Assessing the value of a strategic acquisition.

• Author: Luecal, Scott

For 65 years, the mission of every electric cooperative has been to provide reliable, competitively priced electric service to its members. Some cooperatives have chosen to strengthen or expand this mission by offering other utility and non-utility products or services. Offering additional products or services -- diversification -- may be founded upon several possible objectives, including:

* To fulfill member needs and desires for products and services not now available in the area, or not provided by current businesses at favorable prices or desired levels of customer satisfaction.

* To strengthen the cooperative's relationship with its current members.

* To gain access to and build relationships with consumers outside the cooperative's defined service territory.

* To find additional revenue streams in the event customer choice results in a loss of retail customers for generation service.

Regardless of the reason, cooperatives appear to have three options for entering diversified businesses: they may start-up a new business, they may partner with an existing business, or they may acquire an existing business. The focus of this article is on the third of these options, acquisition. Specifically, we will ask how to determine the amount a cooperative should pay to acquire a business, and what lessons have been learned by other co-ops that have acquired a new business.

1. ASSESSING THE 'RIGHT PRICE' OF AN ACQUISITION

   When considering an acquisition, there are two key questions board members and CEO's should ask. How should we decide what to pay for the acquisition? How should we know when to walk away?

   Let's address the first question. In order to determine how much to pay for the acquisition, several concepts need to be defined. These concepts include the Net Present Value of the acquisition, the purchase price, the market value, and what we will call synergies, or organizational benefits that result from a relationship between the acquired business and the existing business of providing electric distribution service.

   The first concept is "net present value". The net present value (NPV) equals the sum of the present value of the expected future cash flows of the target company completely independent of any acquisition. The net present value is the preferred method to analyze the potential return for different business opportunities. The NPV is used because it provides a consistent calculation for comparing different choices by converting money amounts from future years into current dollars. The present value is the amount of cash today that is equivalent in value to an amount of cash to be received or spent in the future. To calculate the present value, each future net cash flow is multiplied by a discount factor that is based upon the number of future years and a discount rate.

   Net cash flows may be defined as the difference between cash inflows and cash outflows. Cash inflows principally result from the sale of a company's services and products. Cash o u t flows principally result from additional investment in plant and equipment, plus expenses incurred in providing those services and products.

   The discount rate is an interest rate that reflects the cooperative's weighted average cost of capital (WACC) plus an adder for risk. The WACC is used because it is a fair basis for determining the value of capital the cooperative would invest in a potential acquisition. An important footnote is to remember that even if a cooperative has available general funds (cash) to make an acquisition, there is a cost to the cooperative for using that cash. The discount rate is never zero. The adder to the WACC should be determined by the risk associated with the acquisition. Does your cooperative have expertise in the area of the acquisition? How many years are required to achieve profitability? By adding a risk factor to the...