PwC Transactions Blog

How should a firm and its management evidence its decision to invest in a company, in new equipment, in new projects, in new markets? Most of us have learned at some point in our education that such a decision should be based on financial analysis, looking at the payback period, at the internal rate of return or better, at the Net Present Value of the project. We have been taught that we should invest if the Net Present Value (NPV) of the project is positive. Yet many readers will agree with me that in “real life”, projects with a “high” internal rate of return happen to be postponed and that for “strategic reasons”, projects happen to be undertaken when their NPV is negative. And, after all, sometimes these decisions appear to have been the good ones…

So, are the decision tools we were provided with the right ones? Are we missing something? Should we forget NPV to assess our investments and rely on “strategy”, “vision” and “business flair” only?

No ! Tools such as NPV were developed at a time when technology and market developments were evolving at a slower pace than at the beginning of the 21st century, at a time when uncertainties about future prices, sales volumes and regulations were lower than today. These tools have been useful and remain useful in many situations. In some circumstances, however, their use can lead to inappropriate decisions. The key issue for management is to identify when this might happen and in these cases to use better, more appropriate tools.

The NPV approach generally supposes that an irreversible investment is made at some point in time and assumes, in its standard form, a constant business risk. It does not consider the timing of the investment as a parameter. In other words, it does not take into account the fact that postponing an investment provides an opportunity to learn more about the uncertainty of some of the project variables.

A company with an investment project is a company holding a “call option”, a right (but not an obligation) to invest in an asset at some point in the future. When the decision to invest is taken, the option is “killed” and the company gives up on the possibility of learning more about the uncertainties surrounding the project. This lost option value is an opportunity cost that is not captured by  “standard” NPV, but which should be taken into account when making an investment analysis.

Scholars have shown that the “standard” NPV approach is inappropriate when the following conditions are present:

• The “standard” NPV of the project is close to zero or is negative;
• There is a high uncertainty on some of the key value drivers of the projects and the NPV is sensitive to these value drivers;
• Management can react on the resolution of the uncertainties (switch from one production process to another, delay investments, reduce capacity, increase capacity, etc).

When these three conditions are met a Real Option valuation approach is recommended as it will fully capture the optional characteristics of an investment and should lead to a better decision taking process.

The above conditions are usually present in companies investing heavily in R&D (pharmaceutical companies, biotechnology companies), in start-ups (seed capital Venture Capitalists), in natural reserves (oil companies), etc. Today however, in an environment that is changing at an ever-faster speed, these conditions are also beginning to be met in numerous other sectors.

[to be continued – Part II ]

According to OECD Corporate governance principles (also stated in the 2009 Belgian Code on corporate governance), (non-executive) directors should have access to accurate, relevant and timely information including the recourse to independent external advice in order to fulfil their responsibilities.

In the context of transactions, the Belgian acquisition law dated 27 April 2007 specifies in Article 21 that independent directors have to designate independent valuation experts in the context of a transaction involving the majority shareholder. This process is commonly called a fairness opinion and is required to protect minority shareholders. But Belgian Company law also foresees that independent valuation experts be consulted and/or prepare reports in the case of intra-group conflicts of interests and in the case of a contribution in kind.

While corporate governance principles and related laws are naturally designed to protect minority interests and other stakeholders, academic researches also tend to demonstrate that a broad use of independent valuation experts is favourable to shareholders.

According to Bugeja[1], valuation experts tend to be used by target companies as it increases the likelihood that the bidder will higher the offer price. Additionally, the use of experts for valuation purposes is also linked to the complexity of the company to value. Based on the assumption that the valuation experts assist directors to provide shareholders with the correct recommendation then hiring a valuation expert is in shareholders’ interest.

The use of independent valuation experts rather than having financial expertise in the Board is stressed by Güner, Malmendier and Tate[2]. Indeed, their research tends to demonstrate that enhancing the financial expertise of the Board may not be beneficial to shareholders when other conflicts of interests are not adequately addressed. Indeed, the empirical results of the research show that the interest of bankers on the board could result in conflicts of interests between the objectives of the company and the financial institution.

