Module 2: Valuation
1
Issues in Acquisition Valuation
▪ Acquisition valuations are complex, because the valuation often
involved issues like synergy and control, which go beyond just valuing a
stand-alone firm. Two issues:
▪ What is the value of control? How can you estimate the value?
▪ Can synergy be valued, and if so, how?
2
Three types of Valuation
1. Status quo (or stand-alone) valuation: Value the company
as is, with existing inputs from investment, financing, and
dividend policy.
2. Valuation with control premium
3. Valuation with Synergy
3
Valuation with Control Premium
➢ Value the company as if optimally managed. This will usually
mean altering investment, financing, and dividend policy:
▪ Investment Policy: Earn higher returns on projects and divest
unproductive projects.
▪ Financing policy: Move to a better financing structure; e.g.,
optimal capital structure.
▪ Dividend policy: Return cash for which the firm has no need.
➢ Practically,
➢ Look at industry averages for optimal (if lazy).
➢ Do a full-fledged corporate financial analysis.
Valuation with Synergy
Value the combined firm with synergy built in. This value
may include:
▪ Higher margins because of economics of scale
▪ Lower taxes because of tax benefits: tax synergy
▪ Higher debt ratio because of lower risk→ debt capacity
▪ Lower cost of debt→ financing synergy.
Mini case: Compaq and Digital 1997
▪
In 1997, Digital Equipment, a leading manufacturer of mainframe
computers, was the target of an acquisition bid by Compaq, which at that
time was the leading personal computer manufacturer in the world.
▪
The acquisition was partly motivated by the belief that Digital was a poorly
managed firm and that Compaq would be a much better manager of Digital’s
assets.
▪
In addition, Compaq expected synergies, in the form of both cost savings
(from economy of scale) and higher growth (from Compaq selling to Digital’s
customers).
7
Digital
▪ In 1997, Digital had revenues of $13,046 million and EBIT of $391.38 million
(3% of the revenues)
▪ Capital expenditures = $475 million
▪ Depreciation = $ 461 million
▪ Working capital = 15% of revenues.
▪ Revenues, operating income, Depreciation, CapEx will grow 6% a year for the
next 5 years.
▪ The firm has a tax rate of 36%.
▪ See the Excel file for more information
▪
▪
▪
▪
▪
Beta = 1.15
After-tax cost of borrowing = 5%
Debt to capital ratio = 10%
Market risk premium = 5.5%
Treasury bond yield rate = 6%
▪ Cost of Equity = 6% + 1.15 (5.5%) = 12.33%
▪ WACC = 12.33% (.9) + 5% (.1) = 11.59%
8
Status Quo Valuation: FCFF 1998-2002
($million)
1997
1998
1999
2000
2001
2002
Revenue
13046
13828.76
14658.49
15537.99
16470.27
17458.49
EBIT
391.38
414.86
439.75
466.14
494.11
523.75
EBIT(1-t)
250.48
265.51
281.44
298.33
316.23
335.20
Depreciation
461
488.66
517.98
549.06
582.00
616.92
Capital Expenditure
475
503.50
533.71
565.73
599.68
635.66
14
14.84
15.73
16.67
17.67
18.74
1956.90
2074.31
2198.77
2330.70
2470.54
2618.77
Change in NWC
117.41
124.46
131.93
139.84
148.23
FCFF
133.26
141.25
149.73
158.71
168.24
Net Capital Expenditure
Net Working Capital (NWC)
FCFF = EBIT(1-T)+(Dep-CE)-∆NWC = EBIT(1-T) – Net CE - ∆NWC
10
Status Quo Valuation of Digital
After year 5
•
•
•
•
Growth rate = 5%
Capital expenditures = 110% of depreciations in stable growth
Working capital = 15% of revenues
Debt ratio remains at 10%, but after-tax cost of debt drops to 4%. Beta declines to 1.
