Part One Motive
As one of the corporate restructuring approaches, mergers and acquisitions (M&A) is viewed as a wealth creation strategy. Weston and Weaver (2001) suggest that companies deal with new challenges as well as opportunities more efficiently with an M&A process. They also point out that the success of an M&A may lead to the revenue enhancement, profitability improvement and thus the value creation of the company as a whole. Companies tend to boost growth through M&A when they can not find a way to use internal growth opportunities (Jovanoci and Braguinsky, 2002). Arguments for M&A are mainly about its effects on market value enhancement. However, unsuccessful M&A may lead to the results of drop in share price and value destruction. Thus, prudent analysis and consideration is necessary before proceeding with any M&A plan.
The motives for M&A are various. Companies make M&A decisions for a mix of several reasons instead of only one. As summarized by Andrade, Mitchell and Stafford (2001), common motives for M&A are as follows: achieving synergies such as economies of scale; obtaining monopoly power by improving competition position; requirement of market discipline; managerial concern and other agency cost; acquiring benefits from diversifications. Among the three major motives, synergy, agency and hubris motives, Berkovitch and Narayanan (1993) believe that the latter two motives lead to the negative abnormal return for acquiring companies. Consequently, to ensure our motives for M&A will induce good results is important.
Synergy simply means that the value of the combined company is more than that of the sum of two companies when they are operated individually (Weston and Weaver 2001). The assumption involved in synergy motive is that managers of both acquiring and target companies make decisions for the sake of shareholders. In other words, they try to maximize shareholders wealth (Berkovitch and Narayanan 1993). As suggested by Larsson and Finkelstein (1999), synergy realization, rather than anything else, is the key indicator when measuring the outcome of M&A. Sources of synergy includes sales enhancements and cost reduction. Companies benefit from increased market power caused by M&A. The combined firm gains monopoly power, or at least becomes more competitive than before. As suggested by Andrade et al (2001), companies may also expected growth caused by more efficient managing of assets. Cost reductions, such as economy of scale, are another source of synergy. More efficient technical and marketing expertise is helpful in reducing cost as well.
Hubris hypothesis simply states that managers of the acquiring company always pay too much in acquisition (Roll, 1986). One of the explanations is misevaluation of the target. In this circumstance, M&A may be taken even if there is no synergy. The observation of negative abnormal returns may partly duo to acquisitions lead by hubris motives. Narayanan et al (1993) observed negative returns to acquiring company's shareholder in about half of all the cases. Since synergy generates positive returns for shareholders, the observation of negative return indicates the existence of hubris and other motives.
Agency motive focuses on the interest of the managers instead of the wealth of shareholders when making M&A decisions. Some of the managers concern more about their own interest. Datta et al (2001) documented that a positive relationship between the equity-based compensation for managers and stock performance has been found. Furthermore, by making M&A, managers tend to increase the size of the company. As noted by Moeller et al (2004), Jensen (1986) made the argument that rather than payouts to shareholders, empire-building managers prefer making acquisitions. Negative abnormal returns are expected in this case as well.
Besides synergy, hubris and agency consideration, other motives, such as diversification, are also important in explaining the cause of M&A. DeLong (2001) argues that mergers which aims to boost activity and geography diversification has a better performance by 2.0 to 3.0% than other types of mergers. It is well accepted that diversification in unrelated industries reduces risk whereas geographically diversification offers new growth opportunities (DePamphilis, 2007).
Overall, our company aims to improve competition position and gain synergies from the acquisition of J Sainsbury plc. First, an increase in the market share within the retail industry could be anticipated. J Sainsbury plc consists of Sainsbury's and Sainsbury's bank. As the largest chain of supermarket in the UK, Sainsbury's has a chain of 509 supermarkets and 207 convenience stores. Thus, by acquiring J Sainsbury plc, our company will gain new growth opportunities as well as more powerful distribution chains, which will further benefit us by boosting sales and reducing competitions. Second, geographically diversification offers us new growth opportunities within the UK market. Furthermore, since UK market are characterized by good record of corporate governance and corporate social responsibility, and at the time Sainsbury is a responsible company with good customer relationships, we could take the acquisition as a good chance to improve our public image. Finally, as a target of several unsuccessful takeover bids, Sainsbury is certainly a valuable target. Thus, by taking this acquisition successfully, we may win back the investors' confidence.
