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CHAPTERS 15 & 25

CHAPTERS 15 & 25. Corporate Valuation and Merger Analysis. Justifications for Mergers. Valid justifications: Break-up value exceeds value as going concern Synergy Questionable justifications: Diversification Increase firm size. Types of Mergers. Friendly vs. Hostile merger

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CHAPTERS 15 & 25

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  1. CHAPTERS 15 & 25 Corporate Valuation and Merger Analysis

  2. Justifications for Mergers • Valid justifications: • Break-up value exceeds value as going concern • Synergy • Questionable justifications: • Diversification • Increase firm size

  3. Types of Mergers • Friendly vs. Hostile merger • Cash vs. stock swap

  4. Analysis of mergers • Discounted cash flow approach to merger valuation requires: • Estimation of cash flows • Determine the discount rate

  5. Analysis of mergers • The correct cash flows and discount rate depend on the evaluation technique used. • We will use the “Corporate Valuation Model” (from Chapter 15) based on Free Cash Flows, discounted at the WACC

  6. Corporate Valuation Model: Discount Rate • To use the corporate valuation model to value a merger target, we must estimate the post-merger WACC of the target firm.

  7. Free Cash Flow Valuation • The FCF approach estimates the total firm value, rather than the value of equity or per share value directly. • The value of equity (& per share value) can be obtained from the total value of assets by netting out other claims.

  8. Corporate Valuation: A company owns two types of assets. • Operating assets • Nonoperating assets (securities)

  9. NOWC • Operating assets include Net Fixed Assets and Net Operating Working Capital (NOWC). NOWC = Operating CA – Operating CL

  10. Operating current assets • Operating current assets are the CA used to produce and sell the firm’s products. • Op CA include cash, receivables, inventory • Op CA exclude securities (interest earning current assets)

  11. Operating current liabilities • Operating current liabilities are the CL resulting as a normal part of operations. • Op CL: accounts payable and accruals (current liabilities that do not charge interest) • Op CL excludes notes payable because this is a source of financing, not a part of operations.

  12. Applying the Corporate Valuation Model • Free cash flow is the cash flow available for distribution to investors after all necessary additions to operating assets: FCF = NOPAT – net investment in operating assets

  13. Calculating FCF • NOPAT is what a firm’s profit would be if it had no debt and no financial assets: NOPAT = EBIT (1 – tax rate)

  14. Calculating FCF • The net investment in operating assets includes additions to operating assets in excess of depreciation expense.

  15. Corporate value • The PV of their expected future free cash flows, discounted at the WACC, is the value of operations (VOP). • Total corporate value is sum of: Value of operations Value of nonoperating assets

  16. Data for Valuation • FCF0 = $20 million • WACC = 10% • g = 5% • Marketable securities = $100 million • Debt = $200 million • Preferred stock = $50 million • Book value of equity = $210 million

  17. FCF1 Vop = (WACC - g) FCF0(1+g) = (WACC - g) Constant Growth Formula • If FCFs are expected to grow at a constant rate:

  18. FCF0 (1 + g) Vop = (WACC - g) 20(1+0.05) Vop = = 420 (0.10 – 0.05) Find Value of Operations

  19. Value of Equity • Sources of Corporate Value • Value of operations = $420 • Value of non-operating assets = $100 • Claims on Corporate Value • Value of Debt = $200 • Value of Preferred Stock = $50 • Value of Equity = ?

  20. Value of Equity • Total corporate value = Vop + Mkt. Sec. = $420 + $100 = $520 million • Value of equity = Total - Debt - Pref. = $520 - $200 - $50 = $270 million

  21. Valuation if growth is not constant • Often FCFs will be forecast for an initial planning period of N years, after which they are assumed to grow at a constant rate. • In this case, we must calculate the horizon (or “terminal”) value at the end of the planning period. (Cont.)

  22. Valuation if growth is not constant (Cont.) • With nonconstant grown the value of operations is the present value of FCFs for years 1 through N plus the present value of the horizon value.

  23. Alternative valuation techniques • Another method of estimating firm value is based valuation multiples. Examples include value as a multiple of: • Earnings (P/E) • Book value • Sales revenue

  24. Merger winners & losers Target firm shareholders receive an average premium of: Friendly merger 20% Hostile takeover 30%

  25. Merger winners & losers Long-run (five year) stock performance of acquiring firms: Abnormal returns Cash acquisitions 18.5% Stock swaps -24.2%

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