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BFF3351 Investment Banking

Lecture Week 5

Mergers & Acquisitions (part 2)

Today’s Lecture Outline

 Valuation techniques for a corporation:

– DCF
– Comparable ratios/relative valuation – covered in week 2

 Steps in a corporate valuation

 Level of acquisition premiums
 Understanding tax loss recoupment rules.

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References

 From digitised Library Reading List.

 “Takeovers, restructuring & corporate governance” , Weston et al;
 “Investment banking”, Rosenbaum & Pearl- pp125-129; 135-137;
141; 148-150; 151-153.

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A key principle

 Valuation is an art, not a science.

 Meaning – judgement required.

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Approaches to valuation- ASIC Regulatory Guide 111

 An expert should:
– if possible use more than one valuation methodology and
compare the values derived from using different methodologies to
minimise the risk that the opinion is unreliable; and
– justify its choice of methodologies and describe the methods
used: see RG 111.64 – RG 111.73.
 An expert’s opinion should be based on reasonable assumptions and
all material assumptions should be disclosed: see RG 111.74 – RG
111.77.
 An expert should usually give a range of values and that range
should be as narrow as possible: see RG 111.78 – RG 111.79.
 An expert might need to value individual assets in certain
circumstances: see RG 111.80 – RG 111.83

http://www.asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-111-cont
ent-of-expert-reports/

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ASIC Regulatory Guide 111 – RG111.69

It is generally appropriate for an expert to consider using the following

methodologies:
a) the discounted cash flow method (see also RG 111.95–RG 111.101)
and the estimated realisable value of any surplus assets;
b) the application of earnings multiples (appropriate to the business or
industry in which the entity operates) to the estimated future
maintainable earnings or cash flows of the entity, added to the
estimated realisable value of any surplus assets;
c) the amount that would be available for distribution to security
holders on an orderly realisation of assets;
d) the quoted price for listed securities, when there is a liquid and
active market and allowing for the fact that the quoted price may not
reflect their value, should 100% of the securities be available for
sale; and

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ASIC Regulatory Guide 111 – RG111.70

e) any recent genuine offers received by the target for the entire
business, or any business units or assets as a basis for valuation of
those business units or assets.
f) The amount an alternative bidder might be willing to offer if all the
securities in the target were available for purchase may provide a
useful framework for the application of methodologies (e.g. in
selecting earnings multiples) and in underpinning any overall
judgment as to value.
Note: Some valuation methodologies include a premium for control
while others do not. An expert needs to ensure that the choice of
methodology or methodologies is appropriate for the circumstances of
the transaction.

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 The financial analysis should ultimately address the following questions

 What is the maximum price which should be paid for the target
company?
 What are the principal areas of risk?
 What are the earnings, cash flow and balance sheet implications of
the acquisition?
 What is the best way to finance the acquisition?

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Earnings versus cash flow

 Accounting:
– P/E;
– Price-To-Book Ratio;
– Comparable earnings.
 Cash flow:
– DCF techniques including:
 Dividend discount model
 Free cash flow to firm/equity
 Relative valuation: Earnings, EBITDA and cash flow multiples
– Covered in previous topics

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 MONASH
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Steps in valuation
Steps in Valuation

1. Stand alone intrinsic valuation

2. Valuation of synergies
3. Determine maximum value to acquirer
4. Set offer price
5. Determine form of offer
6. Sensitivity analysis
7. Re-run steps 4 and 5 again if necessary

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Stand alone intrinsic valuation

Stand alone intrinsic valuation

 Value of company and shares pre acquisition

 Typically referred to as intrinsic valuation
 Three main sources:
– Current market cap and market price, observable if listed
– Relative valuation
– Discounted cash flows
 Prices will usually vary.
– Need to understand why and make a judgement about intrinsic
value.

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Traditional valuation models

 The earnings are estimated after taking into account any

proposed changes by the acquirer.
 Residual income models:
– Simple Gordon growth model
Pt= Dt+1/ (Ke-g)
– Where:
Ke = cost of equity capital
g = expected constant dividend growth rate.
 Note that this model assumes income, dividends and
share price all increase by g in perpetuity

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 Discounted cash flow model

 Discounted cash flow is used in the majority of valuations. To

establish the maximum acceptable acquisition price estimates
are needed for:
– The incremental cash flows expected to be generated
because of the acquisition, and
– The discount rate applicable to the acquisition.
 Remember the value of a firm is the PV of the cash flows, taking
into account their size, timing and risk.

