Valuation of acquisition candidates is comparable to appraising any investment proposal. In acquisition analysis before the acquisition process, the analyst tries to estimate the incremental cash flows that would result from the M&A. Then he computes the net present value (NPV) of those future cash flows by applying an appropriate risk adjusted discount rate. In the value strategy M&A makes economic sense only where the value of the combined new corporation is greater than aggregate value of the combining companies before the acquisition.
There is synergy when the cash flow of the combined entity is greater than the sum of the cash flows of the amalgamating companies as separate concerns.
The gain from M&A is the present value of this incremental cash flow or difference in cash flows. This is the maximum attainable limit for acquisition deal sale value.
An acquisition candidate is valued according to the source of the estimated resulting gains. Different sources of such synergy carry varying risk profiles.
In appraisal methodology and practice of valuation higher the risk, lower is the discounting rate and vice versa. Again for a given cash flow stream, higher the discounting rate applied with increasing risk profiles, lower will be the present value of the same.
Accordingly tax benefits that can be estimated with reasonable accuracy are discounted at the cost of debt capital.
In contrast, gains from strategic benefits are highly uncertain and difficult to estimate. So in such uncertainties a discount rate higher than the overall cost of capital is appropriate.
Cost savings through superior technology or operational efficiencies can also be projected with some degree of confidence. So in order to arrive at the net present value, such savings may be discounted at the usual weighted average cost of capital.
The net present value (NPV) of an acquisition is equal to the incremental gains minus the cost of the acquisition.
Cost of acquisition depends on whether cash or stock of the buying company is used to pay the shareholders of the selling company under the bargain. The amount of cash paid as consideration is included in the cost of acquisition. In a merger only for cash, the post merger benefits go to the purchasing company alone.
Where stock of the buying company is used as consideration to satisfy the shareholders of the selling company, the cost is equal to the proportionate value of the holding of the members of the acquired company in the combined new corporation. In a stock-for-stock M&A, the post merger benefits are shared proportionately by and between these two groups of members.
The issue whether cash or stock of the buying company would be used in merger depends on many factors. Where the absorbing company’s stock is overvalued, allotment of stock would be a cheaper proposition for the buying company. Moreover, the use of stock option allows erstwhile members of the selling company to share the gains of merger pro rata with the original shareholders of the buying company as well wrest proportionate control over the acquiring concern. Further, an acquisition for cash is a taxable proposition in the hands of the shareholders of the selling company that may lead to higher price.