-
Cost of equity after 2002 = 6%+1.00(5.5%) = 11.5%
-
WACC after 2002 = 11.50%(0.9)+4%(0.1) = 10.75%
1997
1998
1999
2000
2001
2002
2003
Revenue
13046
13828.76
14658.49
15537.99
16470.27
17458.49
18331.42
EBIT
391.38
414.86
439.75
466.14
494.11
523.75
549.94
EBIT(1-t)
250.48
265.51
281.44
298.33
316.23
335.20
351.96
Depreciation
461
488.66
517.98
549.06
582.00
616.92
647.77
Capital Expenditure
475
503.50
533.71
565.73
599.68
635.66
712.54
14
14.84
15.73
16.67
17.67
18.74
64.78
1956.90
2074.31
2198.77
2330.70
2470.54
2618.77
2749.71
Change in NWC
117.41
124.46
131.93
139.84
148.23
130.94
FCFF
133.26
141.25
149.73
158.71
168.24
156.25
($million)
Net Capital Expenditure
Net Working Capital (NWC)
Terminal Value
Firm Value
2717.35
$2,110.62
11
The Value of Control
▪ When the acquirer controls the target, it can make changes on the
target to increase firm value
▪ Value of Control = Value of firm optimally managed - Value of
firm with current management
▪ The value of control should be inversely proportional to the
perceived quality of that management and its capacity to maximize
firm value.
12
Digital: Changes in Control
▪ Pre-tax Operating margin will go up to 4% (close to the industry average).
▪ The reinvestment rate remains unchanged
▪ Expected growth rate in the next 5 years increase to 10%.
▪ Digital will raise its debt ratio to 20%.
▪
▪
▪
▪
New Beta = 1.25 why?
Cost of Equity = 6% + 1.25 (5.5%) = 12.88%
New After-tax Cost of Debt = 5.25%
WACC = 12.88% (0.8) + 5.25% (0.2) = 11.35%
▪ After year 5, the beta will drop to 1, and the after-tax cost of debt will
decline to 4%.
▪ So Cost of equity=11.5%; WACC = 10%
▪ Growth rate = 5%.
13
Digital: The Value of Control
($million)
1997
1998
1999
2000
2001
2002
2003
Revenue
13046
14350.6
15785.66
17364.23
19100.65
21010.71
22061.25
EBIT
521.84
574.02
631.43
694.57
764.03
840.43
882.45
EBIT(1-t)
333.98
367.38
404.11
444.52
488.98
537.87
564.77
Depreciation
461
507.10
557.81
613.59
674.95
742.45
779.57
Capital Expenditure
475
522.50
574.75
632.23
695.45
764.99
857.52
14
15.40
16.94
18.63
20.50
22.55
77.96
1956.90
2152.59
2367.85
2604.63
2865.10
3151.61
3309.19
Change in NWC
195.69
215.26
236.78
260.46
286.51
157.58
FCFF
156.29
171.91
189.11
208.02
228.82
329.23
Net Capital Expenditure
Net Working Capital (NWC)
Terminal Value
6584.62
Firm Value (Optimally Managed)
$4,531.59
Value of Control = 4,531.59 – 2,110.62 = 2,421.33 million
14
A procedure for Valuing Synergy
▪ What form is the synergy expected to take?
▪ Reducing operating costs?
▪ Increasing revenues?
▪ Increasing profit margins?
▪ Increasing future growth?
▪ Increasing the length of the growth period?
▪ Decreasing the cost of capital?
Value of Synergy = Value of the combined firm with synergy - Value
of the combined firm with no synergy
Value of the combined firm with no synergy = Value of the target
firm (Optimally Managed) + Value of the acquiring firm (Status quo)
15
Compaq and Digital: Background Data
Debt/(Debt+Equity) – after year 5
After-tax cost of debt – After year 5
Capex/Depreciation after year 5
Depreciation in the current year
20%
4%
110%
$545 million
20%
4%
110%
$461 million
16
The Value of Compaq (Status quo)
1997
1998
1999
2000
2001
2002
2003
25484
28032.4
30835.6
33919.2
37311.1
41042.2
43094.3
5
EBIT
2987.00
3285.70
3614.27
3975.70
4373.27
4810.59
5051.12
EBIT(1-t)
1911.68
2102.85
2313.13
2544.45
2798.89
3078.78
3232.72
Depreciation
545
599.50
659.45
725.40
797.93
877.73
921.61
Capital Expenditure
729
801.90
882.09
970.30
1067.33
1174.06
1013.78
Net Capital Expenditure
184
202.40
222.64
244.90
269.39
296.33
92.16
3822.60
4204.86
4625.35
5087.88
5596.67
6156.34
6464.15
382.26
420.49
462.53
508.79
559.67
307.82
1518.19
1670.01
1837.01
2020.71
2222.78
2832.74
Revenue
Net Working Capital (NWC)
Change in NWC
FCFF
Terminal Value
Firm Value
56654.8
$38,539.71
17
Combined firm with no Synergy
▪
The value of the combined firm (Compaq+Digital), with no
synergy, should be the sum of the values of the firms valued
independently.
