - Solution 137 Acquiring Target Combined Firm Firm Firm Value Cost of Equity = (Rf+ Bx Risk premium) 7.45% 7.85% After tax cost of debt = Kd= 0.65x5% 3.25% 3.25% Cost of Capital = Ke x We + Kd x Wd 7.03% 7.39% After tax return on capital 18.63% 16.25% Reinvestment Rate 40% 50% Expected Growth rate (return on capital x reinvestment rate) 7.45% 8.125% 05-11-2024  Valuation of Acquiring Firm 138 Year EBIT EBIT (1-t) Reinvest- Reinvest- FCFF PV of FCFF T=@35% ment Rate ment 0 10927 1 11741.0615 7631.69 40% 3053 4579.014 4278.253 2 12615.77058 8200.251 40% 3280 4920.151 4295.041 3 13555.64549 8811.17 40% 3525 5286.702 4311.896 4 14565.54108 9467.602 40% 3787 5680.561 4328.816 5 15650.67389 10172.94 40% 4070 6103.763 4345.803 Terminal 16315.82753 10605.29 60.46% 6412 4193.331 Year Total 21559.81 05-11-2024  Reinvestment rate for perpetuity 139 Acquiring Firm Reinvestment Rate = Expected growth Rate in perpetuity/ Return on capital = 4.25% / 7.03% = 60.46% We assume that both firms will be in stable growth after year 5, growing 4.25% a year in perpetuity and earning no excess returns (i.e., return on capital = cost of capital). 05-11-2024  Valuation of Acquiring Firm 140  Terminal Value = FCFF6 / ( Cost of capital in stable growth - growth rate) = 4193.331 / (7.03% - 4.25%) = 4193.331 / 2.78% = 150,839.2 Rs.  PV of Terminal Value = 150,839.2 / 1.404519 = 107395.7 Rs.  Value of Firm = PV of FCFF + PV of Terminal Value = 21559.81 + 107395.7 = 128,955.5 Rs. 05-11-2024  Valuation of Target Firm 141 Year EBIT EBIT (1-t) Reinvestm Reinvestment FCFF PV of FCFF T=@35% ent Rate 0 2645 1 2859.91 1859 50% 929 929.47 865.51 2 3092.27 2010 50% 1005 1004.99 871.43 3 3343.52 2173 50% 1087 1086.64 877.40 4 3615.18 2350 50% 1175 1174.93 883.40 5 3908.92 2541 50% 1270 1270.40 889.45 Terminal 4075.04 2649 57.51% 1523 1125.47 Year Total 4387.186 05-11-2024  Reinvestment rate for perpetuity 142 Target Firm Reinvestment Rate = Expected growth Rate in perpetuity/ Return on capital = 4.25% / 7.39% = 57.51% We assume that both firms will be in stable growth after year 5, growing 4.25% a year in perpetuity and earning