Corporate Finance Report

There are a variety of reasons that an acquiring company may wish to purchase another company. Some takeovers are opportunistic: the target company may simply be very reasonably priced, for one reason or another, and the acquiring company may decide that in the time period that's important to it, it will end up making money by purchasing the target company, because of its normal profitability. The massive holding company Berkshire Hathaway seems to have profited very well over time by purchasing many companies opportunistically in this way. Berkshire Hathaway is a company headquartered in Omaha, Nebraska, USA, that oversees and manages a number of subsidiary companies (Costanza, 1999)

Other takeovers are strategic in that they are thought to have secondary effects beyond the simple effect of the profitability of the target company being added to the acquiring company's profitability. For example, an acquiring company may decide to purchase a company that is profitable on its own accord but also has good distribution capabilities in new areas which the acquiring company can utilize for its own products as well. A target company might be attractive because it allows the acquiring company to enter a new market with a running start, without having to take on the risk, time, and expense of starting a new division that would compete in this new market. An acquiring company could decide to take over a competitor not only because the competitor is profitable, but in order to eliminate competition in its field and make it easier, in the long term, to raise prices; or in the belief that the combined company can be more profitable than the two companies would be separately due to a reduction of redundant functions; or, if an acquiring company has a major competitor it wants to attack, it may purchase a target company which already competes with that major competitor in some other area or product line.

Critics often charge that very large companies execute takeovers in order to boost their reported revenue (sales to customers), without giving sufficient regard to profit, which generally takes a hit when a company is acquired because of all the costs involved, and because a premium is always paid if the target company is financially healthy and not already desperate to be taken over. The widespread belief in this criticism is demonstrated by the fact that a takeover announcement typically drives up the stock price of the target company, and forces down that of the acquiring company.

Determining an appropriate value for the target company entail valuation. Valuation is the process of calculating the value of an asset (liability). The value is the price of the asset (liability) times the quantity held. Valuations are required in many contexts including finance, property management and the antiques industry.

Generally speaking in advanced economies the valuation rests on some estimate of current price, or estimated fair price now, rather than book value i.e. book price (the latter being the acquisition cost of the asset or liability, or the depreciated book value, rather than it's value now).

In the financial industry, valuations are required for all financial assets (liabilities), for various reasons including tax, regulatory and accounting (including reporting to owners and stakeholders). The valuations are as of specified dates e.g. the end of the accounting quarter or year. They may alternatively be mark-to-market (estimates of the current value of assets {liabilities} as of this minute or this day) for the purposes of managing portfolios and associated financial risk (e.g within large financial firms including investment banks and stockbrokers) (Luehrman, 1999).

Some assets (liabilities) are much easier to value than others. Publicly traded shares and bonds e.g. have prices that are quoted frequently and sometimes minute to minute. Other assets are hard to value e.g. private firms that have no frequently quoted price and financial instruments that have prices that are partly dependent on theoretical constructs of one kind or another. For example, options are generally valued using the Black and Scholes model, whilst the liabilities of life assurance firms are valued using the theory of present value.

It is possible and conventional for financial professionals to make their own estimates of the valuations of assets (liabilities) that they are interested in, and their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cash flow and present value calculations, and analyses of bonds that focuses on credit ratings (e.g. assessments of default risk), risk premia and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices (where applicable) and may or may not result in buying or selling by market participants.

The valuation of a business is a complex and time-consuming undertaking and yet the volume of business valuations being performed each year is increasing significantly. A leading cause of this growth in volume is the increasing use of mergers and acquisitions as vehicles for corporate growth. Business valuations are frequently used in setting the price for a business that is being bought or sold. Another reason for the growth in the volume of business valuations has been their increasing use in areas other than supporting merger and acquisition transactions. For example, business valuations are now being used by financial institutions to determine the amount of credit that should be extended to a company, by courts in determining litigation settlement amounts and by investors in evaluating the performance of company management. Lastly, business valuations are often required under a variety of accounting and tax regulations that are not directly related to mergers and acquisitions.

