The free cash flow (FCF) method is one of the most reliable methods of valuation of a firm when considering a takeover. The formula for calculating the (FCF) is: FCF = EBIT (1 – t) + Depreciation – Capital Expenditures +/- Net Working Capital. Free cash flow represents the free amount of funds that firms require to undertake new projects that are anticipated to increase the value of the firm in form of positive net present value. The free cash flows should be paid to the shareholders of the target company for the shareholders to gain benefits (Palepu 33). A company that is acquiring another one needs cash flows that will enable it to make future investments that will sustain the cash flows enjoyed formerly by the firm they are acquiring.
As such, from the FCF method, it is crucial to gauge the cash flows of the target to establish the value to pay for the new acquisition. The depreciation is added back because it is just a provision in the books of accounts and not a real cash flow, i.e., firms do not set aside any money for depreciation. Capital Expenditures entail investments that the acquiring firm must make to replenish assets and ensure that future revenues and cash flows are guaranteed.
With the growing challenges in the business world, firms sometimes prefer to gain control through acquiring others (Jarrell, James and Jeffrey 48-50). There are various reasons why firms acquire or merge with others. For instance, a firm may acquire another in a different industry to diversify industry-level risks in case one industry is not favorable (Jensen 25). Also, a firm may acquire or merge with another to partake in the attractive cash flows of a target company (Palepu 33-35). Most importantly, a firm may acquire another for strategy purposes like in the case of Innovative Concepts, the M&A team strategy was to reduce the production and marketing cost through the application of technical and marketing expertise.
By agreeing to exchange two shares of Quick resolve products (QRP) for one of the Innovative concepts, the number of shares owned by the target company will be reduced by half. As a result, the price-earnings ratio will increase due to the reduced number of shares, a concept viewed by the management as a relative P/E game. This means that the shareholders are likely to enjoy more dividends in the future with less number of shares.
The maximum justifiable offer price that Innovative Concept (IC) which is expected to pay for QRP will be calculated as follows: FCF = EBIT (1 – t) + Depreciation – Capital Expenditures +/- Net Working Capital. Where the networking capital = current assets-current liabilities-cash= 1000-780-300= (80); therefore, FCF= =19. To be able to calculate what IC will pay to QRP, we need to add the FCF to the total value of assets; = $ 2000 million + $ 19= $ 2019 million.
Both, Cash payment and stock payment for acquiring a company have advantages and limitations. By agreeing on cash payment it differentiates between the acquirer and the acquired. Alternatively:
In a cash deal, it is easy to distinguish between the acquirer and acquired, when it comes to stocks and we end up losing the stock to settle the payment leads to the shares of the acquired appreciating on the announcement of the acquisition while the acquiring company may lose the value of their shares. (Jensen, 2010).
Cash buyouts make it certain that the shareholders of the acquired do not seize all the benefits of the merger or acquisition. In most cases, daring acquirers prefer cash to stock but the market has been seen to react through increased share value while stock buys out react in the opposite direction.
The superior majority is a situation where the management imposes policies that require a large proportion of the shareholders to endorse a takeover. This makes it more difficult for a takeover bid. Secondly, dual-class recapitalization is a situation where the managers issue another class of shares with more voting powers than the ordinary shares and that can be exchanged for the ordinary stock.
Stepping up the basis for the assets for depreciation will imply that the value of depreciation expense will be increased in the books of the consolidated company. The values of the assets will also increase. Hence, the consolidated balance sheet will reflect a higher value for the assets.
The tax issues that IC will consider could be linked with the tax relief on each of the methods of raising finances to fund the acquisition. For instance, the use of debt capital has a tax advantage over the issuing stock to the market. There is an advantage in the diversification for two companies coming from different industries. First, sector-based diversification shields the new company from collapse due to lack of markets. Also, QRP enjoyed a good segment of the market, thus enabling IC to tap into the vast market. The advantage is not much in the presentation because the tax rates are the same in the market (Jensen 25).
Jarrell, Gregg A., James A. Brickley and Jeffry M. Netter. “The Market for Corporate Control: The Empirical Evidence Since 1980.” Journal of Economic Perspectives 2 (1988): pp 49-68.
Jensen, Michael C. “Takeovers: Folklore and Science.” Harvard Business Review (1984): p 20.
Jensen, Michael C. “The Free Cash Flow Theory of Takeovers: A Financial Perspectfve on Mergers and Acquisitions.” Harvard Business Review (2010): p 25.
Palepu, Krishna G. “Predicting Takeover Targets: A Methodological and Empirical Analysis.” Journal of Accounting and Economics 8 (1986): pp 3-35.