Part two Valuation (1000)
1. Methods Comparison (525)425
People may evaluate a company for quite different purposes, and thus use various methods to define a proper value for the company. The most common used methods for evaluation are Asset-Based Valuation, Multiple Approach and Discounted Cash Flow method.
Based on the historical s on balance sheet, asset-based valuation is usually used for accounting purpose. It is useful when information about a company is not adequate, such as for private companies. However, the deficiencies involved can not be ignored. First, it takes neither current asset value nor intangible assets into account. Intangible assets such as good will and management competence are essential components of a company. Second, managers always arrange their own remuneration for tax-saving purpose. Furthermore, it may encounter with the problem of asymmetry information. Overall, adjustment is needed when asset-based valuation is used.
Calculations base on P/E ratio, EBIT or some other multipliers is called Multiple Approach. First step involves determining how much profit the company generates. Then, we'll get firm value by multiply it with a proper multiplier. Though it is a global and comparative approach for evaluation, it has some deficiencies. First, all the calculations are based only on one year's earning. Second, it ignores the effect of gearing. A highly-geared company usually faces a comparatively lower P/E ratio. Further argument emphasizes the ignorance of management competence. Last, P/E ratio for public companies is often higher than that for private companies. All these problems may cast doubt on the accuracy of multiple approach valuation. Thus further adjustment is important if this method is adopted.
As a fundamental valuation method, Discounted Cash Flow (DCF) method focuses on the present value of all the future cash flows that may generate from the investment. The firm value consists of two parts: the value of explicit forecast period and the terminal value. The length of the explicit forecast period may various depending on the time that a company can generate profit from its current configuration. As for the terminal value, it is a value represents all the future cash flows after the company entering a phase of maturity. A normalized cash flow as well as a perpetual growth rate is required for calculating the terminal value. To get the present value of these two parts, a proper discount rate is needed. Usually, the Weighted Average Cost of Capital (WACC), which represents the minimum rate of return on capital employed, is used.
As suggested by Vernimmen (2005), this is a method which has its basis on the real economic performance of the company. Instead using historical s, the evaluation emphasizes the forecasting of future cash flows. However, it also has some deficiencies. First, the results of estimation are volatile duo to assumptions we made. For example, the present value is sensitive to small changes in estimated discount rate. Second, it is difficult to define a proper terminal value. As in our case, the terminal value accounts for 93.5% of the firm value, which means we expect a lot of profit from the far future. Last, forecasting of future performances is quite demanding. Thus, by adopting this method, we need to make carefully-thought estimates.
2. Calculation 800
Before making any suggestion about the profitability of the acquisition plan, a careful calculation is done to present the synergy from this project. We'll get a clear idea about the synergy generated by calculating the stand-alone value and value with synergy of J Sainsbury plc separately. Here DCF method is adopted and a 5-year-estimation is made.
According to DCF method, the data for the performance of the base year, Year 2008, is acquired from the annual report (2008) of Sainsbury. The s are presented in Table 1. The tax rate is 28% according to website: www.scopulus.co.uk/taxsheets/default.htm. Table 2 shows the ratios calculated by using s in Table 1. Assume that the ratios of COGS/Revenue and Administration Cost/Revenue remain the same during the estimated period whereas the item of Other Income remains 30 unchanged (Assumption 1). Such assumption reveals the fact that COGS and administration cost are highly related with the sales; however, this is not the case for Other Income. The calculation of free cash flows is guided by the method shown in Table 3.
(2) Stand-alone Calculation
The first step involves the calculation of EBIT for each year being estimated. Assume that the revenue growth rate is the weighted average rate of the last three years (Assumption 2).Calculation is presented in Table 4. To make an appropriate estimation, the growth rate is adjusted by the inflation rate as shown in Table 5. s of sales for the past four years are obtained from the annual report of Sainsbury. Historic s of inflation rate are acquired from website of National Statistics, whereas the forecasting of inflation rates from 2009 to 2012 is from website of Bank of England. Further assume that the inflation rate for year 2013 remains the same as in year 2012 (Assumption 3). Although the forecasting of inflation rate usually has a range between -1% and 10%, which is not accurate, I still adjust the growth rate by inflation to capture the features of the economy as a whole.
