Equity Research vs Investment banking

• Equity research is a division within either a buy side and sell side firm
which is responsible for the research used by the firm and its clients .
• Equity research does not directly generate revenue.
• Thus, equity research helps determine the attractiveness of an
investment which will help make smart decisions for a private as well
as a corporate investor.
Equity research

• Equity Research primarily means analyzing company's financials,

perform ratio analysis, forecast the financial in excel (financial
modelling) and explore scenarios with an objective of making
BUY/SELL stock investment recommendation.
 Investment banking
• Investment banking is a special segment of banking operation that
helps individuals or organisations raise capital and provide financial
consultancy services to them. They act as intermediaries between
security issuers and investors and help new firms to go public. They
either buy all the available shares at a price estimated by their experts
and resell them to public or sell shares on behalf of the issuer and
take commission on each share.
• Description: They serve many different purposes and business
entities. They provide various types of financial services, mergers and
acquisitions advisory which involves helping organisations in M&As,;
leveraged finance that involves lending money to firms to purchase
assets and settle acquisitions, restructuring that involves improving
structures of companies to make a business more efficient and help it
make maximum profit, and new issues or IPOs, where these banks
help new firms go public.
 Investment banking
• Think of company ABC buying another company XYZ. ABC is not
sure how much company XYZ is really worth and what will be the
long-term benefits in terms of revenues, costs, etc. In this scenario,
the investment bank will go through the process of due diligence to
determine the value of the company, settle the deal by helping ABC
prepare necessary documents and advising it on the appropriate
timing of the deal.
Here the investment bank works on the buy side and some other
investment banks may be working on the sell side to help XYZ. The
bigger the deal size, the more commission the bank will earn.
Bank of America, Barclays Capital, Citigroup Investment Banking,
Deutsche Bank, and JP Morgan are some of the largest investment
banks in India.
 Key Words
• Valuation – It is the act of determining the value or the price of anything.
• Return- The anticipated future cash flow from an investment. The future
cash flow is the only financial benefit to the investor.
• Investment- Investment is an act of incurring immediate cost in the
expectation of future rewards.
• Risk- It measures the uncertainty of the anticipated future cash flows.
APPROACHES TO VALUATION

Income Approach Market Approach Asset Approach

Capitalization Comparable Adjusted

Method Company Book value
Discounted Method Method
Cashflow Liquidation
Method Value Method
Market APPROACH

• COMPARABLE COMPANY APPROACH/RELATIVE VALUATION .

• Under this , the value is determined based on the prices that have
been paid for similar assets in the relevant market place.
• It values an asset or a firm based on how an exactly identical firm is
priced.
 Example:

We assume , Company X had a sales of 100 million , book value of

60 million and a net income of 5 million .
Ratio Company A Company B Company C Average

Market / sales 1.2 1.0 0.8 1.0

Market /book 1.3 1.2 2.0 1.5

Market / net income 20 15 25 20

=
 Comparable transaction analysis

Actual data for company Y Average Market Ratio Indicated value of Equity
Sales 100 1.0 100

Book value of equity 60 1.5 90

Net Income 5 20 100

Therefore, on the basis of the average of all the parameters, the

average value of X comes out to be .......................... However, in
context of mergers, the market refers to the transaction price recently
completed . Typically, merger transactions involve a premium as high
as 30-40% over the prevailing market price.
 Comparable transactions

Ratio Company TA Company TB Company TC Average

Market/ sales 1.4 1.2 1

Market / book 1.5 1.4 2.2

Market / net 25 20 27
income
Company X will be

This value reflects premium of ......over general market valuation relationships. The
implication is that if Company X was going to be purchased and there were
comparable transactions , we will take the approach as shown in table 1 and 2 .
Valuation Multiples and Selection

