Chapter 11

Mergers and Acquisitions: Valuation, Leveraged Buyouts, and Financing by Sheeba Kapil and Kanwal N.
Kapil
Copyright @ 2018
2016 Wiley India Pvt. Ltd. All rights reserved.
Chapter 11
Concepts in Business Valuation
Mergers and Acquisitions: Valuation, Leveraged Buyouts, and Financing by Sheeba Kapil and Kanwal N. Kapil
Copyright @ 2018
Learning objectives
After reading this chapter, you will be able to:
• Understand the concept of discounted cash flow approach (DCF).
• Understand the concept and calculation of free cash flow to the firm
(FCFF).
• Understand the concept and calculation of free cash flow to equity (FCFE).
• Understand the closure in valuation through terminal value.
• Understand the two-stage DCF model of valuation.
• Understand the multi-stage DCF valuation model.
• Understand the unlevering of beta and valuation.
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Introduction
• DCF is a valuation method that measures the efficiency of the firm’s assets. It measures the
productivity of assets in terms of their future cash flow generating capacity.
• High cash flow generating capacity is an indication of good quality of assets. Good quality assets
are more productive and yield higher cash flows.
• All companies strive to include better and good quality assets. Those firms that do not own good
quality assets aim to buy good quality assets of other firms. Good quality assets indicate growth
of the firm.
• Growth is the function of assets (both tangible and intangible). Investments made in good
quality assets ensure higher growth and good return on investment.
• DCF approach projects future cash flows, which the firm is capable of generating. The
cumulative value of these cash flows signifies the worth of the firm.
• Beyond the forecasted period, cash flows are taken to be perpetual in nature.
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Components of DCF
The components of DCF are as follows:
• Free cash flow (FCF) estimation
• Period of FCF estimation
• Growth in FCF
• Perpetuity value beyond FCF period
• Discount rate
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Free Cash Flow Estimation
• The DCF approach involves forecasting earnings and forecasting FCF.
This is the net cash generated by the firm through its assets.
The FCF may be categorized as:

• Free cash flow to the firm (FCFF)
• Free cash flow to equity (FCFE)
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Free Cash Flow to the Firm -FCFF
• This is the cash flow accruing to the firm as a whole. The FCFF is
available to both equity and debt holders.
• This cash flow is the net cash flow derived after adjusting all expenses
that contribute to the firm’s productivity and growth. The expenses are
capital expenditures that create fixed assets and working capital.
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Free Cash Flow to Equity
• This cash flow is available to the equity owners of the firm and is the
net cash flow derived after adjusting operating expenses and capital
expenditures that contribute to the firm’s productivity and growth.
Debt holders’ expenses are adjusted before calculating FCFE.
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Period of FCF Estimation
• The period of FCF is the forecasted period. It is estimated by way of correctness in forecasting the
cash flows.
• The period generally ranges between 5 and 10 years. Beyond this period, forecasting is difficult
and ceases.
• It gets replaced by perpetuity once the forecasting period is over. For example, cash flows are
forecasted for a company for 5 years.
• The NPV of the company can be calculated based on the forecasted cash flows for 5 years.
• However, it does not imply that the company would cease to exist after 5 years or valuation has to
be done on 5-years basis. So beyond 5 years, the company is valued as a perpetual entity.
• The forecasted period is usually a high growth period for the company under valuation. Post
forecasted period, the company is in steady state.
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Growth in FCF
• Growth in FCFF and growth in FCFE will be slightly different from the user’s perspective.
• FCFF is based on the operating income before debt payment. So one has to gauge the growth in operating
income. On the contrary, FCFE is based on the net income or earnings per share, which is calculated after
payment of all dues and obligations of the firm.
• For growth in FCFE one has to gauge the net income.
• Growth in operating income and net income post tax will be different. Firms that are highly leveraged will
have lower growth in operating income relative to growth in net income. Reduced tax payouts will augment
growth in net income due to high leverage.
• Growth in net income = Equity reinvestment rate (ERR) × Return on equity (ROE)
• g = ERR × ROE
• Growth in operating income (EBIT) = RR × ROC
where ROC is the return on capital, RR is the reinvestment rate, ROE = ROC + D/E × (ROC - kd post
tax), D/E is the debt–equity ratio, and kd is the cost of debt post-tax basis.
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Perpetuity Value Beyond FCF Period
• The FCFF and FCFE can be forecasted for a limited period only. Beyond this period, the cash flow
cannot be forecasted. All businesses are established as perpetual entities. Hence, the value of the
firm beyond the forecasted period will be assessed as a perpetual ongoing concern. We will use
terminal value calculation post forecasted period. This is also termed as closure in valuation.
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Discount Rate
• The discount rate is used to calculate the present value of FCFs. When
using FCFF, the discount rate used is WACC. FCFF is the FCF generated
to a firm. Hence, to discount FCFF, the overall cost of capital of the
firm is used, that is, WACC. When using FCFE, the discount rate used
is cost of equity, ke. FCFE is the cash flow generated to the equity
owner; hence, cost of equity is used to discount FCFE.
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Calculating Cost of Equity, ke
The cost of equity can be calculated by the following methods:
• Dividend capitalization approach
• Capital asset pricing model
• Arbitrage pricing theory
• Three-factor Fama model
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Dividend Capitalization Approach
• Dividend capitalization approach is also known as dividend discount
method (DDM). According to this approach, the cost of equity capital
is measured by the rate of return required by the equity holder, which
equates the present value of the expected dividends discounted at
the rate of return required by equity shareholders.
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Capital Asset Pricing Model
• The capital asset pricing model (CAPM) is the most widely used method to calculate the cost of
equity. According to the CAPM approach, there exists a linear relationship between risk and
expected return. In case the investor expects a higher rate of return, he/she has to take greater
risk. The higher the risk, greater is the return and vice versa. The CAPM calculates the cost of
equity by considering the risk-free rate prevalent in the economy and the risk-free premium
desired by the investor. The CAPM also considers β to specify the relationship between the
market and individual equity.
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Arbitrage Pricing Theory
• Unlike the CAPM, APM considers various independent factors which

tend to influence the security in the market. In the CAPM, the risk is
measured as β factor, whereas in the APM the factors considered are
inflation, changes in the expected level of industrial production,
changes in the risk premium on bonds, and unexpected changes in
term structure of interest rates.
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Fama–French Three-Factor Model
• Fama and French in year 19926 extended the CAPM model and
specified that three risks factors determine the portfolio return. Beta
explains about 70% of return on portfolio. However, β along with the
size of shares and price to book value of the shares in the portfolio
explains 95% of a portfolio’s return.
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Copyright @ 2016 Wiley India Pvt. Ltd. All rights reserved.
Weighted Average Cost of Capital
• The overall cost of capital is the WACC. The total capital that a company procures is derived from
various sources.
• Each source of capital has a distinct cost attached to it. After determining the cost of various
components of capital, namely debt, equity, preferred capital, retained earnings, etc.
• WACC is used to discount FCFF as it values the firm and overall assets, irrespective of the sources
that financed it.
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Valuing Firm with DCF
• Once FCF has been forecasted and discount rate determined, we then
value the firm by discounting the cash flows with the discount rate.
• The derived NPV of the firm is the fundamental value of the given
firm. This is termed as DCF approach of valuation.
• As cash flows are forecasted and appropriate discount rates are
determined, the value of the firm through DCF is quite
comprehensive and holistic in approach.
• It gives the worth of tentative cumulative cash flow generating
capacity of the firm as on date.
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Two-Stage Model
• The two-stage model determines the NPV of forecasted cash flows

with growth rate in the first stage. In the second stage, the firm is
valued as perpetuity with stable growth rate.
• So there are two growth rates. One growth rate depicts the growth of
FCFs during the forecasted period and the second growth rate is the
steady state growth for terminal value.
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Multi-Stage Growth Model
• Here the growth rate is different in different years, including the

