Financial institutions, valuations, mergers, and acquisitions : the fair value approach

449 Pages·2001·1.41 MB·English

by  Zabihollah Rezaee

Financial Institutions, Valuations,
Mergers, and Acquisitions:
The Fair Value Approach
Second Edition
Zabihollah Rezaee
John Wiley & Sons,Inc.
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Copyright ©2001 by John Wiley & Sons,Inc. All rights reserved.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Rezaee,Zabihollah,1953-
Financial institutions,valuations,mergers,and acquisitions:the fair value
approach /
Zabihollah Rezaee.—2nd ed.
p. cm.
ISBN 0-471-39449-1 (cloth:alk. paper)
1. Banks and banking—Valuation—United States. 2. Bank mergers—United
States. 3.
Sale of banks—United States. 4. Financial institutions—Valuation—United
States. 5.
Financial institutions—Mergers—United States. 6. Financial
institutions—Purchasing—United States. 7. Consolidation and merger of
corporations—Law and legislation—United States. I. Title.
HG1707.7 .R49 2001
332.1′6—dc21
00-046264
Formerly titled Commercial Bank Valuationby William D. Miller
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
About the Author
Zabihollah Rezaee is a professor of accounting at Middle Tennessee State University. He
received his B.A. degree from Iranian Institute of Advanced Accounting,his M.B.A. from
Tarleton State University in Texas, and his Ph.D. from the University of Mississippi.
Professor Rezaee holds several certifications including certified public accountant (CPA),
certified management accountant (CMA), certified internal auditor (CIA), certified gov-
ernment financial manager (CGFM),and certified fraud examiner (CFE).
Professor Rezaee has published over 130 articles in a variety of accounting, finance,
banking,and economic journals including Journal of Accounting and Economics; Journal
of Business,Finance and Accounting; Journal of Accounting,Auditing and Finance; Ad-
vances in Public Interest Accounting; Journal of Accountancy,Internal Auditors Manage-
ment Accounting; Strategy Finance; and Bankers’Economic and Investment Alert.
Active within the accounting profession and the academic and financial communities,
Dr. Rezaee has made over 120 presentations at conferences and workshops throughout the
world. He teaches financial, management, and international accounting and auditing and
has been involved in financial and management consulting with national and international
organizations including the United Nations. Dr. Rezaee has received numerous research
grants from various sources. He received the 1998 distinguished research award at Middle
Tennessee State University and the Lybrand Bronze Medal for the outstanding article in
1999 selected by the Institute of Management Accountants.
v
Contents
Acknowledgments xviii
Preface xix
Part I The Foundation:Financial Institutions,Valuations,Mergers,
Acquisitions,Regulatory and Accounting Environment 1
Chapter 1 Introduction to Financial Institutions 3
1.1 Introduction 3
1.2 Structural Changes in the Financial Services Industry 5
1.2.1 Consolidation 5
1.2.2 Convergence 7
1.2.3 Competition 15
1.3 Historical Perspective of American Banking 16
1.4 Current Trends in the Banking Industry 17
1.4.1 Changes in Regulations 19
1.4.2 Information Technology 25
1.4.3 Global Marketplace 28
1.4.4 Capital Standards 29
