Required rates of return for individual asset classes
--the empirical evidence from the purchase price allocation
1Author: Meng Wang Student Number: 1581171
Professor: Dr. Ing. Nanne Brunia Coaches Duff & Phelps: Hans le Grand
Amsterdam, September 16th 2007
Abstract: the purchase price allocation2 (PPA) disclosures the fair value of an acquired
entity upon business combination. DCF is a widely-used approach to examine the fair value of individual asset classes3. However, currently there is no clear guidance concerning the determination of the required rates of return (discount rate) for individual asset classes. Appraisers and accountants generally consider the liquidation value, the time to maturity and the ownership of the assets to determine their specific risk and the associated required rates of return. The main hypothesis in practice is that working capital (WC) and tangible fixed assets (FA) have lower required return than intangible assets (INT) and goodwill (GW). Based on Smith and Parr (2005)’s theory, the weighted average cost of capital (WACC) should be equal to the weighted average required return on assets (WARA). This study built a sample containing fair value of US acquired entities in business combination during 2001 and 2006. Then a regression through the origin was conducted with the WACC as the dependent variable and the proportions of individual assets in the total fair value of the firm as the independent variables. The regression coefficients are interpreted as the average required rate of return for the individual assets classes. The average required rates of return for individual asset classes could be used to measure contributory asset charge in the intangible asset valuation. They could also be used as discount rates in DCF valuation analysis. The empirical evidence is consistent with the hypothesis that the average required rate of return for tangible fixed assets is lower than the average required rate of return for identifiable intangible assets and goodwill. The working capital have abnormally high average required rates of return, which are due to the high required rates of return for the liquid part of current assets, including cash, marketable securities and short-term investment. Combined with previous studies, this finding suggests the book value of cash and cash equivalents may need to be discounted to arrive at their fair value.
1. Introduction
1.1 Purchase method and purchase price allocation (PPA)
In June 2001, the Financial Accounting Standards Board (FASB) issued its final statement regarding the accounting for purchased assets upon business combination (SFAS 141). For all transactions closed after June 30, 2001, SFAS 141 eliminates pooling-of-interests method4 in favor of the purchase method. Following the standard setters around the world, including U.S., Canada, and Australia, the International Accounting Standards Board (IASB) issued IFRS 3 Business Combination, which
2 Purchase price allocation is the process of assigning fair values to all assets and liabilities of an acquired entity following a business combination. The report of PPA usually can be found in the notes of the acquiring entity’s annual report following the business combination.
3 The asset classes in this study are based on the accounting concepts. The assets classes include tangible fixed assets, identifiable intangible assets, goodwill, other assets and the working capital, which is the difference between current assets and operating liabilities. Those assets classes and their components will be explained later in the section 1.4.
4Under the pooling-of-interests method, the carrying amount of assets and liabilities recognized in the
requires the use of purchase method in accounting for the acquired entity. European public quoted companies are required to adopt IFRS for accounting periods beginning after 1 January 2005. Under the purchase method, the acquirer, at the acquisition date, is required to allocate the purchase price of the acquisition to the identifiable assets, liabilities and contingent liabilities 5at their fair value6. Acquired goodwill must be stated at its fair value and is to be separate from identifiable intangible assets, the fair value of which is recognized and stated separately. The identifiable intangible assets include five types of intangible assets that can be separated from the goodwill, such as marketing-related, customer-marketing-related, artistic marketing-related, technology-based and contract-based intangible assets7.
1.2 Book-value and Fair-value
One may wonder why we need to value all the assets and liabilities to their fair value rather than directly take the book value on the acquired entity’s financial statement as the fair value of the acquired entity. The accounting book value has been criticized as a poor measure of a firm’s assets.8 The first reason is that sometimes there is a large difference between an individual asset’s book value and its fair value on the valuation date. In most cases, financial statements are prepared based on the cost principle of accounting. That is, assets are usually recorded at their historical purchase cost. Generally the historical cost is not restated for accounting purpose, even if the current fair value of the assets has changed considerably in comparison with their historical cost. The second reason is a large proportion of internal generated intangible assets and some significant liabilities such as contingent liability are not included on the book-value balance sheet.
In order to carry out PPA9, the fair value of individual asset and liability on stand-alone basis should be examined and reported. After the revaluation, there will be a fair-value balance sheet of the acquired entity which has two major differences from the book-value balance sheet that acquired entity maintains before the acquisition. First, the assets and liabilities of the value balance sheet are now stated at fair values. Second, the fair-value balance sheet concludes the fair fair-values of the identifiable intangible assets and the contingent liabilities if any.
The fair value of the equity on the valuation date is then the fair value of total assets minus the fair value of liabilities. This is a fundamental accounting principle. In PPA the total purchase price is the fair value of the equity of the acquired entity.
5 Contingent liabilities, liabilities which may or may not come to pass, such as an outstanding lawsuit, pending tax disputes, pending litigation, pending environmental concerns, etc.
6 FASB 141 (Business Combination) Appendix F: Glossary: The fair value is amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.
7 See the appendix 2 for more information
8 See Damodaran (2006), Prate, Reilly and Schweihs (2000)
Recent research such as Bruner (2004) indicated that the acquiring entities usually suffered a loss on their market value upon the business combination. The PPA, which results to a fair-value balance sheet certainly discloses more information to investors and helps them understand the business combination.
Table (1) shows a typical report of the purchase price allocation of an acquired entity on the acquiring entity’s annual report following the business combination.
The fair value of Exult Inc. on June 15, 2004, the valuation date: (in thousand US dollars) 10
Total purchase price $ 684,969 Cash and cash equivalents 31,585
Short-term investments 110,412 Client receivables and unbilled revenues 79,525 Prepaid expenses and other current assets 46,388 Property and equipment 14,179 Customer relationships 136,593 Core technology 44,000 Purchased software 7,210 Trademarks and trade-names 2,000 Deferred tax assets, net 53,191 Accounts payable and accrued expenses (134,862) Convertible senior notes (102,300) Other liabilities (2,460)
285,461 Goodwill 399,508
Table (1) a typical report of purchase price allocation for an acquired entity’s assets and liabilities
1.3 Valuation approach
Compared with the accounting book value, the fair value is a better measure of an enterprise’s assets. However, it also raises a challenge for accountants and appraisers, that how to determine the fair value of individual assets and liabilities.
