Companies can acquire others depending on a number of factors. For instance, Nike can acquire Lululemon with the aim of expanding its business and making significantly high profits. The trading pattern of Lululemon is a good indicator that the acquiring company will stand to benefit because it trades at a good valuation in the market. Additionally, Nike is stable and has a high valuation, capable of issuing stock in the bid to buy the company (Lululemon). However, even if Nike has been established as one of the largest apparel design makers, Lululemon is amongst its key competitors, meaning that a purchase will increase its competitive advantage. Buying Lululemon will involve significantly higher costs because the acquiring company has to part with reasonable figures depending on the current market valuations as outlined below.
A summary of performance tests and analysis of Lululemon
Lululemon Athletica abbreviated as LULU recorded a profit increment of 10% to $423.5 million for the first quarter of 2016 as compared to the previous year. However, the company's business is affected by the high dollar value since up to 30% of its market is from outside the U.S. the company was able to expand its sales through e-commerce activities, enabling it to continue with its business of roll out some stores in North America and other countries across the world. The company increased its number of stores by 53 in the first financial quarter of 2016 (1Q16) as compared to that of 2015 (1Q15). Also, 13 Ivivva stores were added, resulting to an increment of the overall square footage to 931,000, representing 21.7% growth. Like its main peers such as Nike and Under Armour, the company is vertically integrated and targets at expanding its footprints stores as a strategy of benefiting from direct sales to the final consumers, thus avoiding intermediaries.
LULUs value in terms of operations
Determining the value of organization's operations, the main factor that should be considered is the operating cash flows. This means that the present value of LULU cash flows will have to be determined in this case. This means that the acquiring company must determine the projected future demand, enabling it to predict the payback period.
Operating free cash flows = EBIT (I-T) +depreciation + CAPEX-D working capital- D any other assets.
In this case, EBIT is the earnings before interest and taxes, CAPEX is the capital expenditure, moreover, D working capital is the working capital changes.
Weighted average cost of capital (WACC) for LULU.
The WACC represents an average of after-tax costs that have been associated with the company's sources of capital. This includes preferred stock, common stock, long-term debt and bonds. Companies have two main sources of financing, equity and debt, and the average costs associated with the acquisition of such funds is referred to as the WACC.
WACC = * Re + * Rd * (1 Tc)
Rd is the cost of debt, Re represents the cost of equity, D=market value of debt, E=market value of equity, V=E+D, D/V = Debt financing as a percentage, E/V = Equity financing as a percentage, Tc= the charged rate of corporate tax.
According to gurufocus.com, LULUs current weight of equity
E/(E+D) = 7967.720/(7967.720+ 0) and the answer is one.
The weight of debt is D/(E+D), representing
0/(7967.720+0). Meaning that this value is Zero
From the gurufocus.com, the current cost of equity is 1.775%while the cost of debt is zero, and the average tax rate of 32.705%. This means that WACC = 1 * 1.775% +0 * % * (1-32.705%)Resulting to 1.78% as the current WACC for LULULULUs intrinsic value
The intrinsic value represents a company's actual value and this involves both intangible and tangible variables. This value may differ with the market value in a particular period. The value is determined by applying the following formula.
Where:CFn =Cash flows in period n. d = Discount rate, Weighted Average Cost of Capital (WACC)=162997/(1+1.78)1 = 58,632$
Calculate the firm's market value.
Market Value = Market Capitalization = Stock Price x Number of Shares Outstanding
Share price for Lululemon Athletica as at Jan 29, 2016 = 62.07$
Market Value = 62.07 x637,000 shares
Determine the firm's book value.
Book value per share of common stock is the amount of net assets that each share of common stock represents. Some stockholders have keen interest in knowing the book value of the shares they own.
Book Value= Stockholders Equity/ Number of shares of common stock outstanding
= 1,027,482,000$/637,000 shares
Book value=$1613.00 per share
Determine what the parent company will pay for the target acquisition company. Be sure to include how the target company provides synergies and opportunities to the parent company.
Lululemon has 637,000 shares of stock outstanding. Lululemons stock is selling for $ 62.07 per share and the fair market value of Fulton's debt is $ 0 million.
Market Value of Stock (637,000 x $ 62.07) 39,538,590$USD
Market Value of Debt 0 million
Total Market Value of Lululemon39,538,590$USD
The parent company will pay 39,538,590$ to acquire Lululemon company.
How the target company provides synergies and opportunities to the parent company.
Synergy is the additional value that is generated by combining two firms, creating opportunities that would not been available to these firms operating independently (Bekier & Shelton, 2002). Synergy benefits can come from two potential sources: operating and financial synergy.
Operating synergies are those synergies that allow firms to increase their operating income from existing assets, increase growth or both. We would categorize operating synergies into four types.
Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. In general, we would expect to see economies of scales in mergers of firms in the same business (horizontal mergers) two banks coming together to create a larger bank or two steel companies combining to create a bigger steel company (Berkovitch & Narayanan, 1993).
Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms in the same business and should be more likely to yield benefits when there are relatively few firms in the business to begin with. Thus, combining two firms is far more likely to create an oligopoly with pricing power (Barker, 1999).
Combination of different functional strengths, as would be the case when a firm with strong marketing skills acquires a firm with a good product line. This can apply to wide variety of mergers since functional strengths can be transferable across businesses (Black, 1989).
Higher growth in new or existing markets, arising from the combination of the two firms. This would be case, for instance, when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products. Operating synergies can affect margins, returns and growth, and through these the value of the firms involved in the merger or acquisition (Buono & Bowditch, 1989).
With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate) or both. Included in financial synergies are the following:
A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that can be taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses (Colombo, Conca, Buongiorno, & Gnan, 2007).
Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit usually manifests itself as a lower cost of capital for the combined firm (Damodaran, 2005).
Tax benefits can arise either from the acquisition taking advantage of tax laws to write up the target companys assets or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes and increase its value.
Diversification is the most controversial source of financial synergy. In most publicly traded firms, investors can diversify at far lower cost and with more ease than the firm itself. For private businesses or closely held firms, there can be potential benefits from diversification.
Clearly, there is potential for synergy in many mergers. The more important issues relate to valuing this synergy and determining how much to pay for the synergy.
Barker, R. (1999). The role of dividends in valuation models used by analysts and fund managers. European Accounting Review, 8 (2) , 195-218.
Bekier, M., & Shelton, M. (2002). Keeping your sales force after the merger. The McKinsey Quarterly, 12 (4) , 106-115.
Berkovitch, E., & Narayanan, M. (1993). Motives for takeovers: an empirical investigation. Journal of financial and quantitative analysis, 28 (3) , 347-362.
Black, S. (1989). Bidder overpayments in takeovers. Stanford Law review, 41 (3) , 597-653.
Buono, A., & Bowditch, J. (1989). The Human Side of Mergers and Acquisitions. San Francisco, CA: Jossey-Bass Publishers.
Colombo, G., Conca, V., Buongiorno, M., & Gnan, L. (2007). Integrating cross-border acquisitions: a process-oriented approach. Long Range Planning, 40 (2) , 202-222.
Damodaran, A. (2005). The Value of Synergy. New York, NY: Stern School of Business.
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