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Summary CHAPTER 5

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FINANCIAL MANAGEMENT 354 SUMMARIES IN ENGLISH. CHAPTER 5

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  • October 31, 2019
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  • 2018/2019
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Chapter 5: Valuation
Learning 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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