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Establishing a Value for the Target Company

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An acquiring company may be interested in acquiring entire business or just acquiring individual assets and selling off the rest of the assets. When considering a merger, companies can use capital budgeting techniques to find the value of the company. If the net present value of the relevant cash flows is positive then a merger is considered acceptable.

If the acquiring company is interested in the whole business rather than in just few assets of the target company then post-merger pro forma statements for the target company should be prepared and the cost of capital of the acquiring company must be adjusted to reflect the cost of capital of the target company.

Test yourself:

ABC Company would like to obtain assets of BCD Company. BCD Company is a loss maker, it made losses over the last 4 years. However, it has three assets which ABC needs for its operations which are assets a, b and c. BCD is not willing to sell the assets separately but willing to sell the entire company for $95,000. According to the balance sheet of BCD:

  • asset a is worth $25,000
  • asset b is worth $20,000
  • asset c is worth $50,000
  • BCD also has $5,000 in cash, $12,000 in accounts receivable, and $5,000 in relatively obsolete inventory
  • ABC found out that they can sell accounts receivable and inventory of BCD for $10,000
  • BCD’s liabilities account for $70,000
  • After the merger, three assets of BCD will generate $15,000 in cash inflows over the next 10 years
  • ABC’s cost of capital is 12%

How should ABC establish if it should undertake this investment?

Solution:

BCD requires $95,000. Out of this money, $70,000 will be used to cover liabilities and $25,000 will be going to the owners of the target company. ABC will be able to recover $10,000 from selling accounts receivable and inventory and it will also obtain $5,000 in cash. Therefore, its actual investment is $80,000 ($95,000-10,000-5,000).

Next we need to determine the net present value of the relevant cash flows. Since it is an annuity, we can calculate it very simply. We will use a financial calculator. The calculation is as follows:

PMT: 15,000

N: 10

I: 12

PV: calculate = 84,753

Since investment required is $80,000, we can find the NPV as follows:

84,753 – 80,000 = 4,753

There is another way to calculate NPV using a financial calculator. It is advisable to try them both to make sure that the answer you obtain is correct. The second way is as follows:

CF0: -80,000

CF1: 15,000

Second function Nj: 10

I: 10

Second function NPV: calculate = $4,753

Since both calculations gave us the same answer, we can be confident that the answer is correct.

Since NPV is $4,753 which is higher than zero, a merger with BCD is acceptable.

 

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Purchase versus Lease Decision

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When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

Related Articles:

Operating and Financial Leases (Capital Leases)

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Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

 Related Articles:

Advantages & Disadvantages of Leasing

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Advantages of Leasing

  • Businesses avoid large capital outlays when acquiring the use of an asset, thereby freeing up cash for more productive uses.
  • In the case of the start ups, leasing also helps to ascertain a business’s asset requirements before purchase of assets is made. As an example, a business can rent a building space for a year to obtain a better understanding of the business’s building requirements before committing to purchasing a space.
  • Leasing offers flexibility, especially with assets which tend to become obsolete very fast.
  • Leasing does not result in restrictions on company’s financial operations due to loan covenants.
  • If firm experiences liquidity problem, it can lease back an asset to the lessor that the firm already owns. Sale-leaseback arrangements consist of selling an asset to the lessor and leasing it back. Such action can the improve liquidity of the firm.
  • If the firm will go bankrupt or if it is undertaking reorganization, the firm is better off if assets are leased because the lessor can claim a maximum of 3 years worth of lease payments. Lenders, on the other hand, can claim the entire outstanding debt.
  • Leases usually do not require down payment. Therefore, lease provides 100% financing. In comparison, when an asset is purchased, lenders often usually require down payment of 10% or at least 5% of the asset.
  • Under operational lease some financial ratios look better because the asset is not capitalized, which refers to asset not being recorded in the balance sheet as an asset and corresponding liability.
  • Lease can be undertaken as a hedge against rapid obsolescence of equipment.
  • Leasing allows the revenue generated by the asset to provide funds for the payment for the asset. This benefit is especially relevant for start ups which usually have very limited resources.
  • Organizations can adjust the term of the lease for the duration of time when the leased asset is planned to be used and then update the asset when required.
  • Leasing provides organizations with options. Under a lease agreement the organization may have options of returning the asset, renewing the lease or purchasing the asset.
  • It is usually easier to obtain a lease that to obtain a loan to purchase the asset.
  • Leases may offer tax advantages which depend on how the lease is structured.

