Merger & Acquisitions

Assignment.
1. Business Valuation
Business valuation is a process and a set of procedures used to estimate the economic value of an
owner’s interest in a business. Valuation is used by financial market participants to determine the
price they are willing to pay or receive to consummate a sale of a business. In addition to estimating
the selling price of a business, the same valuation tools are often used by business appraisers to
resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase
price among business assets, establish a formula for estimating the value of partners' ownership
interest for buy-sell agreements, and many other business and legal purposes.

2. Minority interest
A significant but non-controlling ownership of less than 50% of a company's voting shares by either
an investor or another company. Also, a minority interest account is a non-current liability that can
be found on a parent company's balance sheet that represents the proportion of its subsidiaries
owned by minority shareholders.

In accounting terms, if a company owns a minority interest in another company but only has a
minority passive position (i.e. it is unable to exert influence), then all that is recorded from this
investment are the dividends received from the minority interest. If the company has a minority
active position (i.e. it is able to exert influence), then both dividends and a percent of income are
recorded on the company's books.
As for the minority interest account, an example would be if ABC Corp owns 90% of XYZ inc, which
is a $100 million company. On ABC Corp's balance sheet, there would be a $10 million liability in
minority interest account to represent the 10% of XYZ inc. that ABC Corp does not own.
3. Terminal value
The value of an investment at the end of a period, taking into account a specified rate of interest.

The formula to calculate terminal is the same as that for compound interest:

Where:
TV = the total amount
P = the principal amount
r = interest rate
t = period of time

4. Free cash flows

A measure of financial performance calculated as operating cash flow minus capital
expenditures. In other words, free cash flow (FCF) represents the cash that a company is able to
generate after laying out the money required to maintain or expand its asset base. Free cash flow
is important because it allows a company to pursue opportunities that enhance shareholder
value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and
reduce debt.
4. Free cash flows
A measure of financial performance calculated as operating cash flow minus capital expenditures.
In other words, free cash flow (FCF) represents the cash that a company is able to generate after
laying out the money required to maintain or expand its asset base. Free cash flow is important
because it allows a company to pursue opportunities that enhance shareholder value. Without cash,
it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

It can also be calculated by taking operating cash flow and subtracting capital expenditures.

5. Stock Valuation
The most theoretically sound stock valuation method, called income valuation or the discounted
cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows)
the stock will bring to the stockholder in the foreseeable future, and a final value on disposition. The
discounted rate normally includes a risk premium which is commonly based on the capital asset
pricing model.
6. NPV
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used
in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

Formula:

7. Weighted average cost of capital

 A calculation of a firm's cost of capital in which each category of capital is proportionately weighted.
All capital sources - common stock, preferred stock, bonds and any other long-term debt - are
included in a WACC calculation.
WACC is calculated by multiplying the cost of each capital component by its proportional weight
and then summing:
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

8. DCF
A valuation method used to estimate the attractiveness of an investment opportunity. Discounted
cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often
using the weighted average cost of capital) to arrive at a present value, which is used to evaluate
the potential for investment. If the value arrived at through DCF analysis is higher than the current
cost of the investment, the opportunity may be a good one.

Calculated as:
 Discounted Cash Flow Approach
The DCF approach relates the values of the firm to the present
values of its expected future cash flows.

First Step – To estimate the Free Cash Flow for the explicit
forecast period.
 Free Cash Flow – Free Cash Flow from Operation + non-
operating cash flows
 Free Cash Flow from operations = Gross Cash Flow - Gross
Investments
 Computation of Gross Cash Flow –
EBIT
Less: Taxes
= Net operating Profit less Adjusted
Taxes (NOPLAT)
Add: Depreciation
Add: Non-Cash Charges
= Gross Cash Flow
 Computation of Gross Investment
Increase in Net Working Capital
Add: Capital Expenditure Incurred
Add: Increase in Other Assets
= Gross Investment
 Computation of Non-Operating Cash Flows

Non-Operating Cash Flows – Post – Tax Cash

Flows from items other than the regular
operations of the firm e.g. sale profit realized
on sale of fixed assets.
 Second Step - To compute the cost of capital
K0 = Ke S/V + Kp P/V + Kd (1 + t) B/V
Where,
Ko = Weighted average cost of capital
Ke = Cost of equity capital
Kp = Cost of preference capital
Kd = Cost of debt capital
S = Market value of equity capital
P = Market value of preference capital
B = Market value of debt
V =S+P+B
T = Applicable tax rate to the firm.
Third Step: Computing the continuing value of the
firm. Continuing value represents the value of the
Free Cash Flows beyond the explicit forecast
period.