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Free Cash Flow

 Study the Target, determine Key Performance Indicators (KPIs) and use in
projecting Free Cash Flow
Determine the key drivers of financial performance – sales growth,
profitability, and FCF generation. These are then used to calculate Free Cash
Flow to Firm (FCFF) The same as Operating Cash Flow in
 Free cash flow to firm (FCFF): capital budgeting
= EBIT(1-tc) + Depreciation - Capital expenditures - changes in WC
– effectively an ungeared case before capital servicing
– hence, this explains the use of WACC as the discount rate; it
reflects the needs of both equity and debt providers.
 So, we need to distinguish between cash flow and accounting concepts:
– Provisions (accounting charges only), versus
– Cash outlays (excluding non-cash items such as depreciation).
 Note subsequent debt and interest deduction to determine equity value
(FCFE); usually use FCFF.

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Free Cash Flow (2)

 The target’s FCF is typically projected for a period of five years,

but will depend on the target’s sector, stage of development. 5
years is regarded as spanning one business cycle. It is necessary
that a firm reach a steady state.
 But, note general exception for specified resource companies.

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An alternative approach

 Free cash flow to equity:

– FCFE = net income + depreciation – capital expenditure - change
in WC - principal repayments + new debt issues.
– Takes into account the cash flows attributable to debtholders
– Hence, ke is used as the discounting factor.

 The two approaches should provide the same value for equity if:
– Constant assumptions are made about growth.
– Debt/equity ratio is constant
– Bonds are correctly priced. This is due to the deduction from
FCFF calculation.

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 DCF – a summary
Firm valuation approach EBIT Equity valuation approach

Subtract Taxes EBIT(1-Tc) Subtract Interest expense I

Unlevered net income NOPAT Net income before tax

Plus depreciation, less capex, Subtract tax (EBIT – I) (1-Tc)

less Δ working capital
Net income NI
Free Cash Flow to Firm FCFF
Plus depreciation, less capex, less
Discount forecast FCFF at Δ working capital, less Δdebt
WACC to give enterprise value
Free Cash Flow to Equity FCFE
Deduct market value of debt
Discount forecast FCFE at cost of
equity ke

Value of equity
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Cost of equity (CAPM)

 Cost of equity (ke) = Risk Free Rate + Leveraged Beta * Market Risk
Premium.
 Risk free rate : return from investing in “riskless securities” – namely
Government securities.
 Market risk premium: is the spread of the expected market return
over the risk free rate. A return of around 7% is often used.
 Beta (ß ): is a measure of the covariance between the rate of return
on a company’s stock and the overall market return (systematic risk).
As the stock market index has a beta of 1.0, a stock with a beta of
1.0 should have an expected return equal to that of the market- < 1.0
a lower systematic risk than the market and > 1.0 a higher
systematic risk.
You should be familiar with CAPM from previous study.

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Corporate betas (source: Morningstar and Yahoo Finance; 5-year monthly)

Australian Foundation Investment

0.57 (previously 1.05)
Company Limited
Air New Zealand Limited 1.34 (previously 1.76)
ANZ Banking Group Ltd 0.92 (previously 0.86)
Telstra Corporation Limited 0.49 (unchanged)
Santos Limited 2.35 (previously 1.20)
Westpac Banking Corporation 0.85 (previously 0.76)
Wesfarmers Limited 0.53 (previously 0.68)
Qantas Airways Limited 1.01 (previously 1.24)
Pacific Brands Limited 1.86 (acquired by Hanesbrands – 1.41)
CSL Limited 0.32 (trades at P/E ratio of 71)

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Debt calculations

 Cost of debt (kd): reflects a company’s credit

profile at the target capital structure.
 Allow for tax deduction of debt kdTc.