Disadvantages of leasing

  • Purchase is likely to be preferred to lease if the asset is planned to be used for a long duration of time without renewal of asset.
  • If the business no longer requires an asset or if the asset becomes obsolete before the end of the lease term, it may be expensive and very difficult to terminate the lease before the end of the contract. If asset is owned, it may be easier to make appropriate arrangements to sell or rent out the unnecessary or obsolete asset.
  • Although the initial large cash outlay is avoided, over the long-term the lease may account for a larger capital outlay than if firm purchased an asset instead.

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Leasing

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A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.

 

Book value per share

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Book value per share is a value that common stock holders would have received if all assets of the firm were sold for its accounting value and if all liabilities were settled and residual value divided among common stock holders.

In other words, it is a book value of the firm (the net worth of the company, which is assets minus liabilities) divided by the number of shares of common stock outstanding.

The following formula is used to calculate book value per share:

Book value per share = TA-TL/Number of shares of common stock outstanding

Where TA is Total Assets and TL is total liabilities.

Book value per share method is criticized because it relies on historical data and does not take into account the future-expected earnings of the firm. Therefore, it does not reflect the real market value of the firm.

 

Financial Position Statement Format (Balance Sheet)

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As we mentioned earlier, a balance sheet (financial position statement) is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity. A balance sheet (financial position statement) outlines the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

Below we present the general format of the balance sheet (financial position statement). We also explain the items in the balance sheet.

General balance sheet format

(1) ASSETS

(1.1) Current assets comprise:

Cash

+

Marketable securities

+

Accounts receivable

+

Inventories

=

Total current assets

(1.2) Non-current assets (fixed assets) comprise

Land and buildings

+

Machinery and equipment

+

Vehicles

+

Fixtures and Furniture

+

Other (for example financial leases)

=

Total gross fixed assets

Less: Accumulated depreciation

=

Net fixed assets

+

Other assets (investments, goodwill, copyrights and patents)

=

TOTAL ASSETS

(2) LIABILITIES AND (3) EQUITY

Liabilities comprise current and non-current liabilities:

(2.1) Current liabilities:

Accrued expenses

+

Accounts payable

+

Short-term notes (notes payable)

=

Total current liabilities

(2.2) Non-current liabilities

Mortgage

+

Other long-term debt

=

Total Non-current liabilities

(3) Equity comprises:

Common stock

+

Paid-in capital in excess of par on common stock

+

Preferred stock

+

Retained earnings

=

TOTAL EQUITY

=

TOTAL LIABILITIES AND EQUITY

Assets

CURRENT ASSETS

Current assets are listed first in the balance sheet (financial position statement). Current assets are those that can be converted into cash within 12 months. The main reason why small businesses often experience financial trouble is inefficient management of current assets. That is, they run out of cash. This can happen for such reasons as having insufficient cash on hand or underestimating the amount of time it takes to liquidate assets to create cash.

Marketable securities, also often called “near cash”, are liquid securities such as US Treasury bills.

Accounts payable refer to money that has not yet been received from the firm’s debtors. Debtors are the firm’s customers who bought from the firm on credit and still need to pay for a product or service provided.

Inventories refer to the raw materials, products in the process of production and completed products ready for sale. Basically, inventory is the physical products the business intends to sell.

In the balance sheet (financial position statement), the most liquid assets are usually listed before less liquid assets. That is why we also listed current assets in terms of decreasing liquidity: cash, marketable securities, accounts receivable and inventories.

NON-CURRENT ASSETS OR FIXED ASSETS

After current assets are listed, we can list non-current assets in the balance sheet. Non-current assets or fixed assets refer to assets that cannot be converted into cash within a 12 months period. The majority of fixed assets are depreciable. It means that the cost of the asset is allocated over its useful life and deducted as expenses on the income statement. This decreases the amount of tax the firm has to pay.

On the balance sheet we need to show the net fixed assets, which refer to the gross fixed assets (assets before depreciation is taken into account) less accumulated depreciation (depreciation deducted over the useful life of the asset, up to this point). The net fixed assets of the firm is also referred to as the book value.

OTHER ASSETS

Other assets show assets on the balance sheet that do not fit under the first two categories and include such assets as goodwill, copyrights and patents. For some companies this can contribute a sizable portion, if not the majority, of their value.

Liabilities and equity

The second part of the balance sheet presents how the business was financed. It basically shows from which sources assets were financed. The two main sources of financing are debt and equity.

CURRENT LIABILITIES

We start the second part of the balance sheet with current liabilities. Current liabilities include accrued expenses, accounts payable and short-term notes.

Accrued expenses are expenses which the company is obligated to pay within 12 months and includes such items as salaries and wages.

Accounts payable refer to payments that company is still obligated to make within 12 months to the creditors which supplied their product on credit to the company.

Short-term notes refer to the money that must be repaid to the lenders within 12 months.

