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CONTENTS
CAPITAL BUDGETING ................................................................................................................................2
REAL OPTIONS ......................................................................................................................................2
MERGERS AND ACQUISITIONS ADVANCED CONCEPTS .........................................................................4
SYNERGIES ............................................................................................................................................4
CONTROL PREMIUM AND MINORITY DISCOUNT .................................................................................4
MODES OF PAYMENT ...........................................................................................................................5
EXCHANGE OF SHARES IN STOCK-FOR-STOCK TRANSACTIONS ...........................................................6
DEAL STRUCTURING .............................................................................................................................7
TAKEOVER DEFENSE .............................................................................................................................7
SHAREHOLDER ACTIVISM .....................................................................................................................9
CORPORATE RESTRUCTURING ...........................................................................................................10
VALUATION.............................................................................................................................................11
CASH FLOW VALUATION ....................................................................................................................11
ADJUSTED PRESENT VALUE (APV) ................................................................................................. 11
CAPITAL CASH FLOW (CCF) ............................................................................................................ 14
OTHER VALUATION METHODS ...........................................................................................................14
BOOK VALUE .................................................................................................................................. 14
REPLACEMENT COST METHOD...................................................................................................... 14
PRIVATE EQUITY & VENITRE CAPITAL ....................................................................................................15
WHAT ARE PE/VCs? ............................................................................................................................15
KINDS OF PE INVESTMENTS ...............................................................................................................15
STAGES IN VC INVESTMENTS......................................................................................................... 17
STRUCTURING OF PE/VC FUND ..................................................................................................... 18
PE/VC DEAL STRUCTURING ........................................................................................................... 19
MATHEMATICS OF A PE/VC DEAL ................................................................................................. 22
WHAT IS PROJECT FINANCE? ..................................................................................................................25
CAPITAL BUDGETING
REAL OPTIONS
Real Options, as the name suggests, stems from the application of knowledge developed regarding
options in the financial markets to capital budgeting decisions. Those unfamiliar with financial option
pricing would do best to turn to the relevant section on options in the financial markets primer.
This section would attempt to detail the needs for real option valuation in corporate finance and talk
about implementation issues faced in such applications.
Vis--vis standard methods of valuation (read DCF), real options differ by discarding the assumption
that management of a firm is passive once the initial investment decisions have been made. Which is
to say that in a standard DCF valuation, only the most likely or realistic possibilities are modeled and
the flexibility available to managers is ignored. Uncertainty is modeled by adjusting the discount rate
or changing cash flows. In a real model valuation, however, attempts to assume that management is
active and thereby considers all future outcomes and managements response to these outcomes.
In general real option valuation finds application in the following stages of capital investment:
Example: Gold mine with known inventory of 1 million ounces, output rate of 50,000
ounces per year. Price of gold is expected to grow at 3%. Firm owns the rights to mine for 20 years.
Cost of developing the mine is $ 100 million; average production cost is $250 and expected to grow at
5% per year. Standard deviation in cost of gold is 20%, and current price is $375, riskless rate is 6%.
Inputs to the model are:
Value of the underlying asset = Present Value of expected gold sales (@ 50,000 ounces a year) =
(50,000 * 375) * [1- (1.0320/1.0920)]/(.09-.03) - (50,000*250)*[1- (1.0520/1.0920)]/(.09-.05) = $ 211.79
million - $ 164.55 million = $ 47.24 million
Exercise price = Cost of opening mine = $100 million
Variance in ln(gold price) = 0.04
Time to expiration on the option = 20 years
Riskless interest rate = 6%
Dividend Yield = Loss in production for each year of delay = 1 / 20 = 5%
(Note: It will take 20 years to empty the mine, and the firm owns the rights for 20 years.
Every year of delay implies a loss of one year of production.)
