Consulting in financial management

14.5 Mergers and acquisitions

Mergers between companies or the acquisition of one company by another provide many opportunities for consulting work. Most of these opportunities come in the post-merger phase, when work begins on the rationalization of the production and marketing activities, and the reconciliation of the different budgeting systems, personnel policies and a host of other procedures. There is, however, one key financial task that must be undertaken before the merger, and for which consultants are often needed – the determination of the fair value of one or both of the companies involved. A consultant may also be called upon to advise as to the method of payment to be used. He or she will normally have either the acquiring company or the one to be acquired as a client, but in some cases of “friendly merger” may be advising both organizations.

Valuation of a company

There are essentially four approaches to the valuation of a company. Value can be based on:

●the current market price of the company’s common stock (if the stock is listed and actively traded);

●the market value of the assets;

●capitalized future earnings; and

●replacement or duplication value, which is an estimate of the cost of building up a similar organization from scratch.

The first of these, the current market price, is widely used. It does not in fact give a fair value of the company, but provides a “floor price” below which negotiations cannot go: if the common shares have recently been changing hands at, say, US$50, then any offer that values the total company at less than $50 per share is unlikely to be acceptable. The other three approaches do try to establish a fair value. A consultant may be called upon both to advise upon the method to be used and to assist in its implementation.

In recommending a basis for valuation, the consultant should obviously pay close attention to the client’s particular situation and needs. If the client is the company which is receiving the offer, then the appropriate method will be whichever yields the highest value: the consultant will not suggest a price based on current earnings if he or she estimates that the realizable value of the physical and financial assets of the company is higher. But when the client is the acquiring company (that is, the company making the offer) the situation is more complicated. The appropriate valuation method will depend on the company’s motives for making the acquisition, and these motives in turn will depend on its corporate strategy and long-term plans. If the acquisition is being made simply as part of a diversification strategy and the company that is being purchased will

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be allowed to continue its operations largely independently, then a figure based on capitalized earnings will be appropriate. In this case the main task of the consultant will be to scrutinize the current and forecast earnings of the company to ensure that they are credible and based on sound accounting practices, and that no special “window dressing” has taken place to increase reported earnings at the expense of long-term financial health.

The consultant is likely to be most deeply involved when the client organization is making an acquisition for operating reasons rather than pure diversification: in order to gain additional production capacity, for example, or to acquire new products that will complement its existing product range. In such a situation it will be necessary both to establish asset values and to adopt the “replacement” approach. Some consultants have developed particular expertise in asset valuation and have become known specialists in this area.

Method of payment

The selection of the method of payment to be used in making the acquisition is a highly complex question which requires both expert knowledge of the financial markets and special skills in determining the tax consequences of the different methods. Possible methods include a simple cash payment for the shares of the other company, a cash payment for assets, a “stock for stock” exchange, and the use of bonds, notes, preferred stock, convertible bonds, convertible preferred stock, or any combination of these. The transaction may be at a fixed price, or may use a sliding-scale payment contingent upon future performance. Because of the complexity of the matter the consultant should recommend to the client the use of an appropriate team of specialists, which will include investment bankers, tax specialists and legal advisers.

Methods of control

Where the client organization has been systematically growing through acquisitions and has many subsidiaries and affiliates, an important question is how to control the various activities. The optimal relationship between corporate headquarters and the operating entities will depend on the nature of the underlying growth or diversification strategy and the extent of the diversification.

In organizations that have made acquisitions only in areas and activities closely related to the original business – an approach often called the “core strategy” or, more colloquially, “sticking to the knitting” – the relationship is typically one in which all key policies are determined by the corporate headquarters. This approach is described as “strategic control”. In such an organization the line executives in operating units will make major decisions on current operations only after discussion with the corporate level or within clear policy guidelines, and heads of staff activities in the subsidiaries will be similarly subject to supervision and control by their corporate counterparts.

