HOMEWORK #4 1
Corporate Governance, Joint Ventures, Strategic Alliances, Valuation
Assignments
Javier E. Caycedo M.
School of Business, Liberty University
Author Note
Javier E Caycedo M
I have no known conflict of interest to disclose.
Correspondence concerning this article should be addressed to Javier E caycedo M
Email: kcaycedo@liberty.edu
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Corporate Governance, Joint Ventures, Strategic Alliances, Valuation Assignments
Importance of a Systematic Valuation
Even though business valuation has been a known concept for many years, Gaughan says
that systematic valuations became more important during the fourth M&A wave, in which many
companies were targets of many offers (2018, p. 551). It is important, especially for target
companies, to not only know their value, but to also make sure they are being evaluated through
the methods and standards that apply to their company. An article from the Wall Street Journal
(WSJ) says that Chapter 11 valuations could be usually wrong since they are typically performed
during low market standards, which means that supporting debtors are systematically
undervalued (Danilov, 2016). In other words, when a weak market leads a company to file for
Chapter 11 bankruptcy, it is important for business valuators to make sure they are performing a
fair appraisal in order to have a correct market value of the company.
In addition, an article published by Sustainability says that the value of a corporation is
the “market measure of the effectiveness and efficiency of actions taken by the enterprise”
(Miciuła et al., 2020, p. 5). This is why a systematic valuation is so important: because a
valuation that does not account for market conditions could potentially result in a wrong
valuation. It is important that also bidders are honest in the valuation process in order to perform
ethical practices in the M&A transaction. The Bible says that people should give other people
what they deserve and what is due (Romans 4:4, ESV, 2001). It is important for companies to
pay what’s due, especially when many shareholders probably depend on the outcome of the
transaction.
Book Value Valuation Method
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Gaughan describes this method as a the calculation of the total per-share dollar amount
that the company would receive if they were to liquidate every single one of their assets on their
books, and subtracting the amount of money that needs to be paid in order to liquidate financial
obligations (2018, p. 554). As it is evident, this type of valuation only accounts for the internal
situation of the company, and it does not account for the market or fair price of the company. The
Corporate Financial Institute says that one of the issues this method has is the fact that this
valuation strategy does not accurately account for intangible assets in the company, like patents
and intellectual property (2020). This is why appraisers need to make sure they use this method
in the companies that this method applies to.
Discounted Future Cash Flows or Net Present Value Approach
Gaughan defines this method as the approach that calculate the present value of future
cash flows or earrings of the company, and this amount is called Net Present Value (NPV) (2018,
p. 555). In other words, this approach calculates the company’s value by determining how much
the company’s upcoming expected earnings represent in dollars today. Jason Fernando and Julius
Mansa say that this method the idea behind the NPV calculation is to reflect the expected
earrings in relation to an investment (2021). It is important to mention that this approach is also
an internal valuation method, and it does not necessarily accounts for the market price the
company holds in the industry. However, this method does account for the worth to investors in
order to see if the amount they are paying for the acquisition represents a positive NPV and a
great rate of return in a set period of time projected.
Discount Rate
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It is important for a valuation to set a realistic and solid discount rate in order to perform
a valid and accurate NPV calculation of a company. In the context of discounted cash flows, and
in the valuation approach content, Adam Hayes and Gordon Scott define the discount rate as the
tool to calculate how much risk an investor is willing to take, and evaluating the forecasted cash
flows with it (2021). In other words, the discount rate represents how far an investment can go.
Gaughan says, “The choice of the appropriate discount rate to calculate the present value of the
future projected cash flows requires that the riskiness of the target and the volatility of its cash
flows be assessed” (2018, p. 561). In other words, choosing the wrong discount rate for an NPV
transaction could result in a wrong decision made. An article published by the Risk Analysis says
that, “a discount rate is used to convert future benefits or costs into an estimate of present value”
(Wu & Chen, 2017, p. 1522). It is a great responsibility, and it takes great skill to be able to
calculate not only future cash flows, but also to come up with a fair discount rate that can give an
accurate NPV as a result of a valuation. It is important that appraisers choose carefully not just
the method they will use, but also the discount rate they will use if needed. The Bible says those
who walk wisely will become wise (Prov. 13:20, ESV, 2001). If an individual wants to make a
wise decision, then he or she will need to walk in wisdom with the Lord.
Hurdle Rate vs Discount Rate
Even though they are used similarly when it comes to calculate the NPV of an
investment, there are two different situations in which these two individuals are used. Gaughan
says that even thought the bidder company might be interested in using the target’s cost of capital
as the discount rate, it is also good for the buyer to use their own hurdle rate (2018, p. 566). One
can infer that while the discount rate is number that comes from an evaluation, a company
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already has their own determination rate (hurdle rate) that can indicate how much risk they are
willing to take. Nick Lioudis defines the Hurdle Rate as the “minimum acceptable rate of
return” (2020). In other words, the hurdle rate is the lowest an investor, or in the M&A
transactions, a buyer is willing to take as a rate of return in their purchase. On the other hand, we
see that the discount rate is not the minimum amount of return, but the highest level of risk a
company is willing to tolerate when buying another company. Will Kenton and Michael Boyle
say that many companies, as mentioned above, use their cost of capital as their hurdle rate
(2020). In other words, when performing a valuation through this approach, they will need to
have set all this indicator rates in order to perform a wholesome evaluation, and have a fair value
for the company.
