Krishna Arora (Valuation Analyst) CA Finalist

Investment Banking and Valuations Booster

Table of Contents

I. INVESTMENT BANKING ................................................ 2

A. Meaning of Investment Banks ..........................................................................2
B. Functions of Investment Banks .......................................................................2
C. Differences between Commercial Banks and Investment Banks...........3
D. Top Investement Banks ......................................................................................5
II. VALUATIONS ............................................................ 8
A. Meaning of Valuations .........................................................................................8
B. Characteristics of Valuation .............................................................................8
C. Key Methods of Valuation ..................................................................................9
III. RELATIVE VALUATIONS
A. Comparable Companies Analysis (CCA) ………………………………………………….10
 CCA - 7 Steps Process

B. Comparable Transactions Method (CTM) ……………………………………………..15

 CTM - 7 Steps Process

IV. INTRINSIC VALUATION (DCF) ....................................... 16

A. Overview of DCF ................................................................................................. 16
 DCF - 5 Steps Process

B. Projections ............................................................................................................ 18
C. WACC Calculation .............................................................................................. 20
 Beta Calculation – Levered and Unlevered Beta ................................. 20
V. MERGERS AND ACQUISITIONS ...................................... 23
A. Mergers and Acquisitions - Overview ......................................................... 23
B. Steps involved in M&A ..................................................................................... 24
C. Types of Mergers .............................................................................................. 24
D. Challenges and Risks of M&A ......................................................................... 25
VI. FINANCIAL DUE DILIGENCE .......................................... 26
A. Objectives of FDD ............................................................................................ 26
B. Importance of FDD ........................................................................................... 26
C. Key Components of FDD .................................................................................. 27
D. Process of FDD .................................................................................................. 28

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INVESTMENT BANKING
A) Meaning of Investment Banks

Investment banks are financial institutions that specialize in providing services

related to investments, financing, and advisory. They play a key role in the
financial markets and offer a variety of services to corporations, governments,
and other institutions.

B) Functions of Investment Banks

Underwriting and Issuance of Securities: Investment banks help companies raise

capital by underwriting and issuing stocks and bonds. They assist in structuring
and pricing the securities, and then sell them to investors.

Mergers and Acquisitions (M&A) Advisory: Investment banks advise companies on

mergers, acquisitions, and other strategic transactions. They help with valuation,
negotiation, and structuring of deals.

Sales and Trading: They engage in buying and selling of securities, commodities,
and other financial instruments. This can include trading on behalf of clients or
for the bank's own account.

Market Making: Investment banks act as market makers by providing liquidity in

the financial markets. They quote buy and sell prices for securities and help
facilitate trading.

Asset Management: They offer investment management services to individuals

and institutions, managing portfolios of assets like stocks, bonds, and real estate.

Research: Investment banks conduct research and analysis on financial markets,

industries, and individual securities. This research helps inform investment
decisions and provides insights to clients.

Structured Finance: They create complex financial products, such as derivatives,

collateralized debt obligations (CDOs), and securitizations, to meet specific
client needs or to manage financial risks.

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Capital Raising: Beyond traditional equity and debt offerings, investment banks
help clients raise capital through private placements, syndicated loans, and other
financial instruments.

Corporate Restructuring: They provide advisory services related to restructuring

and reorganizing companies, including bankruptcy and insolvency proceedings.

C) Differences between Commercial Banks and Investment Banks

Commercial banks and investment banks are both financial institutions but serve
different purposes and operate in distinct segments of the financial market. Here
are the key differences between commercial banks and investment banks:

Primary Functions:

Commercial Banks: These banks primarily focus on providing services to

individuals and businesses for everyday banking needs. They accept deposits,
offer checking and savings accounts, provide loans (such as mortgages and
personal loans), issue credit cards, and facilitate domestic and international fund
transfers.

Investment Banks: Investment banks, on the other hand, specialize in providing

financial services to large corporations, institutional investors, and governments.
Their core functions include raising capital through underwriting or issuing
securities (like stocks and bonds), advising on mergers and acquisitions (M&A),
providing trading of derivatives and securities, and offering strategic advisory
services.

Regulation:

Commercial Banks: They are typically more heavily regulated due to their role in
safeguarding depositors' funds and maintaining financial stability. Regulations
ensure they operate prudently and manage risks associated with lending and other
financial activities.

