Corporate Finance

AF4801

LECTURE 12

1/8/2023 Syed Muhammad Ali Raza

 Merger & Acquisitions
Advantages and Disadvantages of Discounted Cash Flow Method:

Advantages
• Discounted cash flow analysis can provide investors and companies with an idea of whether a proposed investment is
worthwhile.
• It is analysis that can be applied to a variety of investments and capital projects where future cash flows can be
reasonably estimated.
• Its projections can be tweaked to provide different results for various what if scenarios. This can help users account for
different projections that might be possible.

Disadvantages
• The major limitation of discounted cash flow analysis is that it involves estimates, not actual figures. So the result of
DCF is also an estimate. That means that for DCF to be useful, individual investors and companies must estimate a
discount rate and cash flows correctly.
• Furthermore, future cash flows rely on a variety of factors, such as market demand, the status of the economy,
technology, competition, and unforeseen threats or opportunities. These can't be quantified exactly. Investors must
understand this inherent drawback for their decision-making.
• DCF shouldn't necessarily be relied on exclusively even if solid estimates can be made. Companies and investors
should consider other, known factors as well when sizing up an investment opportunity. In addition, comparable
company analysis and precedent transactions are two other, common valuation methods that might be used.

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 Merger & Acquisitions
Comparable Company Analysis:

Advantages:
• Information is publicly available.
• It gives a better understanding of the market with respect to the frequency of transactions regarding different kinds of
assets.
• It helps in the negotiation and discussion of the deal.
• It provides an understanding of the strategy of different players. Some may seek consolidation, while others may look for
small companies and be acquisitive.
• The range shows the kind of premiums already being paid, and hence is more realistic.

Disadvantages:
• Every deal is unique, with its own pluses and minuses. No two deals can be compared in an absolute manner.
• Choosing one transaction over another can lead to sample bias, and hence can give an inaccurate picture.
• Information available may not be reliable and can be misleading.
• There may be different synergy benefits to different buyers, so identifying the multiples of Company A may not be
relevant for Company C.
• Market conditions such as economic growth, availability of resources, etc. at the time of precedent transactions may be
very different from the current transaction and may provide limited insights.
• Not all issues can be covered in transaction multiples, including customer contracts, vendor relationships, governance
issues, etc., and may not give a true and fair picture.
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 Merger & Acquisitions
Comparable Transaction Analysis:

Advantages:

• The takeover premium does not need to be computed separately since it can directly be derived from comparable
transactions.
• Takeover value estimates are derived from values recently established in the market.
• Litigation risk is reduced by using prices established through other recent transactions.

Disadvantages:

• There is a risk that past transaction values are inaccurate.

• There may be few comparable transactions to use in calculating the takeover value.
• The analysis may not be accurate because it is difficult for an analyst to incorporate any specific plans for the target
in the analysis.

1/8/2023 Syed Muhammad Ali Raza

 Merger & Acquisitions
Post Merger Value of Acquirer:

In any merger that makes economic sense, the combined firm will worth more than the sum of two firms. This
difference is the gain, which is the function of synergies created by the merger and any cash paid to shareholders as
part of the transaction.

In equation form we can donate the post – merger value of the combined company as:

V(AT) = V(A) + V(T) + S –C

Where,
• V(AT) = post-merger value of the combined company (acquirer + target)
• V(A) = Pre – merger value of acquirer
• V(T) = Pre – merger value of target
• S = synergies created by the merger
• C = cash paid to target shareholders

Pre – merger value of the target should be the price of the target merger stock before any market speculation causes
the target’s stock price to jump

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 Merger & Acquisitions
Gains Accrued on Target:

In most merger transactions, acquirer must pay a take over premium to entice the target’s shareholders to approve
the merger. The target’s company management will try to negotiate the highest possible premium relative to the
value target company. From the targets perspective the take over premium is the amount of compensation received
in excess of the pre-merger value of the target’s shares, or:

Gain = TP = P(T) – V(T)

Where,
Gain = gains accrued to target shareholders
TP = takeover premium
P(T) = price paid for target
V(T) = pre-merger value of target