1.4.5 Supervisory Activities 30
1.4.6 Continuous Quality Improvement 32
1.4.7 Valuation Process 34
1.5 Conclusion 35
Chapter 2 Overview of the Valuation Process 38
2.1 Introduction 38
2.2 Valuation Services 39
2.3 Valuation Profession 41
vii
viii Contents
2.4 Attracting Valuation Clients 44
2.5 Accepting a Client 51
2.6 Pricing Valuation Services 58
2.7 Importance of the Engagement Letter 59
2.8 Planning an Appraisal Engagement 59
2.8.1 Conference with Client Personnel 59
2.8.2 Knowledge of the Business 61
2.8.3 Legal Structure 62
2.8.4 Policies 62
2.8.5 Industry and Economic Conditions 62
2.9 General Planning 64
2.9.1 General Planning Decisions to be Made 64
2.9.2 Evidence and Knowledge Obtained to Prepare
Preliminary Appraisal Plan 64
2.9.3 Procedures in Preparing the Preliminary Appraisal Plan 66
2.10 Appraiser’s Traits 67
2.10.1 Able to Function Well Under Intense Pressure 68
2.10.2 Communicate Well Both Orally and in Writing 68
2.10.3 Utilize Both Qualitative and Quantitative Data 68
2.10.4 Be Unfazed by Ambiguity and Uncertainty 68
2.10.5 Continuous Improvement of Valuation Expertise and
Skills through Ongoing Professional Education 68
2.10.6 Continuous Marketing Strategies 69
2.11 Appraiser’s Due Diligence Process 69
2.12 Conclusion 69
Chapter 3 Overview of Mergers and Acquisitions 73
3.1 Introduction 73
3.2 Historical Perspective of M & A 74
3.3 Recent Trends in M & A 74
3.4 Regulations of Bank Mergers 77
3.4.1 Antitrust Regulations 78
3.5 Trends Toward Business Combinations in the Financial Services
Industry 82
3.6 Motives for Business Combinations 84
3.7 Determinants of Mergers and Acquisitions 84
3.8 Perceived Shortcomings of M & A 85
3.8.1 Diminished Services 85
3.8.2 High Financial Services Fees 88
3.8.3 Credit Availability 89
3.8.4 Undesirable Impacts on Competition 89
3.9 Studies on Mergers and Acquisitions 90
Contents ix
3.10 Mergers and Acquisitions Process 93
3.10.1 Strategy Development 95
3.10.2 Target Identification and Selection 95
3.10.3 Identifying Key Issues and Contacting Targets 99
3.10.4 Structuring the Acquisition Transaction 99
3.10.5 Due Diligence Process 99
3.10.6 Risk Assessment 100
3.10.7 Negotiation 102
3.10.8 Financial Structure 103
3.10.9 Closing the Deal 103
3.10.10 Integration 104
3.11 Conclusion 105
Chapter 4 Regulatory Environment and Financial Reporting
Process of Financial Institutions 111
4.1 Introduction 111
4.2 Consolidation 111
4.2.1 Technological Innovations 113
4.2.2 Geographical and Activity Diversification 114
4.2.3 National and Global Competition 114
4.3 Regulatory Environment 116
4.4 Bank Supervision 118
4.4.1 Market Discipline 118
4.4.2 Supervision 119
4.4.3 Minimum Capital Regulation 123
4.4.4 Safety and Soundness 126
4.5 Financial Modernization:The Gramm-Leach-Bliley Act 127
4.6 Financial Reporting Process of Financial Institutions 130
4.7 Statement of Financial Accounting Standards (SFAS) No. 115 133
4.8 Auditing Proper Classifications of Marketable Securities 135
4.9 Tax Consideration of Fair Value 136
4.10 Recent Development of Fair Value Accounting 137
4.11 Financial Reporting Requirements of Financial Institutions 143
4.11.1 Reports Required Under Regulation H and the SEC
Act of 1934 144
4.11.2 Reporting Requirement for International Activities 145
4.12 Corporate Governance of Financial Institutions 147
4.12.1 Financial Reporting 150
