Mergers &

Acquisition and
Restructuring
 MOTIVES FOR
MERGERS
• ACQUIRE UNDER VALUED FIRMS

• DIVERSIFY TO REDUCE RISK

•
• CREATE OPERATING OR FINANCIAL SYNERGY
 MOTIVES FOR
MERGERS
ACQUIRE UNDERVALUED FIRMS: Firms that
are undervalued by financial markets can be
targeted for acquisition by those who
recognize this mispricing as the Acquirer can
gain the difference between the value and the
purchase price.

Profit = Actual value – Market Value

 MOTIVES FOR MERGERS
ACQUIRE UNDERVALUED FIRMS:

• A capacity to find firms that trade at less than true value. It requires a lot of
financial and market analysis skills to understand and estimate the difference in
market value and actual value and can sometimes end up as bad investment for
Acquirer.

•
• To acquire these undervalued firms the acquirer should have access to large capital
that is required to buy these firms. Also the acquirer should have understanding of
buying and post merger integration of acquisition so as to take full benefit of
merger.

•
• The acquirer should have great negotiation skills so that the target company be
bought below the actual value of company.

•
• The buying of undervalued firms require a lot of intuitive appeal as it daunting task
especially when acquiring publicly traded firms in reasonably efficient market,
 MOTIVES OF MERGER

DIVERSIFY TO REDUCE RISK:

The companies operating with single or few stakeholders

would like to buy companies so as diversify their business
and reduce the volatility of income gains by having cash
inflows from businesses in different industries.
 MOTIVES FOR
MERGERS
SYNERGY: Synergy is the additional value that is
generated by combining two firms, creating
opportunities that would not been available to
these firms operating independently

Value of A + Value of B = Value (AB)+ Synergy

 MOTIVES FOR MERGERS
TYPES OF SYNERGIES:

• OPERATIONAL SYNERGIES (stock holders of

acquiring firm are really keen to know about
Operational synergies.
•
• FINANCIAL SYNERGIES
 MOTIVES FOR MERGERS
( Synergies )
OPERATING Synergies include: Operating synergies can
affect margins, returns and growth, and through these
the value of the firms involved in the merger or
acquisition.

• Economies of scale
•
• Greater pricing power
•
• Combination of different functional strengths
•
• Higher growth in new or existing markets
 MOTIVES FOR MERGERS
( Synergies )
Economies of scale: may arise from the
merger, allowing the combined firm to become
more cost-efficient and profitable. In general,
we would expect to see economies of scales in
mergers of firms in the same business
(horizontal mergers) –two banks coming
together (JP Morgan & Chase) to create a
larger bank or two steel companies combining
to create a bigger steel company.
 MOTIVES FOR MERGERS
( Synergies )
Greater pricing power: fromreduced
competition and higher market share, which
should result in higher margins and operating
income. This synergy is also more likely to
show up in mergers of firms in the same
business and should be more likely to yield
benefits when there are relatively few firms in
the business to begin with. Thus, combining
two firms is far more likely to create an
oligopoly with pricing power.
 MOTIVES FOR MERGERS
( Synergies )
Combination of different functional
strengths, as would be the case when a firm with
strong marketing skills acquires a firm with a good
product line. This can apply to wide variety of mergers
since functional strengths can be transferable across
businesses.
 MOTIVES FOR MERGERS
( Synergies )
Higher growth in new or existing
markets: arising from the combination of the
two firms. This would be case, for instance,
when a US consumer products firm acquires
an emerging market firm, with an established
distribution network and brand name
recognition, and uses these strengths to
increase sales of its products.
 MOTIVES FOR MERGERS
( Synergies )
Financial Synergies: With financial synergies, the
payoff can take the form of either higher cash
flows
or a lower cost of capital (discount rate) or both.

• A combination of a firm with excess cash, or

cash slack
•
• Debt capacity
•
• Tax benefits
 MOTIVES FOR MERGERS
( Synergies )
A combination of a firm with excess cash, or
cash slack, (and limited project opportunities): a
firm with high-return projects (and limited cash)
can yield a payoff in terms of higher value for the
combined firm. The increase in value comes from
the projects that can be taken with the excess
cash that otherwise would not have been taken.
This synergy is likely to show up most often when
large firms
acquire smaller firms, or when publicly traded
firms acquire private businesses.
 MOTIVES FOR MERGERS
( Synergies )
Debt capacity: can increase, because when
two firms combine, their earnings and cash
flows may become more stable and
predictable. This, in turn, allows them to
borrow more than they could have as
individual entities, which creates a tax benefit
for the combined firm. This tax benefit usually
manifests itself as a lower cost of capital for
the combined firm.
 MOTIVES FOR MERGERS
( Synergies )
Tax benefits: can arise either from the
acquisition taking advantage of tax laws to
write up the target company’s assets or from
the use of net operating losses to shelter
income. Thus, a profitable firm that acquires a
money-losing firm may be able to use the net
operating losses of the latter to reduce its tax
burden. Alternatively, a firm that is able to
increase its depreciation charges after an
acquisition will save in taxes and increase its
value.
 TYPES OF MERGER
• Horizontal Mergers
•
• Vertical Mergers
•
• Conglomerate Mergers
 TYPES OF MERGERS
Horizontal Mergers:

• A horizontal merger involves two firms operating and competing in the same kind of business. The
merger of JP Morgan and Chase Manhattan is a horizontal merger.

•
• A horizontal mergers generally create synergy through economies of scale. The horizontal
mergers create economies of scale mainly for those companies carrying large scale operations.

•
• Horizontal mergers are regulated by the government for their potential negative effect on
competition in an given industry as the horizontal mergers reduce the number of companies
operating in given industry.

•
• Also horizontal mergers can create profit through monopoly. Horizontal mergers are also believed
by many as potential creating monopoly power on the part of the combined firm enabling it to
engage in anticompetitive practices.

•
• A horizontal merger is when two companies competing in the same market merge or join together
 Types of Mergers
Vertical Mergers:

• vertical mergers occur between firms in different stages of production operation for
example By directly merging with suppliers, a company can decrease reliance and
increase profitability. An example of a vertical merger is a car manufacturer
purchasing a tire company.

