Analysing Strategic Projects and Shareholder Value Creation

The need for organisation to create and sustain value for shareholders:

• Shareholders have claims on the firm based on "ownership"
• Arguments for:
• Shareholders provide the capital for the organisation --> need pay attention to return on investment
• Maximising SHV ic compatible with interests of all stakeholders, if the company successfully increase  SHV, thus all stakeholders will also benefits.
• Arguments against:
• Other stakeholders also provide the capital for the firm an need pay more attention as they argue more about human capital and return on debt investment from debt holders.
• Shareholders are residual claimants after the company fulfil the needs of debt holders.

Traditional measurement for SHV: Dividend Payout Ratio, capital appreciation (increase of share price). Example: EPS, ROI, RONA, ROE.

Stern Stewart's Economic Value Added (EVA) --> the spread between the return on capital and the cost of capital multiplied by the "economic book value" of the capital employed to produce that return.

• EVA = NOPAT - (WACC X Capital Employed)
• Note: 
• EVA is dollar figure, not a rate of return (%). 
• Relates to profit to the amount of resources required to achieve that profit.
• Emphasis after-tax operating profit and actual cost of capital, and eliminates distortions due to financing (not operating) decisions. 
• Strategies to increase EVA:
• Improve operating profits without tying up further capital.
• Draw down more capital, so long as the additional profits management earn by investing the funds in its business more than covers the cost of the additional capital.
• Free up capital and pay down the line of credit, so long as any earnings lost are more than offset by a saving on the capital charge.
• EVA Strength:
• Adjusts for some non-cash flow items (eg amortisation)
• WACC; reflect risk, time value of money and opportunity cost of equity.
• Highly correlated with share prices.
• EVA Weaknesses:
• Complexity (via adjustment)
• Short-term focus, single period measure.
• Comparison across firms may be difficult due to many possible adjustments.

Economic Value of a Project: NPV and IRR.

• Shareholder (and project) value is driven by:
• sales growth rate --> expected Net Cash Flow (NCF) from project
• operating profit margin --> expected Net Cash Flow (NCF) from project
• cash tax rate --> expected Net Cash Flow (NCF) from project
• fixed and working capital requirement --> initial investment + other investment during project life.
• Planning period --> expected project life
• Cost of capital --> hurdle rate/discount rate.
• Strategic issues in project appraisal --> may not profitable in short-term financial perspective, but in long-term and strategic decision, may be different. There are some important factors affecting competitiveness, which often overlooked or excluded in the quantification of project cash flow, for example:
• higher market penetration due to shorter lead times.
• increased product quality and consistency of that quality.
• ability to produce small batches economically.
• flexibility and reduce uncertainty.

M&A Basic Concept & Terminology

• Takeover: transfer of controlling ownership (involves shares); Acquisition: purchase of one firm (involves assets); Merger: combination of two firms into a new legal entity, both shareholders must approved the transaction; Scheme of Arrangement: court approved union of two firms, governed by a set of contract.
• Hostility -- Hostile takeover: takeover without consultation and un-support by target's management. Tender offer, general offer from acquirer to target's shareholder with premium price. Friendly takeover: merger between two firms with support of target's management, target might solicit offer from other potential acquirers (hold-out problem).
• Relatedness -- Horizontal: merger of two firms in the same industry or similar product line; Vertical: merger of two firms in different steps of a production process (supply chain), merger to its upstream suppliers or its downstream buyers; Conglomerate: merger of two firms in unrelated business, to diversify by combining unrelated assets and income stream.
• Financing -- Cash deals: finance by acquirer cash or additional borrowing, size of combined firm less than acquirer+target size (1+1 < 2); Stock deal: finance by acquirer stock, target exchange their shares for acquirer shares, often with specified exchange ratio, size of combined firm near equal or more than acquirer+target size (1+1 = or > 2); Mixed deal: each target share is exchange for either cash or acquirer's shares. Note: buyers tend to offer stock deal when they believe their shares are overvalued and cash deal when their shares are undervalued. Stock deal: target shareholders still remain to control with their stocks, but Cash deal: target shareholders were removed permanently and the company under the indirect control of the bidder's shareholders.
• Vertical benefits: lower transaction costs (when making an economic exchange),;synchronisation of supply and demand along the chain of products; ability to monopolize market through the chain; strategic independence (especially when inputs are rare or highly volatile in price). Vertical disadvantage: higher coordination costs; higher organisation costs of switching to different suppliers/buyers; weaker motivation at the start of supply chain.
• M&A transaction costs might arise from: information asymmetries from searching information of target's synergic benefits; bargaining costs: costs required to reach an acceptable agreement with target; monitoring costs: cost of making sure the other party stick in the rules.
• Corporate control: a party has a dominant control of the firm if they have the veto power over the use of its assets.
• Economic driving forces of M&As waves: technology changes, competition environment, deregulation, privatisation, globalisation, equity and market conditions.
• Benefits of M&As: synergies, change of control (replace inefficient management), market power (to give additional revenue by increase the price), undervalued target (market price < intrinsic value), tax savings (acquire target company that losses in the past but should not in the future).
• Costs of M&As: overpayment (management hubris), merger integration costs (in the initial phase, usually decreasing in profits), agency costs (less of monitoring activities), increased bankruptcy risk (differ in leveraged), taxes, M&As advisory fees.
• Synergy definition: additional value created from combining two firms operations and financial structure. PV(AB) > PV(A) + PV(B) or 1+1 more than 2.
• Sources of synergy: economies of scale, economies of scope, complementary of resources, synergy from financial efficiencies, diversification, adopt a new financial structure, reduced bankruptcy costs.
• Gains in M&As: value of bidder without acquisition+value of a target as a stand alone company+synergies and operating improvements (synergic benefits and control benefits)+profit on sale of excess assets.
• M&As Deal Failures: poor post merger integration, unrealised synergies & control benefits, poor post deal management of target, overoptimism-over bidding-poor due diligence. 