Based upon these inputs, the Black-Scholes model provides the following value for the call:
d1 = -0.1676 N(d1) = 0.4334
d2 = -1.0621 N(d2) = 0.1441
Call Value = 47.24 exp(-0.05)(20) (0.4334) - 100 (exp(-0.09)(20) (0.1441)= $ 3.19 million The value of
the mine as an option is $ 3.19 million, in contrast the static capital budgeting analysis would have
yielded a net present value of -$52.76 million ($47.24 million - $100 million). The additional value
accrues directly from the mine's option characteristics.
(Adapted from The Promise and Peril of Real Options, Aswath Damodaran)
Control premium typically is 20% - 25% of the fair value of the company.
Minority discount is exactly contrasted to Control premium. It is the discount which is to be applied
to the fair value of the acquired company when the acquirer wishes to own a minority, noncontrolling discount in the company. The relation between minority discount and the control
premium is:
Typically, transaction multiples and trading multiples differ due to the control premium/ minority
discount which is embedded in the pricing of transactions.
MODES OF PAYMENT
The preferred mode of payment must be looked at from both the sellers and the buyers
perspective. The primary reason why stock-for-stock transactions are done is because the buyer
wants to share the risk of realizing the synergies, which may not happen. However, this comes at the
price of having to share the actual synergies which do get realized.
From the sellers perspective, he would prefer a complete cash transaction if he felt that either the
seller or the buyers stock was overvalued because in this case the seller would run the risk of
participating in the potential downside as a result of corrections in the valuation, if the transaction
was structured using stock. Similarly, if the sellers and the buyers stock was undervalued, he would
prefer a stock transaction as it allowed him to participate in the potential upside due to a potential
revaluation.
From the buyers perspective, the following issues will be considered when addressing
the question of modes of payment:
They are:
Fixed number of shares
Fixed value of shares
In the first method, the exchange ratio gets fixed at the time of negotiating the deal and then is not
adjusted for any price changes which can occur on completion of deal closing. The parameters for the
valuation hence is completed pre-announcement and remains so till the end. As a result both the
acquirer and the acquiree share the price risk associated with the merger/acquisition, as the
proportional ownership is fixed.
In the second method, the exact exchange ratio is not fixed till the closing date of the transaction. As
a result, the ownership structure is not clear till the last day of completion of the transaction. In such
DEAL STRUCTURING
While structuring a deal, a variety of financial structures can be used to complete the payout from
the buyers perspective, depending on the specific acquisition. In this section, we will look at two
specific methods which can be used while structuring the financials of a deal:
Use of preference shares
Earn-outs
Use of preference shares Preference shares can be used as a lucrative means of paying out the
sellers by issuing high coupons/dividends on the preference shares. These coupons are lucrative
because they are usually tax-free at the hands of shareholders, although the issuing company might
pay taxes on the redistribution of profits. Another benefit which such a structuring ensues is that the
preference shares can be redeemed after a year with/without a premium so as to qualify for a zero
tax regime.
Earn-outs Also known as golden handcuffs, deal structuring involving earn-outs entails paying the
base price in cash and making additional payments contingent upon achieving pre-specified levels of
revenues/profits. The typical period over which this payout is structured is 3-5 years. Such a structure
is usually used when you are wishing to retain the management over the transition period. Similarly,
one can use earn-outs when the acquirer cannot pay the full price or the seller wishes to defer taxes.
The issue with earn-outs is that very often this leads to a short-term focus, hurting the potential for
capture of synergies.
Usually an earn-out feature is combined with a catastrophe clause which allows the acquirer to
terminate the earn-out if the performance falls below a specified threshold.
Apart from the above two methods, several other methods of deal structuring can be used though
we will not discuss them in the Primer.
TAKEOVER DEFENSE
Very often an intended acquisition can turn sour when the company about to get acquired exhibits
resistance to being acquired. More often than not, the resistance comes from the management,
which could be because of a variety of reasons such as uncertainty regarding the managements
future in the combined entity or belief that the firm is being undervalued by the potential acquirer.
