Acquisition Valuation and a CFO Asked to Bend the Discount Rate
Sahara Holdings Ltd is evaluating a cash offer for 100% of Delta Ltd. Delta's free cash flow to the firm for the year just ended was KES 480 million, expected to grow at 4% a year in perpetuity. Delta has debt of KES 900 million at market value and 200 million shares in issue. Sahara's finance director has produced a valuation at an 11% WACC, arguing that Delta can be funded largely with cheap debt and that Sahara's own lower cost of capital should apply. The board is being asked to approve an offer of KES 28 per share. Sahara's group WACC, correctly relevered for Delta's risk and target capital structure, is 14%. Independently assessed net synergies are KES 250 million before KES 180 million of integration costs. Sahara is listed and the offer is unpublished.
1. Value Delta at the appropriate discount rate and determine whether the KES 28 offer creates or destroys value for Sahara's shareholders.
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Step 1 - Value the enterprise at 14%.
FCFF next year = 480 x 1.04 = KES 499.2m Terminal value = 499.2 / (0.14 − 0.04) = 499.2 / 0.10 = KES 4,992m
Step 2 - Equity value. 4,992 − 900 = KES 4,092m; per share = 4,092 / 200 = KES 20.46.
Step 3 - Offer test.
| KES m | |
|---|---|
| Offer: 200m shares x KES 28 | 5,600 |
| Plus debt assumed | 900 |
| Implied enterprise value | 6,500 |
| Stand-alone value at 14% | 4,992 |
| Premium paid | 1,508 |
| Net synergies (250 − 180) | 70 |
| Value destroyed for Sahara shareholders | 1,438 |
The offer transfers KES 1.5 billion to Delta's shareholders against synergies of KES 70 million. Even if the full gross synergy of KES 250m is captured, the deal destroys KES 1,258m. The maximum justifiable price is the stand-alone equity value plus net synergies: (4,092 + 70) / 200 = KES 20.81 per share. KES 28 is 35% above that.
2. Critique the finance director's 11% WACC and quantify how sensitive the valuation is to the discount rate.
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Why 11% is wrong - four separate errors:
- Rate/flow mismatch. FCFF belongs to all providers of capital and must be discounted at a WACC reflecting Delta's business and financial risk. Using Sahara's lower cost of capital to discount Delta's cash flows values Sahara's risk profile, not Delta's.
- Cheap debt is not free money. Adding leverage lowers the WACC only until the cost of equity rises to offset it (Modigliani–Miller with taxes). The finance director has adjusted the debt weight without relevering the equity beta. The correctly relevered figure is 14%.
- Post-acquisition capital structure is irrelevant to stand-alone value. If Delta will be geared to Sahara's target structure, the cash flows must change (interest tax shields) - you cannot lower the rate and leave the flows untouched.
- Synergies cannot be smuggled in through the discount rate. They are a cash flow, valued separately and added once, net of integration cost.
Sensitivity - the rate is the whole valuation:
| WACC | Enterprise value (499.2 / (WACC − 0.04)) | Equity | Per share |
|---|---|---|---|
| 11% | 7,131 | 6,231 | 31.16 |
| 12% | 6,240 | 5,340 | 26.70 |
| 14% | 4,992 | 4,092 | 20.46 |
| 15% | 4,538 | 3,638 | 18.19 |
Each 1% on the WACC moves value by roughly KES 2.50–2.70 per share - 12% of the offer price. A 300-basis-point 'judgement' is not an assumption, it is the answer being chosen in advance.
Additional check. The terminal value is 4,992 − (499.2/1.14) = KES 4,554m, i.e. 91% of the valuation. The board should test the 4% growth rate against the market the company actually operates in, and run a downside case at 2% growth: 489.6/(0.14−0.02) = 4,080m enterprise, KES 15.90 per share.
3. Advise the finance director on the professional and ethical course of action, given that the offer is unpublished and the board has been told the deal is accretive.
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The situation is an ethical problem, not a modelling problem. The finance director has been asked to endorse an assumption chosen to produce a predetermined answer, and the company is listed.
Professional obligations (ICPAK Code of Ethics / IESBA):
- Integrity and objectivity (s.110, s.120). Deliberately selecting a 300bp-inappropriate discount rate to support a board paper is a misrepresentation of a professional judgement, not an aggressive assumption.
- Professional competence and due care (s.130). Presenting a single-point valuation of a 91%-terminal-value cash flow, with no sensitivity analysis, falls below the standard expected of a CFO.
- Pressure and self-interest threats. The finance director's own bonus or continued employment may depend on the deal; if so, the threat must be identified, evaluated and documented, and the work independently reviewed.
Insider dealing and market abuse. The offer is unpublished. Anyone who trades Sahara or Delta securities, or tips another person, commits an offence. The finance director must ensure the deal team is on a restricted list, that the information is held under a documented wall, and that no one (including family) deals.
The course of action:
- Restate the paper at 14%, with a sensitivity table and the walk from stand-alone value to synergies to offer price. State the maximum justifiable price of KES 20.81.
- Do not sign a board paper you believe to be misleading. If the paper goes forward over objection, record the dissent in the minutes and put the objection in writing to the audit committee chair and, if necessary, the board.
- Escalate. Non-executive directors exist precisely for this; the external auditors should also be made aware for the purpose of the going-concern and impairment assessments.
- Document everything contemporaneously - what was asked, what was refused, and why. The file, not memory, is the defence.
- Consider resignation only if the misstatement is issued or a market disclosure is made on a figure the finance director believes to be false; resignation itself carries a duty to report to the regulator.
Bottom line: the correct answer is to present the 14% valuation and the KES 20.81 ceiling, whatever the board decides. The decision to overpay is a commercial decision the board may legitimately take and defend; the valuation supporting it must not be doctored.