4.12.2 Internal Control Structure 150
4.12.3 Independent Audit Committee 154
4.12.4 Functions of Audit Committees 155
4.13 Conclusion 157
x Contents
Part II Fundamentals of Valuations:Concepts,Standards,and
Techniques 163
Chapter 5 Value and Valuation:A Conceptual Foundation 165
5.1 The Nature of Value 165
5.2 Twelve Concepts of Value 166
5.3 Types of Property That Can Be Valued 172
5.4 Relationship Among Different Types of Value 173
5.5 Principles of Valuation Theory 174
5.5.1 Principle of Alternatives 174
5.5.2 Principle of Replacement 174
5.5.3 Principle of Substitution 174
5.5.4 Principle of Future Benefits 175
5.6 Pricing Value Versus Reporting Value 175
5.7 Limitations of the Valuation Process 176
Chapter 6 Approaches to Measuring Value 177
6.1 Overview of the Valuation Process 177
6.2 The Cost Approach to Valuation 178
6.3 The Market Approach to Valuation 180
6.3.1 Identifying Comparables 180
6.3.2 Adjusting for Lack of Comparability 181
6.4 The Income Approach to Valuation 182
6.4.1 The Stabilized Income Method 183
6.4.2 The Discounted Future Income Method 184
6.4.3 Discounted Cash Earnings 185
6.4.4 Selecting the Type of Income to Use 186
6.4.5 Estimating the Stabilized Level of Income 187
6.4.6 Projecting Future Income Levels 189
6.4.7 Selecting the Capitalization and Discount Rates 189
6.4.8 Dividend Capitalization Model 197
6.4.9 The Effects of Inflation 198
6.5 Special Topics—Approaches to Intangible Asset Valuation 199
6.5.1 Cost of Replacement of Intangible Asset 199
6.5.2 Income from Intangible Asset 199
6.5.3 Cost Savings from Intangible Asset 200
6.5.4 Excess Earnings Method 201
6.6 Special Topics—Business Valuation 202
6.6.1 Market-to-Book Value Method 202
6.6.2 Total Enterprise Value Versus Value of Equity 202
6.6.3 Existence of Preferred Stock 203
6.6.4 Adjusted Book Value to Compute Market Value of Equity 206
6.6.5 Liquidation of Business 206
Contents xi
6.7 Valuation and Business Concentrations 207
6.8 Special Topics—Closely Held Stock 207
6.8.1 Revenue Ruling 59-60 208
6.8.2 Discounts for Minority Position/Premium for
Control 209
6.8.3 Discount for Lack of Marketability 211
6.9 Special Topics—Valuing Widely Traded Companies 211
Chapter 7 Valuations for Tax and Accounting Purposes 213
7.1 Tax Aspects of Mergers and Acquisitions 213
7.1.1 Nontaxable Transactions 213
7.1.2 Taxable Transactions 214
7.2 Typical Tax-Oriented Valuations 215
7.3 Accounting Aspects of Mergers and Acquisitions 217
7.3.1 Pooling Versus Purchase Accounting 217
7.3.2 Requirements for Use of Pooling Accounting 217
7.3.3 Advantages and Disadvantages of Purchase and Pooling
Accounting 220
7.4 Typical Accounting-Oriented Valuations 220
Chapter 8 Intangible Asset Valuation 223
8.1 Nature and Types of Intangible Assets 223
8.1.1 Criteria for Defining Intangible Assets 223
8.1.2 Core Deposit Base 224
8.1.3 Loan Servicing Contracts 224
8.1.4 Safe Deposit Box Contracts 224
8.1.5 Proprietary Computer Software 224
8.1.6 Trust Accounts 224
8.1.7 Leasehold Interests 225
8.1.8 Assembled Work Force 225
8.1.9 Goodwill 225
8.2 Amortizable Versus Nonamortizable Intangible Assets 225
8.2.1 Benefits of Amortization 225
8.2.2 Requirements for Amortization 226
8.3 Measuring the Useful Life of an Intangible Asset 227
8.3.1 Unique Experience 227
8.3.2 Individual Component Analysis 228