Poison Pill
Poison Put
Staggered Board
Supermajority
White Knight
Pac-Man Defense
Poison Pill In this mechanism, existing shareholders are given rights which allow them to be
purchase additional shares at a discount, if an acquiring company acquires more than a particular
percentage of the total outstanding stock in the market. This dilutes the stake of the acquirer and
makes it difficult and expensive for the acquirer to make further acquisition of the stock.
Poison Put By the mechanism, existing creditors have the option of seeking repayment of all
outstanding debt in case the management of the company undergoes a change. In case of use of a
poison put, the acquirer will have to initiate talks with the creditors of the company and seek their
support in completing the acquisition or else the poison put could be triggered. This again makes the
process of acquisition difficult, time-consuming and potentially expensive.
Staggered Board In this mechanism, the board of directors are selected in a staggered manner on
an annual basis, as a result of which any acquirer can only control a section of the board immediately
after the acquisition, and only after a reasonably substantial period of time, say 3 years, can the
board potentially be controlled completely by the acquirer.
Supermajority Very often, companies alter their charter to incorporate draconian requirements
such as the requirement of approval of 80% of the shareholders for an acquisition to go through.
White Knight - An extremely common takeover defense tactic, in this the acquiree prefers to find a
third company which can offer better terms of purchase or better trust as compared to the original
acquirer. E.g. Severstal was for long seen as a White Knight for Arcelor when Mittal Steels was
bidding for it. The White Knight strategy however failed in this case but did make the acquisition
process more difficult and expensive for the Mittals in the end.
SHAREHOLDER ACTIVISM
An activist shareholder is one who uses his rights guaranteed to him by his stake in a firm to put
public pressure on the management, particularly related to issues concerning governance standards
as well as broader strategic issues. Shareholder activism has been used as a potent tool in the USA
particularly given the lower costs associated with this mechanism as opposed to a full-blown
takeover attempt. However, in the past activist shareholders were perceived not so favorably by the
corporate community as well as the public and were popularly known as corporate raiders. Corporate
raiders were notorious for buying up small stakes (~8-10%) from other shareholders and use the
small yet substantial stake to pressure the management to force action which can unlock immediate
value for the shareholders. Very often the purpose of the activism was to force the management into
buying back the stake at a premium in return for a promise to not trouble the firm in the future. Such
a tactic was called greenmail.
In recent past, however activist shareholders have been perceived favorably particularly given the
series of corporate governance issues which have arisen in several companies across the globe. This
activism can take a variety of forms publicity campaigns, litigation, proxy battles and shareholder
CORPORATE RESTRUCTURING
Corporate restructuring is mainly associated with the need to contract and reduce the scale and size
of operations, as opposed to mergers and acquisitions which mainly focus on business expansion.
Several reasons are attributed for companys using corporate restructuring as an effective tool of
executing business strategy and as a means of creating long-term sustainable value. These are:
Companies might want to sell specific business lines which have been underperforming
Specific assets/businesses might be sold purely because of the threat of an overall weak market
for that particular product/business
In some cases, companies can seek to sell off businesses which, as part of their strategy, is
classified as non-core businesses so as to focus on their core operations
Most importantly, firms might choose to pursue divestiture if the break-up value of all the
businesses is greater than the value of the firm as a whole.
Firms may also be forced to dispose of businesses as a result of regulatory issues or due to
immediate requirements for cash.
Asset sale
Equity carve-outs
Spin-offs
Split-offs
Split-ups
Asset sales can be broadly defined as the sale of any asset/business by a firm to another firm. In
some cases, the sale can be partial but in other cases it could refer to the complete sale of the
asset/business.
An equity carve-out is a method of disposing of an asset/business that involves the sale of the equity
interest in the business to external shareholders. In equity carve-outs, a new legal entity is created
with a stockholder distribution which will differ from that of the parent company
A spin-off involves the creation of a separate legal entity in which the current shareholders of the
parent company are issued fresh stock in the new entity on a pro-rata basis. The spun-off companys
management is different and is run as a separate company.
