Question

1. Do small changes in the assumptions pertaining to the estimation of the terminal value have a significant impact on the calculation of the total value of the target firm? If so, why? Also, what could be the impact of the COVID-19 outbreak on Mergers & Acquisitions?

Answer 1

Answer-

The small changes in the assumptions for the estimation of terminal value will significantly impact the total value of target firm. The reason for this is due to the high terminal value compared to present value of cash flows in the valuation of target firm.  

Terminal Value (TV) = FCFFn x ( 1 +g) / (WACC -g)

FCFFn = Free cash flow of firm in nth or last year
WACC = Weighted average cost of capital
g = estimated growth rate in perpetuity

The assumptions in the growth rate in perpetuity and the FCFFn will have a high impact in the obtained terminal value.

Research shows that the terminal value can contribute approximately 70- 75% of the value in a 5-year Discounted Cash Flow (DCF) method of evaluation  and 45 - 50% of the value in a 10-year DCF evaluation. The rest are the present values of estimated cash flows.

The 70-75 % of the value for a 5 year DCF model is staggering and can impact the final target value obtained on calculation.

Therefore the small changes in assumptions to calculate terminal value will significantly impact the target value due to its high contribution in DCF method which is a commonly used methodology in valuations.

Answer -

Impact of the COVID-19 outbreak on Mergers & Acquisitions

COVID- 19 is a pandemic disease which has rattled the economy and has impacted the economy badly leading to crash in stock prices.

COVID-19 related low company valuations (and lower multiples) of the large industry companies could attract cash rich PE investors or strategic investors to takeovers with minority stakes and takeover bids for listed companies whose stock prices has almost decreased by 50 % after the effect of COVID-19 has started.

This COVID 19 will is going to increase the consolidation in many industries by strategic players and will broaden value chain which includes both horizontal and vertical integration and create synergies because of lower valuations or weakness.in financial health of the companies.