EARNINGS MULTIPLE BOOK VALUE MULTIPLES REVENUE MULTIPLES ENTERPRISE MULTIPLES

P/E PRICE TO PRICE TO EV/EBITDA

BOOK RATIOS SALES RATIO
PEG RATIO VALUE TO VALUE TO EV /SALES
BOOK RATIOS SALES RATIO
RELATIVE P/E EV/ TA
RATIO
 EARNINGS MULTIPLE
• P/E = MARKET PRICE PER SHARE / EARNINGS PER SHARE
• It is most apt for the profitable companies
• Stable capital structure
• PEG RATIO = P/E RATIO /EXPECTED EARNINGS GROWTH
• Lower the PEG , more undervalued the stock
• Lower than 1 PEG IS DESIRABLE
• RELATIVE P/E = CURRENT P/E(FIRM)/CURRENT PE (MARKET)
• It is usually compared for a time period
• EV/EBITDA= Enterprise value / EBITDA
Enterprise value = Market cap+ Debt-Cash
What is an undervalued stock ?
A stock that trades lower than its fair market value OR intrinsic value
 Book value multiples
• It is a simple benchmark for comparison
• These can be used across similar firms for comparisons.
• Even firms with negative earnings can be evaluated using these multiples.
• Price / Book = Market price per share/ book value of equity per share
• Value to Book= Firm value/ book value of firm
• Firm value = Market value of Equity +Market value of Debt
Revenue Multiples

• Measures the value of the equity or business relative to the revenues

that it generates.
• Firms that trade at low multiples are viewed as cheap vis a vis the
companies that trade at high multiples
• Revenue multiples are available for the most young and troubled
companies.
• Revenue multiples are more stable
• Revenues are not influenced by the accounting decisions
Revenue multiples

• Price/ sales ratio= market price per share/ Revenue per share
• Value /sales ratio= Total value of firm to Total revenues
• DISADVANTAGE
There is a possibility of assigning high values to firms that are
generating high revenue growth. Ultimately, a firm has to generate
earnings and cash flows for it to have value.
Page 111
Limitations

• The comparable methods fail to arrive at definitive values.

• The companies used in comparisons are likely to have different track
records and opportunities though might be in similar business and
comparable in size :
• Prospective growth rates in revenues
• Riskiness of companies
• Prospective growth rates in cash flows
• Stages in the life cycles of industry and company
• Competitive pressures
• Opportunities for moving into new expansion
areas
Intrinsic value

• Intrinsic value is the perceived or calculated value of a company,

including tangible and intangible factors, using fundamental analysis.
Also called the true value, the intrinsic value may or may not be the
same as the current market value.
• DCF is the common method to determine company’s intrinsic value
• DCF uses company’s FCFF and WACC which accounts for TVM and
then discounts all its future cashflow back to the present day.
• If
• A)Intrinsic value = market value , the stock is correctly priced.
• B) Intrinsic value < market value, the stock is ..........................
• C) Intrinsic value > market value, the stock is ...........................
Income Approach

• Single–Period Capitalization Method – It involves the capitalization

of the return at the cost of capital for a company for one year.
• Multiple–Period Discounted Cash Flow Method- It involves two
stages.
• The first stage involves forecasting of cash flows for a specific number of
years.
• The second stage involves estimating the terminal value i.e. The value for all
the years after the forecast period.
Illustration:

• An acquiring firm A has the opportunity to buy a target company .

The target company can be purchased for US$ 180 . The relevant cash
flows will be recd from the target company of US$ 40 for 10 years.
The relevant cost of capital for analyzing the purchase of target is
14%. Does this acquisition represent a positive NPV project?
 DISCOUNTED CASH FLOW MODEL
t=n
• Value = ∑ CFt/(1+K)ˆt

• Where, n=t=1
life of the asset
• CFt = cash flow period t
• k= Discount rate

The discount rate is the function of the risk of the estimated cash flows . Riskier assets have
..............
and safer asets have ...................... Discount rates
 Cash flow to firm model
• It is used to compute the value of the entire firm.
• Cash flows available to all the suppliers of capital such
as...............................................
• All expected cash flows of the firm after meeting all operating expenses ,
reinvestment needs and taxes , but before any payments to either debt or
equity holders.
• The cash flows are discounted at the weighted average cost of capital.
Discounted cash flow models

• Cash flow to Equity Model

• It is used to value only the equity stake in the business.
• CFE are all cash flows remaining after meeting all expenses,
reinvestment needs, tax obligations and net debt payments.
• The cash flows are discounted at the rate of return required by
equity investors in the firm.
• Value of Equity =∑CF to Equity/1+Ke ˆt
 Adjusted Present Value Approach
• The value of equity is computed as a first step , assuming that the firm is
financed only with equity.
• The value added (or taken away) by debt by considering the value of tax
benefits that flow from the debt by considering the present value of the tax
benefits that flow from debt .
• The expected bankruptcy costs is considered.
• Value of the Firm= Value of all equity financed firm +PV of tax benefits –
Expected bankruptcy costs.
Steps

• Estimating the Free cash flow for the period.