In a split-off, the existing shareholders of the parent company are given the option of being allocated
new shares of the divested business in exchange of the shares which they hold of the parent
company.
A split-up is a series of spin-offs as a result of which the parent company no longer exists, leaving a
set of new formed companies.
VALUATION
CASH FLOW VALUATION
ADJUSTED PRESENT VALUE (APV)
The Adjusted Present Value (APV) method values a firm in two steps. First, it assumes that the firm is
financed entirely by equity. In the second step, the additional value which accrues due to the effect
of financing is added separately to calculate the total value of the firm.
To elucidate, in the Adjusted Present Value (APV) approach, the firm is first valued assuming no debt
followed by adding the positive (Tax benefits) and negative (Bankruptcy costs) effects of debt.
We follow three steps to value such a firm using the APV approach
Estimate the value of all equity (unlevered) firm
Calculate the present value of the expected tax shield using current debt level
Incorporate the change of default risk and of expected bankruptcy costs due to the current debt
levels
Unlevered Value of the firm
1. Calculate the unlevered cost of equity for the firm. Please note that, the unlevered cost of equity
for the firm can be different for the current period and the stable (further into future) period.
Unlevered Cost of Equity = Rf + (Unlevered Beta) * (Risk Premium)
2. Calculate the Free cash flows to firm using the method
3. Calculate the Terminal Value of the firm using the method
4. Calculate the Unlevered Value of the firm use FCFF and unlevered cost of capital.
Expected Tax benefits = PV (interest tax shield over the valuation period)
Calculation of expected Bankruptcy cost
To calculate the expected cost of bankruptcy we first need the probability of default and present
value of bankruptcy costs.
Illustration
The following particulars are available for a firm:
2011
150
EBIT
Depreciation 40
2000
Debt
2012
200
35
1500
2013
250
30
1200
Cost of equity
Interest Rate on Debt
Tax Rate
Terminal growth rate
2014
300
25
1000
2015
250
20
500
14%
8%
30%
4%
The value of the firm using APV can be calculated in the following manner:
EBIT
EBIT * (1-t)
Add:
Depreciation
Free Cash flow
(for 100% equity
financed firm)
Present Value @
14% discount
rate
Terminal Value
Base Case NPV
Interest paid
Debt tax Shield
(Interest * tax)
P.V. @ 8%
Terminal Value
of tax shield
NPV of
Financing effects
Value of firm
2011
150
105
40
2012
200
140
35
2013
250
175
30
2014
300
210
25
2015
250
175
20
145
175
205
235
195
641
2028
1694
160
48
120
36
96
29
80
24
40
12
124
312
336
2030
|
Venture Capital (VC) can be considered as a special form of PE, which specializes in small
firms, start-ups and provides funding, advice and support to entrepreneurs.
PE Funds and VC Funds are the companies that specialize in investing in such private companies.
While there are many well-known independent PE and VC funds such as Blackstone, KKR, Apax,
Temasek, GIC, Sequoia, Khosla Ventures, Kleiner Perkins etc., most of the large investment banks have
their own internal PE practice as well.
Some PE and VC funds specialize (or start by specializing) in certain sectors of the economy or certain
kinds of investments. As an example, Khosla Ventures currently focuses on investments in the energy
sector and KKR started out as a specialist in buyouts.
KINDS OF PE INVESTMENTS
PE investments typically differ based on the intent behind the investment, the quantum of
investment and the structure of the investment. Following are a few of the popular types of PE
investments:
Buyouts
Buyout refers to the investments that result in the change of ownership of the target company.
The buyout entity (which could be the management or a PE/VC fund) takes controlling interest in
the company by buying out existing shareholders.
If it is the management that buys out the equity interest of existing shareholders, it is referred to
as a Management Buyout or an MBO.
