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FINANCIAL MANAGEMENT 354 SUMMARIES IN ENGLISH. CHAPTER 5
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Chapter 5: ValuationLearning Outcomes
Explain how the discounted cash flow valuation method is applied to value business combination
Indicate how a company’s free cash flow is calculated
Illustrate how the relevant costs of capital figure required for valuation is estimated
Discuss the effect that synergies, changes in control and capital structure and tax implications could have on
the value of an M&A transaction
Illustrate the effect of synergies, changes in control and capital structure and tax on valuation
Illustrate how two variants of the free Cashflow approach, namely the free cash flow to equity approach and
the capital cash flow approach, can be used during the valuation of a business combination
Provide an overview of other valuation methods that could be employed to value an M&A transaction, and
illustrate their application.
Introduction
- Most NB part of an M&A transaction is calculating the value of the transaction
- If pay too much then transfer value of existing shareholders to shareholders of the target
- It pay too little then the shareholders of the target may reject the offer and accept a competing offer
- Therefore very NB to conduct a specific analysis for the benefits of the transaction & base value on these
- Look at aspects such as the profit, tax benefits, improved management and strategic motive
- Must consider all the stakeholders in the transaction
- Look at the cashflows that will result from the transaction
Discounted Cashflow Valuation
- Consider the long-term benefits in relation to the initial investment
- This will show whether the transaction provides the required rate of return for the company
- Decide on the financial feasibility of a project by comparing the projects rate of return with the required
rate of return
- Utilise assumptions with regard to – economic lifetime, expected future profits, expenses and investment
levels
- Use assumptions because the economic lifetime is infinite since there is no plan to close business
- Use these assumptions to calculate the discounted amount of cash flows = NPV
- To calculate NPV – discount a series of expected cash flows at the projects required rate of return
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, considering an investment in new assets that will enable them to expand their current activities. The assets will generate additional c
200 000. Suppose that WCB Ltd. has a cost of capital of 10%, and that the assets required for the expansion currently cost R700 000.
This value is less than the R700 000 required to pursue this venture – therefore should reject the expansion project. It doesn’t ach
If pay too much for the entity then will destroy the shareholders wealth.
Present Value of the Target Company
- Use NPV calculation to determine the value of the target company and then decide on the value for
transaction
- Discount cash flows over the expected lifetime of the company
The company’s life is indefinite – therefore must break the valuation down into two parts
1.) Forecast Period - attempt to estimate the expected cash flows that will be generated by combination
- usually include very specific assumptions
- period where abnormal growth occurs – the period of time when the company is
expected to yield a competitive advantage.
- after the competitive advantage is exhausted the constant growth is included in the
terminal value calculation
2.) Terminal Value - based on the final cash flow estimated during the forecast period
- constant growth assumption and indefinite period of time
- perpetual flow of constantly growing cash flows = estimation of the present value of
the cash flows generated after the forecast period.
Terminal Value = FCFt x ( 1 + g )
( WACC – g )
FCFt = the free cash flow during the final year of the forecast period consisting of t years
g = the constant growth rate assumed after the forecast period
WACC = the company’s weighted cost of capital
NB! When working with calculation of the terminal value – conservative assumptions must be made
Since valuation happens over a long period of time – small changes have a profound effect.
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