C2. Valuation for acquisitions and mergers

Question 1

Problem of overvaluation

Answer 1

When a company acquires a target company, it will pay a ‘bid premium’ above the target’s current market value. Where this premium is excessive, this creates a problem of overvaluation. Although shareholder of the target company may enjoy the benefit of the ‘bid premium’, shareholders of the acquirer often do not benefit as a result of overvaluation. Mergers enhance shareholders’ value if there are:
• Synergies
• Significant improvements in the management of the assets of the target company that could be realised by an acquisition

Question 2

A number of behavioural factors may explain why acquisitions are often overvalued.

Answer 2

• Overconfidence. People tend to overestimate their capabilities. At a board level it my lead to the board overestimating their ability to turn around a firm and to produce higher returns than previous management.
• Loss aversion. Many takeover bids are contested, and therefore there is a likelihood that the bid price will be pushed to excessively high levels. Threat of taken away leads to stronger desire to possess.
• Entrapment. Where strategy is failing, management may become unwilling to move away from it and may commit even more funds (lets say to buy another company for excessive amounts – seen as crucial) in desperate amount to turn around failing business.
• Anchoring. In valuing an unlisted company, the bidder may be strongly influenced by that company’s initial asking price, i.e. it becomes a biased reference point for the valuation.
• Agency issues. Managers may follow their own self-interest, instead of focusing on shareholders (make large acquisitions paying too much to avoid being taken over)

Question 3

The three acquisition types

Answer 3

• Type I acquisitions. These are acquisitions that do not disturb the acquirer’s exposure to either business risk or financial risk. In theory, the value of the acquired company, and hence the maximum amount that should be paid for it, is the Present Value of the future cash flows of the target business discounted at the WACC of the acquirer.
• Type II acquisitions. These are acquisitions which do not disturb the exposure to business risk, but do impact upon the acquirer’s exposure to financial risk, eg through changing the gearing levels of the acquirer. Such acquisitions may be valued using the Adjusted Present Value (APV) technique by discounting the Free Cash Flows of the acquiree using an ungeared cost of equity and then adjusting for the tax shield.
• Type III acquisitions. These are acquisitions that impact upon the acquirer’s exposure to both business risk and financial risk. In order to estimate WACC there is a need to establish the cost of capital of the combined businesses

Question 4

The valuation of Start-ups

Answer 4

The valuation of Start-ups creates additional problems to that of well established businesses. This may be due to:
• their lack of a proven track record,
• initial on-going losses,
• untested products with little market acceptance,
• little market presence,
• unknown competition,
• high development costs, and
• inexperienced managers with over-ambitious expectations of the future.