There are three groups of approach to consider when one examines the fair value of individual assets and liability11:
1. Market approach
Under the market approach, the price of the subject asset or liability in an active market will be used to examine the value of the subject. If no active market exists, it should be considered whether a comparable transaction can be used to determine the value of the subject asset or liability. Whenever a developed market for a certain asset exists, the market value should be used, for it is in line with the definition of fair value. As active markets exist for most financial assets, such as marketable securities, short-term
10This is the fair value of the Exult Inc. disclosed by its acquirer Hewitt Associates Inc. The information is
investment, financial instruments, etc., the market price will thus be used to measure their fair value.
2. Cost approach
This approach may consider the cost of producing an exact duplicate of the asset (the reproduction cost method) or, alternatively, the cost of producing an asset having the same utility (the replacement cost method). The cost can be estimated from the cost new less estimated accumulated depreciation. Cost approach is usually used to value tangible fixed assets, e.g. property, plant and equipment. It is also used to value raw materials.
3. Income approach12 (DCF)
The income approach is based on the argument that the value of the subject asset is measured by its ability to generate future cash flows. The value of an asset is the present value, at the valuation date, of the future cash flows derived by the asset during the asset’s expected useful life, and from its disposal, where applicable. The main tasks under the income approach are the projection of the future cash flows and the determination of an appropriate discount rate. Normally no active market exists for most intangible assets, due to their intangible characteristics and their dependency on the owner. It is thus also difficult to estimate the reproduction cost or replacement cost of intangible assets. The income approach is thus usually used to value the fair value of intangible assets in PPA. Also notice that in using the income approach to determine an asset’s fair value, the asset must be treated as a separate taxable item, taking into account the relevant tax policies. In PPA, the value determined by the income approach is in line with the definition of fair value, because the value is also the selling price of the subject asset paid by the acquiring entity.
Normally there is no strict rule about which approach should be used when we value certain assets, except that the market approach is preferred whenever the information is available. Analyst should decide which approach to use taking into consideration the availability of data and the applicability of approach. However, certain approaches are more suitable to certain assets compared with other approaches. The recognition of assets and liabilities and their corresponding valuation approaches are briefly discussed below
1.4 Identification of assets and liability and the valuation guidance13.
All of the acquired entity’s individual assets and liabilities are analyzed and valued separately in order to carry out PPA. It involves a separate identification and individual valuation. FASB 141 contains identification of assets and liabilities. It also provides guidance for allocating purchase price to acquired assets and liabilities, which is in the appendix 1. A company’s total asset is a portfolio of various asses. In this study, the
12 Income approach is a widely-accepted name in accounting practice. The DCF approach may be a more appropriate name since DCF is actually the foundation of the income approach.
13
company’s assets are divided into five classes, including current asset, tangible fixed asset, identifiable intangible assets, goodwill and other assets.
Current assets (CA)
The current assets are expected to be sold or used up within a short period, normally within a year. The current assets generally constitute cash and cash equivalent, inventory, accounts and notes receivables, and prepaid expense. The financial markets exists for marketable securities, therefore the fair value of marketable securities and other cash equivalents are determined by the market price. The fair value of inventory is based on its selling price less the costs to complete (only applicable to the work in process), the costs of disposal and a reasonable profit allowance. The fair values of raw materials are the current replacement costs. The fair value of receivables are present values of amounts to be received determined at appropriate discount rate, less allowances for failure of collection and collection costs, if necessary. If the accounts receivable is going to be collected within a year, the discount effect could be ignored. In most cases, either the market approach or the cost approach is used to determine the fair value of current asset.
Tangible fixed assets (FA)
Tangible fixed assets contain plant, property and equipment (PPE), land, and natural resources. The fair value of fixed assets can be determined by the cost approach, the income approach or the market approach. The fair value of fixed assets is normally determined at the current replacement cost for similar capacity if the fixed assets are going to be used. If the fixed asset is no longer produced, the replacement cost of the most comparable available substitute asset is used as the starting point in the cost approach. If there is active renting/lease market for the subject fixed asset, the value of the subject is often the present value of the rental charge. If an appropriate secondary market is available for the subject fixed asset, the value of the subject asset is estimated by the price that it would command in its secondary market.
Identifiable intangible assets (INT)
to value intangible assets apart from goodwill. Some common methods14 under the
income approach include the so called relief-from-royalty method, the excess earnings method and the incremental cash flow method. Following are brief explanations for these methods.
----Relief-from-royalty method
The royalty is what a company would pay to use the subject intangible assets as if the company had not owned the intangible assets. Under the relief-from-royalty method, the royalties are determined based on the market royalty rates for comparable intangible assets. The royalty saved are discounted at appropriate discount rate to the valuation date. The present value of royalty saved is thus the value of the subject intangible assets. The center challenge of this method is whether the comparable intangibles that used to arrive at the royalty rate are fundamentally identical to the subject intangible assets. Examples that usually require using of the relief-from-royalty method are patent and technology.
----Incremental cash flow method
Under the incremental cash flow method, value of a company with an intangible asset is compared with the value of a company without such intangible asset. Other things being equal, the difference is then the value of the intangible asset. Value of brand is usually determined by incremental cash flow method. For example, the so called generic brands15
of consumer products (often supermarket goods) are distinguished by the absence of a brand name. On the package of a generic brand product, there is no name or label, only what the contents are. The generic brand products are usually cheaper than those with brand names, though they have equal qualities. Some generic brand products are produced on the same production line as the products with brand names. The price difference between a generic brands product and an identical product with brand name is a good measure of the incremental cash flow generated by the brand name. Discounting the incremental cash flow with an appropriate discount rate, we get the fair value of the brand name.
----Excess earnings method
If the cash flow that attributable to individual asset can be distinguished, such cash flow will be discounted at risk-adjusted discount rate to the valuation date to determine the fair value. Under the excess earnings method, the present value of the cash flows generated by, and only by, the intangible asset is determined. Intangible assets do not generate cash flows in a vacuum; they also rely on the use of other assets (referred to as ‘contributory assets’). In arriving at the cash flows that generated only by the intangible assets, the cash flows generated by the intangible assets in combination with other assets are therefore reduced by subtracting notional cash flows for the “contributory” assets (the contributory asset charges). Typical contributory assets are working capital, fixed asset, workforce, trademark, trade name, and parents. This method will be explained more in section 1.5 as
14 Although the name of those methods may be misleading, they are widely-accepted in the accounting practice. The earning actually refers to the cash flow.
it is related to the major interest of this study, the required rates of return for individual asset classes.