•
• A vertical merger is one in which a firm or company combines with a supplier or
distributor. This type of merger can be viewed as anticompetitive because it can
often rob supply business from its competition.

•
•
• If a contractor has been receiving a material from two separate firms, and then
decides to acquire the two supplying firms, the vertical merger could cause the
contractor’s competitors to go out of business (say, if General Motors were to buy
up Bridgestone Tyres and Michelin Tyres).

•
 TYPES OF MERGERS
Examples of Vertical Mergers: Vertical mergers can best be
understood from examining real world deals.

• One such merger occurred between Time Warner Incorporated, a

major cable operation, and the Turner Corporation, which
produces CNN, TBS, and other programming. In this merger, the
Federal Trade Commission (FTC) was alarmed by the fact that
such a merger would allow Time Warner to monopolize much of
the programming on television. Ultimately, the FTC voted to allow
the merger but stipulated that the merger could not act in the
interests of anti-competitiveness to the point at which the public
good was harmed.
 TYPES OF MERGERS
Conglomerate Mergers:

• Conglomerate mergers involve firms engaged in

unrelated types of business activity. There are
three types of mergers.
•
• Product Extension mergers
•
• Geographic (Market) Extension mergers
•
• Pure conglomerate mergers
 TYPES OF MERGERS
Conglomerate Mergers: Production extension mergers

• Product extension merger: takes place between two

business organizations that deal in products that
are related to each other and operate in the same
market.
•
• The product extension merger allows the merging
companies to group together their products and get
access to a bigger set of consumers. This ensures
that they earn higher profits.
•
• Product extension merger is meant to add to the
existing variety of products and services offered by
 TYPE OF MERGERS
Conglomerate Mergers: Market extension mergers

• market extension merger takes place between

two companies that deal in the same products
but in separate markets. The main purpose of
the market extension merger is to make sure
that the merging companies can get access to
a bigger market and that ensures a bigger
client base.
•
• Market-Extension Merger occurs between two
companies that sell identical products in
different markets. It basically expands the
market base of the product.
 TYPES OF MERGERS
Conglomerate mergers: Pure Conglomerate

• Pure conglomerate merges often referred to as mergers involving

unrelated business activities.
•
• Pure conglomerate mergers do not qualify as Product extension
or market extension mergers.
•
• Conglomerate companies unlike Private equity funds control the
companies to whey they make major investments. The
conglomerates control all the investments, operations, strategy
and board of respective companies under the big umbrella of
conglomerate. Also the diversification is achieved mainly by
acquisitions and not by internal development.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Approval of Board of Directors for the
scheme :

Board of Directors for transferor and

transferee companies are required to approve
the scheme of amalgamation.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Approval of the scheme by specialized
financial institutions/ banks/trustees :

for debenture holders The Board of Directors

should in fact approve the scheme only after it
has been cleared by the financial
institutions/banks, which have granted loans
to these companies or the debenture trustees
to avoid any major change in the meeting of
creditors to be convened at the instance of the
Company Court’s under section 391 of the
Companies Act, 1956.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Approval of Reserve Bank of India:

• is also needed where the scheme of amalgamation

contemplates issue of share/payment of cash to non-
resident Indians or foreign national under the
provisions of Foreign Exchange Management
(Transfer or Issue of Security by a Person Resident
Outside India) Regulations, 2000.

• In particular, regulation 7 of the above regulations

provide for compliance of certain conditions in the
case of scheme of merger or amalgamation as
approved by the court.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Intimation to Stock Exchange about
proposed amalgamation:

Listing agreements entered into between

company and stock exchange require the
company to communicate price-sensitive
information to the stock exchange
immediately and simultaneously when
released to press and other electronic media
on conclusion of Board meeting according
approval to the scheme.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Application to Court for directions:

The next step is to make an application under section 39(1) to the

High Court having jurisdiction over the Registered Office of the
company, and the transferee company should make separate
applications to the High Court. The application shall be made by a
Judge’s summons in Form No. 33 supported by an affidavit in Form
No. 34 (see rule 82 of the Companies (Court) rules, 1959). The
following documents should be submitted with the Judge’s
summons:

(a)A true copy of the Company’s Memorandum and Articles

(b) A true copy of the Company’s latest audited balance sheet

(c) A copy of the Board resolution, which authorizes the Director to

 LEGAL ASPECTS OF
MERGER / AMALGAMATION
High Court directions for members’
meeting :
•
• Upon the hearing of the summons, the High
Court shall give directions fixing the date, time
and venue and quorum for the members
meeting and appoint an Advocate Chairman to
preside over the meeting and submit a report to
the Court.

• Similar directions are issued by the court for

calling the meeting of creditors in case such a
request has been made in the application.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Approval of Registrar of High Court to notice for
calling the meeting of members/creditors:

• Pursuant to the directions of the Court, the transferor as

well as the transferee companies shall submit for approval
to the Registrar of the respective High Courts the draft
notices calling the meetings of the members in Form No.
36 together with a scheme of arrangements and
explanations, statement under section 393 of the
Companies Act and
form of proxy in Form No. 37 of the Companies (Court) Rules
to be sent members along with the said notice.

• Once Registrar has accorded approval to the notice, it

should be got signed by the Chairman appointed for
meeting by the High Court who shall preside over the
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Dispatch of notices to
members/shareholders

Once the notice has been signed by the

chairman of the forthcoming meeting as
aforesaid it could be dispatched to the
members under certificate of posting at least
21 days before the date of meeting (Rule 73 of
Companies (Court) Rules, 1959).
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Advertisement of the notice of members’ meetings:

• The Court may direct the issuance of notice of the meeting of

these shareholders by advertisement. In such case rule 74 of the
Companies (Court) Rules provides that the notice of the meeting
should be advertised in; such newspaper and in such manner as
the Court might direct not less than 21 clear days before the date
fixed for the meeting. The advertisement shall be in Form No. 38
appended to the Companies (Court)Rules.