• Estimating the growth in earnings.
• Computing the cost of capital.
• Computing the continuing value .
• Determination of value of the firm.
FREE CASH FLOw

• Free cash flow is a company's operational cash flows less the cash it needs to
fund capital expenditures and net working capital needed to maintain current
growth.
• Since it is typically difficult to estimate capital expenditures well in advance, a
company often uses its historical average to estimate this number.
• Free cash flow can flow to equity or to the firm in general. If the company has a
large debt load, then the interest and principal payments on the debt will reduce
the free cash flow available for equity holders.
• Using the free cash flow method of valuation requires you to discount the
anticipated, or forecast, future free cash flows back to the present.
• This calculation can be complex, because it involves some assumptions about
operational cash flows, capital expenditures, working capital increases and
growth.
FREE CASH FLOW to FIRM (FCFF)

• EBIT(1-t)+Depreciation-Capex-change in working capital.

• EBITDA (1-t)+Depreciation(tax rate)-Capex-change in working Capital
• CFO +Interest (1-t)-Capex
• Where
• CFO= NI +Depreciation +Amortization-Increase in net working capital
• EBITDA=FCFF+EBIT(1-t)+capex +change in working capital
FCFF Vs FCFE

• FCFF is also termed as UNLEVERED CASH FLOW as it is the cash flow

before interest on debt in considered.
• FCFF can be reconciled with FCFE as the diff. Between the two is :
• Interest paid on debt
• Net new debt financing ( Rasing new debt – redemption of old debt)
Therefore, FCFE=FCFF-Interest(1-t)- Net borrowings
Estimation of Cash flows

• Cash flows should be after taxes.

• Non cash charges reduce the taxable income but does not cause cash
outflow.
• Consequently, depreciation is added back to the net income to arrive
at the cash flows on a project.
Estimation of Cash flows

• Cash flows should be Incremental

• Only those cash flows which affect the inflow or outflow that is
a direct or indirect consequence of taking up a particular project for
which the valuation is done should be included.
• SUNK COSTS, WORKING CAPITAL, OPPORTUNITY COSTS, ALLOCATED
COSTS
Sunk costs

• The expenses that have been incurred before the project analysis is
done and cannot be recovered if the project is not taken up .
• Such expenses cannot be recovered if the project is rejected , hence,
sunk costs are to be ignored.
Working capital

• Working capital requirements is a function of the expected growth in

revenues and expenses on the project.
• An increase in working capital can be viewed as ...............................
• A decrease in non cash working capital can be viewed as
...........................
• After tax CFF =
EBIT(1-t)+Depreciation – Capital Expenditure- Change in
working capital
Opportunity costs

• Opportunity cost of an investment is the expected return that would

be earned in the next best investment .
• The opportunity cost usually takes the form of the lost rental revenue
or the foregone sale price or the cost of replacing the asset.
• Hence, the present value of opportunity costs estimated should be
added to the initial investment while estimating the net present
value of the project.
STEP 2 Earnings Growth Estimation

• In case of valuation of equity in aggregate , we consider net income

as earnings.
• In case of valuation of equity per share , we consider the earnings per
share.
• The growth rate in earnings in a particular year is the excess of
earnings which the firm has earned over the previous year.
• Growth in Net Income=
(Net income in year t –Net income in year t-1)
Net income of year t-1
Earnings Growth Estimation/ Forecast
Dividend Growth
• Growth Rate =
• Retention ratio (b) X Return on Equity (RoE)

• Equity reinvested=
(Capital Expenditure- Depreciation) +Change in
working capital
–(New debt issued –Debt Repaid)
• Equity reinvestment rate = Equity reinvested / Net Income
Operating iNcome Growth Estimation

• Expected Growth Rate = Reinvestment rate X .....................