Other assets (O)
Other assets other than goodwill are the rest of the total assets that can not be classified into the above three asset classes. Other assets may include non-marketable securities, long-term financial assets, deferred tax assets, deferred compensation and assets held for sale. The valuation of those assets varies for the information availability and the characteristics of the assets. The market approach should be used whenever the market information is available. Otherwise, the cost approach or income approach should be used to measure the fair value of those assets.
Liabilities
Liabilities in this study will be divided into two groups, the operating liabilities (OL)
and the debt and debt equivalents (D). The typical operating liabilities are those related
to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue), and the government (income taxes payable), according to Koller, Goedhart and Wessels (2005). The rest liabilities are defined as the debt and debt equivalents, normally including long-term debt, other claims payable, liabilities due to pension or postretirement benefit other than pensions, various accruals and other liabilities and commitments—such as unfavorable leases. The fair value of a liability is the amount for which it could be redeemed, taking into consideration the current level of interest rates. To value liabilities without active market information, it is important to match the risk and duration of subject liability with comparable liability traded on active markets. Contingent liabilities are, for example, pending tax disputes, pending litigation, pending environmental concerns, and so on. The contingent liabilities are also recognized as a part of the debt and debt equivalents. The fair value of a contingent liability is usually disclosed at footnote in financial statements. It is measured at the amount that an unrelated third party would demand for assuming the contingent liability. A probability weighted calculation of the expected value of the loss is required. Expectations as to future cash flows are to be taken into account by considering different scenarios and the likelihood of their realization.
Goodwill (GW)
As described above, all assets and liabilities of the acquired entity, whether recorded or unrecorded by acquired entity pre-acquisition, are identified and recorded by the acquiring entity and that only the residual purchase price that cannot be allocated to identified assets and liabilities is allocated to goodwill. Accounting standard setters, such as FASB recognized two components of goodwill as the core goodwill16. The first is the going-concern value of the acquired entity’s existing business. It represents synergies that the acquired entity’s established business worth more than as a collection of individual assets to be put to separate uses. The other component of the core goodwill is the fair value of the expected synergies and other benefits from combining the acquiring entity’s and the acquired entity’s net assets and businesses. The goodwill is considered as a part
of the acquired entity’s assets. One may argue that the second component of the core goodwill is not a part of the acquired entity. However, as appraisers in Duff & Phelps claimed, in an efficient market the fair value of the expected synergies and other benefits from combining the acquiring entity’s and the acquired entity’s net assets and businesses are identical to any acquirer. In other words, the fair value of the goodwill in PPA does not include any acquirer-specific synergy. Under FASB 142: Goodwill and Other Intangible Assets, goodwill is no longer amortized, but a impairment test will be conduct on regular basis to measure the change, if any, of the fair value of goodwill. The composition and the economic meaning of goodwill are beyond the scope of this study and thus will not be discussed in detail.
Fair-value balance sheet
After the recognition and valuation of all the assets and liabilities, a new fair-value balance sheet emerged for the acquired entity. Still taking the PPA in table (1) as an example, the assets in table (1) now can be divided into the five assets classes. The current assets include the cash and cash equivalents, the short-term investments, the client receivables and unbilled revenues, and the prepaid expenses and other current assets. The tangible fixed asset is the property and equipment. The identifiable intangible assets include the customer relationships, the core technology, the purchased software and the trademarks and trade-names. The other asset that has been recognized is the deferred tax asset. And then there is the goodwill, which is part of the acquired entity’s assets. Liabilities in this example include the operating liabilities, which are the accounts payable and accrued expenses, and the debt and debt equivalents, which contain the convertible senior notes and other liabilities. There is no contingent liability in this example. Thereafter, a new fair-value balance sheet in the table (2) is constructed according to the PPA presented in the table (1)
Table (2) the fair-value balance sheet based on the example of the Exult Inc.’s PPA.
Fair value of current assets ($267,910) Fair value of tangible fixed assets ($14,179) Fair value of identifiable
intangibleassets ($189,803)
Fair value of the goodwill ($399,508)
Fair value of operating liabilities ($134, 862)
Fair value of the debt and debt equivalents
($104,760)
Fair value of equity (Total purchase price)
($684,969) Fair value of other assets
This leads to the following equation (1), the fair values of the total assets equal to the sum of the fair value of operating liabilities, the fair values of the debt and debt equivalents, and the fair value of the equity.
VCA + VFA + VINT + VGW + VO = VOL + VD + VE (1)
VCA: fair value of current assets
VFA: fair value of tangible fixed assets
VINT: fair value of identifiable intangible assets
VGW: fair value of the goodwill
VO: fair value of other assets
VOL: fairvalue of operating liabilities
VD: fairvalue of debt and debt equivalents
VE: fair value of the equity
The working capital, which is the current assets minus the operating liabilities, is often used instead of the current assets and operating liabilities in valuation practice such as in the Duff & Phelps’s analysis. For the purpose of this study, the balance sheet is further rearranged:
Working capital = current assets – operating liabilities.
Table (3) the rearranged fair-value balance sheet based on the example of the Exult Inc.’s PPA. The equality in table (3) is also presented in the equation (2).
VWC + VFA + VINT + VGW + VO =VD + VE (2)
VWC: fair value of the working capital
VFA: fair value of tangible fixed assets
VINT: fair value of identifiable intangible assets
VGW: fair value of the goodwill
VO: fair value of other assets
Fair value of the working capital ($133,048) Fair value of tangible fixed assets ($14,179) Fair value of identifiable intangibleassets ($189,803)
Fair value of the goodwill ($399,508)
Fair value of debt and debt equivalents
($104,760)
Fair value of equity (Total purchase price)
($684,969) Fair value of other assets
VD: fairvalue of debt and debt equivalents
VE: fair value of the equity
1.5 Contributory asset charge and required rates of return
As mentioned above, active trading market or secondary markets normally are not existed for intangible assets. Therefore, the cost approach and the market approach are usually not applicable to intangible assets. On the other hand, the relief-from-royalty method and incremental-cash-flow method are only applicable to certain types of intangible assets, e.g. patent, brand and trademark. Hence, the excess earnings method becomes a common tool to value intangible assets in accounting and valuation practice. One major challenge of this method is to estimate the required rate of return for different assets classes.
