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,Click to edit Master title style,Click to edit Master text styles,Second Level,Third Level,Fourth Level,Fifth Level,M&A-Guobo Huang,*,Click to edit Master title style,Click to edit Master text styles,Second Level,Third Level,Fourth Level,Fifth Level,M&A-Guobo Huang,*,M&A-Guobo Huang,1,Lecture 4,Alternative Approaches to Valuation,Part A:Valuation approaches,Part B:Case study,Reading:Chs 9,10,M&A-Guobo Huang,2,Chapter 9-2,Part A,valuation approaches,Valuation critical in M&As,Framework essential to discipline valuation estimates,M&A-Guobo Huang,3,Chapter 9-3,1.Comparable Companies Method,Group of companies comparable with respect to:,Products,Future prospects,Key ratios are calculated for each company,Key ratios are averaged for group,Average ratios applied to absolute data for company of interest,M&A-Guobo Huang,4,Chapter 9-4,Indicated market values obtained from each ratio,Valuation judgments are made,Advantages,Limitations,M&A-Guobo Huang,5,Chapter 9-5,2.Comparable Transactions Method,Market value refers to transactions in a completed deal,More directly applicable than company comparisons,May be difficult to find transactions within a relevant time frame,M&A-Guobo Huang,6,Chapter 9-6,3.Spreadsheet Approach to Valuation and Mergers,Procedure,Historical data for each element of balance sheet,income statement,and cash flow statement are presented:7 to 10 years,Detailed financial analysis is performed to discover financial patterns,M&A-Guobo Huang,7,Chapter 9-7,Additional analysis,Business economics of industry in which company operates,Companys competitive position,Assessments of financial patterns,strategies,and actions of competitors,Based on analysis,relevant cash flows are projected,Procedures similar to capital budgeting analysis,Capital budgeting decisions,Spreadsheet projections,Provide great flexibility in projections,M&A-Guobo Huang,8,Chapter 9-8,NPV of acquisition obtained from sum of free cash flows discounted at applicable cost of capital,Advantages of spreadsheet approach,Expressed in financial statements,Any desired detail of individual balance sheet or income statement accounts,Flexibility in formulating projections,M&A-Guobo Huang,9,Chapter 9-9,Disadvantages of spreadsheet approach,Numbers used in projections may create illusion that they are actual or correct numbers,May lack link between projected numbers and business logic,May become highly complex,Details may obscure important driving factors,M&A-Guobo Huang,10,Chapter 9-10,4.Formula Approach,No real distinction between spreadsheet approach and formula approach,Both use discounted cash flow analysis,Spreadsheet approach expressed in form of financial statements over period of time,Formula approach summarizes same data in compact form,Formula approach helps focus on underlying drivers of valuation,M&A-Guobo Huang,11,Chapter 9-11,Development of compact valuation formulas,Valuation necessarily requires forecasts,Usually assumes systematic relations between time periods,variables,Key variables and relationships,Total capital(,A,t,),Investment(,I,t,):defined as the change in total capital over the previous period,(,A,t,-,A,t,-1,),M&A-Guobo Huang,12,Chapter 9-12,Net operating income(,X,t,)defined as a function of last periods total capital,i.e.,X,t,=,a,A,t,-1,where,a,is a constant,After-tax net operating income=,X,t,(1-,T,),Profitability rate(,R,t,):defined in terms of change in net operating income as a result of the investment in the previous period,After-tax profitability rate=,R,t,(1-,T,)=,r,t,:,defined in terms of change in after-tax net operating income as a result of investment in the previous period,M&A-Guobo Huang,13,Chapter 9-13,Investment requirements,opportunities per dollar of after-tax cash flows(,b,):defined as ratio of investment to after-tax net operating income,Growth rate(,g,):defined as rate of change in after-tax cash flows or in net operating income,In this model,g,is determined by the product of other variables:the investment rate times the profitability rate,M&A-Guobo Huang,14,Chapter 9-14,Insights from use of formula approach,When,r,is greater than,k,increasing investment(,b,)results in higher,g,and higher values,Valuation is very sensitive to the cost of capital(,k,)used in analysis,Sensitivity to,n,and,T,predictable in direction and magnitude,M&A-Guobo Huang,15,Chapter 9-15,Limitations of the formula approach,Less flexibility in reflecting forecasts for individual years,Calculations use financial statement data not directly shown in the formulas,M&A-Guobo Huang,16,Chapter 9-16,5.Cost of Capital Measurement,Steps involved in calculation of cost of capital,Calculate cost of equity capital,Calculate cost of debt,Formulate applicable financial structure or financial proportions,Apply applicable financial proportions to cost of equity and cost of debt,Final result is weighted cost of capital,M&A-Guobo Huang,17,Chapter 9-17,Cost of equity,Capital Asset Pricing Model(CAPM),Bond yield plus equity risk premium,Cost of equity=
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