Module-2

Financial Evaluation of M&A

Merger as a Capital Budgeting:

The most important capital budgeting decision a firm may make is a merger or acquisition,
Mergers are frequently analyzed based on the two prespective
 Exchange rate determination and
 The impact on earnings per share

Usually, the main focus is given on income per share, but when capital budgeting on total, both
are studied individually.
Capital budgeting is the process of evaluating and selecting long-term investment projects or
opportunities that require significant capital investment. When a company considers an M&A
transaction, it is essentially making a capital budgeting decision to invest in the acquisition of
another business.

Business Valuation Approaches:

Income-based approaches value a business based upon the past, current, or expected future
cash flows of the business and the risk that the business will not produce the desired return.
Estimating and valuing flows of income is done through a process called capitalization.
Capitalizing the income streams will produce a so-called present value. Risk is incorporated into
this valuation through a discounting process.

The three primary income-based methods are the Discounted Cash Flow (DCF), Capitalization
of Earnings and Earnings Excess methods.

 The Discounted Cash Flow (DCF) method is based on the concept that the company’s
total value is based on its projected future earnings. This approach is often more suitable
to investment opportunities. An appraiser will determine an appropriate discount rate that
accounts for the time value of money and what returns can be expected in the future over
a set period of time, such as 5-years. Accurate historical financials of the business in
question are useful for this method to work so that future projections of revenue,
operating costs, cost of capital and working capital can be accurately forecasted.
 The Capitalization of Earnings method determines value based on future estimated
earnings and cash flow generated by a company, capitalized using an acceptable
capitalization rate. This method assumes that all assets (tangible and intangible) are
aggregated parts of the business and does not try to separate out their unique values. It is
appropriate when valuing a profitable business where an investor or owner is seeking a
return on investment over time based on total cash flow.
 The Excess Earnings method derives value based on the net income generated from a
company’s intangible value. While useful in some scenarios, this method is risky due to
the difficulty in establishing accurate values for key factors including the rate of return on
normal income and normal tangible equity of the company and in estimating the
capitalization rate for excess earnings. IRS Revenue Ruling 68-609 says this approach
may be used only if there is not a better basis available and the IRS has since concluded
that “to get two fairly accurate rates, one for tangibles and another for intangibles, other
than by the use of pure guesswork, is impossible”.

Asset-based valuation : It is a form of valuation in business that focuses on the value of a

company’s assets or the fair market value of its total assets after deducting liabilities. Assets are
evaluated, and the fair market value is obtained.

Cost includes actual machinery and equipment, as well as furniture. However, it’s important to
note that cost comprises lost income, especially in cases where a business is listed. Items wear
out, and they need to be replaced eventually.

The key values used in the asset-based approach are Book Value, Going Concern Value and
Liquidation Value.

 The Book Value is calculated by subtracting the book value of a company’s liabilities
from the book value of its assets. This method is most often used in buy/sell agreements
but, in many ways, comes with serious flaws. Many privately held companies use GAAP
 accounting standards which are not intended to reflect current asset values or adjust the
value of liabilities using rates.
 The Going Concern method derives value by determining what existing business assets
are worth, minus any outstanding liabilities.
 The Liquidation method is based on the value of the company’s assets if it were to go out
of business and assets were sold off in an auction or wholesale event where the Seller
would be compelled or forced to sell. Be aware, this method does not effectively value
intangible or goodwill asset values such as patents, trademarks or brand awareness.
Appraisers with expertise in machinery and equipment along with other tangible asset
values in the event of a forced liquidation are well-versed in using this method.

 Market approach: A market-based approach looks at similar business that sold recently
to estimate the value of a company. This method is frequently used when there are other
businesses, such as the seller's company in the same niche and geographic area. After all,
a business that recently sold in another state or country does not provide useful data. This
method isn't likely to be used with companies run by individuals or maverick companies
in hybrid niches, since direct competitors are scarce.

 Cost approach: The most straightforward approach, a cost-based valuation estimates

what it would cost to replicate the business from scratch. This approach works best with
businesses that are physical or tangible in nature. For example, you could gauge the cost
of replicating an e-commerce business by summing the total of assets for the business.
Cost approaches to company valuations work less well for businesses that rely on
intellectual capital. To give an example, it's difficult to objectively value an employee's
talents or skills in a service-based businesses, so these companies are less likely to be
valued with a cost approach.