In most cases, a business valuation is completed by an appraiser or a Certified Public Accountant (hereinafter, appraiser) using a combination of judgment, experience and an understanding of generally accepted valuation principles. The two primary types of business valuations that are widely used an d accepted are income valuation and asset valuations. Market valuations are also used in some cases but their use is restricted because of the difficulty inherent in trying to compare two different companies.

The usefulness of business valuations to business owners and managers is limited for another reason--valuations typically determine only the value of the business as a whole. To provide information that would be useful in improving the business, the valuation would have to furnish supporting detail that would highlight the value of different elements of the business. An operating manager would then be able to use a series of business valuations to identify elements within a business that have been decreasing in value. This information could also be used to identify corrective action programs and to track the progress that these programs have made in increasing business value. This same information could also be used to identify elements that are contributing to an increase in business value. This information could be used to identify elements where increased levels of investment would have a significant favorable impact on the overall health of the business.

Knowing the business valuation for the success of financing take overis important however business plan needs to be in place. Business plans are used internally for management and planning and are also used to convince outsiders such as banks or venture capitalists to invest money into a venture. Business plans are noted for often quickly becoming out of date. One common belief within business circles is that the actual plan may have little value, but what is more important is the process of planning, through which the manager gains a greater understanding of the business and of the options available. A business plan can be seen as a collection of sub-plans including a marketing plan, financial plan, production plan, and human resource plan. The business plan has many forms. There is however a format that is typical. In finance, the business plan must look upon the source of funds, expected return, break even analysis, monthly pro-forma cash flow statement, existing loans and liabilities (Dixit and Pindyck, 1995).

One of the alternative methods on financing the takeover bid is the company must have planning strategies for management in doubled doubling the size of the company. Strategic management is the process of specifying an organization's objectives, developing policies and plans to achieve these objectives, and allocating resources so as to implement the plans. It is the highest level of managerial activity, usually performed by the company's Chief Executive Officer (CEO) and executive team. It provides overall direction to the whole enterprise. An organization’s strategy must be appropriate for an organizations resources, circumstances, and objectives. The process involves matching the companies' strategic advantages to the business environment the organization faces. One objective of an overall corporate strategy is to put the organization into a position to carry out its mission effectively and efficiently. A good corporate strategy should integrate an organization’s goals, policies, and action sequences (tactics) into a cohesive whole (Levi, 1992).

Strategic management can be seen as a combination of strategy formulation and strategy implementation. Strategy formulation involves: Doing a situation analysis: both internal and external; both micro-environmental and macro-environmental; Concurrent with this assessment, objectives are set. This involves crafting vision statements (long term), mission statements (medium term), overall corporate objectives (both financial and strategic), strategic business unit objectives (both financial and strategic), and tactical objectives; These objectives should, in the light of the situation analysis, suggest a strategic plan. The plan provides the details of how to obtain these goals.

This three-step strategy formation process is sometimes referred to as determining where you are now, determining where you want to go, and then determining how to get there. These three questions are the essence of strategic planning.

Strategy implementation involves: Allocation of sufficient resources (financial, personnel, time, computer system support); Establishing a chain of command or some alternative structure (such as cross functional teams); Assigning responsibility of specific tasks or processes to specific individuals or groups ; It also involves managing the process. This includes monitoring results, comparing to benchmarks and best practices, evaluating the efficacy and efficiency of the process, controlling for variances, and making adjustments to the process as necessary; When implementing specific programs, this involves acquiring the requisite resources, developing the process, training, process testing, documentation, and integration with (and/or conversion from) legacy processes.

Strategy formation and implementation is an on-going, never-ending, integrated process requiring continuous reassessment and reformation. Strategic management is dynamic. It involves a complex pattern of actions and reactions. It is partially planned and partially unplanned. Strategy is both planned and emergent, dynamic, and interactive. Some people (such as Andy Grove at Intel) feel that there are critical points at which a strategy must take a new direction in order to be in step with a changing business environment. These critical points of change are called strategic inflection points.