• Total reinvestment =
• Reinvestment rate = Reinvestment/
Determinants of Return On Equity

• RoE=RoC+D/E[RoC-i(1-t)]
• RoC=EBIT(1-t)/ (BV of Debt+ BV of Equity)
• Therefore g=..................................
• WACC= kd (1-t)B/V+ KpP/V+KeS/V
Where,
B= M.V of debt
P=M.V of Preference shares
S= M.V of equity
Perpetuity Value beyond FCF Period

• Perpetuity value / Terminal Value = FCFF (n+1)

WACC – Stable growth rate

Stable growth rate is the rate at which the firm will grow in the stable period .
This growth cannot be more than the economic growth rate of the country.
STEP 3 Cost of capital

• Cost of Equity
• Cost of Preference shares
• Cost of Debt
Cost of Equity

• 1) Dividend Capitalization Approach

Constant Dividends
• A) Ke = Dt/Po ( Constant dividends)
Constant Dividend Growth
• B) Ke= (D1/Po)+g (Constant dividend growth)
Floatation costs are there
• C) Ke= [D1/(Po-f)]+g (Floatation costs are also there)
Limitations of dividend Capitalisation Method

• The model is applicable to mature stable companies that pay

consistent dividends.
• However, there are several companies that have high growth
opportunities and abstain from paying regular dividend
• Another assumption is the dividend is paid out of earnings. Dividend
may not be correlated with earnings of the firm.
• Dividend model is not highly recommended for valuation purpose.
Cost of Equity

2)Capital Asset Pricing Model

Expected return on equity/ Ke =Rf+β (Rm-Rf)
• Rm =Dividend Yield+ g
• βl= βu [1+(1-t)(D/E)]
• Rf= Risk Free Interest rate
• Market Risk Premium=
Where, Dividend Yield=
g=
BETA

• Equity return relationship with market return.

• BETA includes both business risk (operating assets) and financial risk
(use of debt in capital structure)
• Beta is determined by
• Nature of business
• Operating Leverage
• Financial Leverage
Factors Affecting Beta

1)Type of business of the firm

High beta for cyclical firms
High beta for firms which are sensitive to market
conditions.
2)Degree of Operating Leverage
Effect of change in rev. on the change in EBIT
3)Degree of Financial Leverage
Effect of change in EBIT on EPS
Calculation OF BETA

• βl= βu [1+(1-t)(D/E)]
• Pg 85 and 86
 Application of UNLEVERED BETA
• Valuing Private firms
• Valuing business divisions
• Valuing firms with changing gearing ratio
• Valuing a new company post M&A
• Note: Unlevered Beta is also called Asset Beta
• It reflects only the business risk of the firm.
• It remains constant till the time the company operates in the same business

• Levered Beta is also called Equity Beta

• The EQUITY BETA is remains constant , till Debt / equity ratio is same .
LIMITATIONS OF CAPM

• CAPM assumes that Rf and Rm are constant for all investments in a

given market at all times.
• The CAPM is a one year period model , limiting its use for multi-
period investments.
• There are many other factors other than Rm that determine the
expected return on investments such as earnings/price ratios,
B.V/M.V ratios, relative size( M.V of co’s stock relative to Total stock
M.V)
Cost of Debt and Pref. Shares

• After tax cost of debt= Pre tax cost of debt (1-t)

• Cost of Pref. share=Dividend per share /market price per preference
share
Equity valuation model

• FREE CASHFLOW TO Equity

• Dividend discount model
• The Gordon Growth Model
• Two Stage Dividend Discount Model
• Constant Growth rate during the high Growth Period
• Constant Growth Initially followed by gradual reduction to stable growth
• Three Stage Dividend Discount Model
Equity Valuation model (CaSE 1-DDM)

• It is a specialized case of equity valuation.

• The value of equity is the present value of expected future dividends.
• DIVIDEND DISCOUNT MODEL
• THE VALUE OF STOCK IS THE PRESENT VALUE OF THE DIVIDENDS DISCOUNTED AT THE
RATE APT TO THE RISK OF CASH FLOWS.
• Value of equity= ∑(DPS) / (1+ke)ˆt
• where, DPS = Expected dividend per share
• Ke = Cost of Equity
Considerations DDM

• Two basic inputs: Expected Dividends and Cost of Equity

• Expected dividends
• We make assumptions about expected future growth rates in earnings and pay out ratios.