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An alternative philosophy exists, however. The completely unlimited approach to diversification – buying whatever appears to be a bargain without consideration of its strategic fit – was the hallmark of the conglomerates of the 1960s and 1970s and is now in disrepute. Organizations created in this way proved eventually to be unmanageable. But a number of large organizations – with the Hanson Group in the United Kingdom and United States markets being the best-known example – have been very successful through a policy of expansion into “manageable” activities: any product or service that can be allowed to operate largely independently with a minimum of head office involvement. For Hanson, this means activities that are concerned with “commodity” type products and services, requiring little capital investment and no sophisticated research and development.

In such an organization, the corporate headquarters directs through a system of essentially financial control. The management teams appointed to run the subsidiary activities are given performance objectives set in financial terms, particularly return on investment. Superior performance is rewarded, and underperformers are replaced. In such an organization, the setting and monitoring of financial objectives are clearly among the key activities.

Acquisitions and shareholder value

Useful though acquisitions may sometimes be in achieving a company’s strategic objectives, a note of caution is appropriate here. As stated previously, the objective of all managerial decisions and actions should be the creation of value for the shareholders. The price paid in such transactions is therefore critical. If the price is too high, value is being taken away from the acquiring company’s shareholders and given to the shareholders of the company being acquired.

In almost all acquisitions, the price paid is above the market value for the shares of the acquired company; if the transaction is a contested one, that premium may be as high as 40–50 per cent above market price. However, financial theory asserts that the markets are quite efficient, and fairly value companies on the basis of all known information. The payment of a price so far above the market price, then, can only be justified if it is believed that the acquisition will produce enormous synergy, and that the acquired company will be worth much more under its new management than it was before. Sometimes this is true. In many cases, however, synergy is illusory and the price paid proves to have been unjustifiably high. One of the most valuable services that any consultant can perform for the client is to persuade the chief executive not to become so involved with a potential acquisition that he or she pays a price that destroys value for his or her shareholders.

Corporate divestments and spin-offs

It is sometimes necessary to point out to clients that a company can create value for its shareholders by selling off some of its operations rather than

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acquiring others, particularly where those operations produce little or no synergy with the core activities but are consuming capital and executive time. The potential for creating value may be even greater if some of the existing operations can be “taken public” rather than simply sold. Many large and diversified companies have strategic business units (SBUs) operating in areas that the market capitalizes at a higher rate than it does the parent company’s principal line of business. This was once particularly true of the major tobacco companies, which had diversified widely simply to reduce their dependence on tobacco sales. The result can be that some divisions, which would have a price/earnings ratio (P/E) of perhaps 20 if they were separate legal entities, are instead being included with the parent and awarded a P/E of only 12. If the directors of the company do not recognize the situation for themselves and release value for their shareholders by spinning off these divisions as separate companies, it is almost certain that a predator will do it for them.

14.6Finance and operations: capital investment analysis

Most business organizations tend to generate more investment proposals than they can immediately finance. They therefore require a systematic method of calculating the economic attractions of such investment proposals, and of ranking them in order of preference so that the limited funds available go to the most productive investments. In most companies, the analysis of capital investment proposals is still done partly or wholly on the basis of “rules of thumb” or personal preference, which again leaves scope for useful input from a consultant.

Choosing among analytical methods

The consultant’s first task in this area should be to persuade the client that outdated and simplistic methods of investment appraisal, such as a simple rate- of-return analysis or the “years to payback” principle, are unsatisfactory and yield misleading results. This is one area in which the need to maximize shareholder value appears in its sharpest perspective. Investment in projects that produce a return that exceeds the company’s cost of capital will create value. Investment in any other projects will destroy value. The simple methods of the past are unable to distinguish between the two.

The consultant, therefore, should encourage the use of a technique based upon the time value of money. The general term used for this approach is discounted cash flow (DCF) analysis, and there are two methods of implementing it. Most textbooks advocate the calculation of net present value (NPV) and the use of NPV per dollar invested as the decision criterion.

