In the event of Business Combinations tangible assets (current – Non-current) are best valued with the market or income approaches. If adequate data are not available to derive an indication of value through these methods, an appraiser may use the replacement cost method, which adjusts the original cost for changes in the price level to determine its current replacement cost. The current replacement cost is then adjusted due to physical use or functional obsolescence.
Property, Plant and Equipment (PP&E) must be recognized at fair value for current capacity. Accumulated depreciation is not carried forward. An appraiser may use the cost approach, in which a market participant would pay no more for an asset than the amount necessary to replace it to produce at current capacity.
Separate valuation allowances are not recognized for acquired assets that are measured at fair value, including allowance for doubtful accounts and allowance for loan losses. Uncertainties regarding future cash flows are included in their fair values.
Enterprise Valuation represents the fair value of the acquired entity’s interest-bearing debt and shareholder’s equity. It is a key valuation tool in measuring the fair value of assets acquired and liabilities assumed.
Prospective financial information (PFI) is used to determine the enterprise value of the acquired entity. As a helpful diagnostic, the valuation specialist would also look to the internal rate of return (IRR) implied by the acquisition (in the case of an acquisition of a business) to obtain an additional indication of the overall entity’s return. After the market participant PFI has been determined (that is, entity-specific synergies have been removed), the IRR is derived by equating the sum of the prospective cash flows on a present-value basis to the consideration transferred, which assumes that the amount paid represents fair value. Because PFI generally represents the cash flows expected from the acquiree’s operating assets and liabilities, the calculation of the IRR would also need to consider adjustments when non-operating assets or liabilities exist.
In the case of an acquisition of assets that do not constitute a business, a use of the IRR calculation as a diagnostic may be difficult. The IRR can also be used to assess the calculation accuracy of the Weighted Average Cost of Capital (WACC). However, valuation specialists should be careful to not use it simply to adjust the WACC calculation because under certain circumstances, such as bargain purchases, IRR and WACC may deviate from each other.
Prospective Financial Information
PFI starts with the cash flows used in determining the acquisition price of the transaction. These cash flows are adjusted to reflect market participants’ assumptions, including any synergies other companies would expect to realize if they acquired the acquiree. Financial projections must also be adjusted to remove any entity specific synergies between the acquirer and acquiree.
IRR and WACC Reconciliation
Conceptually, the IRR should be consistent with the WACC. This should be the case for all types of PFI, such as conditional, probability-weighted, and PFI with “mixed” attributes. If the implied IRR and WACC differ, it may be an indication that entity-specific synergies are included in the PFI, that cash flows are not consistent with the expectations of market participants, or that the price paid for the business was not representative of its fair value.
If such a scenario exists, the valuation specialist would analyze the assumptions in the PFI to ensure that only market participant assumptions are reflected (that is, excludes entity-specific synergies or biased PFI) to derive expected cash flows for the overall entity and asset. Alternatively, if there is evidence of the price not reflecting fair value, the valuation specialist would need to impute fair value for the acquisition if that imputed value is to be used in WACC, IRR and Weighted Average Return on Assets (WARA) comparison.
The WARA analysis is applied to the fair value of the assets to generate the implied rate of return on goodwill based on the IRR. The purpose of the WARA analysis is to determine the reasonableness of the returns for the identifiable intangible assets and the implied return on goodwill.
The following summarizes the relationship between the IRR and WACC and the implications for the selection of PFI in the instance of a business combination:
IRR = WACC — Indicates that the PFI likely properly reflects market participant assumptions, and the transaction consideration is likely representative of the fair value
IRR > WACC — Indicates that the PFI may include some or all of the impact of entity-specific synergies, may reflect an optimistic bias, may reflect a bargain purchase, or all three
IRR < WACC — Indicates that the PFI may exclude some or all of the impact of market participant synergies, may reflect a conservative bias, may reflect an overpayment, or all three