• The companies should submit the draft for the notice to be

published in Form No. 38 in an English daily together with a
translation thereof in the regional language to the Registrar of
High Court for his approval. The advertisement should be
released in the newspapers after the Registrar approves the
draft.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Confirmation about service of the notice:

Ensure that at least one week before the date

of the meeting, the Chairman appointed for
the meeting files an Affidavit to the Court
about the service of notices to the
shareholders that the directions regarding the
issue of notices and advertisement have been
duly complied with.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Holding the shareholders general meeting and
passing the resolutions:

The general meeting should be held on the appointed

date. Rule 77 of the Companies (Court) Rules
prescribes that the decisions of the meeting held
pursuant to the court order should be ascertained only
by taking a poll. The amalgamation scheme should be
approved by the members, by a majority in number of
members present in person or on proxy and voting on
the resolution and this majority must represent at least
¾ this in value of the shares held by the members who
vote in the poll.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Filing of resolutions of general meeting with Registrar
of Companies:

• Once the shareholders general meeting approves the

amalgamation scheme by a majority in number of
members holding not less than 3/4 in value of the equity
shares, the scheme is binding on all the members of the
company.

• A copy of the resolution passed by the shareholders

approving the scheme of amalgamation should be filed
with the Registrar of Companies in Form No. 23 appended
to the Companies (Central Government’s) General Rules
and Forms, 1956 within 30 days from the date of passing
the resolution.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Submission of report of the chairman of the
general meeting to Court:

The chairman of the general meeting of the

shareholders is required to submit to the Court
within seven days from the date of the meeting a
report in Form No. 39, Companies (Court) Rules,
1959 setting out therein the number of persons
who attend either personally or by proxy, and the
percentage of shareholders who voted in favor of
the scheme as well as the resolution passed by the
meeting.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Submission of Joint petition to court for
sanctioning the scheme:

• Within seven days from the date on which the

Chairman has submitted his report about the result of
the meeting to the Court, both the companies should
make a joint petition to the High Court for approving
the scheme of amalgamation.

• This petition is to be made in Form No. 40 of

Companies (Court) Rules. The Court will fix a date of
hearing of the petition. The notice of the hearing
should be advertised in the same papers in which the
notice of the meeting was advertised or in such other
newspapers as the Court may direct, not less than 10
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Issue of notice to Regional Director,
Company Law Board under section 394 –
A

On receipt of the petition for amalgamation

under section 391 of Companies Act, 1956 the
Court will give notice of the petition to the
Regional Director, Company Law Board and
will take into consideration
the representations, if any, made by him.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Hearing of petition and confirmation of scheme

• Having taken up the petition by the Court for hearing

it will hear the objections first and if there is no
objection to the amalgamation scheme from Regional
Director or from any other person who is entitled to
oppose the scheme, the Court may pass an order
approving the scheme of amalgamation in; Form No.
41 or Form No. 42 of Companies (Court) Rules.

• The court may also pass order directing that all the
property, rights and powers of the transferor
company specified in the schedules annexed to the
order be transferred without further act or deed to
the transferee company and that all the liabilities and
duties of the transferor company be transferred
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Filing of Court order with ROC by both the
companies

• Both the transferor and transferee companies

should obtain the Court’s order sanctioning the
scheme of amalgamation and file the same with
ROC with their respective jurisdiction as required
vide section 394(3) of the Companies Act, 1956
within 30 days after the date of the Court’s order
in Form No. 21 prescribed under the (Central
Government’s) General Rules and Forms, 1956.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Court order to be annexed to memorandum
of transferee company

• It is the mandatory requirement vide section

391(4) of the Companies Act, 1956 that after the
certified copy of the Court’s order sanctioning
the scheme of amalgamation is filed with
Registrar, it should be annexed to every copy of
the Memorandum issued by the transferee
company.

• Failure to comply with requirement renders the

 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Transfer of the assets and liabilities

• Section 394(2) vests power in the High Court

to order for the transfer of any property or
liabilities from transferor company to
transferee company.

• In pursuance of and by virtue of such order

such properties and liabilities of the
transferor shall automatically stand
transferred to transferee company without
any further act or deed from the date the
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Preservation of books and papers of
amalgamated Co.

Section 396A of the Act requires that the

books and papers of the amalgamated
company should be preserved and not be
disposed of without prior permission of the
Central Government.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
The Post merger secretarial obligations:

These formalities include filing of returns with Registrar

of Companies, transfer of investments of transferor
company in; the name of the transferee.

• intimating banks and financial institutions, creditors

and debtors about the transfer of the transferor
company’s assets and liabilities in the name of the
transferee company, etc.

• All these aspects along with restructuring of

organization and management and capital are
discussed in chapter relating to post-merger
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Withdrawal of the Scheme not
permissible

Once the scheme for merger has been

approved by requisite majority of shareholders
and creditors, the scheme cannot be
withdrawn by subsequent meeting of
shareholders by passing Resolution for
withdrawal of the petition submitted to the
court under section 391 for sanctioning the
scheme.
 LEGAL ASPECTS OF
MERGER / AMALGAMATION
Cancellation of the scheme and order of
winding-up:

If scheme is cancelled under section 392(2) on

the ground that it cannot be satisfactorily
worked and a winding-up order is passed
under section 433.
 Scheme of
Amalgamation

Scheme of amalgamation: The scheme of

amalgamation should be prepared by the
companies, which have arrived at a consensus
to merge. There is no specific form prescribed
for scheme of amalgamation but scheme
should generally contain the following
information:
 Scheme of
Amalgamation
Scheme of Amalgamation:

• Particulars about transferee and transferor

companies
 
• Appointed date
 
• Main terms of transfer of assets from transferor
to transferee with power to execute on behalf or
for transferee the deed or documents being
given to transferee.
 
• Main terms of transfer liabilities from transferor
to transferee covering any conditions attached
to loans/debentures/bonds/other liabilities from
 Scheme of
Amalgamation
• Effective date when the scheme will come into
effect
•
• Conditions as to carrying on the business
activities by transferor between ‘appointed ate’
and ‘effective date’.

• Description of happenings and consequences of

the scheme coming into effect on effective date.
 
• Share capital of transferor company specifying
authorized capital, issued capital and subscribed
and paid up capital
 Scheme of
Amalgamation
• Share capital of transferee company covering above
heads.
 
• Description of proposed share exchange ratio, any
conditions attached thereto, any fractional share
certificates to be issued, transferee company’s
responsibility to obtain consent of concerned
authorities for issue and allotment of shares and
listing.
 