Following is a simple example to help one understand the procedure of the excess-earning method. This is a company which only has working capital, tangible fixed asset and one kind of identifiable intangible asset. The excess earnings method is used to measure the fair value of the intangible asset.
Table (4): the excess earnings method
To value the intangible asset, the working capital and the fixed assets are the contributory assets. The fair values of the contributory assets are known as they are usually measured by either market approach or cost approach. The total cash flows produced by the total assets are allocated between the intangible assets and the contributory assets through the valuation periods. The contributory asset charges are the cash flows generated by the contributory assets, which are not directly observable but are calculated as the product of the fair value of the contributory assets and their corresponding required rates of return. Normally the projection of cash flow is year based. The contributory asset charges are thus calculated for each year. Subtracting the contributory asset charges from the total
Cash flow generated by INT = total cash flows – contributory asset charges
Fair value of total assets Fair value of the working
capital (WC) Fair value of tangible fixed assets (FA) Fair value of the identifiable intangibleasset (INT) Contributory assets
Contributory asset charges Cash flow generated by
WC =the required rate of return for WC * the fair value of WC
Cash flow generated by FA =the required rate of return for FA * the fair value of FA
cash flow will get the cash flows that only attributable to the intangible asset, which are of course also not directly observable. Those cash flows are then discounted to the valuation date at the required rate of return (discount rate) for the intangible asset. The resulted present value is thus the fair value of the intangible asset on the valuation date. From the above example we know that the required rate of return has two applications in the excess earnings method. First, the required rates of return for the contributory assets are needed to calculate the present value of the contributory asset charges. Second, the required rate of return for the intangible asset is used as the discount rate to determine the fair value of the intangible asset.
In Duff & Phelps and other valuation practice, the excess earnings method is often used to examine the fair value of the identifiable intangible assets. The required rates of return for different assets classes are key inputs in this method. How to determine the required rates of return becomes a challenge.
When we value an overall business enterprise with DCF model, the weighted average cost of capital (WACC) is usually used to discount the cash flows produced by the whole group of assets. WACC is the weighted average cost of the enterprise’s all financial resources’ costs, normally the cost of equity and the cost of debt. When the company issues equity and/or bond or borrows money to finance its operations, investors (equity holders and debt holders) require fair rates of return on their investments. Both the cost of equity and the cost of debt are associated with their specific risks. As a result, the net present value of cash flows generated by the enterprise’s aggregate assets is then the present fair value of the enterprise. However, when individual assets or asset classes are to be valued, the WACC is no longer an appropriate discount rate for all kinds of assets due to the different risk nature of individual assets. If investors can choose in which asset classes that he/she would like to invest, he/she will require different rates of return for their investments in different asset classes. According to Reilly and Schweihs (1998), one consideration regarding risk is whether the asset is being valued as part of a going concern business enterprise or as an independent economic unit (to be sold or exchanged separately from other business assets). In the former case, an overall business enterprise discount rate (WACC) is widely used. Since the PPA is the valuation on stand-alone basis, it is common to use a specific discount rate (required rate of return) to reflect the different investment risk associated with different assets.
Appendix 1 demonstrated that an appropriate discount rate should be used to determine the fair value of assets, but the accounting standards are not clear on how to find out the appropriate discount rate. The determination of an appropriate required rate of return (discount rate) for individual asset classes is then the main research question in this study.
The next section of this study contains the literature review. I describe the methodology framework and the data in the section 3 and 4, respectively. Empirical results are discussed in the section 5. The section 6 summaries the findings, and suggest future directions for empirical research in this area.
2 Literature review
It is common to value a company to its fair value as a whole, but it is unusual to assign a fair value to an individual asset or a class of individual assets. Besides that there is usually no need to do this. The valuation of the identifiable intangible assets is not required by accounting standard setters except in the PPA upon the business combination. The excess earnings method is also a relatively new method. Therefore, there are very few literatures which include information directly about what are the required rates of return for individual asset classes and how to determine them.
The DCF (income approach) is a well-established approach for valuation. Implementation of DCF requires two factors: the projection of cash flows and the determination of the discount rate. The required rate of return is used as the discount rate to discount the cash flow. The required return is the minimum return on the asset required by investor. Greenwald (1980) claimed that a required return should be “commensurate with returns on investment in other enterprises having corresponding risk” (the comparable return standard) and “sufficient to attract capital” (the capital attraction standard).The required rate of return represents the opportunity cost that investors face for investing their funds in one particular asset instead of others with similar risk. The required rate of return and discount rate are used interchangeable in this study.
Based on Prate, Reilly and Schweihs (2000), Elton and Gruber (1995) and the practice of Duff & Phelps, one needs to take into consideration the following three common risk factors when one tries to measure the required rates of return for different asset classes. (1) The liquidity of the assets
Liquidity is an important risk factor to distinguish the required rates of return for different assets. An asset is liquid if it can be bought or sold at the current market price quickly and at low cost. Illiquidity is thus related to the costs of executing a transaction in the capital markets. Other things being equal, the liquid assets generally have lower required rates of return than the illiquid assets.
(2) The time to maturity, namely the duration of the investment in certain asset.
According to Elton and Gruber (1995), in general the longer the maturity the more risky it is
(3) The ownership
assets or the goodwill. For example, a company does not own its important customers but it is benefited from the non-contractual customer relationships, which is an identifiable intangible asset. The customers, however, can easily choose not to continue co-operating with the company and the cash flows of the company will decrease. Therefore, the smaller the ownership the more risky it is.
Working capital
The working capital is the difference between the current assets and the operating liabilities. The current assets mainly constitute of cash, marketable securities17, inventory, and accounts receivables, prepaid and short-term investments. They are the most liquid in the portfolio of a firm’s total assets. Comparing with investments in other assets, the duration of working capital investment is also the shortest. As a result, working capital should have the lowest required rate of return compared with other asset classes in the company’s portfolio of total assets.