LONG-TERM LIABILITIES

The next step in compiling the balance sheet requires us to list long-term liabilities. Long-term liabilities refer to debt payment which is due in a period longer than 12 months.

EQUITY

The last step in compiling the balance sheet requires us to illustrate the equity position of the firm. Equity indicates the claims of firm’s owners on the firm.

Items “common stock” and “paid-in capital in excess of par on common stock” indicate the amount paid by common stock shareholders for their shares of common stock.

Preferred stock shows the amount of money received from issuing preferred stock.

Retained earning show the earnings of the firm which were not distributed in the form of dividends to the shareholders.

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Overview of the Balance Sheet (Financial Position Statement)

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A balance sheet – financial position statement is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity.

A balance sheet is the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

How to think about a balance sheet (financial position statement)

A good way to compare the balance sheet statement, income statement and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over a specific period. The balance sheet – financial position statement is the dam. Everything collects there.

Therefore, by looking at the balance sheet we can see how everything comes together at a given point in time. If the company is reporting strong cash-flow in the statement of cash-flows, then that cash must be collecting somewhere, in the balance sheet. Provided a balance sheet is constructed honestly and correctly, it is a wonderful source of information about the company. Like a dam, any poisonous material or waste, gets washed down into the balance sheet. Therefore, paying careful attention to the balance sheet (financial position statement) allows to evaluate important information about the company.

Understanding the balance sheet (financial position statement)

To understand the balance sheet (financial position statement), one first needs to understand the difference between assets and liabilities. A simple explanation is as follows: if you take an unpaid vacation or are between jobs for a while, assets will or will have the potential of adding money to your bank account every month. Liabilities, however, will deduct money from your bank.

For example, if you own a fully paid-off house, which is currently empty, this is an asset. You may choose to earn money from this asset by renting it out. Therefore, even if you are not working, you will have rental income generated from your asset. However, if you leased an expensive car and lost your job, the bank will still deduct money from your bank account every month. Therefore, this is a liability. Alternatively, if the car is fully paid-off, it is an asset and you could generate income from it.

We also can define assets and liabilities more formally.

ASSETS

Assets are any tangible or intangible economic resources that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in the case of an individual, retirement savings and stocks are examples of assets. In the case of a company, fully owned equipment and buildings are examples of assets.

As represented on the balance sheet, current assets are assets which are excepted to be converted into cash within 12 months and non-current assets are assets which are expected to be converted into cash at some point in the future which is longer than 12 months.

LIABILITIES

Liability is a legal obligation to settle debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

As represented on the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts which must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be a personal loan that must be repaid to the bank. Company liability examples include accrued expenses such as wages as well as long-term loans.

 

Long term sources of finance

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Here we will focus only on the long term sources of finance because only long-term sources provide permanent financing. Long-term sources of finance (also called long-term sources of capital) refer to long-term debt and equity on the balance sheet. They include long-term debt, preferred stock and common stock equity, which in turn include issues of new common stock and retained earnings.

Permanent financing generally refers to financing long-term fixed assets, such as machinery or factory. If the pay-off from the asset is over the long-term period (longer than 1 year), the long-term sources of finance should be used to ensure it is less risky to finance such assets. For example, if long-term debt (one of the long-term sources of finance) rather than short-term debt is used, business can be more certain money will be available to cover obligations as they come due.

While focusing on the long-term sources of finance, we will need to focus on the specific cost of finance. We will need to obtain the specific cost of each of the long-term sources of finance, which refers to the after-tax cost of using each of the sources today.

Read related article: Cost of Long Term Debt 

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Terminal Cash flow in capital budgeting decisions

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Terminal cash flow refers to the cash flow, which takes place at the end of the project life. Terminal cash flow takes into account a net salvage value received at the end (liquidation) of the project (such as sale of the asset).

Terminal cash flow excludes operation cash inflow from the last year of the project but includes cash flow due to change in net working capital. Generally, change in net working capital results in the cash inflow which is the recovered amount of cash outflow (due to increase in net working capital) that were taken into account at the beginning of the project (when calculating the initial investment).

The calculation of the terminal cash flow is as follows:

After-tax proceeds from the new asset

LESS: After-tax proceeds from the old asset

LESS/ADD: Change in net working capital

= TERMINAL CASH FLOW

As stated above, when we calculate a terminal cash flow, we reverse the change in net working capital, which was taken into account during the calculation of the initial cash outflow (initial investment) .

If there was an increase in net working capital at the beginning of the project than we see it as inflow when calculating the terminal cash flow and vice versa. In other words, if there was an outflow due to change in net working capital at the beginning of the project than we reverse it by adding it back during calculation of the terminal cash flow.

Tax considerations in calculation of the terminal cash flow are the same as explained in initial cash outflow (initial investment) section earlier.

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