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It should be noted, however, that this method requires the company to calculate its overall average cost of capital, which is then used as the discounting rate, and that this figure is difficult to develop and often unstable (see the section “Calculating the cost of capital” below). The alternative approach, the internal rate of return (IRR), has some theoretical disadvantages but enjoys the practical advantage of not requiring a cost-of-capital calculation. It is much more widely used than the NPV approach and should be the consultant’s first choice if the client is not financially sophisticated.

The selection of an analytical method and a decision criterion, however, by no means solves all the problems in this area. The various investment proposals facing a company are likely to be very different in nature. In particular, some of them, such as proposals to replace old machinery which is giving rise to high maintenance costs with new but similar equipment, involve neither risk nor uncertainty. Other projects, such as the replacement of a known but outdated technology with an advanced but unfamiliar one, clearly involve both uncertainty and risk. It becomes very difficult to rank one project against another unless some adjustment is made for the differing degrees of risk.

Calculating the cost of capital

In order to apply the NPV approach for project evaluation it is necessary to use the correct discounting rate, which should be the company’s weighted average cost of capital. This is not easy. The cost of loans and debt capital is generally evident: because the interest on debt is tax-deductible, the cost of debt funds is the interest cost less the tax shield. Thus, if a company has an interest cost of 6 per cent and pays corporate taxes of 36 per cent, the effective cost of its debt is 6 x (1 – 0.36), which is 3.84 per cent.

The cost of equity capital, however, is not the cost of the dividends paid out (some companies pay no dividends) but the rate of return that the equity market requires the company to make. A useful benchmark is available to estimate this. The general rate of return on the equity market is known. If the particular company under study is considered more or less risky than the market, its required return will be accordingly higher or lower. This riskiness is determined by plotting the past pattern of returns that the company has produced over a number of years against the corresponding returns for the equity market as a whole. The resulting relationship (actually a covariance, but shown graphically as the slope of the regression line) is called the “beta” of the company. A company that is neither more nor less risky than the market is said to have a beta of 1.00. A company with more risk than the market – that is, more volatile returns – will have a beta of more than 1.00, and a low-risk company a beta of less than 1.00.

If the return on the equity market is known, subtracting the risk-free rate (the yield on short-dated government securities) gives the equity market

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risk premium. By applying the company’s beta to this, the cost of equity is obtained.

For example, if:

Risk-free rate	=	5%
Equity market return	=	15%
Company beta	=	1.25
Then the cost of equity capital	=	5% + (15% – 5%) x 1.25 = 17.5%

and it now becomes straightforward to calculate the overall weighted cost of capital.

Sensitivity analysis

In order to arrive at a ranking for proposed projects, many companies will need outside assistance. The most satisfactory solution is to adopt a “sensitivity analysis” approach. Projects that are seen as important but also as involving a high degree of uncertainty should be modelled (simulated), so that the model can be run many times with different values for key variables. A project to build a plant for the production of a radically new product, for example, may involve considerable uncertainty both about the time needed to bring the new product into production and about its market acceptance. The model would therefore require numerous reruns with different assumptions about the time needed to bring the plant on stream and about the likely sales volumes; a probability distribution of expected net cash flows should be developed from the results.

Once again, this is an area in which the consulting organization will best be able to help its clients if it can offer the services of a specialist team in which financial consultants work closely with computer experts.

Follow-up of project effectiveness

There is yet another valuable service that the consultant can provide in this area. Many companies, even those that have adopted relatively sophisticated procedures for the evaluation of project proposals, overlook the need for systematic follow-up and monitoring of subsequent project performance. A project may be adopted because it appears to promise a very high discountadjusted rate of return. If it fails to perform as well as expected, it is important to find out why. Was there an unexpected downturn in the economic environment? Did the project encounter unforeseen technical problems? Were the marketing staff unduly optimistic in predicting sales? Or were the forecasts of sales and earnings consciously inflated for political purposes by an “empirebuilding” divisional head? The development and installation of a follow-up system to answer such questions will rapidly pay off in improvements in project selection, and is one of the most useful tools that the consultant can provide.

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