However, the required rate of return for the working capital also depends on the managing skills on working capital. As described by Strischek (2003), a firm’s managing skill on working capital ultimately affects its shareholder’s value. If the firm is too easygoing in collecting its receivables, too overstocked in inventory, too slow in paying its trade suppliers, and too thin in its cash reserves, the firm is then too risky to banks. These accounting considerations would boost the firm’s cost of debt and ultimately decrease the firm's shareholder value. Thus companies have to manage their working capital more prudently to adapt to the changing financial environment. Kargar and Blumenthal (1994) demonstrated that many enterprises go bankrupt despite healthy operations and profits owing to mismanagement of working capital. Corporate cash holdings may affect the required rate of return for working capital. Stowe, Watson and Robertson (1980) found that high-risk businesses rely simultaneously on relatively larger proportion in cash and marketable securities on the left-hand side and less leverage on the right-hand side. This finding indicates higher risk is associated with higher level of working capital and low level of debt. It is basically because a company will have difficulty to get a loan from bank when its risk is high. As a result, the working capital have higher required rate of return in high-risk companies. Opler, Pinkowitz, Stulz and Williamson (1999) conducted empirical research to examine the determinants of corporate holding of cash and marketable securities among public traded US firms from 1971 to 1994. The empirical evidence illustrate that firms with strong growth opportunities, firms with riskier cash flows and small firms hold relatively high ratios of cash to total non-cash assets. Firms that have the greatest access to the capital markets, such as large firms and those with high credit ratings, tend to hold lower ratios of cash to total non-cash assets. These results are consistent with the view that firms hold liquid assets to ensure that they will be able to keep investing when cash flow is too low and when external funds are expensive. Faulkender and Wang (2006) examined the marginal value of the corporate cash holdings that arises from differences in corporate financial policies. The empirical result on more than 40,000 U.S. firms from 1997 to 2001 suggests
that the average marginal value of one dollar across all firms is $0.94. This indicates the value of corporate cash holdings has been discounted by the market.
Stegink, Schauten and Graaff (2006) in their study suggest that the required rates of return for current assets are the average required returns for the different components, including cash, marketable securities, inventories, receivables and other current assets. And they assume the required rate of return for the current assets are the same for all the companies in their sample including 500 companies from the S&P 500. However, in their study they did not point out what are the required returns for the different components. Eckel, Fortin and Fisher (2003) analyzed the choice of the discount rates (required rates of return) for individual assets for external reporting purpose. They suggest the discount rate for accounts receivables should be related to the risk of the debtors. But they also did not point out which rate should be used. The practice of Duff & Phelps usually assumes the required rate of return for the working capital equal to the yield of short-term securities with low risk.
Tangible fixed asset,
The tangible fixed assets, though less liquid than working capital, can be sold, bought or leased on existing markets. Because it is thought that the markets for tangible fixed assets are generally less liquid than the markets for working capital, and the tangible fixed assets are always hold by a company for a period longer than one year, the fixed assets are considered risky than the working capital. Hence, the required rates of return for tangible fixed assets are considered generally higher than the required rates of return for the working capital.
The yield in mortgage market and long-term bond yield are usually considered by accounting practice as proxies of required rate of return for tangible fixed assets. KPMG18 in one PPA case recorded that the rates of a Baa rated corporate bonds is used
as a proxy based for the type of financing that would be used to acquire fixed assets. Herrmann, Saudagaran and Thomas (2006) also indicated that the fair value of investment property (real estate) determined through independent appraisals is relied upon heavily in the mortgage loan industry. Stegink, Schauten and Graaff (2006) in their study used the required return on the Bloomberg Real Estate Investment Trust Index (BBREIT) as proxy estimating the required rate of return for the tangible fixed assets.
Identifiable intangible assets
The risks of identifiable intangible assets are first due to their lack of liquidity and relatively longer maturity. Another reason, according to Reilly and Schweihs (1998), is that there are many uncertainties in intangibles’ cash-flow-generating capacity. The cash flows generated by the subject intangible assets may vary by different amounts and percentages, and in different directions, during the term of the projection period. For example, in-process R&D will have higher risk than other asset because the R&D may not succeed or the future cash flow from the R&D may not reach the expectation. Many intangible assets require periodic investment in research and development, function maintenance, marketing and promotion, legal, and other expenses in order for the
intangible assets to maintain its cash-flow-generating capacity. In addition to the maintenance expenditure, some external factors that affect the cash-flow-generating capacity of the intangible assets should be considered, including the effects of expected competition in the industry and the effects of an expected replacement for the subject intangible asset, which could be developed by a competitor. As mentioned above, a company may have incomplete ownership in certain intangible assets or the ownership of certain intangible asset is only valid within a time period, such as the term of patents. The risks associated with intangible assets increase with the uncertainty in their cash-flow-generating capacity.
As mentioned above, Stegink, Schauten and Graaff (2006) tested several common estimators of the required rate of return for the identifiable intangible assets based on their assumptions about the required rates of return for the working capital and the tangible fixed assets. These estimators include the WACC, the un-levered cost of equity and the levered cost of equity. In seven out of the eight industry sectors, the levered cost of equity appears to be the best proxy for the required rate of return for the intangible assets.
Goodwill
Generally, goodwill has appeared to be an umbrella concept embracing many features of a company's activities that could lead to superior earning power, such as excellent management, an outstanding workforce, effective advertising and market penetration. The goodwill is even more illiquid than intangible assets, as there is no existing market where people trade only the goodwill. There are many uncertainties in the ownership and in the cash-flow-generating capacity of the goodwill. Therefore the goodwill is considered as the most risky part of the total assets.
Taliendo (2006) compared two approaches used in measuring goodwill, the excess earnings estimate and the residual value approach. Based on his model, he indicated that application of a rate higher than the normal WACC to discount the forecast excess earnings would inevitably lead to an amount of goodwill different from the result of the residual value approach. However, this indication is debatable because when he calculated the excess earnings of the goodwill, he implicitly assumes the discount rate of other assets is the entity’s WACC.
Link between asset side and equity and debt side of balance sheet
and the remainder by the owners’ equity. Stowe, Watson and Robertson (1980) conducted a canonical correlation analysis to link the asset side and liability side of balance sheet. The empirical findings in their paper include: (1) Companies match the maturity structure of individual assets with liabilities; (2) assets such as accounts receivable and real estate were in general used as collateral for short-term bank or factor loans and mortgages; Founding (1) and (2) implicitly indicate risk of accounts receivable is associated with current liabilities, and the risk of real estate is associated with the mortgage market. Jan and Simon from Duff & Phelps (2006) followed Stowe etc. and conducted also a canonical correlation analysis on a large sample including companies in both U.S. and Europe. They found that (1) a link exists between the asset-side of the balance sheet and the liability side of the balance sheet; (2) equity was highly associated with goodwill, and that the fixed assets were highly associated with long-term debt. The links if existing would provide a solution to determine the required rates of return of individual asset classes. However, there is no solid prove that certain type of assets is only financed by certain financing resource. As Johnson and Lewellen (1972) claimed, it has been established not to be conceptually possible to associate a specific financing arrangement--e.g., a loan-with a specific project undertaken even though the two happen, in the course of corporate affairs, to occur simultaneously. This study will not attempt to find out whether a link of financing exists between the asset side and the equity and liability side of the balance sheet.