• Cost of Equity
• The required rate of return is determined by its riskiness.
• The riskiness is measured by.......................
GORDON GROWTH MODEL

• It is used to value a firm that is in steady state with dividends growing

at a rate that can be sustained forever.
• It relates the value of a stock to its expected dividends in the next
time period , the cost of equity and the expected growth rate in
earnings.
• Suitability – For firms growing at a rate comparable to or lower than
the nominal growth in the economy.
• Have well established dividend payout policies which is intended to
continue in future.
GORDON GROWTH MODEL

• Value a regulated firm: Consolidated Edison in May 2001 Consolidated Edison is

the electric utility that supplies power to homes and businesses in New York and
its environs. It is a monopoly whose prices and profits are regulated by the State
of New York.
• Rationale for using the model · The firm is in stable growth; based upon size and
the area that it serves. Its rates are also regulated. It is unlikely that the
regulators will allow profits to grow at extraordinary rates. · The firm is in a stable
business and regulation is likely to restrict expansion into new businesses. ·
• The firm is in stable leverage. · The firm pays out dividends that are roughly
equal to FCFE. ·
• Average Annual FCFE between 1996 and 2000 = $551 million ·
• Average Annual Dividends between 1996 and 2000 = $506 million ·
• Dividends as % of FCFE = 91.54%
• Background Information Earnings per share in 2000 = $3.13
• Dividend Payout Ratio in 1994 = 69.97%
• Dividends per share in 2000 = $2.19
• Return on equity = 11.63%
Gordon Growth MODEL

• We first estimate the cost of equity, using a bottom-up levered beta for
electric utilities of 0.90, a risk free rate of 5.40% and a market risk
premium of 4%. Con Ed Beta = 0.90 Cost of Equity = 5.4% + 0.90*4% = 9%
• We estimate the expected growth rate from fundamentals. Expected
growth rate = (1- Payout ratio) Return on equity = (1-0.6997)(0.1163) =
3.49% 1
• The average payout ratio for large stable firms in the United States is
about 60%. 6 Valuation
• We now use the Gordon growth model to value the equity per share at
Con Ed:
• Value of Equity = $41.15
• Con Ed was trading for $36.59 on the day of this analysis (May 14, 2001).
Based upon this valuation, the stock would have been under valued. .
TWO STAGE DDM

• There are two stages of growth

• Initial Phase – Growth rate is not a stable growth
• Next stage – Growth is stable and steady and is expected to remain same in long term .
• Generally , the growth rate during the initial phase is higher than the stable growth rate .
• However, the model can be adapted to value companies that are expected to post low
or even negative growth rates.
• Value of stock= P.V of dividends during the extraordinary phase+ P.V of terminal price.
Two Stage DDM

• The first problem is defining the length of the extraordinary growth

period.
• The second issue lies in the assumption that the growth rate is high
during the initial period and is transformed to a lower stable rate at
the end of the period.
The H Model

• The H model is two stage model for growth.

• The growth rate in the initial phase is not constant but declines
linearly over time to reach the stable growth rate in steady stage.
• Po= DPSo(1+gn)+DPSo*H*)(ga-gn)
(Ke –gn) (Ke-gn)
The H model

• Alcatel is a French telecommunications firm, paid dividends per share

of 0.72 Ffr on earnings per share of 1.25 Ffr in 2000. The firm’s
earnings per share had grown at 12% over the prior 5 years but the
growth rate is expected to decline linearly over the next 10 years to
5%, while the payout ratio remains unchanged. The beta for the stock
is 0.8, the riskfree rate is 5.1% and the market risk premium is 4%.
• Ans : 30.55.
The Three stage Model

