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Determination of Share Exchange Ratio for Amalgamation

Rasesh 
on 11 March 2010

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The Provisions relating to Merger and Amalgamation are contained in sections 391 to 396A (Chapter V of Part VI of the Companies Act, 1956.)

 

The Scheme of Amalgamation is the basic document which contains the terms and conditions under which the amalgamation takes place. It is this document which gets approved first by the Board of Directors of the transferor and the transferee company, then the shareholders & creditors and finally the High Court.

 

While the creditors are interested in knowing the financial health of the transferee company, the equity shareholders are more interested in the Share Exchange Ratio i.e. the Ratio in which Shares are issued to the Shareholders of the Transferor Company for their shares in the Transferee Company.

 

The Share Exchange Ratio is mutually determined by the Board of Directors of both the Companies on the basis of the Valuation done by a Chartered Accountant. Considering the Valuation Report, Share Exchange Ratio is arrived upon. In most Amalgamation cases, both the Transferor Company and the Transferee Company obtain Separate Valuation Reports from Independent Chartered Accountants. Though it is not mandatory to obtain report from a Chartered Accountant, it is important to arrive at Share Exchange Ratio on the basis of such a report only as the High Courts would rely to a greater degree on such reports, if given by financial experts. Shareholders and the Investor Community, in general are also suspicious of genuineness of Share Exchange Ratio which has been arrived at without such a report.

 

APPROACH TO VALUATION


Valuation of Shares and consequent determination of the Share Exchange Ratio is a subjective exercise. It is dependent upon various parameters adopted, method employed, perception of the risks involved, assumptions made and judgmental analysis.

 

It is the duty of the Valuers to not only arrive at the value of each of the company’s shares but also recommend the fair way in which the shares are exchanged so that the shareholders of both the companies are treated in a fair manner.

 

Different approaches are used in the valuation of shares. The approach tend to change keeping in mind the objective of valuation, nature of the companies, and availability of the accurate data and instructions of the participating companies. Within the approach, different methods produce different results and therefore it is necessary that the Valuers choose the most appropriate method and also specify the reasons for selecting a particular method.

 

The determination of fair value is the ultimate aim of the different methods of valuation. What is a fair valuation depends on the circumstances of each case and no thumb rule can be adopted.

 

 

METHODS USED IN VALUATION

 

A.        Net Asset Value

 

Net Asset Value (NAV) approach is the most popular and easy approaches of valuation. There are two methods within the NAV approach.

 

i) NAV at Book Values

 

This approach involves determining value of the company on the basis of value of the assets and liabilities as disclosed in its Balance Sheet. This is a conservative approach of valuation and is treated as the minimum value for any transaction.

 

ii) NAV at Market Values

 

Most companies have investments in marketable securities, inventory or fixed assets and the value of such assets is substantially higher than their Book Values. Book value therefore does not provide the correct estimate of the NAV. In this method, the market value of these assets is substituted for determining the NAV.

 

B.        Income Approach

 

The Income Approach is based on the future earnings that are available for distribution to the equity holders. The Income based approaches are explained in detail.

 

i) Profit Earning Capacity Value (PECV)

 

It is one of the traditional methods of business valuation whereby maintainable future profits after tax, which are ascertained on the basis of past earnings, are discounted using a suitable discounting factor and capitalized on the basis of a standard Price Earnings Ratio.

 

The followings steps are followed to determine the value per equity share as per PECV:

 

a.                   The future maintainable profit is arrived at on the basis of projected profit before tax for the next three years as provided by the Management.

 

b.                  The projected earnings for the next three years is to be discounted using Weighted Average Cost to Capital (WACC) to arrive at the present value of the projected earnings. Terminal growth rate has to be considered as may be suitable to the case.

 

c.                   Future Maintainable Profit should be capitalized net of WACC and terminal growth rate to arrive at the Value of the Company.  

 

 

d.                  The book value of the outstanding preference shares should be appropriately reduced from the capitalized value for working out the value per share for equity shares.

 

e.                   After arriving at the Capitalized Earnings on the basis of the above principles, the same is divided by the number of outstanding equity shares for arriving at the Value per Share under this method.

 

ii) Discounted Cash Flow (DCF) Method

 

The followings steps are followed to determine the value per equity share as per Discounted Cash Flow Method:

 

a.                   The free cash flow is determined on the basis of projected profit before tax for the next three years as provided by the Management.

 

b.                  The free cash flow to the firm for the next three years is discounted using WACC to arrive at the Net Present Value (NPV) for the explicit period.

 

c.                   Terminal Value should be identified by discounting cash flow of the last year in explicit period considering the terminal growth rate and excess of WACC over terminal value growth rate.

 

d.                  The aggregate of book value of the Loans and outstanding preference shares, if any, should be appropriately reduced from total value of operating equity to the company i.e. aggregate of NPV for the explicit period and terminal value.

 

e.                   After arriving at the total value of operating equity on the basis of the above principles, the same is to be divided by the number of outstanding equity shares for arriving at the Value per Share under this method.

 

C.        Market Price of Shares Method

 

The Market Price Method evaluates the share price on the basis of weighted average rate of the transactions entered on the stock exchanges. This rate is considered as indicative of the value perception for the shares by investors operating under free market conditions. This method may not be of use in case of shares of a Company which are not listed or not frequently traded on the stock exchanges.

 

To arrive at the value as per this method, the following methodology is followed:

 

a.                   Firstly, the average of monthly high and low of closing prices for last six months (prior to the valuation date) on the stock exchange is calculated and simple average value is arrived on that basis.

 

b.                  Secondly, the average of weekly high and low of closing prices for last two weeks (prior to the valuation date) on the stock exchanges is calculated and simple average value is arrived on that basis.

 

c.                   The value which is higher of a) or b) above is considered as the value of the equity shares as per this Method.

 

D.        The Liquidation method

 

The Liquidation method of valuation relates to the special condition when a company has to liquidate part or all of its assets and claims. Under a situation of business failure or intense pressure from creditors, the management will find that the liquidation value is considerably lower than the potential market value. As a consequence, liquidation value is normally applicable only for the limited purpose intended. In case of going concerns, this method is not considered.

 

FINAL STEP: ASSIGNING WEIGHTS

 

It is common to use a combination of the methods indicated above. Fair value can be arrived at by assigning weights to the individual methods depending on their relevance to the company under review. The weighted average of the above is then considered as the fair value per share.

 

OTHER GENERAL PRINCIPLES TO BE CONSIDERED FOR ARRIVING AT FAIR VALUATION

 

1)         Normally, both the transferor and the transferee Company should be valued by using the same methodology and parameters. However, if the circumstances and the facts justify using different methods, then different methods should be used for different participating companies.

2)         The importance of each method in the Transferee Company and Transferor Company varies on factors like nature of business and exposure to the external environment with respect to variety of assets and liabilities carried as at the latest reported balance sheet.

In case, any members has any doubts, I would be glad to provide clarifications in the matter.




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