• Surrender of shares by shareholder of transferor
company for exchange into new share
certificates.
 
• Conditions about payment of dividend, ranking of
equity shares, pro rata dividend declaration and
 Scheme of
Amalgamation
• Status of employees of the transferor companies from
effective date and the status of the provident fund,
gratuity fund, super annuity fund or any special scheme or
funds created or existing for the benefit of the employees.
•
• Treatment on effective date of any debit balance of
transferor company balance.
•
• Miscellaneous provisions covering income-tax dues,
contingencies and other accounting entries deserving
attention or treatment.
•
• Commitment of transferor and transferee companies
towards making applications/petitions under section 391
and 394 and other applicable provisions of the con
 Scheme of
Amalgamation
• Enhancement of borrowing limits of the
transferee company upon the scheme coming
into effect.
•
• Transferor and transferee companies give assent
to change in the scheme by the court or other
authorities under the law and exercising the
powers on behalf of the companies by their
respective Boards.
•
• Description of powers of delegate of transferee
to give effect to the scheme.
 Scheme of
Amalgamation
• Qualification attached to the scheme, which
requires approval of different agencies, etc.
•
• Description of revocation/cancellation of the
scheme in the absence of approvals qualified
in clause 20 above not granted by concerned
authorities.
•
• Statement to bear costs etc. in connection
with the scheme by the transferee company
 Valuation of
Business for M & A
• Status Quo Valuation of Company
•
• Valuation of Optimal Operation
•
• Valuation of Synergy
 Status Quo
Valuation
• Cash flow Basis
•
• Dividends discount model (Earnings basis)
•
• Relative valuation
 Cash Flow
Valuation
Cash flow valuation requires:

• Calculation of Wt. average Cost of Capital

•
• Growth rate analysis of Cash flows.
•
•
 Cash flow Valuation
WACC: Wt. average cost of capital requires:

• Beta that defines equity risk which in turn is used to

calculate Cost of Equity.
•
• Interest coverage ratio analysis for synthetic debt rating
which derives the cost of debt based on debt ratings.
•
• Interest expense as percentage of long term debt analysis
to find cost of debt.
•
• Book value of equity and book value of debt of most
recent year filing.
 WACC
Beta Bottoms Up Approach:

Breaking down betas into their business,

operating leverage and financial leverage
components provides us with an alternative
way of estimating betas.
•
•
 WACC
Process of finding bottoms up Beta:

• Identify the business or businesses that

make up the firm, whose beta we are trying
to estimate. Most firms provide a breakdown
of their revenues and operating income by
business in their annual reports and financial
filings.
•
•
 WACC
Estimate the average unlevered betas of other
publicly traded firms that are primarily or only in
each of these businesses. Following are considered
while making the estimate:

• Comparable firms: In most businesses, there are

at least a few comparable firms and in some
businesses, there can be hundreds. Begin with a
narrow definition of comparable firms, and widen
it if the number of comparable firms is too small.
 WACC
Beta Estimation: Once a list of comparable
firms has been put together, we need to
estimate the betas of each of these firms.

Unlever first or last: We can compute an

unlevered beta for each firm in the
comparable firm list, using the debt to equity
ratio and tax rate for that firm, or we can
compute the average beta, debt to equity ratio
and tax rate for the sector and unlever using
the averages.
 WACC
Unlevered beta for respective comparables is
calculate by using:

Unlevered beta = levered beta/ (1+ D/E *(1-

taxes))
 WACC
To find the levered beta of the respective
company impose the debt to equity structure
of respective company to Unlevered beta of
Comparable companies.

Leveraged beta of company = unlevered beta

of comparables *(1+(1-taxes)*debt/equity)).
 WACC
To the cost of equity we need levered beta, risk free rate and
risk premium:

Cost of equity = risk free rate + Beta * (Market rate – risk

free rate)

• The risk free rate is like investing government securities

and should be taken for high growth rate period only (for
e.g.. If you are valuing a company with high growth period
of 5 years then take the government bond risk free rate for
5 years)
•
• Take market risk premium as the expectancy of market to
perform in relative to risk free market (for example if risk
free rate for 5 year government bond is 5% then take risk
 WACC
Cost of Debt: We determine cost of debt in three steps:

1. First, take historical interest expense for at least 3 years and

divide these by respective years Total long term debt. Then
take average of all these years ratios (interest
expense/total long term debt) and you will get cost of debt
as expressed by interest expense.
2.
3. Second, calculate historical interest coverage ratio (EBIT/Interest
expense) for at least 3 historical years and then compare
them with industry debt ratings and default spread to
analyze the respective ratings for every years. After this you
can take weighted average of default rates for these
historical years.
4.
5. Last, we take the average of cost of debt from interest expense
and cost of debt from synthetic ratings to determine Cost of
 WACC
Cost of preferred shares

Cost of preferred equity = preferred

dividends/ preferred shares.

• generally preferred shares have fixed

dividends which they get before common
share holders (for simplicity of model you
can take total dividends for calculating cost
of preferred shares).
•
 WACC
WACC = Cost of equity * wt. of equity + cost of debt *
(1-taxes) * wt. of debt + cost of preferred equity * wt.
of preferred equity.

Wt. of equity = total common equity/ (preferred shares

value + long term debt + total common equity)

Wt. of debt = total long term debt/ (total long term

debt + total common shares + total preferred shares
value)

Wt. of preferred shares = total preferred share value /

(total preferred shares + total common equity + total
 CASH FLOW ANALYSIS
( business valuation )
The elements of Growth rate in Cash flows are :

• Re-Investment rate
•
• Return on Capital
 CASH FLOW ANALYSIS
( business valuation )
Re-Investment rate:

• is the proportion of after-tax operating income

that goes into net new investments.

