Valuation of acquisitions (Part 2)

In part 2 of my acquisition series, we`ll head over to type 2 acquisitions where the acquiring company is exposed to financial risk only. Business risk remains unchanged here.

The average investor/ trader would rarely use this method to intrinsically value a counter unless there`s an acquisition that changes the financial risk of the joint entity.

An example of this type of acquisition is the recent merger between CIMB, RHB and Malaysian Building Society. Fundamentally, all three companies are involved in a similar business but the financial risk is changed due to the differences in capital structure and debt.

Think of the acquisition in terms of a project, when the capital structure changes, the adjusted present value (APV) model is used. This model can indicate how the net present value of a project (or in this case, an acquisition) is affected by the difference in financing. An acquisition is valued by discounting the free cash flows by the ungeared cost of equity followed by adding the present value of the tax shield.

APV = Value of target company (Fully equity financed) + PV of debt tax shields - Initial investment 

Steps:

1. Calculate the net present value as if it is ungeared.

2. Add the present value of the tax saved from the debt interest payments.

3. Deduct the debt of the target company to arrive at the value of equity.

4. Minus out the cost of acquisition to arrive at the net equity figure.