Investment Banks: While they are also subject to regulations, these are often
focused more on market conduct and the securities they trade rather than
deposit protection and liquidity.

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Risk Profile:

Commercial Banks: Their risk profile tends to be lower compared to investment

banks because they deal with traditional banking activities and are often
protected by deposit insurance schemes (like FDIC in the United States).

Investment Banks: These banks engage in higher-risk activities such as trading in

complex financial instruments (derivatives, structured products), which can lead
to significant gains or losses. They are more exposed to market fluctuations and
economic downturns.

Clientele:

Commercial Banks: They serve retail customers (individuals and small to medium-
sized businesses) and focus on providing services that cater to everyday financial
needs.

Investment Banks: They primarily serve large corporations, institutional

investors, and governments that require specialized financial services, including
access to capital markets, strategic financial advice, and risk management
solutions.

Structure:

Commercial Banks: These banks typically have a more straightforward

organizational structure, with branches that serve local communities and
centralized operations for managing deposits and loans.

Investment Banks: They often have a more complex structure, with divisions
specializing in different financial services such as investment banking, trading,
asset management, and research.

Culture and Focus:

Commercial Banks: They focus on maintaining customer relationships, managing

savings and loans, and providing stability in financial transactions for individuals
and businesses.

Investment Banks: Their culture is often driven by deal-making, market trading,

and generating returns for clients and shareholders through sophisticated
financial transactions and advisory services.

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In summary, while both commercial banks and investment banks are crucial
components of the financial system, they differ significantly in terms of their
primary functions, clientele, risk profiles, regulatory oversight, and organizational
structures. These differences stem from their distinct roles in providing
financial services to different segments of the economy and their varying
approaches to managing financial risks and opportunities.

D) Top Investment Banks

GLOBAL:

Some of the top investment banks globally includes:

1) Goldman Sachs - It is known for its investment banking, securities, and

investment management services.

2) JPMorgan Chase - It offers investment banking, financial services for

consumers and businesses, and asset management.

3) Morgan Stanley - It provides investment banking, securities, investment

management, and wealth management services.

4) Bank of America Merrill Lynch - It is known for its global investment banking

and financial services.

5) Citigroup - It offers investment banking, financial services, and wealth

management across the globe.

6) Barclays - It provides investment banking, wealth management, and retail

banking services globally.

7) Credit Suisse - It is known for its investment banking, private banking, and

asset management services.

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8) Deutsche Bank - It offers a wide range of financial services, including

investment banking and asset management.

9) UBS - It provides wealth management, asset management, and investment

banking services globally.

10) HSBC - It offers a range of financial services, including investment banking

and wealth management.

INDIAN:

In India, the top investment banks are primarily those that offer a range of
financial services including investment banking, advisory services, securities
trading, and asset management. Some of the top Indian investment banks include:

1) ICICI Securities - One of the largest integrated securities firms in India

offering a wide range of services including investment banking, institutional
broking, and wealth management.

2) Axis Capital - A leading player in the investment banking space in India,

providing a range of financial advisory and capital raising services.

3) Kotak Mahindra Capital Company - It is known for its expertise in equity capital
markets, mergers and acquisitions advisory, and restructuring services.

4) HDFC Bank - While primarily a commercial bank, HDFC Bank also has a strong
investment banking arm that offers services such as advisory for mergers and
acquisitions, capital raising, and structured finance.

5) SBI Capital Markets - The investment banking subsidiary of the State Bank of
India, offering services in project advisory, debt syndication, equity capital
markets, and mergers and acquisitions.

6) Edelweiss Financial Services - It provides investment banking, institutional

equities, asset management, and insurance broking services.

7) JM Financial - A diversified financial services group offering investment

banking, institutional equity sales, trading, research, and asset management.

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8) Citigroup Global Markets India - It is a part of the global Citigroup network,

offering investment banking, capital markets, and advisory services in India.

9) Nomura Financial Advisory and Securities (India) - The Indian arm of Nomura
Holdings, offering a range of financial services including investment banking,
equity and debt capital markets, and advisory services.

10) Ambit Capital - It provides investment banking and institutional equities

services including advisory on mergers and acquisitions, equity capital markets,
and structured finance.