• is the rate which is invested by the company as

percentage of EBIT*(1- taxes) to run the
company so as to see growth in cash flows.
 CASH FLOW ANALYSIS
( business valuation )
• Re-Investment rate:
•
• The cash flow to the firm is computed after
reinvestments. Two components go into
estimating reinvestment.
•
• The first is net capital expenditures, which is the
difference between capital expenditures and
depreciation.
•
• The other is investment in non-cash working
 CASH FLOW ANALYSIS
( business valuation )
Net Capital Expenditures

In estimating net capital expenditures, we

generally deduct depreciation from capital
expenditures. The rationale is that the positive
cash flows from depreciation pay for atleast a
portion of capital expenditures and it is only the
excess that represents a drain on the firm’s cash
flows.

While information on capital spending and

depreciation are usually easily accessible in most
financial statements, forecasting these
expenditures can be difficult for three reasons.
 CASH FLOW ANALYSIS
( business valuation )
Net Capital Expenditure: Problems in calculation
•
• The first is that firms often incur capital spending
in chunks – a large investment in one year can
be followed by small investments in subsequent
years.
•
• The second is that the accounting definition of
capital spending does not incorporate those
capital expenses that are treated as operating
expenses such as R&D expenses.
•
• The third is that acquisitions are not classified by
accountants as capital expenditures. For firms
 CASH FLOW ANALYSIS
( business valuation )
Net Capital Expenditure: Two ways to normalize Capital
Expenditure

• The simplest normalization technique is to average capital

expenditures over a number of years.
•
• For instance, we could estimate the average capital
expenditures over the last three years for a manufacturing
firm and use that number rather the capital expenditures
from the most recent year. By doing so, we could capture
the fact that the firm may invest in a new plant every
three years.
•
• In regard to number of historical years used to calculate
Net Cap expenditure The answer will vary across firms and
will depend upon how infrequently the firm makes large
 CASH FLOW ANALYSIS
( business valuation )
Net Capital Expenditure: Two ways to normalize Capital
Expenditure

•
• If instead, we had used the capital expenditures from
the most recent year, we would either have over
estimated capital expenditures (if the firm built a new
plant that year) or under estimated it (if the plant
had been built in an earlier year).
•
• For firms with a limited history or firms that have
changed their business mix over time, averaging
over time is either not an option or will yield numbers
that are not indicative of its true capital expenditure
needs. For these firms, industry averages for capital
 CASH FLOW ANALYSIS
( business valuation )
Net Capital Expenditure: Two ways to normalize
Capital Expenditure: why industry average for
companies with limited history

Since the sizes of firms can vary across an

industry, the averages are usually computed with
capital expenditures as a percent of a base input –
revenues and total assets are common choices.
We prefer to look at capital expenditures as a
percent of depreciation and average this statistic
for the industry.

In fact, if there are enough firms in the sample, we

could look at the average for a subset of firms that
are at the same stage of the life cycle as the firm
 CASH FLOW ANALYSIS
( business valuation )
Working capital is usually defined to be the difference
between current assets and current liabilities. However,
we will modify that definition when we measure
working capital for valuation purposes:

Current assets:

• We will back out cash and investments in marketable

securities from current assets. This is because cash is
usually invested by firms in treasury bills, short term
government securities or commercial paper. While
the return on these investments may be lower than
what the firm may make on its real investments, they
represent a fair return for riskless investments.
 CASH FLOW ANALYSIS
( business valuation )
Working capital: Current assets

• Unlike inventory, accounts receivable and

other current assets, cash then earns a fair
return and should not be included in
measures of working capital.
•
•
 CASH FLOW ANALYSIS
( business valuation )
Working capital: Current Liabilities

We will also back out all interest bearing debt

– short-term debt and the portion of long term
debt that is due in the current period – from
the current liabilities. This debt will be
considered when computing cost of capital
and it would be inappropriate to count it twice.
 CASH FLOW ANALYSIS
( business valuation )
Estimating Expected Changes in non-cash
Working Capital

• While we can estimate the non-cash working

capital change fairly simply for any year
using financial statements, this estimate has
to be used with caution.

• Changes in non-cash working capital are

unstable, with big increases in some years
followed by big decreases in the following
 CASH FLOW ANALYSIS
( business valuation )
• To ensure that the projections are not the result of an
unusual base year, we should tie the changes in
working capital to expected changes in revenues or
costs of goods sold at the firm over time.

• The non-cash working capital as a percent of

revenues/operating margin can be used, in
conjunction with expected revenue/operating margin
changes each period, to estimate projected changes
in non-cash working capital over time.

• We can obtain the non-cash working capital as a

percent of revenues/operating margin by looking at
the firm’s history or at industry standards.
•
 CASH FLOW ANALYSIS
( business valuation )
The best way is to base our changes on the
non-cash working capital as a percent of
revenues/operating margin over a historical
period. For instance, non-cash working capital
as a percent of revenues between 2000 and
2004 averaged out to 8% of revenues.

The advantage of this approach is that it

smoothes out year-to-year shifts, but it may
not be appropriate if there is a trend (upwards
or downwards) in working capital.
 CASH FLOW ANALYSIS
( business valuation )
Re-Investment:

Once the historical average Net Capital

expenditure and historical average Change in
Non Cash working capital are determined we
work on determining the average historical re-
investment rate:

Re-investment rate = (Net Cap exp + change

in non cash W.C. )/ EBIT*(1-Taxes)
 CASH FLOW ANALYSIS
( business valuation )
Future Re-Investment rate: you need to brain storm by
reading MD&A (Management discussion and analysis) of
respective companies 10-k report to determine the future
growth. By this we mean the following:

• Is the company going to invest more in Capital

expenditure (property plant and equipment, R&D ).
•
• Is it going to increase working capital in the future
•
• Or the Re-Investment rate will remain the same.
•
A subjective analysis will make us understand and determine
the amount by which the change will in Re-investment rate
will happen if any.
 CASH FLOW ANALYSIS
( business valuation )
RETURN ON CAPITAL: EBIT*(1-Taxes)/(debt +
equity)

• The return on capital is often based upon the

firm's return on existing investments, where the
book value of capital is assumed to measure the
capital invested in these investments.
•
• Implicitly, you assume that the current
accounting return on capital is a good measure
of the true returns earned on existing
investments and that this return is a good proxy
for returns that will be made on future
 CASH FLOW ANALYSIS
( business valuation )
RETURN ON CAPITAL: the assumption of
current accounting return on capital will
remain the same is open to questions for the
following questions:

The book value of capital might not be a good

measure of the capital invested in existing
investments, since it reflects the historical cost of
these assets and accounting decisions on
depreciation. When the book value understates
the capital invested, the return on capital will be
overstated; when book value overstates the
capital invested, the return on capital will be
understated. This problem is exacerbated if the
book value of capital is not adjusted to reflect the
 CASH FLOW ANALYSIS
( business valuation )
Assumptions issues continued:
•
• The operating income, like the book value of
capital, is an accounting measure of the earnings
made by a firm during a period. All the problems
in using unadjusted operating income described
in Chapter 4 continue to apply.