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 WACC

 WACC is predicated on choosing a target capital structure for the

company that is consistent with the company’s long term strategy.
 Calculation of WACC:
– rd*(1-tc) * Wd + re * We
– Where Wd and We are proportions of debt and equity respectively
– Assuming classical tax system

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 Terminal/residual value

 Two questions need to be considered:

1. What is the basis for setting the length of the forecast period?
2. How is the residual value of the acquisition established at the end of the
forecast period?
 Residual/Terminal value
– The life of a business acquisition is theoretically infinite. The importance
of calculating terminal value is that it represents a significant portion of
overall firm valuation. So, the basis of calculation is important.
 Concept of residual:
– based on perpetuity concept:
 No growth,
– so, no new investment in working capital or capital expenditure.
 Constant Growth,
– new investment in working capital and capital expenditure.

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Terminal/residual value( 2)

 Constant growth formula (at time n):

– TVn = CFn * (1+g)/(WACC – g)
– Remember the formula PVn = CFn+1/(r – g)
The same as dividend discount model:
 No Growth formula: P0 = D1/(r-g)
– TVn = CFn +1/WACC

 Note: this is for FCFF; use discount rate ke if using FCFE

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 FCFF example

$m 2015 2016 2017 2018

Forecast
2019 2020
Assumptions
Operating revenue 160.10 163.30 166.57 169.90 173.30 176.76 Growth 2% p.a.
Operating expenses 126.60
EBITDA 33.50 34.29 34.98 35.68 36.39 37.12 Sales margin 21%
Less: Depn/amort 2.30 2.38 2.46 2.55 2.64 2.73 Growth 3.5% p.a.
EBIT 31.20 31.91 32.52 33.13 33.75 34.39 EBITDA - Depn
Net interest
1.00 1.05 1.10 1.16 1.22 1.28
Growth 5% p.a.
expense
Pre-tax profit 30.20 30.86 31.41 31.97 32.54 33.11 EBIT - Interest
Tax expense 9.34 9.26 9.42 9.59 9.76 9.93 Tax @ 30%
NPAT 20.86 21.60 21.99 22.38 22.78 23.18 Pre-tax profit (1-t)
NOPAT 21.84 22.34 22.76 23.19 23.63 24.07 EBIT(1-t)

2015 is current year, so results are from annual report

Other years are forecasts based on stated assumptions
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 FCFF example (2)

2015 2016 2017 2018 2019 2020TV Assumptions

NOPAT 21.84 22.34 22.76 23.19 23.63 24.07 From previous slide
Depn/amort 2.30 2.38 2.46 2.55 2.64 2.73 From previous slide
Capex 5.72 5.83 5.95 6.07 6.19 5% of sales
Δ working
0.16 0.16 0.17 0.17 0.17 WC = 5% sales
capital
Free cash NOPAT +depn –capex -
24.14 18.84 19.23 19.63 20.03 20.44 286.47
flow ΔWC
PV 17.41 16.42 15.49 14.61 13.78 193.10WACC = 8.21%

TV = CF2020(1+g)/(r-g). Terminal g = 1%.

EV = $270.72
D = $23
E = $247.82
Shares on issue 232.8 so price per share = $1.06

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Valuation

 In this case, market price is $1.07

 P/E ratio is 12
 EPS = NPAT/(no. of shares) = $1.08
 Therefore, intrinsic value is around $1.06 per share
 It may not be as easy in your assignment.

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Valuation of synergies
Adjustments for synergies

 Benefits include:
– Synergies such as sales gains from accessing new markets;
– Margin improvements from better negotiating power with
suppliers.

 Costs include:
– One time cash out flows from items such as incremental capital
payments, severance payments, lease cancellation costs and
other internal restructuring costs;

 Further:
– Synergies are achieved progressively over time;
– Market and employment certainty may also result in losses.

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Example

($millions) 2016 2017 2018 2019 2020 TV

Cost savings (B) 6.50 6.57 6.63 6.70 6.76 94.78 $6m, grow at 1%
Post-tax cash Tax @30%
flows 4.55 4.60 4.64 4.69 4.73 66.35
PV 4.20 3.92 3.66 3.42 3.19 44.72 WACC = 8.21%

PV of synergies = 63.125
Synergy per share = 0.27

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Set offer price

Forms of valuation

A. Stand-alone valuation
– Calculated without benefits of synergies.
– The choice of the terminal value growth rate depends on the
characteristics of the target.
– The benefits of this value are:
 It provides a floor price for the negotiations;
 A stand-alone DCF calculation can be compared with the target’s
current market price.
 If the relationship is reasonable, the target’s market value can be
used confidently in ratio model calculations.