▪
Value of Digital (Optimally Managed) = $4,531 million
▪
Value of Compaq (Status quo) = $38,539 million
▪
Value of combined firm with no synergy = 43,070 million
18
Compaq and Digital – Combined Firm with Synergy
▪ The Combined firm will have some economies of scale, allowing it
to increase its current after-tax operating margin slightly. The dollar
savings will be approximately $ 100 million.
▪ Current Operating Margin = (2987+522)/(25484+13046) = 9.11%
▪ New Operating Margin = (2987+522+100)/(25484+13046)
=3609/38530= 9.36%
▪ The combined firm will also have a slightly higher growth rate of
10.50% over the next 5 years, because of operating synergies.
19
Combined firm with Synergy
1997
1998
1999
2000
2001
2002
2003
38530
42575.6
47046.1
51985.9
57444.4
63476.1
66649.9
EBIT
3608.72
3987.64
4406.34
4869.00
5380.25
5945.17
6242.43
EBIT(1-t)
2309.58
2552.09
2820.06
3116.16
3443.36
3804.91
3995.16
Depreciation
1006
1111.63
1228.35
1357.33
1499.85
1657.33
1740.20
Capital Expenditure
1204
1330.42
1470.11
1624.48
1795.05
1983.53
1914.22
198
218.79
241.76
267.15
295.20
326.19
174.02
5779.50
6386.35
7056.91
7797.89
8616.67
9521.42
9997.49
606.85
670.57
740.98
818.78
904.75
476.07
1726.45
1907.73
2108.04
2329.38
2573.97
3345.07
Revenue
Net Capital Expenditure
Net Working Capital
(NWC)
Change in NWC
FCFF
66901.3
Terminal Value
Firm Value
$45,446.3
20
Compaq and Digital – Combined Firm with Synergy
▪ The WACC of the combined firm is computed in two steps:
▪ Step 1. calculate combined firm’s unlevered beta
▪ Digital’s Unlevered Beta = 1.07; Compaq’s Unlevered Beta=1.17
▪ Digital’s Firm Value = 4.5; Compaq’s Firm Value = 38.6
▪ Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16
▪ Step 2 calculate combined firm’s levered beta and WACC
▪ Combined Firm’s Debt/Equity Ratio
=(0.1*38,539+0.2*4,531)/(38,539+4,531- 0.1*38,539+0.2*4,531)
= 12.43%
▪ Levered Beta = 1.16 (1+(1-0.36)(.1243)) = 1.25
▪ Cost of equity = 6% + 1.25 (5.5%) = 12.88%
▪ WACC = 12.88% (.89) + 5% (.11) = 12.01%
21
Compaq and Digital: Value of Synergy
Value of Synergy
▪ Value of Combined Firm with Synergy = $45,446 million
▪ Value of Compaq + Value of Digital = 38,539 + 4531 = $ 43,070 million
▪ Total Value of Synergy = $ 2,376 million
▪ If it takes Compaq and Digital three years to create the synergy. The
present value of synergy can be estimated, using the combined firm’s WACC
as the discount rate:
▪ = 2,376/(1+12.01)3
22
Digital: Valuation Summary
Value of Firm - Status Quo
+ Value of Control
= $ 2,110 million
= $ 2,421 million
Value of Firm with Changes of Control = $ 4,531 million
+ Value of Synergy
= $ 2,376 million
Total Value of Digital with Synergy = $ 6,907 million
23
An alternative ways of valuing synergy
Step 1. Calculate the yearly incremental FCFs due to synergy
Step 2. Discount them at an appropriate cost of capital.
25