To get the free cash flow, further assumptions are need.
Since the company uses the method of straight line for depreciation, s remains unchanged in each year. Capital Expenditure is estimated according to J Sainsbury plc's own plan, which is presented in the annual report 2008.
All the estimation about Steady state is based on the performance of Year 5. Assume that the annual constant growth rate () is the risk free rate of UK market (Assumption 7). The terminal value is calculated by following the formula:
The Weighted Average Cost of Capital (WACC) is usually used as the discounted rate in calculation. As shown in Table 6, the cost debt is assumed to be the interest rate of long term debt which is obtained from the annual report (Assumption 8). The cost of equity is obtained by using CAPM model as shown in Table 7. The of β is acquired form Yahoo finance.com. It measures the risk of a company's common stock. f is represented by UK 10 year benchmark bond rate is the expected market risk premium. Here FTSE 100 return rate is used to represent for our company is one of the components of FTSE 100 indices. Monthly data for both and are acquired from data-stream. Then I annualize them to get the absolute annual return.
The process of stand-alone valuation is presented in Table 8 and results of the enterprise value in Table 9. The stand-alone firm value is ￡6784.82 million.
The expected synergy comes from both revenue enhancement and cost reduction. If the acquisition of J Sainsbury plc is successful, a further increase in the revenue of 3% for the first year and 1% for the next 3 years could be expected. The ratio of COGS/Revenue will drop by 2% and reaches 92.38%. The Administration costs/ sales ratio will also has a decrease as much as 20%, drops from 2.81% to 2.25%. Thus, after taking all these changes into consideration, the company's value with synergy is ￡18711.85 million, which is nearly 3 times of the stand-alone value. The synergy generated by acquisition is ￡11927.02 million. The calculation and result of firm value with synergy are presented in Table 10 and Table 11 respectively.
4. Sensitive Analysis
The value of synergy is accurate only when our prediction about sales increase is correct. It is quite possible that, however, sales will not reach the target. The recession which the entire economy is experiencing now may last longer than expected. Furthermore, it is usually the case that grocery industry is usually the last to recover. As suggested by Vernimmen (2005), several scenarios are preferred for this method to capture the effect of different growth assumptions. Thus, sensitive analysis is done separately for the case that sales increase is 1% less than expected (Scenario 1) and the case of no sales increase at all (Scenario 2).
As shown in Table 12, the synergy will drop by 7.48% and 11.26% respectively in Scenario 1 and 2. If the sales increase is 1% less than expected, the synergy generated is ￡11034.96 million. Even if there is no sales improvement, the synergy is still as much as ￡10584.47 million. That's what we could expect simply from the cost reduction caused by acquisition.
Part three Financing (883)
Apparently, J Sainsbury plc is a profitable investment according to the valuation. If we make this acquisition successfully, synergies as much as ￡11927.02 million could be gained. However, how to finance this project is still a problem. As summarized by Martin (1996), payment methods used in M&A are cash and stock exchange. As for cash financing, we have the choices of using free cash flow, issuing equity or issuing debt. Method of payment is of importance duo to the fact that it is one of the determinants of value creation in M&A.
Companies have the choice of making M&A either by cash or by stock. A cash deal simply means that the acquiring company pays a fixed amount of money to the target company's shareholders. On the contrary, new shares of the acquirer are issued directly to the shareholder of the target company in a stock deal. Choice on payment methods has great impact on the value of the acquiring company. Travlos (1987) argues that stock exchange acquisition leads to significant losses whereas cash deals experiences positive returns. This result has been further convinced by Amihud et al. (1990). They argue that managers tend to use stock exchange method when the shares of the acquiring company are overvalued. Fuller et al (2002) found evidence, though only for public companies, that stock-swap is used when their stock are overvalued and cash is used when stock are undervalued or correctly valued. Thus, the announcement of a stock swap may lead to a negative market reaction and thus a negative effect on acquirer's share price.
As for our case, cash payment should be suggested for several reasons. First, we pay a fixed amount for a cash deal whereas the total payment for a stock swap is not precise. Furthermore, considering the fact that our company is financially sound, we could make the bid by cash to boost shareholders' confidence. Last, issuing debt may be easier for large companies as ours.