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VALUATIONS
A) Meaning of Valuations

Valuations refer to the process of determining the current worth of an asset or

a company. It involves assessing various factors to arrive at an estimated value,
which can be used for investment, taxation, financial reporting, or strategic
decision-making purposes. Valuations can be conducted on different types of
assets such as real estate, stocks, bonds, intellectual property, and businesses.
The methods used for valuation vary depending on the asset type and the purpose
of the valuation.
B) Characteristics of Valuations

Key characteristics of valuations includes:

Subjectivity: Valuations often involve subjective judgment, especially when

assessing factors like future growth potential, market conditions, and
management quality.

Purpose-driven: The purpose of the valuation influences the approach taken and
the factors considered. Valuations for financial reporting, tax assessments,
investment decisions, or mergers and acquisitions can differ significantly.

Methodology: There are various methods used to determine value, such as

discounted cash flow (DCF), comparable company analysis, asset-based valuation,
and others. The choice of method depends on the nature of the asset and the
availability of data.

Assumptions: Valuations rely on assumptions about future performance, market

conditions, discount rates, and other factors. These assumptions can significantly
impact the final valuation figure.

Complexity: Valuations can be complex due to the multitude of factors involved

and the need for specialized knowledge in finance, accounting, and economics.

Time Sensitivity: The value of an asset or company can change over time due to
market fluctuations, economic conditions, changes in regulations, or shifts in

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industry trends. Thus, valuations are often time-sensitive and need to be
periodically updated.

Interpretation: The results of a valuation are open to interpretation and can vary
based on the perspective of different stakeholders, such as buyers, sellers,
investors, and regulators.

Risk and Uncertainty: There are inherent risks and uncertainties in valuations,
particularly when forecasting future cash flows or determining appropriate
discount rates.

Legal and Regulatory Considerations: Valuations may need to comply with specific
legal and regulatory requirements, such as fair value accounting standards or tax
regulations.

Professional Standards: Professional standards and guidelines, such as those set

by financial regulators or industry bodies, often govern the conduct of valuations
to ensure transparency and accuracy.

C) Key Methods of Valuations

1) Relative Valuation

 Comparable Companies Analysis (CCA)

 Comparable Transactions Method (CTM)

2) Intrinsic Valuation

 Discounted Cash Flow (DCF)

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RELATIVE VALUATION
Comparable Companies Analysis (CCA)

Comparable means finding the value of the target company by doing a comparison
with other companies. Under this technique, we try to find the implied value of
our target company based on how other similar companies are priced in the Equity
Market.

» The process of “Comparable Companies Analysis” is just like valuing a real estate
property based on how other real estate properties of similar type are Priced in
the market.

» As absolute values of companies or assets are not comparable, for doing this
comparison, we first have to convert absolute values into standardized measures
of value which is called “Multiple”.

» Multiples calculated above become the basis of

 Comparison of the market price of similar assets/companies

 Finding of Implied value of our target asset/company

Comparable Companies Analysis – 7 Steps Process

Step 1) Screening of Comparable Companies:

Under this step, we will build list of Companies:

 Which are listed in the Equity market, and

 Comparable to our Target Company

This is most important part of CCA, as if our comparable companies are not
defined correctly, the resulting value of the target company would also be
incorrect.

While doing the initial screening of comparable companies, we normally select

these companies on the basis of the following key parameters:

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1. Geography: Comparable companies' geography of operation should be the same

or close to our target company.

2. Sector and Industry: While choosing comparable companies, we pick companies

from Sector and Industry that closely resemble to Sector and Industry of our
target company.

3. Size: To keep the fundamental of companies close to our target companies, we

also make sure that the size of comparable companies is also close to our target
company. The size of companies can be defined based on their market
Capitalisation or Revenue.

Step 2) Calculation of Market Capitalisation:

Market Capitalisation is the total value of all outstanding shares of the company.
It is also referred to as Market Cap. Market Cap is calculated by multiplying
market price per share by the number of shares outstanding of the company.

Market Cap = Market Price Per Share x Diluted Number of Shares Outstanding

 Market price is the price at which stock of the company is trading in the
Equity Market.
 Source of Information: Can be sourced from various market portal like:
Bloomberg, Capital 1Q, Marketscreener.com, Googlefinance.com,
investing.com, etc.
 Price should be closing market price on the date of valuation. Say if we are
doing valuation on 31st March 2024, the Market price of shares should also
be of 31st March 2024 of all comparable companies.
 Diluted Number of Shares = Basic Shares O/S + Dilution
 Basic Shares O/S = Total Shares issued by the company – Treasury Shares
 Dilution means potential increase in number of shares of the company in
future. Dilution can be caused by various dilutive instruments issued by the
company, such as:
 Employees Stock Options Plans (ESOP)
 Restricted Shares Units (RSU)
 Performance Share Units (PSU)
 Stock Appreciation Rights (SARs)
 Employees Stock Purchase Plan (ESPP)
 Convertible Debenture
 Convertible Preference Shares
 Stock Warrants

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Step 3) Calculation of Enterprise Value:

Enterprise Value is the value a buyer would pay for the business independent of
its capital structure.