As one of the famous Warren Buffet’s statements stressed “Price is what you pay. Value is what you get.”… and the whole game is having the first close to the latter!

Accounting for acquisitions has changed. The International Accounting Standards Board released a revised standard on business combinations in January 2008 (IFRS 3 Revised), accompanied by a revised standard on consolidated financial statements (IAS 27 Revised).

 The new standards are expected to add to earnings volatility, making earnings harder to predict.

 PwC has produced a guide IFRS 3R: Impact on earnings, the crucial Q&A for decision-makers  which aims to help dealmakers and preparers of financial statements communicate the consequences of a business combination on the current and future earnings.

 I would like to highlight in this posting 2 aspects in particular:

-          transaction costs no longer form part of the acquisition price; they should be expensed as they are incurred and the related services are received

-          contingent consideration (like earn-outs payable based on post-acquisition earnings or on the success of a significant uncertain project) is required to be recognised at fair value, even it is not deemed to be probable of payment at the date of acquisition. All subsequent changes in debt contingent consideration are then recognised in the income statement, rather than against goodwill as today. This means that an increase in the liability for strong performance results in an expense in the income statement. Acquirers will have to explain this component of the performance: the acquired business has performed well but earnings are lower because of additional payments due to the seller.

 As you can see with these two examples, acquisitive companies can expect increased earnings volatility, both in the year of the acquisition and in the years following.

 As a result, the standards will also:

-          influence acquisition negotiations and deal structures in an effort to mitigate unwanted earnings impact

-          potentially impact the scope and extent of due diligence and data-gathering exercises prior to acquisition

-          expand the call for valuation expertise

While fair value is the standard valuation basis for the measurement of assets and liabilities in the preparation of balance sheet following an acquisition, the new IFRS 3 (IFRS 3 revised or IFRS 3R) requests an even wider use of the notion of fair value. Moreover, IFRS 3R requires the amount of goodwill to be fixed at the date at which the control is obtained.

Consequently, a change in fair value subsequent to the acquisition date will not result in an adjustment to goodwill as with the current version of IFRS 3, even in a buyout context (subject to a 12-month period allowed for finalising the business combination accounting).

Another impact of IFRS 3R will be the rise in number and complexity of valuations to be performed when acquiring new businesses. Indeed, the fair value measurement has been expanded to include contingent considerations (e.g. earn-out clauses), whether probable at the acquisition date or not. The fair value measurement has also been expanded to include re-assessment and potential reclassification of some financial instruments.

A third consequence is a potential greater volatility of the results as adjustments (subsequent to the acquisition balance sheet date) to the identified assets and liabilities values (and goodwill) will directly impact the income statement.

Another change is that transaction costs will not be part of the purchase price anymore. Transaction costs will have to be expensed and gains related to previously held interests (step acquisitions) will have to be recognised in the profit or loss (these gains were previously recognised as a revaluation surplus in equity).

As a result, the wider use of fair value will increase the incentive for more accurate and reliable value assessments.

Such accurate and reliable value assessment can usually be achieved through detailed analyses of historical and projected financial statements. These analyses provide an insight into the determinants of the intangibles to be recognised and contribute to more reliable measurement.

Both market factors (e.g. market surveys, sector benchmarking reports) and company specific factors should be studied during this process. The application of specific and sometimes sophisticated valuation methods (Multi-period excess earning method, relief from royalty method to name a few) which include models to assess the probability of performance objectives being achieved may also increase accuracy.

The best way to avoid (bad) surprises (especially in the current market conditions where, for example, debt covenants play a crucial role) is to anticipate the consequences of the proposed transaction terms in the framework of the new accounting standard at an early stage (i.e. prior transaction date, during negotiations) and to model potential scenarios.