As stated above, a company has three choices when they make a cash deal. Pure cash deal is rare and used only when the acquiring company is large company with plenty of cash whereas the target is small in size. Thus, we could raise money either by issuing equity or issuing debt.
Issuing equity is not preferred when taking corporate control into consideration. As noted by Ghost and Ruland (1998), financing by issuing equity has a dilution effect on the control power of the acquiring company's shareholder. As suggested by Faccio et al (2005), the bidder's financing decision may be influenced by their desire to control the company. Since the new issued equity may dilute the right of the original shareholders, the company faces with the risk of losing control and becoming minority shareholders.
Another problem caused by issuing equity may the asymmetric information. Managers of the acquiring company tend to issuing equity when their stock price is over valued (Loughran and Vijh, 1997). The company will benefit from the overvalued part by selling them on the stock market. Though issuing equity shows confidence in the new investment, since the market are not sure about the motives behind this decision, they may view it as a signal of overvalued company.
Thus, issuing equity may face a negative market reaction.
Capital structure of the acquiring company should also be considered. Issuing debt indicates a rising financial distress costs (Faccio et al, 2005). Both the debt capacity and existing leverage are important for the decision. As noted by Titman (2001), tangible assets, growth of earnings and diversification have positive influences on a company's debt capacity. Since our company has a good financial status, and at the same time, the investment on J Sainsbury is expected to generate positive returns and enhance the growth of the company as a whole, issuing debt may not be so difficult for us. Furthermore, the present leverage ratio is within its target. This indicates that we still have the choice of issuing debt without much financial risk.
One of the deficiencies of issuing debt may be the fact that the acquiring company bears the whole business risk in this case. If the investment is not valuable, or in another words, if there is no synergy could be gain by M&A, the acquiring company's shareholders have to bear all the losses. However, the expected synergy is as much as ￡11927.02 million according to our evaluation. This is still ￡10584.47 million even there is no sales increase. Thus the risk accompanied with issuing debt is much less in our case.
According to the above analysis, it is not wise for us to finance the acquisition by issuing equity. Not only because the dilution effects on our shareholder's right, but also for the consideration of negative market reaction. Instead, issuing debt may show confidence in the profitability of our investment. Furthermore, increase in Debt/Equity ratio, as long as within our capital structure target, will offer the benefit from tax shield. Last, the acquisition within grocery industry is always paid by cash. When QIA tend to takeover J Sainsbury in 2007, it is the additional ￡1 billion cash payment required by Sainsbury's shareholders that lead to the failure of the deal. Thus, cash payment by issuing debt is suitable in our case.
Part Four Recommendation (344)
According to the above analysis and evaluation, J Sainsbury plc is a valuable investment for us. Benefits from acquisition of J Sainsbury are various. First, we could expect the improvement in our competition position and more growth opportunities from this deal. Second, our company can take this change to improve our public image. Further, the synergy anticipated in our case is large. Last, it is a good opportunity to enter the UK and even the European market. Thus, what we need now is a specific plan to make the acquisition successful.
1. The decision on offer price for J Sainsbury will be based on our valuation and history bid prices. Sainsbury is the target of unsuccessful takeover bids made by QIA in 2007. The bid is made before the financial crisis and recession. QIA offered a price as much as ￡10.6 billion. Since the failure of that deal is not because of the price, this could be a benchmark for our bids. Considering the synergy generated from this deal, an initial bid price of ￡8.5 billion is reasonable. The ceiling price will range between ￡12 billion and ￡13 billion, otherwise it will leave us too small benefit but the whole business risks.
2. Our company should issuing debt to finance the acquisition. Besides the reasons mentioned above, the cash payment is more attractive to Sainsbury's shareholders during the time of recession.
3. As a company with a long history, the sizeable minority shareholders may not want to sell it. The Sainsbury family has named the company after their family name and owned it for generations. Thus, let the Sainsbury family be a shareholder in the combined firm will be helpful.
4. The J Sainsbury plc has a bank sector which is not profitable. Thus, a further discussion is necessary on whether to keep it or sell it to another bank.
Further consideration on details, such as timing of the bid, are necessary. The acquisition on the whole is a valuable investment. Thus, we should make every effort to achieve it.