• Even if the operating income and book value of

capital are measured correctly, the return on
capital on existing investments may not be equal
to the marginal return on capital that the firm
expects to make on new investments, especially
 CASH FLOW ANALYSIS
( business valuation )
Assumptions about Return on capital:

Given the concerns mentioned in previous slides,

you should consider not only a firm’s current
return on capital, but any trends in this return as
well as the industry average return on capital. If
the current return on capital for a firm is
significantly higher than the industry average, the
forecasted return on capital should be set lower
than the current return to reflect the erosion that
is likely to occur as competition responds.
 CASH FLOW ANALYSIS
( business valuation )
Assumptions about Return on capital:

Finally, any firm that earns a return on capital

greater than its cost of capital is earning an
excess return. The excess returns are the
result of a firm’s competitive advantages or
barriers to entry into the industry. High excess
returns locked in for very long periods imply
that this firm has a permanent competitive
advantage
 CASH FLOW ANALYSIS
( business valuation )
Candidates for Changing Average Return on
Capital

What types of firms are likely to see their return on capital change over
time?

• One category would include firms with poor returns on capital

that improve their operating efficiency and margins, and
consequently their return on capital. In these firms, the expected
growth rate will be much higher than the product of the
reinvestment rate and the return on capital. In fact, since the
return on capital on these firms is usually low before the turn-
around, small changes in the return on capital translate into big
changes in the growth rate. Thus, an increase in the return on
capital on existing assets of 1% to 2% doubles the earnings
(resulting in a growth rate of 100%).
 CASH FLOW ANALYSIS
( business valuation )

Growth Rate in EBIT = Re-investment rate *

ROC

ROC = return on capital

Length of High Growth
Period
The question of how long a firm will be able to
sustain high growth is perhaps one of the most
difficult questions to answer in a valuation, but
two points are worth making.

• First One is that it is not a question of whether

but when firms hit the stable growth wall. All
firms ultimately become stable growth firms, in
the best case, because high growth makes a firm
larger and the firm’s size will eventually become
a barrier to further high growth. In the worst-
case scenario, firms may not survive and will be
Length of High Growth
Period
Second Point:

The second is that high growth in valuation, or at least

high growth that creates value, comes from firms
earning excess returns on their marginal investments.
In other words, increased value comes from firms
having a return on capital that is well in excess of the
cost of capital (or a return on equity that exceeds the
cost of equity). Thus, when you assume that a firm will
experience high growth for the next 5 or 10 years, you
are also implicitly assuming that it will earn excess
returns (over and above the required return) during
that period. In a competitive market, these excess
returns will eventually draw in new competitors and the
excess returns will disappear.
 How long can a firm
maintain high growth
Period
We should look at three factors when considering how
long a firm will be able to maintain high growth

1. Size of the firm: Smaller firms are much more likely

to earn excess returns and maintain these excess
returns than otherwise similar larger firms. This is
because they have more room to grow and a larger
potential market. Small firms in large markets should
have the potential for high growth (at least in
revenues) over long periods. When looking at the size
of the firm, you should look not only at its current
market share, but also at the potential growth in the
total market for its products or services. A firm may
have a large market share of its current market, but it
may be able to grow in spite of this because the entire
market is growing rapidly.
 How long can a firm
maintain high growth
Period
2. Existing growth rate and excess returns:
Momentum does matter, when it comes to
projecting growth. Firms that have been
reporting rapidly growing revenues are
more likely to see revenues grow rapidly at
least in the near future. Firms that are
earnings high returns on capital and high
excess returns in the current period are likely
to sustain these excess returns for the next
few years.
 How long can a firm
maintain high growth
Period
3. Magnitude and Sustainability of Competitive
Advantages:

This is perhaps the most critical determinant of

the length of the high growth period. If there are
significant barriers to entry and sustainable
competitive advantages, firms can maintain high
growth for longer periods. If, on the other hand,
there are no or minor barriers to entry or if the
firm’s existing competitive advantages are fading,
you should be far more conservative about
allowing for long growth periods. The quality of
existing management also influences growth.
Some top managers have the capacity to make
the strategic choices that increase competitive
 Terminal Value
Since you cannot estimate cash flows forever,
you generally impose closure in discounted
cash flow valuation by stopping your
estimation of cash flows sometime in the
future and then computing a terminal value
that reflects the value of the firm at that point.
 Terminal Value
• the growth rate in cash flow is actually the
economic growth rate of economy.
•
• the Return on capital in terminal growth rate
is Industry average growth rate.
•
• the Re-investment rate in terminal period =
economic growth rate/ ROC (Industry
average)
•
 Terminal Value
Cost of capital in terminal period:

• Cost of equity: take beta as industry average

Beta (or market beta).
•
• Weighted average Cost of debt remains the
same.
•
• Debt to equity ratio can be taken as industry
average debt to equity ratio (or can be taken as
average of last five years).
 Terminal Value
Terminal value = Cash flow in last year of high
growth period * (1+ g)/(cost of capital in high
growth period- growth rate in economic growth
rate)

• Then find the present value of Terminal value

= Terminal value/(1+cost of capital)^n
•
n is the length of high growth period.
 Cash flow analysis
high growth period .
2010 2011201220132014
E B I T * ( 1 - T a x e s 7) 9 97 118 144 176
R e - I n v e s t m e n 6t 9R a t e8 4 1 0 2 1 2 5 1 5 2
C a s h F l o w s t o 1F 1i r m 1 3 1 6 1 9 2 4
P r e s e n t v a l u e$ 5o 5f C F
 Terminal Value
Terminal Value (Value of cash flows after high growth period)

Growth Rate 5.00% Termianal Value 947

ROC 10.00% WACC 7.63%
Re-Investment rate 50.00% P.V. Terminal Value 656
Beta 1
Cost of Equity 11.00%
Cost of debt 10.20%
 Value of Business
• Value of business = present value of cash
flows in high growth period + present value
of terminal value.

