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Valuation Techniques
Valuation Techniques
- Harsh - F - 3 - R. No. 19
TABLE OF COTENTS
INTRODUCTION INCOME APPROACH DISCOUNTED CASH FLOW TECHNIQUE FREE CASH FLOW FROM EQUITY TECHNIQUE MARKET APPROACH ASSET APPROACH NET ASSET VALUE TECHNIQUE ECONOMIC VALUE ADDED TECHNIQUE MARKET VALUE ADDED TECHNIQUE CONCLUSION 3 6 7 9 10 11 12 14 15 17
A merger is said to occur when two or more business combine into one. This can happen through absorption of an existing company by another. In a consolidation, which is a form of merger, a new company is formed to takeover existing business of two or more companies. In India, mergers are called amalgamations in legal parlance. The acquisition refers to the acquisition of controlling interest in an existing company. A takeover is same as acquisition, except that a takeover has a flavor of hostility in majority of cases. For this reason, the company taken over is usually called the target company and the acquirer is called the predator. The mergers are different from acquisitions in the sense that acquisitions generally do not involve liquidation of the target company. Why Mergers and Acquisitions take place? The common objective of both the parties in a M&A transaction is to seek synergy in operating economies by combining their resources and efforts. Now we shall see the reasons for M&A from the perspective of both, the buyer company as well as the seller company.
Obtaining tax concessions Eliminating competition Achieving diversification with minimum cost Improving corporate image and business value Gaining access to management or technical talent Objective for Companies to offer themselves for sale? Declining earnings and profitability To raise funds for more promising lines of business Desire to maximize growth Give itself the benefit of image of larger company Lack of adequate management or technical skills M&A under the Companies Act, 1956 The procedure for putting through a M&A transaction under the Companies Act, 1956 is very tedious and a lot of time is consumed in completion of the process. Sections 391 to 396 deal with the procedure, powers of the court and allied matters. The basic difference between a merger and an acquisition is that the transferor company will be dissolved in case of a merger, whereas in case of acquisition the transferor company continues to exist. M&A under the Income Tax Act, 1961 Tax implications can be understood from the following three perspectives: a) Tax concessions to the Amalgamated (Buyer) Company b) Tax concessions to the Amalgamating (Seller) Company c) Tax concessions to the shareholders of an Amalgamating Company
The principal incentive for a merger is that the business value of the combined business is expected to be greater than the sum of the independent business values of the merging entities. The difference between the combined value and the sum of the values of individual companies is the synergy gain attributable to the M&A transaction. Hence, Value of acquirer + Stand alone value of Target + Value of Synergy = Combined Value. There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid over the market value plus other costs of integration. Therefore, the net gain is the value of synergy minus premium paid. Suppose VA = Rs. 200 (Merging Company, or Acquirer) VB = Rs. 50 (Merging Company, or Target) VAB = Rs. 300 (Merged or Amalgamated Entity) Therefore, Synergy = VAB ( VA + VB ) = Rs. 50. If the premium paid for this merger is Rs. 20, Net gain from merger of A and B will be Rs. 30 (i.e. Rs. 50 Rs. 20). It is this 30, because of which companies merge or acquire. One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range of models in practice for measuring the value of the Target firm. These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification: it is easier to understand where individual models fit into the bigger picture, why they provide different results and where they have fundamental errors in logic. There are only three approaches to value a business or business interest. However, there are numerous techniques within each one of the approaches that the analysts may
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Income Approach
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation. Under this approach two primary used methods to value a business interest include: a) Discounted Cash flow method b) Capitalized Cash flow method Each of these methods depends on the present value of an enterprises future cash flows.
WACC = Wd*kd*(1-T) + We*ke , where: k d is the interest rate on new debt. ke is the cost of equity capital (see below). Wd, We are target percentages of debt and equity (using market values of debt and equity.) T is the marginal tax rate. Step III: Cash flows computed in Step I are discounted at the rate arrived at in Step II. Step IV: Estimate the Terminal Value of the business, which is the present value of cash flows occurring after the forecast period. TV = CFt (1+ g) , k-g where, CFt is the cash flow in last year, g is constant growth rate and k is the discount rate Step V: Add the present value of free cash flows as arrived at in Step III and the Terminal Value as arrived at in Step IV. This will give the value of firm. Step VI: Subtract the value of debt and other obligations assumed by the acquirer to arrive at the value of equity. So, in all Terminal Value is,
Market Approach
The origin of market approach of business valuation is established in the economic rationale of competition. It states that in case of a free market, the demand and supply effects direct the value of business properties to a particular balance. The purchasers are not ready to pay higher amounts for the business and the vendors are not ready to receive any amount, which is lower in comparison to the value of a corresponding commercial entity. It the value of a firm by performing a comparison between the firms concerned with organizations in the similar location, of equal volume or operating in the similar sector. It has a large number of resemblances with the comparable sales technique, which is generally utilized in case of real estate estimation. The market value of shares of companies that are traded publicly and are involved in identical commercial activities may be a logical signal of the value of commercial operation. In this case the company shares are bought and sold in an open and free market. This process allows purposeful comparison of the market value of shares. The problem exists in distinguishing public companies, which are adequately corresponding to the company concerned for this intention. In addition, in case of a private company, the liquidity of the equity is lower (put differently, its shares are difficult to trade) in comparison to a public company. The value is regarded as somewhat lesser in comparison to that a market-based valuation will render. E.g. - Suppose a company operating in the same industry as ABC with comparable size and other situations has been sold at Rs. 500 crores in last week provides a good measurement for valuation of business. Considering the circumstances,
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value of the business of ABC should be around Rs. 500 crores under market approach.
Assets Approach
The first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuation date. Each recorded asset including intangible assets must be identified, examined and adjusted to fair market value. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived as above to reach at the fair market value of equity of the business. It is important to note here that any unrecorded assets or liabilities should also be considered while arriving at the value of business by the assets approach.
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200 crores
divided
by 10
crores
NAV can also be calculated by adding all the assets, and then subtracting all the outside liabilities from them. This will again boil down to net worth only. One can use any of the two methods to find out NAV. One can compare the NAV with the going market price while taking investment decisions.
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The higher the MVA the better it is. A high MVA indicates the company has created substantial wealth for the shareholders. A negative MVA means that the value of management's actions and investments are less than the value of the capital contributed to the company by the
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capital market (or that wealth and value have been destroyed). MVA is the present value of a series of EVA values. MVA is economically equivalent to the traditional NPV measure of worth for evaluating an after-tax cash flow profile of a project if the cost of capital is used for discounting. None of the above methods is the best or none of them is the worst but each one has its own advantages and viewpoints different from others. All these methods should be used in combinations to arrive at proper valuation of the business.
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CONCLUSION
These aspects, which we talked about in this article, will justify the exchange process in a Merger & Acquisition transaction if they are duly considered and their impact is properly arrived at. Hence their review becomes a prime and critical stage before proceeding with the big deal. These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses that are similarly situated. I would also say that no method is Perfect. Every situation demands different approaches to be applied, and quite often more than one approach would be used.
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