• The three-stage dividend discount model combines the features of

the two-stage model and the H-model.
• It allows for an initial period of high growth, a transitional period
where growth declines and a final stable growth phase.
• The value of the stock is then the present value of expected
dividends during the high growth and the transitional periods and of
the terminal price at the start of the final stable growth phase.
 Limitations of DDM
• It is used to value only those stocks which pay high dividends.
• The dividend discount model does not reflect the value of unutilized assets .
• The model does not consider other ways of returning cash to the
shareholders except dividends .
• It does not capture the true capacity to generate cash flows for stock holders
as many firms do not pay FCF as dividends.
• What are the other ways of returning cash to shareholders?
 Free Cash flow to equity
• The FCFE is defined as the residual cash flow left over after meeting interest
and principal payments and providing for capital expenditures to maintain
existing assets and create new assets for future growth.
• FCFE = Net Income+ depreciation–Capital Spending-Change in working
capital-Principal repayments + New debt issues.
• The value of stock =
• Present value of FCFE +Terminal Price
FCFE vs DDM

RESULTS OF FCFE AND DDM

• Case I – FCFE = Dividend, The values obtained are same
• Case II - FCFE>Dividends
• a) Excess cash is invested in projects ,where
NPV =0
b)Excess cash is invested in projects
where NPV= -ve , the value from FCFE >
then DDM
c)Firm borrows to pay the dividends, the
firm might become over levered. This
will lead to capital rationing constraints
where good projects will be rejected ,
resulting in a loss of value.
FCFE OR DDM

• If the probability of mgt change or takeover is high, then FCFE is a

more apt benchmark.
• However, in case change in the corporate control is difficult , then
DDM is more apt.
ASSET APPROACH

• ADJUSTED BOOK VALUE

• WHEN THE ASSET VALUATION IS BASED ON THE GOING CONCERN PREMISE.
• Under this method, it is assumed that the business will continue operating
and the assets are evaluated based on their value in use.
• LIQUIDATION METHOD
• Under this method, it is assumed that the operations of the business will
cease and liquidation will occur. The assets are valued at the proceeds they
generate in a sale.The costs involved in liquidating the business must be
subtracted
Business Valuation AND consideration paid in
M&A
• EVA
• EVA determines the monetary value of a business by taking into account all capital costs
including owners equity .
• EVA assesses the ability of the firm to generate profits over and above the cost of capital
employed to generate the profits.
• Cost of capital of a firm should be less than the profit generated by it .
• EVA= NOPAT - (WACC X Capital employed)
• A positive EVA implies that firms have generated profits in excess of the funds it
employed to generate the same.
• Capital Employed = Total Assets – Current liabilities

Pg:323
Historical Cost Approach

• Under this, the information from the company’s balance sheet is

used .
• It can be done in two ways
• Investor Claim Approach -Total claim of investors
• Share Capital+ Reserves and Surplus + Secured Loans + Unsecured Loans
• Asset Liabilities Approach- Total Assets –(Cl+ provisions)
• Current Assets+ Fixed Assets –( Current Liabilities +Provisions)
CONSIDERATIONS IN M&A

• Consideration – The total payment for the target firm.

• It has two components
• The base (Fundamental) value of the firm
• Relative Valuation Method
• DCF Method
• Balance sheet Method
• EVA Method
• The acquisition premium
• The Acquisition premium can further be bifurcated into
• Efficiency Gains
• Opportunity cost involved with the acquirer.
• Non operating assets (Non Controlling interest held by the firm)
• Synergy Gains
Efficiency Gains

• Efficiency gain is the gain achieved by the better management of

existing resources of the target.
• Target firm may have the scope of efficiency gains. How?
• May have underutilized resources
• Thus , thru, efficient and optimum utilization of resources, efficiency gains might occur.
• Improving the operating margins
• Optimal Capital Structure (Since, debt is considered to be the cheapest source of finance.)
• Full utilization of cash.
Opportunity Costs

• It means the loss of other alternatives , if one alternative is chosen.

• The acquirer, faces losing to the competitors, in an event of strong
entry barriers and few players.
• Example: A , B and C are three players. If A acquires C, B would lose
some of its business. In such a case , the acquirer would add to the
FV of the target co. , the value of the loss incurred by it , if the other
competitor acquires the target firm.
NON OPERATING ASSETS

• The target firm may hold stake in non –operating assets.