1/8/2023 Syed Muhammad Ali Raza

 Merger & Acquisitions
Gains Accrued to the Acquirer:

Acquirer’s are willing to pay a takeover premium because they expect to generate their own gains from any synergies
created by the transaction. The acquirer gain is therefore equal to the synergies received less premium paid to the
target’s shareholders, or:

Gain = S - TP = S - (P(T) – V(T))

Where,
Gain = gains accrued to acquirer
TP = takeover premium
P(T) = price paid for target
V(T) = pre-merger value of target
S = synergies

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 Merger & Acquisitions
Cash Payment V/s Stock Payment

In addition to the price paid, the ultimate gain to the acquirer or the target is also affected by the choice of payment
method. Mergers can be either financed through cash or through an exchange of shares of the combined firm. The
chosen payment method typically reflects how confident both parties are about estimated value of the synergies
resulting from merger. This is because different methods of payment will give the acquirer and target different risk
exposures with respect to misestimating the value of synergies.

With a stock offer, the gain will be determined in part by the value of the combined firm, because the target’s firm
shareholders do not receive any cash and just walk away, but rather retain ownership in the new firm. Accordingly,
for a stock deal we must adjust our formula for the price of the target.

PT = (N * P(AT))

Where,
N = number of new shares the target receives
P(AT) = price per share of combined firm after the merger announcement.

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 Merger & Acquisitions
Example – Evaluating a merger bid
Giant Foods and Kazimierz's Grocery are negotiating a friendly acquisition of Kazmaier by Giant’s Foods. The
management teams at both companies have tentatively agreed upon a transaction value of about $27 per share for
Kazimierz's stock. But are presently negotiating alternative methods of payment. Jennifer Nagy, works for Kozlowski
Inc, the investment banking firm representing Giant Foods, Nagy has complied the data in the following figure to
analyze the transactions.

Merger Evaluations Input:

Giant Foods Kazmaier Grocery
Pre – merger stock price $36 $24
No. of Shares outstanding (millions) 50 24
Pre-merger market value (millions) $1800 $576
Estimated NPV of cost reduction $ 120 million
synergies
Calculate the post-merger value of the combined firm, gains accrued to the target & acquirer under the
following scenario:
• Cash offer of $ 27 per share for Kazmaier’s stock
• Stock offer of 0.75 shares of Giant Foods stock per share of Kazmaiers

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 Divestitures, Equity Carves – outs, Spin-Offs, Split-Offs & Liquidation

Divestitures, equity carve-outs, spin-offs, split-offs, and liquidation are all methods by which a firm separates a portion of its
operations from the parent company.

Divestitures refer to a company selling, liquidating, or spinning off a division or subsidary. Most divestitures involve a direct
sale of a portion of a firm to an outside buyer. The selling firm is typically paid in cash and gives up control of the portion of
the firm sold.

Equity carve-outs create a new, independent company by giving an equity interest in a subsidiary to outside shareholders.
Shares of the subsidary are issued in a public offering of stock, and a subsidiary becomes a new legal entity whose
management team and operations are separate from the parent company.

Spin-Offs are like carve-outs in that they create a new independent company that is distinct from the parent company. The
primary difference is that shares are not issued to the public, but are instead distributed proportionately to the parent
company’s shareholders. This means that the shareholder base of the spin-off will be the same as that of the parent
company, but the management team and operations are completely separate. Since shares of the new company are simply
distributed to existing shareholders, the parent company does not receive any cash in the transaction.

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 Divestitures, Equity Carves – outs, Spin-Offs, Split-Offs & Liquidation

Split-offs allow shareholders to receive new shares of a division of the parent company in exchange for a portion of their
shares in the parent company. The key here is that shareholders are giving up a portion of their ownership in the parent
company to receive new shares of stock in the divisions.

Liquidation breaks up the firm and sells it assets piece by piece. Most liquidations are associated with bankruptcy.

Major Reasons for Divestitures

• Division no longer fits into management strategy

• Lack of Profitability
• Individual parts are worth more than the whole
• Infusion of Cash

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