 Enterprise Value is a more comprehensive measure of value than Equity

value as it looks at all component of capital invested in the business rather
than just the Equity Value.

 It doesn’t matter how business is financed; its Enterprise value stays the
same.

Enterprise Value = Market Cap + Non-Controlling Interest + Preferred

Stock + Net debt

 Non-Controlling Interest (Minority Interest): It means the portion of

subsidiary company that is not owned by the holding company.
 Preferred Stock are hybrid securities sharing features of both equity and
debt.
 They are treated more as debt, because of their fixed dividend right and
higher priority in asset and earning claims than common stock.
 In an acquisition, they normally must be repaid just like debt.
 In case preferred stock is listed, market price can be taken otherwise book
value of preferred stock can be taken as proxy of market value.
 Net Debt = Total Debt — Cash & Cash Equivalent
 Operating EV = Market Capitalisation + Minority Interest + Preferred
Shares + Market Value of Debt - Cash and Cash Equivalent - Non-Operating
Assets in the Business

Step 4) Calculation of Company’s Performance Metrics:

Under this step, we would calculate the Financial and Operating Metrics of the
Company, which are key indicators of its performance.

Examples of Financial Metrics used to measure the performance of the company:

 Revenue
 EBITDA
 EBITA
 EBIT
 NOPAT

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 Net Income
 Free Cash Flows

Examples of Operating Metrics used to measure the performance of the company:

 No of Subscribers
 No of Visitors on the Website
 No of Beds in Hospital
 Ton Capacity of a Cement Plant
 Mega Watt Capacity of Power Plant

Step 5) Calculation of Multiples:

In this step, we will calculate multiples, a standardized measure of value, by

relating companies’ Market Value (Equity Value, Enterprise values) with their
financial or operating metrics.

 Financial Metrics Based Multiple: EV/Sales, EV/EBITDA, EV/EBIT,

EV/NOPAT, P/E, P/BV, etc.
 Operating Metrics Based Multiples: EV/Subscribers, EV/Ton Capacity,
EV/No of Beds, etc.

» While calculating multiples, we should make sure that the values we are relating
should make sense, i.e., it should be an apple-to-apple comparison of values in
numerator vs denominator.

 For example, it makes sense to relate equity value with EPS as both
numbers belong to equity, but we can’t relate EV to EPS as EV belongs to
the entire firm whereas EPS belongs to equity holders.
 Likewise, it makes sense to relate EV with EBIT and EBITDA as both
numbers belong to the firm, but it does not make sense to relate EV with
EPS as one belongs to the firm and another belongs to equity.

Step 6) Calculation of Industry Benchmark Multiples:

Under this step we will calculate industry benchmark multiples on the basis of
comparable companies’ multiples.

 Median or Average of all comparable companies’ multiples.

OR
 25 and 75% Percentile instead of Median as Industry benchmark multiples.

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These Industry multiples indicate where market consensus lies about valuation of
an industry. For Example. we can say that in the IT sector, the average industry
PE multiple is 10x or as per market, the IT industry is priced 10x times its
earnings.

EV/Sales

EV/Sales measure is frequently applied for initial growth phase companies having
negative and volatile earnings and cash flows such as technology firms.

It can also be applied to businesses where operating margins are standard or in

tight range such as the retail industry.

EV/EBITDA

EV/EBITDA is a more complete measure than EV/Sales as it captures a picture

of profitability of comparable, but slightly more affected by accounting
differences.

EV/EBITDA is a very popular multiple, the reason being it captures all benefits
of EV multiples and is less exposed to accounting differences compared to other
profit measures such as EBIT, Net Income, etc.

Step 7) Calculation of Implied Value of Target Company:

Under this step, we will calculate the implied value of our “Target Company”, the
company we want to value, on the basis of industry multiples.