Factors Contribute to a Company Valuation in an M&A

 Assets: Adding the material worth of a company's assets and subtracting liabilities is a
simple yet effective way to gauge value.
 Earnings before interest, tax, depreciation & amortization (EBITDA): Taking EBITDA
allows buyers to compare the seller's company with competitors by taking out these four
factors.
 Revenue multiple: This determines the value of a business proportionate to its revenue
and can be used to determine whether the seller's company is “cheap” or expensive to
acquire.
 Real option analysis: “Real options” are simply asset-based choices, such as machinery
or business property, rather than intangible assets such as IP. Enticing or valuable real
options can sweeten a deal.
 P/E (price earnings) ratio: The ratio expresses a company's share price divided by after-
tax profits, and can help buyers and sellers compare a company to competitors.
 Dividend yield: Similar to discounted cash flow, this gauges the present value of a future
dividend to “prove” worth.
 Entry cost: The entry cost sums up the cost from scratch to start an equivalent business; it
helps the buyer weigh the pros and cons of the M&A terms.
  Precedent analysis: Comparable to the cost valuation method, this gauges the precedent
price paid in similar M&A deals.

Exchange Ratio

The exchange ratio is the relative number of new shares that will be given to
existing shareholders of a company that has been acquired or that has merged with another.
After the old company shares have been delivered, the exchange ratio is used to give
shareholders the same relative value in new shares of the merged entity.

Swap ratio :

The swap ratio is the exchange rate of the shares of the companies that undergo a merger.

A swap ratio is a rate at an acquiring company will offer its own shares in exchange for the target
company’s shares during a merger or acquisition. Of course, M&A transactions don’t only have
to be conducted with a cash purchase of the target company’s equity shares. Instead, the
acquiring company can pay cash outright, convert the target company’s stock to its own or use a
mixture of cash and stock. To convert stock of one company to that of another company,
however, both companies need to agree on a particular exchange rate.

In order to calculate the swap ratio, there are certain financial ratios of the companies that are
analyzed in the share swap ratio formula. This includes profits after tax, earnings per share,
book value, and other factors like company size, strategic reasons for acquisition or merger,
and long-term debts. The share market value is considered a key factor when the target company
is listed. The final swap ratio may also take into account factors such as the size of the
companies and the target company’s long-term

debts, as well as subjective aspects such as the companies’ reasoning for the M&A transaction.

Calculating the Exchange Ratio

The exchange ratio only exists in deals that are paid for in stock or a mix of stock and cash as
opposed to just cash. The calculation for the exchange ratio is:

Exchange Ratio = Target Share Price / Acquirer Share Price

Methods of Determining Exchange Rate:

1. Floating Exchange Rate: In a floating or flexible exchange rate system, the exchange
rate is determined by the foreign exchange market based on the forces of supply and
demand. Governments or central banks do not directly intervene to peg the rate. Instead,
it is influenced by various economic factors, such as interest rates, inflation, trade
balances, political stability, and market speculation.
2. Fixed Exchange Rate: In a fixed exchange rate system, the government or central bank
sets and maintains a specific rate against another currency. This is typically done by
buying or selling its own currency in the foreign exchange market to stabilize the rate.
Fixed rates can be periodically adjusted or pegged to a single currency or a basket of
currencies.
3. Crawling Peg: A crawling peg is a system where a country's exchange rate is adjusted
periodically, typically in response to inflation differentials. The rate is allowed to move
within a defined band or through regular, small, incremental adjustments.
4. Managed Float: Some countries maintain a managed or dirty float. In this system, while
the exchange rate is primarily determined by market forces, the central bank may
occasionally intervene to influence the rate, stabilizing it or preventing excessive
volatility.
5. Purchasing Power Parity (PPP): PPP is an economic theory used to estimate an
exchange rate based on the relative price levels of two countries. According to PPP, in
the long run, exchange rates should adjust to equate the purchasing power of different
currencies. This method is based on the law of one price, which suggests that identical
goods should sell for the same price when expressed in a common currency.
6. Interest Rate Parity (IRP): IRP is a theory used to estimate exchange rates based on
interest rate differentials between two countries. It suggests that exchange rates will
adjust to equalize returns on similar assets in different currencies.
7. Balance of Payments (BOP): The balance of payments accounts for a country's
international transactions. The exchange rate can be influenced by a country's trade
balance (exports and imports), capital flows (investment), and financial transactions. An
exchange rate may be adjusted to correct imbalances in the BOP.
8. Central Bank Intervention: In some cases, central banks may directly intervene in the
foreign exchange market to stabilize or influence exchange rates. They can buy or sell
their own currency in large quantities to affect the exchange rate.
9. Forward Rates: Forward exchange rates are determined by the interest rate differentials
between two currencies and market expectations. They reflect the expected future
exchange rate and can be used for hedging against currency risk