STAGES IN VC INVESTMENTS
Start-up companies generally have two distinct kinds of risks:
1. Concept Risk
The risk that the idea of the product/service itself might not be accepted
2. Execution Risk
The risk that the entrepreneur and his team might not be able to execute the idea well, might
not be able to manage a cash-constrained situation and/or might not be able to run the
company well to earn desired returns for the investors
Different kinds of VC investments vary depending on the development/maturity stage the target
company is in.
Angel investing is generally the earliest source of external investment in a start-up. It is also
referred to as Seed Stage Investment. The risk is the highest at this stage because both the concept
and the execution capabilities of the entrepreneurs team have not been proved. Hence, angel
investors take relatively higher % stakes in the companies for relatively lower absolute amount of
investment, commensurate with the risk that they undertake.
A start-up then generally does multiple rounds of raising further capital depending on its capital
needs for different stages. All subsequent rounds are based on reaching some milestones, such as
completion of product development, prototype development, obtaining necessary regulatory
approvals (such as FDA approvals in case of healthcare drug start-ups) etc. If the start-up is doing
well, all subsequent rounds are done at a price per share higher than the previous round. This is
Stage of Financing
Seed Stage
Start-up
First Stage
Second-Stage
Bridge
As an example, consider a company A, which has 1,000 shares outstanding, all held by
the promoters currently. In the first round of financing, the company raises INR 500 at INR 1 per
share from investor X (i.e. 500 shares).
Thus, Pre-money Valuation for Round 1 = INR 1 x 1,000 = INR 1,000
Post-money Valuation at the end of Round 1 = INR 1,000 + INR 500 = INR 1,500
Hence, % stake of Investor X at the end of Round 1 = 500/1,500 = 33%
And, % stake of Promoters at the end of Round 1 = 1,000/1,500 = 67%
Now, suppose the company does a second round of financing wherein it raises INR 10,000 at INR 10
per share (i.e. 1,000 new shares) from Investor Y.
Then, Pre-money Valuation for Round 2 = INR 10 x (1,000 + 500) = INR 15,000
Post-money Valuation at the end of Round 2 = INR 15,000 + INR 10,000 = INR 25,000
Hence, % stake of Investor Y at the end of Round 2 = 10,000/25,000 = 40%
% stake of Investor X at the end of Round 2 = 500 x 10/25,000 = 20%
% stake of Promoters at the end of Round 2 = 1,000 x 10/25,000 = 40%
As a closing comment, one must remember that in the case of PE/VC investments, it is as much about
the team and the management of the private company as it is about the idea and its potential. A
great idea but a bad management team means high execution risk, which means that the idea might
never see the light of the market. Hence, a PE/VC Fund invests as much time in evaluating the
management team and the promoters as in evaluating the potential of the product/service idea.
Cash Available for Debt Servicing (CADS) : It includes the pre-tax cash operating income
plus the interest income from the debt reserve account minus mandatory expenses (working capital,
maintenance and infrastructure improvements). This cash does not include the debt reserve account.
Debt Service is the debt liability, including the principal and interest payment, due for
the year.
Debt Reserve is an account maintained to cover for the shortfall in future in payment of
debt obligations. This is generally a percentage of the revenue or any other parameter. A larger debt
reserve affects the Equity IRR by building up a buffer for future debt payments.
Debt Service Coverage Ratio (DSCR): This ratio is an indicator of the capability of the
project to pay its debt obligations, both interest as well as principal, for a particular year. Thus,
project financing institutions demand a minimum level of DSCR over the loan period which reflects
the risk-profile of the project.
Example: DSCR is typically 1.3x for an independent power project with PPA (Power
Purchase Agreement) as almost all risks have been mitigated. However, DSCR for a merchant power
plant ill typically be 2x because of exposure to market risks.
Equity IRR: Cash flows to equity investors (or project sponsors) happen after all
mandatory expenditures, debt service and payment to debt reserves is done. The IRR of these set of
cash flows is the return that sponsors get on their investments.