 Selection of appropriate multiples: We will select appropriate multiples as

per industry and situation.
 Compute Implied Enterprise and Equity Value of target company based on
Industry Benchmark multiples
 We can use this technique to value both public as well as private companies.

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Comparable Transactions Method (CTM)

Transaction Comparable means finding the value of the target company by doing
a comparison with other M&A Transactions. Under this technique, we try to find
implied value of our target company based on how other similar companies were
priced in the previous M&A deals.

» The process of “Transactions Comps” is just like “Trading Comps”.

» The only difference between Trading and Transaction Comps is

 In Trading Comps, multiples are calculated based on trading price of

comparable companies, whereas
 In Transaction comps multiples are calculated based on acquisition price
paid by the acquirer in an M&A deal.

» Multiples calculated above become the basis of finding the Implied value of our
target business, we want to value.

» Transaction Multiples help buyer and seller in understanding valuation trend in

recent M&A deals.

Comparable Transactions Method – 7 Steps Process

(7 Steps Process followed in Comparable Transactions Method is similar to the

one applied in Comparable Companies Analysis)

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INTRINSIC VALUATION
DISCOUNTED CASH FLOW METHOD (DCF)

A) Overview of DCF

DCF valuation, also called Intrinsic Valuation, is a technique under which

Investment Bankers/Finance Professionals try to value a company based on its
future cash flows.

DCF value calculated above is different from the relative value of the company
derived using trading comps or precedent transaction technique. Bankers use DCF
valuation to check the valuation they are getting under the relative valuation
technique which might be distorted by existing abnormal or extreme situations in
the market.

Discounted Cash Flow Method – 5 Steps Process

Step 1) Projections of Free Cash Flows

Step 2) Calculation of Discount rate; WACC or Ke depending upon the cash flows
we are discounting

Step 3) Calculation of Terminal value with:

 Perpetual Growth Method
 Exit Multiple Approach

Step 4) Discounting projected cash flows (calculated in Step I) and Terminal

value (calculated in Step III) using a discount rate (calculated in Step II)

Step 5) DCF Value = Sum of PV of Projected Cash Flows and PV of Terminal Value

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DCF Valuation — FCFF/WACC

DCF Value of Equity = PV of FCFF + PV of TV + Non-Operating Assets – MV of

Net Debt – Minority Interest

Free Cash Flows to Firm (FCFF) = Earnings before Interest and Taxes (EBIT) –
Taxes on EBIT +/- Non-Cash Charges/Earnings – Capital Expenditure +/- Change
in Working Capital

WACC = Cost of Debt (Kd) * (1 – Tax Rate) * Weight of Debt (D/V) + Cost of
Equity (Ke) * Weight of Equity (E/V)

Terminal Value:

 Exit Multiple Method: EBITDA of Exit Year * Exit EV/EBITDA Multiple

 Perpetual Growth Method: FCFF / (WACC – g)

Present Value of Terminal Values: TV / (1 + WACC) ^ n

DCF Valuation — FCFE/Ke

DCF Value of Equity = PV of FCFE + PV of TV + Non-Operating Assets – Minority

Interest

Free Cash Flows to Equity (FCFE) = FCFF – Interest * (1 – Tax Rate) +/- Net
Change in Debt

Ke = Risk Free Rate (Rf) + Beta * (Market Risk Premium)

Terminal Value:

 Exit Multiple Method: Net Income of Exit Year * Exit P/E Multiple

 Perpetual Growth Method: FCFE / (Ke – g)

Present Value of Terminal Values: TV / (1 + Ke) ^ n

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B) Projections

We can split the forecast period in two or three phases depending on the growth
phase of the business.

Phase I: It’s a high growth period of the company. During this period company
grows at a rate higher than the steady growth rate of the company. Size of this
period varies from 0 year to 5 years depending on the business lifecycle of the
company. For this phase, we forecast a detailed business plan.

Phase II: During this period, the company's growth starts moderating due to the
company's competition and size. This period starts from the end of the high
growth period and ends at the start of the company's steady growth phase of
the company. This phase usually extends up to 5 years.

Phase III: This is a steady growth phase of the company. During this phase, the
company grows steadily during its remaining life, which in most cases extend up
to infinity. We don't project this phase but capture the value of cash flow by
calculating terminal value. The terminal value represents the value of future cash
flows generated by the company in the years after the detailed/extended
forecast period.