Interest Rates and Acquisition Prices
According to Gaughan, studies made after the fifth M&A wave shows that with lower
interest rates there are lower discount rates (2018, p. 567). This means that with lower discount
rates, the lower the risk companies are willing to take. The level of the interest rates will not only
affect the prices in the acquisitions, but as a ripple effect, it will affect the overall economy. Mary
Hall says that when the interest rates rise, the amount of money spent in the overall economy
decreases; but, when the interest rates fall, the market incentives the population and the
companies to spend more money because they could finally feel like the can afford a big
purchase (2020). It is important to recognize the benefits and the opportunities when they are
available, but also to think on the long-term consequences.
In the M&A prices, Gaughan says that, “When interest rates fall for an extended period of
time, evaluators lower their discount rates, resulting in higher acquisition values” (2018, p. 568).
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It is evident to see that with lower rates, lover risk, therefore higher values in order to
compensate for the amount of risk that buyers do not have to take. Would this mean that if the
market wants to see lower acquisition prices, does the federal government need to increase the
interest rates for bonds and loans? Tobias Schwetz says that even though rising interest rates
slowly grows the economy, doing this has a negative impact on the M&A market. He proposes
that more than a slow increasing, a gradual increasing in interest rate levels will also gradually
strengthen the M&A activity (2020). Even though there might not be a solid solution to
strengthen the M&A transactions, a strong economy will always lead to strong markets, even
when the interest rates are high. However, it is important for everyone in the nation, from
corporations to individuals, to be responsible with the debt they acquire, and to pay what they
vow to pay as it is written in Ecclesiastes 5:5 (ESV, 2001). A great sense of responsibility is
needed when handling debt, no matter the interest rate.
Cash Flows
In business valuation, and as mentioned in previous sections, strong past cash flows will
be taken as a reference to forecast future cash flows, which means that there will be a greater
value for the company. Cash flows are a vital part of M&A activities because, as Gaughan says,
they are used to calculate and represent the current price of a company’s value, or a future
investment (2018, p. 555). A company could be able to have many assets, and even a large
inventory, but the future cash flows will determine the company’s value. According to the Small
Business website, “lack of cash is one of the biggest reasons small business fail” (Jen Murray,
2020). This is the reason why it is important for valuations to be analyzed through multiple
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approaches and not just one. As it is evident, the book value approach does not account for cash
flows, and the discounted cash flow approach does not account for all assets in the books.
In addition, the CPA journal mentions that perhaps, one of the most important numbers
that one can identify in the cash flows of a company is the cash flow from operations, since it
truly shows all the cash that comes into a company as a result from the daily operations in the
corporation (J. Ketz, 2016). This is why companies need to not only focus on building up their
book value, but also the value in their cash flows. This is why it is important for a company not
only to build wealth in the assets they possess, but also to leave a good cash flow for the next
generations for them to inherit a company with great value, as it is written in Proverbs 13:22
(ESV, 2001). No matter the capacity of the cash flow, good company management will
strengthen their operations to enhance their future cash flows.
P/E Multiples in Business Valuation
In the business valuation world, when a company needs to be assessed, and compared to
the market value, often valuators will use P/E multiples as a fair indicators. Every industry has
many different multiples that are more significant than others. In fact, Gaughan says that, when a
person uses P/E multiples for a valuation, he or she needs to be initiative since every industry’s
expected earnings growth is different (2018, p. 577). This means that the selection of P/E
multiples is subjective to the individual performing the valuation.
Jason Fernando and Thomas Brock say that the usage of P/E multiples in valuation can
help to determine if the company’s stock price is undervalue or overvalue (2020). For this and
many other reasons, is why using P/E multiples is one of the most accurate ways as a valuation
approach, since it is using industry data to compare the company to its market and its market
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value. Additionally, the Corporate Finance Institute says that is very common to see these
multiples being misinterpreted and can lead to wrong valuations (2018). Even though this
method could be very beneficial, it needs to be performed accurately.
Taxable Acquisitions and Non-Taxable Acquisitions
A taxable or non-taxable M&A transaction is determined by the structure in which the
transaction is made. Gaughan says that the involvement of stock in transactions may be a deal
breaker for transactions to qualify as tax free, for example (2018, p. 614). The Accounting Tools
official website define a tax-free acquisition as “the purchase of a target company in which the
recognition of a gain can be deferred” (2020). In other words, the transaction must fulfill certain
stipulations that may qualify them as tax-free. On the other hand, the Financial Dictionary
defines a taxable acquisition as “A merger where the value of the assets a stockholder receives at
the end of the transaction is substantially different from the value of assets before the transaction
began” (‘Taxable Acquisitions,” n.d.). In other words, the big determining factor is if the stock
issued, or if the shareholders are affected or not, is what determines the taxable status of a
transaction.