• Value of equity = value of business – long

term debt + total cash (cash + short term
investment + marketable securities)
 Earnings Based
Model
• First Determine Cost of equity ( it is
determined the same way it is determined in
Cash flow basis model)
•
• Second determine Cash flows
 Earnings Based
Model
To Determine cash flows we need the
following:

• Re-Investment rate
•
• Return on Equity
 Earnings based
model
Re-Investment rate:

• In recent years companies around the globe have

increasingly turned to stock buybacks as a way of
returning cash to stockholders.
•
• Focusing strictly on dividends paid as the only cash
returned to stockholders exposes us to the risk that
we might be missing significant cash returned to
stockholders in the form of stock buybacks.
•
• In addition, firms may sometimes buyback stock as
way of increasing financial leverage.
 Earnings Based
Model
Re-Investment rate:

• Modified dividend payout ratio = (dividends

+ stock buybacks – long term debt issues)/
Net Income
•
• Consequently, a much better estimate of the
modified payout ratio can be obtained by
looking at the average value over a four or
five year period.
 Earnings Based
Model
Re-Investment rate:

Re-Investment rate = 1- average modified

payout ratio
 Earnings Based Model

Return on Equity:

ROE = ROC + D/E (ROC – Net cost of debt)

ROC = Return on Capital

D/E = Debt to equity ratio

Net cost of debt = Cost of debt* (1- tax rate)

 Earnings Based
Model
Why ROE = ROC + D/E (ROC – Net cost of debt)

• Return on equity affected by the leverage of the

firm
•
• The advantage of this formulation is that it
allows the analyst valuing the firm to bring in the
effect of the investment, financing and dividend
decisions of the firm, not only in current periods
but also in the future periods.
 Earnings Based
Model

Growth in Net Income in high growth period =

Re-Investment rate * Return on equity
 Earnings Based Model
High Growth Period:

2010 2011 2012 2013 2014

NI 98.33 113.75131.58152.21176.08
D i v i d e d p a y o u t R a t28.84%28.84%28.84%28.84%28.84%
io
Ex p e cte d D iv i d e n d s28.35 32.80 37.94 43.89 50.78

P re se n t v al u e o f D i v24.87
i d e n d25.24
s 25.62 26.00 26.38
 Earnings Based
Model
Te rm inal V alue T e r m i n a l V a8 l4u6e. 2 7

M o d if ie d D i vid e n d P ayo
50.00%
ut
1 8 4 t. 8e 9r m i n a l c a s h f l o w s
F u tu re N o m alize d R O 1E0.00%
5 0 . 0d0 i%v i d e n d p a y o u t
B ETA 1.00
R e - In ve stm e n t 50.00% 9 2 . e4 4x p e c t e d d i v i d e n d s
C o st o f e q u ity 11.00%
Exp e cte d G ro w th in Earn 5.00%
in gs 4 3 9 (. 6P 9. V . o f T e r m i n a l V a l u e )
 Earnings Based
Model
Terminal Value:

• Cost of equity : take Beta as industry average or market

beta depending upon industry judgment and determine
cost of equity.
•
• Return on equity should be taken as Industry average
return on equity.
•
• Growth in Net Income should be taken as Economic
Growth rate.
•
• Re-Investment rate = growth in net income / return on
equity
•
 Earnings Based
Model
Terminal Value:

• Terminal value = Net income last year of

high growth * (1 + economic growth rate)/
(cost of equity – economic growth rate)
•
• Present value of Terminal Value = Terminal
value / (1+ terminal cost of equity)^n
•
n is length of high growth period.
•
 Earnings Based
Model
Value of equity = Present value of cash flows
in high growth period + Present value of
Terminal value.
 Value of Business
Under Optimal
Conditions
Value of optimal conditions is actually value of control. The
value of controlling a firm derives from the fact that you
believe that you or someone else would operate the firm
differently from the way it is operated currently.
•
• Value of the company as if optimally managed. This will
usually mean that investment, financing and dividend
policy will be altered:
•
• Investment policy: high returns on projects and divesting
unproductive projects.
•
• Financing policy: move to a better financing structure e.g.
optimal capital structure.
•
 Value of Business
Under Optimal
Conditions
For value under Optimal conditions we will focus
on reducing the Cost of Financing.

• The cost of capital for a firm was defined earlier

to be a composite cost of debt and equity
financing. The cash flows generated over time
are discounted back at the cost of capital.

• Holding the cash flows constant, reducing the

cost of capital will increase the value of the firm
 Value of Business
Under Optimal
Conditions
Steps in finding Optimal debt ratio:

• first take different debt ratios like 0%, 10%, 20% etc.
and the calculate debt to equity ratio at different
debt levels.
•
• Then take Unlevered beta of the company and apply
debt to equity ratio to find Levered beta for every
debt ratio. Based on this beta calculate cost of equity
for respective betas.
•
• Take Debt ratio data for Respective Industries from
S&P 500 including cost of debt at different debt
ratios.
•
 Value of Synergy
Value of combined firm with synergy built in. This
may include:

• higher growth rate in cash flows from increase in

re-investment rate and/or return on
capital/return on equity.
•
• Higher margins because of economies of scale
•
• Lower cost of debt because of financing synergy.
•
• Higher debt ratio because of lower risk: debt
capacity.
 Value of Equity
Maximum Value of equity for M&A = Status
Quo Valuation + Optimal value + Synergy
Value.