.
Hypothesis
Though there is some inconsistency, the indications from above literatures and analysis generally point out a hypothesis that the required rate of return for the working capital and fixed asset should be generally lower than the required rate of return for intangible assets and goodwill. This prediction, though not empirically proved, has been applied by many analysts and appraisers to examine fair value, including Duff and Phelps. Therefore, the main hypothesis going to be tested in this study is:
RWC < RFA < RINT<RGW
RWC: Requiredrate of return for the working capital
RFA: Requiredrate of return for tangible fixed assets
RINT: Requiredrate of return for identifiable intangible assets
RGW: Requiredrate of return for the goodwill
3 Methodology framework
Smith and Parr (2005) proposed a concept of weighted average of return on assets (WARA) and the WARA is equal to the WACC.
RWC*WWC + RFA*WFA + RINT*WINT+ RGW*WGW +RO*WO = CE*WE + (1-T)*CD *WD
(4)19
R: required rate of return (discount rate) for a specific asset class
W: weight of a specific asset class, calculated as the fair value of an asset class / the sum of the fair value of all the asset classes, including WC, FA, INT, GW and O. WE =
E/(E+D), WD = D/(E+D)
CE: cost of the equity
CD: cost of the debt and debt equivalents
T: effective tax rate
In this study, a regression formula (5) is used to examine the required rate of return on assets.
WACC= CE*WE + (1-T)*CD * WD
WACC = RWC*WWC + RFA*WFA + RINT*WINT+ RGW*WGW +RO*WO + (5)
R: required rate of return (discount rate) for a specific asset class
W: weight of a specific asset classes, calculated as the fair value of an asset class / the sum of the fair value of all the assets class, including WC, FA, INT, GW and O.
WE = E/(E+D), WD = D/(E+D)
CE: cost of equity
CD: cost of debt and debt equivalents
T: effective tax rate : the error term
In this regression, the weights of asset classes are independent variables. The WACC is the dependent variable. The error term leaves space for the estimating error in the cost of debt and debt equivalents and the cost of equity. Notice that this is a regression through origin, there is thus not necessary to drop off any independent variable even the sum of the four independent variables equals to one. The reason to use a regression through origin is basically because it is illogical to assume a company has required return when there is no asset exists. Each coefficient can be interpreted as the average required rate of return for the specific asset classes. Based on the data availability, the sample will be divided into different sub-samples according to the industry classification. Results of different industries will be compared to explore the differences if any on the required rates of return for the asset classes in different industries.
4 Data
A database is constructed with the PPA information disclosed in the acquiring entities’ annual reports after the business combination. Most of them are like what it shows in the table (1). This study is built on the PPA for several reasons. The PPA is the most detailed disclosure of the fair value of an enterprise’s all assets and liabilities. Therefore, all the
weights (independent variables) in the regression (5) are calculated with fair value instead of accounting book value. The empirical results are going to be used in the PPA. Hence, the research on the PPA itself will provide the most direct and reliable results. From the Thomson Financial database, the deals of business combination are selected based on following selection criterions:
1) Acquisitions are completed between 6/30/2001 and 12/31/2006 with the purchase price over 200 million US dollars.
2) Targets and acquirers are public quoted and headquartered in U.S. 3) Financial companies are not included.
4) Acquired percentage is above 50% of the acquired entity.
Detailed information about those deals include the name of acquiring entity and acquired entity, deal effective date, announcement date, business description, SIC code and enterprise value. The detailed PPA will then be found in acquiring entity’s annual report and recorded, which discloses the acquired entity’s fair market value of assets, liabilities and equity on the acquisition date. The annual report of the acquiring entity is mostly from Capital IQ. Not every acquiring entity disclosed the fair value in their annual reports. Some companies report only an aggregate number of the fair value of net tangible assets. As a result, the sample size is 201, including 97 firms with detailed break-down of current assets. The 201 firms were divided into 5 industry portfolios (consumer, health, high-tech, manufacturing and other) based on the definition employed by Fama and French20. The sample contains 23 consumer firms, 29 health firms, 77 high-tech firms, 41 manufacturing firms and 31 others.
The fair value disclosed includes fair value of assets and fair value of liabilities. The original disclosure contains many items, which are classified into the five asset classes, including current assets (CA), tangible fixed assets (FA), identifiable intangible assets (INT), the goodwill (GW) and other assets (O). The liabilities disclosed are also classified into operating liabilities (OL) and debt and debt equivalents (D). The working capital (WC) is then calculated as the fair value of current assets (CA) minus the fair value of operating liabilities (OL). The weights, the independent variables, are calculated as described in the methodology.
According to the best practice of Duff & Phelps, some assumptions are made for calculating the WACC. For each deal of business combination, pre-tax cost of debt and debt equivalents (CD) is equal to the yield to maturity on 15-year US BBB composite
index on the acquisition date. Effective tax rate (T) is set to be 30% for each acquired entity. Cost of equity (CE) is estimated with the CAPM. The risk-free rate (RF) is equal to
the yield to maturity on 15-year US treasury strip on the acquisition date. The market premium (RM) is set to be 5%. Beta is calculated with weekly return index of acquired
entities within different time frames. The weekly return index contains the information of dividend and stock repurchase/split, and thus a good measure of the market value of
stocks. 2-year weekly return index eliminate some noisy variation in the daily return index and contains enough observations for the beta calculation compared with monthly return index. Using 2-year weekly return index to calculate betas is thus considered stable and reliable. The data of weekly return index for each acquired entity are retrieved from the DataStream.
To test the robustness of the empirical results, betas are calculated for different time frames, including
(1) Betas are calculated with 2-year weekly return index ending 12 weeks (three months) before the announcement date. Thereafter, this is beta (1) and the WACC calculated with the beta (1) is the WACC (1).