8.4 Establishing Value of Intangible Assets 229
8.4.1 The Cost Approach 229
8.4.2 The Market Approach 229
8.4.3 The Income Approach 230
8.5 Amortization Methods 230
8.6 Supporting Intangible Asset Valuation and Amortization 231
xii Contents
Part III Assessment of Financial Institutions 233
Chapter 9 Financial Analysis of Banks and Bank Holding
Companies 235
9.1 Types and Sources of Financial Data 235
9.1.1 The Uniform Bank Performance Report 235
9.1.2 The Bank Holding Company Performance Report 236
9.1.3 Other Public Sources 236
9.1.4 Private Sources 237
9.1.5 Internal Data Sources 237
9.2 Overview of Financial Statements 238
9.2.1 Income Generation and Income Statement 238
9.2.2 Balance Sheet 240
9.3 Composition of Bank Assets 241
9.3.1 Cash and Due Froms 242
9.3.2 Investment Securities 242
9.3.3 Fed Funds Sold and Reverse Repos 242
9.3.4 Loans and Lease Financing Receivables 243
9.3.5 Assets Held in Trading Accounts 244
9.3.6 Premises and Fixed Assets 244
9.3.7 Other Real Estate Owned 244
9.3.8 Investments in Unconsolidated Subsidiaries and
Associated Companies 244
9.3.9 Customer Liabilities to Bank on Acceptances
Outstanding 244
9.3.10 Intangible Assets 245
9.3.11 Other Assets 245
9.4 Composition of Bank Liabilities 245
9.4.1 Deposits 245
9.4.2 Fed Funds Purchased and Repos 246
9.4.3 Demand Notes Issued to U. S. Treasury 246
9.4.4 Other Borrowed Money 246
9.4.5 Mortgage Indebtedness/Capitalized Leases 247
9.4.6 Bank’s Liability on Acceptances Executed and
Outstanding 247
9.4.7 Subordinated Notes and Debentures 247
9.4.8 Other Liabilities 247
9.5 Off-Balance Sheet Items 247
9.6 Composition of Bank Capital 248
9.6.1 Par Value of Stock 248
9.6.2 Surplus 248
9.6.3 Undivided Profits 249
9.6.4 Capital Reserves 249
Contents xiii
9.7 Regulatory Capital Components 249
9.7.1 Capital Components—Banks 249
9.7.2 Capital Components—Bank Holding Companies 251
9.8 Risk-Based Capital 252
9.9 Value-at-Risk (VAR) Models 255
9.10 Composition of Bank Income 256
9.10.1 Interest Income 256
9.10.2 Noninterest Income 257
9.10.3 Extraordinary Gains (Losses) 258
9.11 Composition of Bank Expenses 258
9.11.1 Interest Expense 258
9.11.2 Noninterest Expense 259
9.11.3 Provision for Loan and Lease Losses and Allocated
Transfer Risk 260
9.11.4 Income Taxes 260
9.12 Balance Sheet Analysis Illustration 261
9.12.1 Asset Growth Rates 266
9.12.2 Asset Composition 266
9.12.3 Asset Composition—Peer Group Comparison 266
9.12.4 Liability Growth Rates 267
9.12.5 Liability Composition 267
9.12.6 Liability Composition—Peer Group Comparison 267
9.12.7 Capital Levels and Trends 267
9.13 Income Statement and Profitability Analysis Illustration 267
9.13.1 Overall Income and Expenses 272
9.13.2 Sources of Profitability 272
9.14 Loan Risk Analysis Illustration 273
9.14.1 The Magnified Impact of Loan Losses 273
9.14.2 Delinquent and Classified Loan Analysis 274
9.14.3 Historical Loan Risk Analysis 277
9.15 Liquidity and Investment Portfolio Analysis Illustration 277
9.16 Portfolio Equities Analysis (Realm Model) 278
9.17 Special Bank Holding Company Considerations 278
Chapter 10 Internal Characteristics Assessment 280
10.1 Objectives and Benefits of an Internal Characteristics
Assessment 281
10.2 The “Ten P Factor”Framework 281
10.2.1 Profits 282
10.2.2 People 283
10.2.3 Personality 285
10.2.4 Physical Distribution 286
10.2.5 Portfolio 287