How to value company in M&A transactions

Basically, this methods frequently being used:

1. Deal Comparable
2. Firm Comparable
3. Discounted Cash Flow (using WACC and Adjusted Present Value)

Deal Comparable: use recent M&A deals in target's industry; calculate comparable ratios such as: Price Earnings (P/E) ratio, revenue based multiple, cash-flow multiple, book-value based multiple.
Disadvantages:  simple one dimensional view of valuation (a single denominator: sales, EBIDTA); small sample size, deals in the past would not be the same concurrence with the present, based on outdated valuations and time mismatch.

Firm Comparable: compare between similar (peer) firms to target; determined a range of valuation based on appropriate multiples and placed the target within the range.
Disadvantage: simple one dimensional valuation; does not incorporate synergies and control benefits; does not incorporate shareholders resistance; subject to creative accounting.

Discounted Cash Flow: more complex valuation, but could incorporate synergies and control benefits and M&A dynamics; may avoid accounting manipulations.
Requirements:

• needs adjustments for financing effects (ex: tax shield. finance vs operating lease)
• adjusted annual free cash flow by adjusted after tax WACC (be careful: please handle tax adjustments to discount rates, might be incorrect substitutes)
• adjusted annual free cash flow by APV (adjusted present value) -- First, value the firm assuming all equity financing (discounted at the un-levered cost of equity) and then add on the present value of the tax shield. Note: APV will give different valuation instead of WACC, however APV is more suitable for highly levered situations.

Google -- Motorola

In 2001, Google paid $12.5 billion for Motorola Mobility which represents a 65% premium on a struggling firm.

Breakdown of purchasing price:

• Patents: $5.5 billion
• Cash: $2.9 billion
• Goodwill / synergies: $2.6 billion
• Customers: $0.73 billion
• Others: $0.67 billion
• Total: $12.5 billion

Compared to book assets of Motorola of:

• Cash: $3.5 billion
• Other current assets: $3.2 billion
• PPE: $0.8 billion
• Goodwill: $1.4 billion
• Other assets: $0.7 billion
• Total: $9.6 billion

Q: Why this number differ significantly? Is this premium price reasonable?

Possible answers:

1. Google might pay Motorola a premium price because of valuable Motorola's intangible assets (such as patents, goodwill, trademarks, etc) which drives from Motorola's technology advance and complementary R&D capabilities. Although this premium is still questionable as this intangible assets are hardly to quantify as precise and accurate, but Google might expect the intrinsic value will result in future benefits and could be amortised annually as goodwill of combined firms.
2. The offers might be unreasonable, since we consider about the nature of intangible assets, but in this case, by considering future cash flows, Google really give a bear hug to Motorola business and technology advance. Lots number are different, but the intense of this offer is about the appreciation of the company's intangible future performance. For example, google might consider to integrate their online business with mobile technology, since Motorola holds several mobile techno patents and rights. Customers good relationships could be quantify in synergic benefits, although in book value accounting of Motorola not recorded this number.