Revenue Projections

» Projecting revenue is the first and most important step of any projection. All
projections of the company's financials starts with revenue projections.

» In Revenue projection, we first need to decide about the projection period (i.e.
for how long we want to do explicit projection).

 While doing valuation, we usually assume that the life of the company, being
a going concern, is infinite. Infinite life means the operation of the company
will go on forever. However, we do explicit projections only for high growth
period (i.e. period before maturity stage).
 For the remaining period (i.e. period of steady growth) we can find value of
cash flows by applying the perpetuity method.

» Company's growth rate falls to a level which it can sustain forever. We usually
assume this growth rate is close to the economic growth rate.

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» Return on new capital investment falls close to or equal to WACC. In other

words, the size of alpha (difference between actual return and minimum required
return) declines or becomes zero.

» Usually in the model, we do explicit projections of the company for 5-10 years
(i.e. we assume that the company would reach a steady growth stage in 5 - 10
years time period.

Extended projection period (Projection beyond 10 years): If we are doing a

valuation of pretty young company, we can assume extended high growth period,
provided we have strong reasons to believe that the company can sustain high
growth period for an extended period and it will not be justified to limit this to
5-10 years. Characteristics of such type of companies can be:

¥ Operating in a niche industry

¥ Has proven and tested business model
¥ High entry barriers due to technology, regulatory, or capital intensity of the
business

Shorter projection period: If a company is already matured or maturing fast,

then it's not necessary to project even 5 or 10 years.

¥ If it has already matured then no projection is required and we can calculate

terminal value at year 0.

¥ If it is maturing fast then we might consider limiting the projection period from
3 to 5 years depending growth potential of the company.

From the above discussion, we can conclude that the projection period for a
company is dependent upon the growth stage the company is in right now. If it's
already matured then no projection is required and if it's a pretty young company,
we might consider extending the company projection period beyond 10 years.
However, it's always recommended to be slightly conservative on the high growth
period and don’t go overboard, as DCF valuation is entirely projection-based
valuation and very sensitive to high growth period. Therefore, taking a high
growth period beyond a reasonable time period will increase the risk of
overvaluation under DCF.

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C) WACC Calculations

WACC = Kd * (l - t) * (D / V) + (Rf + Beta * ERP) * (E / V)

 Pre-Tax Cost of Debt: The cost of debt should be assumed to be the

current cost of issuing new long-term debt for the company or project
being analyzed. Don't use book interest rate (i.e. interest rate company is
paying as per books of account), if it is different from the current cost of
debt of the company being analyzed.

 Marginal Tax Rate: The prevailing statutory (combined federal and state)
tax rate should be used in calculating the after-tax cost of debt.

 Capital Structure: Debt includes all interest-bearing liabilities (short-

term debt, long-term debt, capital lease, etc.). The equity component
should be indicative of the public market value of the equity.

 Risk-Free Rate: Usually, government bond rates are a good measure of

the risk-free rate of the country. But that's true if the country has no
default spread (like Aaa rated US country). If the country has a default
spread because of a lower sovereign rating then, that default spread should
be subtracted from the government bond yield to calculate the true risk-
free rate.

 Beta: Beta is a measure of exposure to macroeconomic risk (systematic

risk). It's the risk of variance around the expectation of investors. The
companies are exposed to two types of risk; 1) Business Risk and 2)
Leverage Risk.

 Business risk is the risk associated with the operation of the company (e.g.
business risk of IBM is different from Walmart. IBM caters Technology
sector whereas Walmart caters to the Retail sector)

 Leverage risk is the risk associated with having debt in the capital
structure. More debt in the capital structure of the company higher would
be risk of bankruptcy, resulting in a higher beta.

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 The total beta of the company is also called levered beta as it includes both
the risk, business as well as leverage risk.

 Unlevered beta includes only business risk.

There are two approaches to calculate beta:

 Approach 1: Regression Beta: Calculated based on historical price volatility,

relative to the market

Beta = Covar (re, rm) / Var (rm)

Where, re = percentage change in stock price

rm = percentage change in market index

Period: 2-3 years of data is sufficient to calculate regression beta. Too short-period
beta may be noisy due to the small data size. Too large-period beta may not be
relevant due to changes in the risk profile of the company. Weekly change is
preferred over daily change.

Step-by-Step Approach

Step 1: Calculate the regression beta of the company based on its historical price
volatility relative to the market.