Also, risk management is very important before the financing of takingover bid. As applied to corporate finance, risk management is a technique for measuring, monitoring and controlling the financial risk on a firm's balance sheet. The value at risk is one of the better alternatives to think before the taking over will be settled (Levi, 1996). the Value at risk, or VaR, is a measure used to estimate how the value of an asset or of a portfolio of assets will decrease over a certain time period (usually over 1 day or 10 days) under usual conditions. It is typically used by securities houses or investment banks to measure the market risk of their asset portfolios, but is actually a very general concept that has broad application. VaR has two parameters: the time period we are going to analyze (i. e. the length of time over which we plan to hold the assets in the portfolio - the “holding period“) and the confidence level at which we plan to make the estimate. The typical holding period is 1 day, although 10 days are, for example, required to compute capital requirements under the European Capital Adequacy Directive (CAD). For some problems, even a holding period of 1 year is appropriate. Popular confidence levels usually are 99% and 95%.

As an example, an investment bank might report that its portfolio has a 1-day VaR of $5 million at the 95% confidence level. This implies that (provided usual conditions will prevail over the 1 day) the bank can expect that, with a probability of 95%, the value of its portfolio will decrease by 5 million or less during 1 day, or in other words: it can expect that with a probability of 5% (i. e. 100%-95%) the value of its portfolio will decrease by more than 5 million during 1 day. Stated yet differently, the bank can expect that the value of its portfolio will decrease by 5 million or less on 95 out of 100 usual trading days, in other words by more than 5 million on 5 out of every 100 usual trading days.

VaR (1 day; 95%) measures what will be my maximum loss (i. e. decrease in portfolio value) over 1 day, if I assume that the 1 day will not be one of the 5% days that are my worst under normal conditions. It thus measures how much we could lose, but it also provides an indication of how much money might be put aside as a cushion for days when losses are unexpectedly large. Thus VaR is not only a risk measurement tool, but also facilitates risk management.

After taking over of the company, there are several reasons why the takeovers fails to deliver what is expected in returns. The main reason why taking over fails to return what is expected is due to the failure of the strategic plans which was then arranged before the takeover takes place. There are many reasons why strategic plans fail, especially:

Inability to predict environmental reaction, what will competitors do, fighting brands, price wars, will government intervene, over-estimation of resource competence, can the staff, equipment, and processes handle the new strategy, failure to develop new employee and management skills; Failure to coordinate, reporting and control relationships not adequate, organizational structure not flexible enough; Failure to obtain senior management commitment, failure to get management involved right from the start, failure to obtain sufficient company resources to accomplish task; Failure to obtain employee commitment, new strategy not well explained to employees, no incentives given to workers to embrace the new strategy; Under-estimation of time requirements, no critical path analysis done; Failure to follow the plan, no follow through after initial planning, no tracking of progress against plan, no consequences for above. Depending on the complexity of the financial environment, in economics and finance scenario analysis can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns (Myer, 1974). In scenario analysis "risk" is distinct from "threat." "Threat" refers to a very low-probability but high-impact event - which cannot typically be assigned a probability in a risk assessment because it has never occurred, and for which no effective preventive measure is available. The difference is most clearly illustrated by the precautionary principle which seeks to reduce threat by requiring it to be reduced to a set of well-defined risks before an action, project, innovation or experiment is allowed to proceed.

References:

Costanza, R. (1999) Three General Policies to Achieve Sustainability. Center for Environmental and Estuarine Studies. University of Maryland. unpublished.

Dixit, A., and R. Pindyck (1995) The Options Approach to Capital Investment. Harvard Business Review. pp. 105-115.

Levi, M. (1992) The Teaching of International Finance in Global Perspective: Internationalising Management Education.Centre for International Business Studies. University of British Columbia.

Levi, M. (1996) International Finance: the Markets and Financial Management of Multinational Business, Third Edition. McGraw-Hill, New York.

Luehrman, A. (1997) What's it Worth? A General Manager's Guide to Valuation. Harvard Business Review. pp. 132-142.

Myers, S. (1974) Interactions of Corporate Financing and Investment Decisions- Implication for Capital Budgeting. Journal of Finance. vol. 29 pp. 1-25.