B. Valuation with synergies

– The stand-alone model is then adjusted for the incremental costs
and benefits associated with the acquisition.

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Set offer price

 The valuation with synergies is the value as an acquisition and

hence the maximum price the company is worth
– At this price, NPV = 0
– It includes the takeover premium
 The current market price is the minimum the company is worth
– However, existing shareholders will not sell at this price
– They want a portion of the takeover premium
 Offer price is usually a premium of around 15 - 20% of current
market price
– Entice current shareholders
 But remember, NPV > 0

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Example

In our example:
 Market price is $1.07
 Valuation with synergies is $1.34
 Offer, say, $1.20

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Form of offer
Derive amount and structure of offer

 In simple terms – cash or shares or a combination. However, in

some circumstances a share offer is not practical.
 Decision will be influenced by:
– Your D/E ratio;
– How it compares with peer group of companies.
 Cash:
– Either use excess cash or borrow
– May impact leverage and risk
– Cost of borrowing
 Shares:
– Dilute existing shareholders

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 Example

Shares 2015 2016 2017 2018 2019 2020

Acq. EBIT 168.2 176.7 185.5 194.8 204.5 214.7 5% growth
Target EBIT (base) 31.2 31.9 32.5 33.1 33.8 34.4 From FCFF
Target EBIT From synergies
(synergies) 4.2 3.9 3.7 3.4 3.2
Total EBIT 212.8 221.9 231.6 241.7 252.3
Interest 46.02 46.02 46.02 46.02 46.02 Current interest
EBT 166.75 175.90 185.53 195.65 206.28
Tax 50.02 52.77 55.66 58.69 61.88 Tax @ 30%
EAT 116.72 123.13 129.87 136.95 144.40
EPS 0.26 0.27 0.29 0.30 0.32 365.1 shares

Per share increase 0.01 0.01 0.00 -0.00 -0.00

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Sensitivity analysis
Sensitivity analyses

 This step is based on the realisation that we are using FORECAST

assumptions in our projections – some of which will be correct BUT
others will be incorrect in term of either timing or magnitude or both.
 These studies are made to give us confidence in the robustness of
the projections, and are essential for a responsible review by a
Board.
 Are they always performed?
– For successful acquisitions – yes.
– For unsuccessful projects – probably not – hubris!

 Like “kicking tyres” of your first car (say $3,500) prior to purchase –
where are the potential defects?”

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Sensitivity analyses(2)

 Decision:
– What are key factors which influence viability of acquisition?
 Probably growth in sales revenue and operating costs.
– What are the worst case scenarios in a normal economic
environment?
 Say 5% for revenue and 3% for operating costs.
 Then run evaluation again, firstly for a revenue decline AND THEN
for an operating cost increase.
 Simply change one set of figures on each occasion and the Excel
model will calculate revised NPV.
 Use revised NPV to calculate revised projected share values.
 If these amounts are above your proposed offer price – relax! If they
are below – a managerial decision is needed.

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Income Assessment Act provisions – past tax losses of acquired companies

 A company cannot deduct a tax loss unless:

a) it has the same owners and the same control
throughout the period from the start of the loss year to
the end of the income year (this test will generally not
be satisfied after a successful takeover); or
b) it satisfies the same business test by carrying on the
same business, entering into no new kinds of
transactions and conducting no new kinds of business
(this test is interpreted strictly).

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The following aspects should be understood

 Valuation techniques:
– DCF approach – FCFF and FCFE
– Ratios:
 Price/earnings;
 Price/Book;
 Comparable ratios.
 Steps in a corporate valuation:
– Projected profit;
– Projected cash flow;
– Sensitivity analysis;
– Income/decretive nature of recommended offer price/structure.

 Realisation of acquired past tax losses.

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