• These exist as minority interest or non controlling interest held by
the target firm.
• The value of these investments need to be added to the value of the
target firm.
CONSIDERATIONS IN M&A

• Synergy Gains
• These are generated when an acquirer and the target firm combines their
resources.
• The SG generated through economies of scale and scope aim at enhancing
revenues and reducing variable costs.
• Therefore,
Synergy Gain = Increase in value generated post merger of acquirer and
target firm less the cost incurred towards deal execution and integration post
M&A.
Pg:331
Identifying opportunities in m&A

Investment banks activities- Buy side Advisory

• Identify the tentative potential targets for acquisition
• Preliminary due diligence for the proposed buyers
• Select the best feasible option for the buyer
• Carry out complete financial due diligence for the selected target
• Write and fix the pre–purchase agreement.
• Negotiate with the target firms and close the deal.
• It also includes arrangement for financing the deal and raising of
bridge loans.
Buyer Motivation

• Synergy gain
• Operating Synergy Gains
• These are derived by combining the complementary resources of the two companies
• These are generated from economies of scale or economies of scope
• By cross selling and reducing the overlapping and redundant activities.
• Financial Synergy
• It is created by tax advantage, cash richness of target and investment opportunities in the
target business.
Financing Options for BUYER

• Stock Payment
• Exchange ratio= Pt/Pa
• where,
• Pt = Price of target firm,Pa =price of the acquirer before the announcement of the deal.
• The minimum exchange ratio = FVt/FVa
• Where, FV = Fundamental Value
• The Maximum exchange ratio = FVt+AP/FVa
• AP = Acquisition Premium

• The final exchange ratio will depend on the negotiating skills. The
above three values would give the range . Acquirer would want to
pay min. and the target would like to get the max. This is called the
exchange ratio continuum.
Financing Options for BUYER

• CASH PAYMENT
• Cash on hand
• Debt Financing
• Bridge Loan – Interim Loan taken by the .............from the banking consortium . It is
converted into long term funds in the capital structure.
• Bonds and debentures – Issued to public to raise funds
• Senior debt notes – It carries less risk and relatively less return
• Junior Debt – Subrodinated debt.- A popular form is Mezzanine debt , it has an equity
component in built like warrant , which is an option to buy in future the stock of the
company at a pre- specified low price
• Line of credit or revolver credit – This is a type of loan like working capital loan wherein
interest is charged only on the amount that is used by the firm
EPS Accretion ( Dilution Analysis)
• Accretion or Dilution Analysis measures the impact of transaction on a
potential acquirer’s earnings under a specific financing structure.
• It is a comparison of EPS post M&A in combined format with acquirer’s
standalone basis pre M&A.
• Accretion Combined EPS >Acquirer’s EPS Dilution Combined EPS <
Acquirer’s EPS
Breakeven No impact on Acquirer’s EPS
Pg 82 (IB Module)
STEPS to CALCULATE ACCRETION OR DILUTION
• Estimate the net income of the combined firm called proforma income.
• ADJUSTMENTS
• Synergies created in M&A
• Increased int. Expense (new debt used to finance the transaction)
• Decreased Interest income
• Increased amortization
• Increased Depreciation

• Calculate the new share of the combined firm.

• Divide the estimated net income of the combined firm by the new share
count.
P/E VS DEAL

• PURE STOCK PAYMENT

• P/E (Acquirer)> P/E Target ...Deal is always accretive
• P/E (Acquirer) < P/E Target ....Deal is always dilutive
 Consideration
• If FV > Consideration , value created for acquirer shareholders
• In case of acquisition premium
• Consideration should be (More/Less) than FV +S.G
• In case
• A.P> S.G , then wealth transfer from (Acquirer/target) to target shareholders.
• A.P < S.G, then wealth created for (Acquirer/ Target)
REASONS FoR EPS DILUTION

• The target Company has negative net income

• The target’s P/E multiple is greater than the acquirer’s
• The M&A creates a lot of intangible assets
• Increased interest expense due to debt used to finance the M&A
• Low or negative synergies
Due DILIGENCE

• Due diligence involves:

• Identifying the target
• Doing valuation of fundamental Value
• Calculating acquisition premium justified in the deal
• Determining the modes of payment by buyer for value maximisation
• Legal structure of the deal
FooTBALL FIELD

• It is a graphical display of valuation.

• Assigned to target firm by different methods.
• Process includes
• Entering the time period data for valuations
• Determining the minimum and maximum values
• Determining the diff. Between the max and min. Values
• Making the stacked bar chart.
Merger Model