Step 2: Unlever the beta calculated under step 1 with the historical capital
structure of the company (take out the average historical leverage risk from levered
beta).

Step 3: Relever the beta calculated under step 2 with the target capital structure
of the company.

(Note: Step 2 and 3 are required in case the target

leverage is different from historical leverage.)

 Approach 2: Bottom-Up Beta: Calculated based on beta of peer group

companies.

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Step-by-Step Approach

Step 1: Take the levered beta of peer group companies (the more the number of
peers, the better it would be).

Step 2: Calculate the Unlevered Beta of the peers based on their respective capital
structure.

Step 3: Calculate the average unlevered beta of the industry.

Step 4: Relever the beta calculated under step 3 with the target capital structure
of the company being analyzed.

Bottom-up beta is generally preferred over regression beta due to the following
reasons:

 Law of large numbers: Chances of error would be less in the case of bottom-
up beta as it is based on the data of the larger number of firms compared to
just one firm data in the case of regression beta.

 If there are some exceptional movements in the stock price of the company
in the past not explained by the market, in that case, regression beta tends
to be low even for the highly risky company.

Unlevered and Relevered Beta

Calculation of Unlevered Beta

Unlevered Beta = Levered Beta * (Equity / Equity + Debt * (1 - Tax rate))

Calculation of Relevered Beta

Relevered Beta = Unlevered Beta * (Equity + Debt * (1 - Tax rate) / Equity)

Note: Use the current capital structure in case of regression beta or industry
average capital structure in case of bottom-up beta.

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MERGERS AND ACQUISITIONS

A) Mergers and Acquisitions - Overview

Mergers and Acquisitions (M&A) refer to the processes of combining two

companies into one or acquiring one company with another. These strategic moves
are often undertaken to achieve various business objectives, such as growth,
synergy creation, diversification, market expansion, or cost savings. Here's a
detailed look into each aspect:

Mergers:

A merger occurs when two companies agree to combine their operations into a
single entity. This could be due to:

Strategic Fit: Companies merge to leverage each other’s strengths and

weaknesses, creating a more competitive and diversified entity in the market.

Synergy: Mergers can achieve synergies where the combined entity is more
valuable than the sum of its parts. Synergies can be in cost savings, increased
revenue opportunities, or operational efficiencies.

Market Expansion: Merging allows companies to enter new markets or strengthen

their position in existing ones by combining resources and capabilities.

Diversification: Companies merge to diversify their product offerings, customer

base, or geographic presence, reducing risk and enhancing stability.

Acquisitions:

An acquisition involves one company (the acquirer) purchasing another company

(the target). Acquisitions can be friendly or hostile:

Friendly Acquisition: The target company agrees to be acquired, often because it

sees strategic benefits or the price is attractive.

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Hostile Takeover: If the target company resists the acquisition, the acquirer can
attempt a hostile takeover by buying a majority of its shares or convincing
shareholders to replace management.

B) Steps involved in M&A

Regardless of whether it's a merger or acquisition, the process typically involves

several key steps:

Strategic Intent: Identifying the strategic reasons for pursuing the M&A, such
as expanding market reach, gaining technology, or eliminating competition.

Valuation: Determining the value of the target company through financial analysis,
considering factors like revenue, assets, liabilities, and future potential.

Due Diligence: Conducting a thorough investigation of the target company’s

finances, operations, legal status, and other relevant aspects to assess risks and
opportunities.

Negotiation: Negotiating the terms of the deal, including price, payment

structure, and any conditions or contingencies.

Legal and Regulatory Approval: Obtaining necessary approvals from regulatory

bodies and complying with legal requirements to complete the transaction.

Integration: Post-merger/acquisition, integrating the operations, systems,

cultures, and employees of both companies to achieve the desired synergies and
goals.

C) Types of Mergers

Mergers can be categorized into several types based on their strategic intent:

Horizontal Merger: Between companies operating in the same industry and market.

Vertical Merger: Between companies in the same industry but at different stages
of the supply chain.

Conglomerate Merger: Between companies in unrelated industries to diversify risk

or enter new markets.

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D) Challenges and Risks of M&A

M&A activities come with inherent risks and challenges, such as:

Integration Issues: Cultural clashes, operational integration challenges, and

technology alignment problems.

Financial Risks: Overpayment, unexpected liabilities, or underestimated costs of

integration.