(2) Betas are calculated with 2-year weekly return index ending 26 weeks (half a year) before the announcement date. Thereafter, this is beta (2) and the WACC calculated with the beta (2) is the WACC (2).
(3) Betas are calculated with 2-year weekly return index before the deal effective date. Thereafter, this is beta (3) and the WACC calculated with beta (3) is the WACC (3).
The betas (1) and (2) which are calculated before the announcement date reflects the normal business risk of acquired entity without taking into consideration the acquisition effect, which may lead to somewhat abnormal fluctuations in stock price. Results from recent research such as Bruner (2004) indicate that acquired entity often experience an increase in stock price within short-term around the announcement date. On the contrary, the stock price of acquiring entity sometimes decreases after the announcement date. The increase in market capitalization of acquired entity can be seen as an indication that acquired entity is benefited with the goodwill produced by the acquisition. Betas (3) contain the recent development of business but may also contain noise information due to the acquisition effect.
The three kinds of betas are all used to calculate the cost of equity and then the WACC. The results are robust no matter which type of WACC is used. Hence, I will focus on the results with WACC (1) in the later results analysis.
5 Results analysis and discussion 5.1 The descriptive analysis
The sample at first contains 201 cases. Following is a descriptive analysis
WACC (1) WACC (2) WACC (3)
Mean 9.3% 9.4% 9.6% Std. Deviation 3.3% 3.2% 3.2% Minimum 2.6% 3.0% 4.2% Maximum 24.0% 21.2% 20.8% N Valid 176 183 173 Missing 25 18 28
The various sample sizes are due to the lack of information. Table (5-part1) the descriptive analysis of the whole sample
The WACC, though calculated with different betas, are quite similar to each other. It means the WACC of most companies in this sample is stable through different time periods.
Some extreme cases have been eliminated, including those with extremely large portion in certain asset class (according to the rule of the mean plus three standard deviations) or the weight of the asset (except of working capital) is negative. Cases with negative betas are also eliminated from the sample. It can be seen from this table that on average company has more identifiable intangible assets and goodwill than tangible assets. Although goodwill in purchase price contains some part of the acquisition premium, this large portion of intangible assets and the goodwill, represents the increase of importance of intangible assets and the goodwill in the company’s assets portfolio.
WCA WOL WWC WFA WINT WGW WO Leverage Mean 22.3 % 11.2% 11.7% 16.8% 19.7% 43.3% 8.40% 0.3 Std. Deviation 18.7% 14% 14.1% 23.8% 16.7% 21.2% 13.9% 0.36 Minimum -9.4% 0 % -31.5% 0% 0% -13.8% 0% 0 Maximum 123.4% 115.7 % 58.7% 97.2% 90% 91.2% 92% 1.83 N 201 201 201 201 201 201 201 201
W: weights of individual asset classes; CA: current assets; OL: operating liabilities; WC: working capital; FA: tangible fixed assets; INT: identifiable intangible assets; GW: goodwill; O: other assets; Leverage: D/E Table (5-part2) the descriptive analysis of the whole sample
After the elimination, a correlation in table (6) demonstrates the relations between different asset classes and the WACC (1). The appearance of negative correlation among asset classes indicates that assets compete for limited financial resources; the increase of one asset class’s proportion would thus decrease the proportion of other asset classes. Negative correlation between WACC (1) and WFA shows the increase of fixed assets in
total asset would decrease the total cost of capital. This is consistent with the prediction. However, working capital has a positive correlation with WACC (1), which may indicate that high working capital is associated with high WACC, vise versa.
***: The correlation is significant at the 0.01 level (2-tailed). **: The correlation is significant at the 0.05 level (2-tailed).
W: weights of individual asset classes; WC: working capital; FA: tangible fixed assets; INT: identifiable intangible assets; GW: goodwill; O: other assets
Table (6) Correlation analysis of the whole sample
Dividing the whole sample by industries provided interesting information to this study. Due to the sample size, only the high-tech industry and the manufacturing industry have enough samples (over 30) for the regression analysis. Table (7) provided descriptive analysis for the two industries. WACC of the high-tech firms are higher than the manufacturing firms on average. This is mainly because the high-tech firms are generally more risky than manufacturing firms and thus the market requires more return from high-tech firms than manufacturing firms. High-high-tech firms have more working capital then manufacturing firms, which seems in line with the theory mentioned before that high risk firms tend to hold more liquidity balance such as cash and cash equivalents. The difference in WFA, WINT and WGW reflect the industry’s difference in their value drivers.
High-tech firms rely on intangibles and goodwill and they hold a relatively few amount of tangible fixed assets. Manufacturing firms, on the other hand, have on average nearly 40% of their total assets in tangible fixed assets because they produce tangible products. They also rely lightly on the intangible assets and the goodwill comparing with high-tech firms.
N: 58 High –Tech Firms
WACC (1) WWC WFA WINT WGW WO Mean 11.8% 14.6% 3.8% 21.1% 54.0% 6.5% Median 11.5% 15% 2.1% 18.7% 54.2% 2.8% S.D. 3.2% 13.2% 5.3% 12.0% 16.4% 9.3% Minimum 5.3% 10.8% 0 4.8% 14.9% 0 Maximum 18.9% 39.9% 24.2% 61.5% 91.2% 45.9% N: 36 Manufacturing Firms WACC (1) WWC WFA WINT WGW WO Mean 7.8% 6.8% 39.9% 10.4% 33.9% 6.0% Median 7.4% 3.3% 35.4% 6.2% 32.4% 2.0% S.D. 20.6% 14.2% 27.6% 12.1% 17.2% 8.5% Minimum 4.9% -24.9% 0 0 1.4% 0 Maximum 14.7% 50.7% 83.4% 42.7% 74.4% 35.2%
W: weights of individual asset classes; WC: working capital; FA: tangible fixed assets; INT: identifiable intangible assets; GW: goodwill; O: other assets
Table (7) Descriptive Analysis of high-tech firms and manufacturing firms
5.2 The regression analysis
and 5, respectively. No multi-collinearity has been found in this study. Eisenhauer (2003) pointed out the R square and relevant analysis is not valid under regression through origin. It is thus not provided in the table (8). Since there is no ready package in the SPSS, the white test in the Eviews is used to test the homoskedasticity of the error term. The following table shows the Obs * R-squared value (18.75) is lower than the critical value at 1% (21.67). Hence, there is no problem of heteroskedasticity at 1% level.