Maximum value of business = value of equity

+ long term debt - cash
 Financing Mergers
There are many ways to finance a mergers and
these are:

• merger can be financed by taking debt on assets

of acquirer or the target.
•
• Also the acquirer can issue new equity to raise
cash to pay to the target company (don’t
confuse this with exchange ratio).
•
• Also if the acquirer is cash rich then it can use
cash to buy the target.
 Financing Mergers
Debt and equity instruments to raise cash:

• Senior secured debt can be raised by using

assets of target or acquirer to raise cash for
merger. These debt holders are first ones to get
paid if bankruptcy happens.
•
• Unsecured debt can be raised based on
credibility of acquire and/or target to raise cash.
•
• Mezzanine debt can raised by acquirer to get
cash. The mezzanine debt as debt life of 3 to 5
years and after that has a option to be converted
to equity shares.
Computation of Impact
on EPS ( Earnings
Model )
Steps in computation of impact on EPS for Earnings based
model;

• Add up the Net Income of both target and acquirer to

come up with combined Net Income for the most recent
year filing.
•
• based on dividend pay ratio for respective years following
merger calculate dividend paid year on year basis.
•
• Next to check impact on EPS share = (Net Income –
Dividends)/ Total shares outstanding for ever year.
•
• Then check growth in EPS on year on year basis by =
•
Computation of Impact
on EPS ( Cash flow
Model )
Steps in computation of impact on EPS for cash flow based model:

• Add up the EBIT of both target and acquirer to come up with

combined EBIT for the most recent year filing.
•
• Then after determining synergy growth rate of cash flows for
combined growth , calculate EBIT for respective future years.
•
• After that, take weighted average cost of debt and calculate
interest expense by multiplying cost of debt with long term debt.
Then take taxes out based on tax rate and subtract interest
expense and tax rate from EBIT to Net Income.
•
• EPS = Net Income/ Total shares
•
 Determining Exchange
Ratio
• first perform status quo valuation, optimal valuation
and synergy valuation for target company’s equity.

Maximum value of target equity = Status quo

valuation + optimal valuation + synergy valuation.

• Second negotiate the premium to be paid for

acquisition.
•
• Third value of equity for M&A = status quo valuation
+ premium
•
• Exchange ratio = Value of target equity (negotiated
equity)/ value of acquirer.
 MBO / LBO
INTRODUCTION:

A leveraged buyout (Bootstrap" transaction) occurs when an

investor, typically financial sponsor, acquires a controlling
interest in a company's equity and where a significant
percentage of the purchase price is financed through
leverage (debt).

The assets of the acquired company are used as collateral

for the borrowed capital, sometimes with assets of the
acquiring company.

Typically, leveraged buyout uses a combination of various

debt instruments from bank and debt capital markets. The
bonds or other paper issued for leveraged buyouts are
commonly considered not to be investment grade because
of the significant risks involved.
 Sources and Uses
of Funds
In reality, a large leveraged buyout will likely be
financed with multiple tranches of debt that could
include (in decreasing order of seniority) some or
all of the following:

• A revolving credit facility (“bank revolver”)

is a source of funds that the bought-out firm
can draw upon as its working capital needs
dictate.
•
• Term debt, which is often secured by the
assets of the bought-out firm, is also provided
 Sources and Uses
of Funds
• Mezzanine Financing is so named
because it exists in the middle of the
capital structure and generally fills the gap
between bank debt and the equity in a
transaction. Mezzanine financing is junior to
the bank debt incurred in financing the
leveraged buyout and can take the form of
subordinated notes from the private
placement market or high-yield bonds from
the public markets, depending on the size
and attractiveness of the deal.
 Sources and Uses
of Funds
In addition to the debt component of an LBO, there is
also an equity component in financing the transaction:

• Private equity firms typically invest alongside

management to ensure the alignment of
management and shareholder interests. In large
LBOs, private equity firms will sometimes team up to
create a consortium of buyers, thereby reducing the
amount of capital exposed to any one investment.
•
• Another potential source of financing for leveraged
buyouts is preferred equity. Preferred equity is often
attractive because its dividend interest payments
represent a minimum return on investment while its
equity ownership component allows holders to
 LBO Candidate
Criteria
Given the proportion of debt used in financing a transaction, a
financial buyer’s interest in an LBO candidate depends on the
existence of, or the opportunity to improve upon, a number of
factors. Specific criteria for a good LBO candidate include:

• Steady and predictable cash flow

•
• Divestible assets

• Clean balance sheet with little debt

• Strong management team

• Strong, defensible market position

•
• Viable exit strategy
 LBO / MBO
• Limited working capital requirements

• Synergy opportunities

• Minimal future capital requirements

• Potential for expense reduction

• Heavy asset base for loan collateral

 Defense Against
Hostile Take Over
Poison Pill

An antitakeover tactic in which warrants are

issued to a firm's stockholders, giving them
the right to purchase shares of the firm's stock
at a bargain price in the event that a suitor
hostile to management acquires a stipulated
percentage of the firm's stock. The poison pill
is intended to make the takeover so expensive
that any attempt to take control will be
abandoned.
 Poison Pill
Flip-over: If a hostile takeover occurs, investors
have the option to purchase the bidder’s shares at
a discount, thereby devaluing the acquirer’s stock
and diluting its stake in the company.

Flip-in: Management offers shares to investors at a

discount if an acquirer merely purchases a certain
percentage of the company. The discount is not
available to the acquirer, and so it becomes
extremely expensive for that acquirer to complete
the takeover. Experts estimate that it would cost
an unwanted bidder, on average, four to five times
more to “swallow” a poison pill in order to acquire
a target.
 Bear Hug
Bear Hug:

The name "bear hug" reflects the persuasiveness

of the offering company's overly generous offer to
the target company. By offering a price far in
excess of the target company's current value, the
offering party can usually obtain an agreement.
The target company's management is essentially
forced to accept such a generous offer because it
is legally obligated to look out for the best
interests of its shareholders.
 Greenmail
A situation in which a large block of stock is
held by an unfriendly company. This forces the
target company to repurchase the stock at a
substantial premium to prevent a takeover.

It is also known as a "bon voyage bonus" or a

"goodbye kiss".
 PACMAN
To employ the Pac-Man defense, a company will
scare off another company that had tried to
acquire it by purchasing large amounts of the
acquiring company's stock. By doing so, the
defending company signals to the acquiring
company that it is resistant to a takeover and will
use the majority, if not all, of its assets to prevent
the acquisition.

The resisting company may even sell off non-vital

assets to procure enough assets to buy out the
acquirer. Often, the acquiring company sees the
potential risk of being taken over as motivation to