Regulatory Hurdles: Antitrust laws, government approvals, and international

regulations.

Strategic Fit: Ensuring that the merger or acquisition aligns with the long-term
strategic goals of the company.

Mergers and acquisitions are complex processes that require careful planning,
execution, and integration to achieve success. While they offer opportunities for
growth, synergy creation, and market expansion, they also pose significant risks
if not managed effectively. Companies engaging in M&A must conduct thorough
due diligence, negotiate wisely, and plan meticulously to maximize the benefits and
minimize the pitfalls of these strategic transactions.

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FINANCIAL DUE DILIGENCE

Financial due diligence is a critical process conducted by potential buyers or

investors to assess the financial health and viability of a target company before
completing an acquisition, investment, or merger. This process involves a thorough
review and analysis of the target company's financial statements, accounting
practices, financial controls, and other relevant financial information. Here’s a
detailed look at financial due diligence:

A) Objectives of FDD

Identifying Financial Risks: Assessing the financial risks associated with the
target company, such as liquidity issues, debt levels, contingent liabilities, and
potential financial misstatements.

Evaluating Financial Performance: Analyzing the historical financial performance

to understand revenue trends, profitability, cost structure, and key financial
metrics.

Assessing Asset and Liability Quality: Reviewing the quality and valuation of
assets (such as inventory, receivables, and fixed assets) and liabilities (such as
debt, provisions, and contingent liabilities).

Understanding Cash Flows: Analyzing cash flow statements to evaluate the

company's ability to generate cash, manage working capital, and meet its financial
obligations.

Validating Financial Projections: Scrutinizing the accuracy and reasonableness of

the target company's financial forecasts and projections for future performance.

B) Importance of FDD

Risk Mitigation: It helps to identify and assess financial risks associated with the
target company.

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Valuation Accuracy: It provides a clearer picture of the target company’s financial
performance and valuation.

Negotiation Power: It equips the buyer or investor with information to negotiate

favorable terms and conditions.

Post-Transaction Integration: It facilitates smoother integration by

understanding financial and operational complexities beforehand.

C) Key Components of FDD

1) Financial Statements Review:

Balance Sheet: Analyzing assets, liabilities, and equity to understand financial

position and leverage.

Income Statement: Examining revenue, expenses, and profitability trends over

time.

Cash Flow Statement: Assessing operating, investing, and financing cash flows to
understand cash generation and utilization.

2) Accounting Policies and Practices:

 Evaluating the consistency and appropriateness of accounting policies used by

the target company.

 Identifying any changes in accounting policies and their impact on financial

statements.

3) Quality of Earnings:

 Adjusting reported earnings for one-time or non-recurring items to understand

the underlying, sustainable earnings power of the business.

 Identifying potential earnings management or manipulation issues.

4) Working Capital Analysis:

 Assessing the adequacy of working capital to support ongoing operations and

growth.

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 Analyzing trends in accounts receivable, inventory, and accounts payable
turnover.

5) Debt and Financing Structure:

 Reviewing the terms and conditions of existing debt facilities.

 Assessing debt levels, repayment schedules, and covenants.

6) Tax Review:

 Examining tax compliance and potential tax liabilities.

 Assessing the adequacy of tax reserves and potential tax exposures.

7) Legal and Regulatory Compliance:

 Review legal agreements, contracts, and regulatory filings for any potential
liabilities or risks.

 Ensuring compliance with industry regulations and standards.

D) Process of FDD

Planning and Preparation: Defining the scope of due diligence, assembling a due
diligence team (including financial experts, auditors, and legal advisors), and
developing a due diligence checklist.

Data Collection: Requesting and collecting relevant financial documents and

information from the target company, including financial statements, tax returns,
budgets, forecasts, and internal reports.

Analysis and Review: Conducting detailed analysis of the financial data, identifying
key issues, discrepancies, or areas requiring further investigation.

Reporting and Communication: Documenting findings and preparing a due diligence

report highlighting key financial risks, opportunities, and recommendations for
the potential buyer or investor.

Decision Making: Using the findings from financial due diligence to make informed
decisions regarding valuation, negotiation of terms, and mitigation of risks.

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In conclusion, financial due diligence is a comprehensive and systematic process

that plays a crucial role in assessing the financial viability, risks, and opportunities
of a target company, thereby enabling informed decision-making in mergers,
acquisitions, or investments.

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