White Heteroskedasticity Test (no cross term): on the overall sample as the WACC (1) as the dependent variable
F-statistic 2.208508 Probability 0.024252 Obs*R-squared 18.74754 Probability 0.027427
Model 1a Model 1b Model 1c Model 2a Model 2b Model 3
WACC(1) WACC(2) WACC(3) WACC(1) WACC(1) WACC(1)
High-tech Manufacturi ng Break-down CA RWC 11.1%*** 11.2%*** 12.4%*** 10.9%*** 12.9%*** RFA 3.9%*** 4.0%*** 4.4%*** 5.4%*** 4.4%*** RINT 9.4%*** 9.4%*** 9.2%*** 9.4%*** 8.6%*** 9.8%*** RGW 11.2%*** 11.2%*** 11.4%*** 14.7%*** 8.7%*** 11.2%*** RO 8.4%*** 6.9%*** 8.2%*** 2.5% 9.2%*** 10.9%*** Rliquid 13.4%*** Roperating 3.3% ROL -6.3% Pr> F 0 0 0 0 0 0 N 164 159 171 58 36 78
***: The T-stat is significant at the 0.01 level **: The T-stat is significant at the 0.05 level
R: average required rates of return for individual asset classes; WC: working capital; FA: tangible fixed assets; INT: identifiable intangible assets; GW: goodwill; O: other assets; OL: operating liabilities; Liquid part of CA: cash, marketable securities and short-term investment
Operating part of CA: accounts receivables, inventory and other current assets Table (8): The regression analysis
Model 1a, Model 1b and Model 1c are regressions on the overall sample with different
WACC. The sample sizes are different due to the data elimination and data unavailability as described in the section 5.1. Regression results are robust with different WACC and sample sizes. For tangible fixed assets, identifiable intangible assets and the goodwill, the average required rates of return are around 4%, 9% and 11%, respectively. The average required rate of return for tangible fixed assets is significantly lower than required rate of return for identified intangible assets and goodwill on the significance level of 5%21. The finding is consistent with the hypothesis.
Model 2a and Model 2b show the differences between industries. The dependent
variable in these two regressions is the WACC (1). Since in the sub-sample of high-tech
firms, there are 17 firms have no tangible fixed assets and more than 80% high-tech firms’ WFA arelower than 5%, the tangible fixed assets are classified into other assets. On
average the high-tech firms have higher RINT and RGW thanthe manufacturing firms. The
manufacturing firms have higher average required rate of return for tangible fixed assets. RFA is lower than RINT and RGW, which is inline with the hypothesis.
Model 3
However, the high average required rate of return for the working capital is quite inconsistent with the hypothesis. Therefore, instead of the working capital, current assets and operating liabilities have been included in the regression to analyze the reason. Current assets are break-down into two parts. First is the liquid part which is considered not highly associated with the business operation. The liquid part of current assets constitutes of cash, marketable securities and short-term investment. The separation has another concern that these three components of current assets are in many cases reported together in the PPA. The second part is the operating part, mainly including accounts receivables and the inventory, which are considered highly associated with the firm-specific characters. The average required rates of return for the liquid part and the operating part are the Rliquid andRoperating, respectively, in the regression model 3.
Regression result of the model 3 is based on a sub-sample of 78 firms. The sub-sample contains detailed information for components of current asset. The dependent variable is the WACC (1). The weight of those components is the fair value of them divided by the fair value of equity plus debt and debt equivalents. The sign of the average cost of operating liability is negative. This is mathematically correct, for the working capital is constructed as the result of the current assets minus the operating liabilities.
The average required rate of return for fixed assets, identifiable intangible assets and the goodwill are still around 4%, 9% and 11%, which represents the robustness of the results and is consistent with the hypothesis. Although the sample size is relatively small, it gives a hint that the high required return on working capital is mainly associated with the liquid part of the working capital, including cash, marketable securities and short-term investment.
Wliquid Woperating WFA WINT WGW WO WOL WACC(1)
W: weights of individual asset classes; FA: tangible fixed assets; INT: identifiable intangible assets; GW: goodwill; O: other assets; OL: operating liabilities
Liquid part of CA: cash, marketable securities and short-term investment Operating part of CA: accounts receivables, inventory and other current assets Table (9) descriptive statistic for the model 3
the likely use of them. The agency theory holds a view that managers in cash rich firm would use cash to invest rather than pay back to shareholders. These investments are sometimes in favor of management’s objective but reduce shareholders’ value. The possibility that management could be using cash for its own objectives raises the costs of outside funds, because outsiders do not know whether management is raising cash to increase shareholder value or to pursue its own objectives. Firms may also hold cash and cash equivalents to ensure that they will be able to keep investing when cash flow is too low and when outside funds are expensive according to Opler, Pinkowitz, Stulz and Williamson (1999).
Koller, Goedhart and Wessels (2005) examined the cash balance of S&P 500 non-financial companies between 1993 and 2000. The evidence shows the 2% of sales is a good proxy for working cash. Any cash above this rate should be considered excess. The sales of the acquired entity at the acquisition date is not available, but table (9) shows that the average weight of liquid part of current assets is 12%, which is fairly high compared with other asset classes. They suggest to value excess cash and marketable securities separately from the operating assets of a company. According to their theory, the practice in Duff & Phelps is to separate the cash from working capital and value them separately as none-operating assets. The value of excess cash and cash equivalents are still the book value. However, the results in this study suggest the book value of corporate cash holdings may need to be discounted to arrive at their fair value.
6 Conclusion
Purchase price allocation is required by worldwide accounting standard setters to disclose the fair value information of acquired entity after business combination. In order to implement the PPA, appraisers and accountants need to determine the required rates of return (discount rates) for individual asset classes. The required rates of return for individual asset classes should be associated with their specific risks. Based on Smith and Parr’s theory (2005), the empirical results from PPA indicate the average required rates of return are around 4%, 9% and 11% for tangible fixed assets, identifiable intangible assets and the goodwill, respectively. The empirical finding on the average level is consistent with the hypothesis that RFA < RINT < RGW. Comparison of the regression
This study also has some limitations. As more and more acquiring entities disclose their PPA of acquired entity, the future research could have more empirical results for European firms and/or other industries. More control variables such as the size, leverage could be introduced into the regression by running the regression on separated sub-samples.
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