CVn = FCFn+i / (K – g)
Where,
CVn = Continuing value of the firm at the end of the
year n.
FCFn+1 = Expected free cash flow for the year
n+1
K = weighted average cost of capital
G = expected perpetual growth rate of the free cash
flow.
Last step: Determination of the value of the
firm.
The free cash flow projections & continuing
value of the firm are discounted by the cost of
capital to get the present value of the cash
flows and value of non-operating assets like
investments one added to it. Market value of
all claim are deducted to arrive at the
ownership value of the firm.
Example
Swagat Enterprises is engaged in the construction business. Its current financials are as follows:

Rs. (in Crore)

Sales 100
Operating Expenses 40
EBDIT 60
Depreciation 10
EBIT 50
Tax (@ 40%) 20

The current level of its net fixed assets is Rs. 80 crore. The corresponding level of net current
assets stands at Rs. 10 crore.

The sales of the firm are expected to grow at the rate of 10% per year for the next 5 years. During
the same period, the operating expenses are expected to increase at the rate of 8% per annum.
Depreciation is to be charged @ 10% of the net fixed assets at the beginning of the year. To
finance this expansion, Swagat Enterprises will be making the following investments:
 Year Investment in fixed
assets (Rs. Crore)
1 20
2 0
3 10
4 15
5 0

Throughout the five-year period, the net current assets will remain at 10% of the net fixed assets.
All the investments will be made at the beginning of the respective years.
The tax rate will continue to be at 40%. The post-tax non-operating cash flows will be as follows:

Year Non-operating cash

flows (Rs. Crore)
1 10
3 5
4 20

The post-tax cost of debt is 8% for the firm. The cost of equity is 15%.
The market value of debt is Rs. 40 crore, and the market value of equity is Rs. 110 crore.
From the sixth year onwards, the free cash flow is expected to grow @ 10% per annum.

Calculate the value of Swagat Enterprises.

 
Solution:
Step I

Calculation the Gross Cash Flow for the explicit forecast period

Year 1 2 3 4 5

Sales 110 121 133 146 161

Operating 43 47 50 54 59
Expenses

EBDIT 67 74 83 92 102

Depreciation** 10 9 9 10 9

EBIT 57 65 74 82 94

Taxes 23 26 29 33 37

NOPLAT 34 39 44 49 56

Gross Cash Flow 44 48 53 59 65

** Depreciation is calculated as follows:

Year 1 2 3 4 5

Net fixed assets 80 90 81 82 87

at the end of
previous year
Additions at the 20 0 10 15 0
beginning of the
year
Total 100 90 91 97 87
Depreciation for 10 9 9 10 9
the year
Net fixed assets 90 81 82 87 78
at the end of the
year
Step 2

Calculating the gross investment

a. Investment in Net Current Assets

Year 1 2 3 4 5
Total Net 10 9 9 10 9
Current Assets
Net Currnent 10 10 9 9 10
assets at the
end of previous
year
Investment in 0 -1 0 1 -1
net current
assets
b. investment 20 0 10 15 0
Gross 20 -1 10 16 1
investment
Step 3

Calculating the Free Cash Flow

Year 1 2 3 4 5
Gross Cash 44 48 53 59 65
Flow
Gross 20 -1 10 16 -1
Investment
Free Cash 24 49 43 43 66
flow from
operations
Non- 10 0 5 20 0
operating
cash flow
Free Cash 34 49 48 63 66
flow

Step 4

Ascertaining the cost of capital

Cost of Capital = (0.08 x 40/150) + (0.15 x 110/150)

= 13.13%
 
Step 5

Determine the present value of the free cash flow

Year Free Cash PV factor Present

Flow Value
1 34 0.8839 30.12
2 49 0.7813 38.45
3 48 0.6906 33.26
4 63 0.6104 38.75
5 66 0.5396 35.52

Total 176.10
Step 6

Calculating the discounted continuing value

Discounted continuing value = 66 (1.10)/0.1313 – 0.10 = 2319

Value of the firm = Discounted free cash flows

+
Discounted continuing value

= 176.10 + 2319 = Rs. 2,495 crore

Market value of debt = Rs. 40 Crore

Value of equity = Rs. (2495 – 40) crore

= Rs. 2455 crore