The Bible is very specific when it comes to taxes. Jesus said very clear that it is important
that people give the government what is from the government, and to God what is to God, as it is
famously written in Matthew 22:22 (ESV, 2001). Companies are better off doing the right thing
and paying what must be paid, than making every possible way to avoid taxes and have bad
repercussions in the future.
Tax Consequence #1 – Taxable Purchases of Stock
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Gaughan explains that when in a M&A transaction, the stock of a company is sod to a
loss, there will be no tax liability from the implicated (2018, p. 617). Brianna Komppa also
explains that, “A seller often prefers to sell stock, rather than assets, because it avoids the double
taxation problem. The sale of stock does not result in a taxable gain or loss at the corporate level”
(2016). In other words, companies usually go through this route because it is more affordable in
tax terms.
Tax Consequence #2 – Taxable Purchases of Assets
Gaughan says that, “The potential tax liability is measured by comparing the purchase
price of the assets with the adjusted basis of these assets” (2018, p. 617). This means that there
may be some asset-based transactions that can potentially be non-taxable, but the nature of the
transaction will define the outcome. The Journal of Accountancy says that, “the tax basis of the
purchased assets will be revalued to fair market value (FMV) at amounts to be mutually agreed
upon between the buyer and the seller” (Wilcox & LaSaracina, 2017). This means that after a
market valuation of the asset that has been sold, the tax status of the transaction will be revealed
if the transaction is determined on a profit or a loss.
Tax Consequence #3 – Tax Loss Carryforwards
Gaughan explains this type of consequence with the example in which, “A company that
has earned profits may find value in the tax losses of a target corporation that can be used to
offset the income it plans to earn” (2018, p. 617). In other words, if a buyer buys a company for
less value than the value of the target, the target company can get tax benefits since they are
reporting a loss. Results from a study published in an article from the SSRN Electronic Journal
says that, “the tax loss carryforward disclosure level decreases with the amount of forecasted
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earnings” (Flagmeier & Mueller, 2017, p. 20). This means that companies can decrease their
carryforward if their earrings are expected to grow after the M&A transaction.
Tax Consequences Influence in the Merger Decision
A mentioned in previous sections in this text, there are amny scenarios in which
transaxtions may have taxable benefits. Gaughan says that, “There is an intuitive relationship
between the premium a bidder offers and the tax ramifications of the acquisition” (2018, p. 620).
This could be because the bidder and the target will do whatever is in their reach, to be able to
get the most benefits possible. Allan J. Auerbach says in his textbook that, “the tax benefits
associated with acquiring a firm having we tax losses or unused tax credits appear to exert an
insignificant influence on merger activity” (1987, p. 178). In other words, the possible tax status
of the outcome of the transaction is a very important factor that needs to be considered when
developing a merger, in both the bidder and the target. Denis Breen says that it is also in the
government interest to see what tax reasons drive decisions in mergers (1987, p. 9). The
anticipation of tax consequences should definitely be something companies should think about
before making a merger decision.
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References
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CORPORATE TAKEOVERS: CAUSES AND CONSEQUENCES, 157-190.
https://doi.org/10.3386/w2192
BReen, D. (1987). Federal Trade Commission | Protecting America's Consumers.
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motive-survey-current-knowledge-and-research-opportunities/232069.pdf
Corporate Finance Institute. (2018, June 15). Multiples analysis – Definition and explanation of
valuation. https://corporatefinanceinstitute.com/resources/knowledge/valuation/multiples-
analysis/
Corporate Finance Institute. (2020, December 4). Book value - Definition, importance, and the
issue of intangibles.
https://corporatefinanceinstitute.com/resources/knowledge/accounting/book-value/
Danilov, K. A. (2016, April 12). Commentary: Are Chapter 11 valuations unfair? The data say
no. WSJ. https://www.wsj.com/articles/BL-BANKB-21909
English Standard Bible. (2001). the Bible. ESV Bible Online. https://esv.org
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Fernando, J., & Mansa, J. (2021, March 1). Net Present Value (NPV). Investopedia.com.
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Hall, M. (2020, August 12). How do interest rates affect the stock market? Investopedia.
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Kenton, W., & Boyle, M. (2020, October 23). Hurdle rate. Investopedia.
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KEtz, J. (2016, November). Free cash flow and business combinations. The CPA Journal.
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Komppa, B. N. (2016, July 1). Mergers and acquisitions: Basic tax considerations for taxable
asset and stock sales. Wipfli LLP | Assurance, Accounting, Tax and Consulting Solutions.
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