terminal value.
• The growth rate of FCFs differs each year and gradually tapers to the
terminal growth rate.
• The equation of DCF remains same only with differing growth rates
each year.
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Unlevering Beta and Firm Valuation
• Beta is a measure of the firm’s volatility called systematic or

unavoidable risk. It is rewarded by the market to the investor. Hence,
return on equity is directly proportional to beta as risk measure. Beta
is a key input in DCF or DCF valuations. Beta is best understood by
understanding the key variables of the CAPM equation.
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Levered Beta
• Normal beta that we calculate for a listed company is the levered

beta. Levered beta contains the effect of capital structure, that is,
mode of financing (debt and equity).
• Levered beta is called equity beta. Equity beta represents both
systematic and unsystematic risks of the firm, and remains constant
till the time the company has the same debt–equity ratio.
• As debt–equity ratio is increased, the equity beta will also increase.
All equity or zero debt firms will have equity beta equal to asset beta.
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Unlevered Beta
• Unlevered beta is the beta calculated after removing the effects of
debt financing. The effect of financial leverage is removed.
Unlevered beta is also called asset beta, and it reflects only the
business risk of the firm. Asset beta remains constant till the time
the company operates in the same business.
Where βu is unlevered beta and β1 is levered beta, D/E is debt equity

ratio and T is corporate tax rate.
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Applications of Unlevered Beta
The unlevered or asset beta has several applications in valuation as
follows:
• Valuing private firms
• Valuing business divisions
• Valuing firms with changing gearing ratio
• Valuing a new company post M&A
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Valuing Private Firms
When valuing private firms, the discount factor or WACC is calculated by calculating WACC and
equity. For cost of equity of a private firm, beta estimation is difficult without any share price. In
this case, the process for beta calculation of private unlisted company is as follows:
• Determine the industry average levered beta to which the company belongs βlever (average).
• Determine the unlevered beta of the industry by using an average debt–equity ratio of the
industry βunlever (average).
• Determine the beta levered of a private unlisted company by using industry average beta
unlevered and debt–equity ratio of the private company.
• Using the beta levered of the listed company, calculate the cost of equity that will be sued in
WACC calculation.
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Valuing Business Divisions
1. Determine levered beta of comparable firms for each division.
2. Unlever the average levered beta determined in step 1 using the average debt equity of
comparable firms.
3. This unlevered beta of industry is unlevered beta of the division.
4. Determine the weighted average unlevered beta of all divisions.
5. The weight will be the weight of revenues earned by various divisions.
6. The weighted average unlevered beta of the parent firm derived in step 4 will be levered using
debt equity of the parent firm.
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Valuing Firms with Changing Gearing Ratio
The steps involved in the process are as follows:

• Unlever the beta of the firm using the existing debt–equity ratio
• Lever the beta using the new debt–equity ratio
• The new levered beta is used for subsequent cost calculation
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Valuing a New Company Post M&A
The steps involved in the process are as follows:
• Take beta levered of the acquirer and beta levered of the target, and
unlever it using debt equity of each of the company, respectively.
• Determine the weighted average unlevered beta of the merged entity.
• Weight will be based on the market value of the firms, or their DCF
values.
• Weighted average unlevered beta will be used along with the target
debt–equity ratio of the merged entity to determine the levered beta
of the merged entity.
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Mergers and Acquisitions: Valuation, Leveraged Buyouts, and Financing by Sheeba Kapil and Kanwal N.

The FCF may be categorized as:

• Unlike the CAPM, APM considers various independent factors which

• The two-stage model determines the NPV of forecasted cash flows

• Here the growth rate is different in different years, including the

• Beta is a measure of the firm’s volatility called systematic or

• Normal beta that we calculate for a listed company is the levered

Where βu is unlevered beta and β1 is levered beta, D/E is debt equity

The steps involved in the process are as follows:

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