Post on 10-Apr-2018
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Required Returns:Cost of Equity (ke)
Capital Asset Pricing Model:
ke = Rf+ (Rm Rf) + FSP
Where Rf = risk free rate of return
= beta
Rm = expected rate of return on equities
Rm Rf = 5.5% (i.e., its historical average since1963)
FSP = firm size premium
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Estimates of Size Premium
Market Value (000,000)
>$12,400$5,250 to $12,400$2,600 to $5,250
$1,650 to $2,600.$700 to $1,650$450 to $700$250 to $450$100 to $250$50 to $100
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Required Returns: Cost of Capital
Weighted Average Cost of Capital (WACC):
WACC = ke x E + i (1-t) x D + kpr x __PR__(E+D+PR) (E+D+PR) (E+D+PR)
Where E = the market value of equityD = the market value of debt
PR = the market value of preferred stockke = cost of equitykpr= cost of preferred stocki = the interest rate on debt
t = the firms marginal tax rate
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Analyzing Risk
Risk consists of a diversifiable and non-diversifiablecomponent
Beta () is a measure of non-diversifiable risk
Beta is estimated by regressing stock returns (Rj)against market returns (Rm). The intercept provides a
measure of Rjs performance vs. market relative to whatCAPM would have predicted.
Rj = a + Rm (regression equation formulation)
Rj = Rf+ (Rm Rf) = Rf+RmRf= Rf(1-) + Rm(CAPM formulation)
If a > Rf(1-), Rj outperformed the CAPM estimate.
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Effects of Leverage on Beta
Leveraged vs. Unleveraged Betas:
l = u (1 + (1-t) (D/E)) ( Leveraged beta)
u = Bl / (1 + (1-t) (D/E)) ( Unleveraged beta)
Where l and u are leveraged and unleveraged betas, respectively.
Implications:
--Increasing levels of debt relative to equity, which raise the firmsbreakeven point, increase shareholder risk associated with the firm.
--The tax shelter effects provided by the tax deductibility of interestreduce shareholder risk by increasing after-tax cash available forshareholders.
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Calculating Free Cash Flowto Equity Investors (FCFE)
FCFE (equity cash flow) represents cash flow available forpaying dividends or repurchasing common equity, aftertaxes, debt repayments, new issues, and allreinvestment requirements.
FCFE = (Net Income + Depreciation - Net WorkingCapital1)2 Gross Capital Expenditures3 + (NewPreferred Equity Issues Preferred Dividends + NewDebt Issues Principal Repayments)4
1Excludes cash in excess of normal operating requirements.2Cash from operating activities.3Cash from investing activities.4Cash from financing activities.
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Calculating Free Cash Flowto the Firm (FCFF)
FCFF (enterprise cash flow) is cash flow available to repaylenders and/or pay common and preferred dividends andrepurchase equity, after taxes and reinvestmentrequirements but before debt repayments.
FCFF = (Earnings before interest & taxes (1-tax rate) +Depreciation Net Working Capital1)2 Gross CapitalExpenditures3
1Excludes cash in excess of normal operating requirements.2Cash from operating activities.3Cash from investing activities.
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Comparing Free Cash Flowto the Firm and to Equity
Free Cash Flowto the Firm
Free Cash Flowto Equity
Cash from Operating
Activities
40 40
Cash from InvestingActivities
(22) (22)
Cash from FinancingActivities
(10)
Total Cash Flow 18 8
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Things to Remember
CAPM is widely used to estimate COE Weights for WACC should reflect the acquiring firms
target capital structure
Pre-tax cost of debt for non-rated firms can be
approximated by comparison with similarly ratedfirms.
FCFF is widely used for valuing target firms becauseit does not require an estimate of financing needs.
FCFE is used primarily in the absence of debt or forvaluing equity in leveraged buyouts and financialservice firms.
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Commonly Used Discounted Cash
Flow Valuation Methods
Zero Growth Model
Constant Growth Model
Variable Growth Model
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Zero Growth Model
Free cash flow is constant in perpetuity.
P0 = FCFF0 / WACC, where FCFF0 is free cash
flow to the firm and WACC is the weightedaverage the cost of capital
P0 = FCFE0 / ke where FCFE0 is free cash flowto equity investors and ke is the cost of
equity
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Zero Growth Model Example
What is the value of a firm, whose annualFCFF0 of $1 million is expected to remainconstant in perpetuity and whose weightedaverage cost of capital is 12%.
P0
= $1 / .12 = $8.3 million
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Constant Growth Model
Cash flow next year (i.e., FCFF1, the first year of the
forecast period) is expected to grow at a constant rate.
FCFF1=FCFF0(1+g)
P0 = FCFF1 / (WACC-g), where g is the expected rate of
growth of FCFF1.
P0 = FCFE1 / (ke g), where g is the expected rate of
growth of FCFE1.
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Constant Growth Model Example
Estimate the value of a firm (P0) whose cost ofequity is 15% and whose cash flow in the prioryear is projected to grow 20% in the current yearand then at a constant 10% annual ratethereafter. Cash flow in the prior year is $2million.
P0 = ($2 x 1.2)(1.1) / (.15 - .10) = $52.8 million
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Variable Growth Model
Cash flow exhibits both a high and a stable growthperiod.
High growth period: The firms growth rate exceeds arate that can be sustained long-term.
Stable growth period: The firm is expected to grow at arate that can be sustained indefinitely (e.g., industryaverage growth rate).
Discount rates: Reflecting the slower growth rate duringthe stable growth period, the discount rate during the
stable period should be lower than doing the high growthperiod (e.g., industry average discount rate).
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Variable Growth Model Example
Estimate the value of a firm (P0) whosecash flow is projected to grow at acompound annual average rate of 35% forthe next five years and then assume a
more normal 5% annual growth rate. Thecurrent years cash flow is $4 million. Thefirms weighted average cost of capitalduring the high growth period is 18% and
then drops to the industry average rate of12% beyond the fifth year.
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Variable Growth Model ExampleSolution
PV1-5 = $4 x 1.35 + $4 x (1.35)2 + $4 x (1.35)3 +
(1.18) (1.18)2 (1.18)3
$4 x (1.35)4 + $4 x (1.35)5
(1.18)4 (1.18)5
= $30.5
PV5 = (($4 x (1.35)5 x 1.05)) / (.12 - .05) = $117.65
(1.18)5
P0 = PV1-5 + PV5 = $30.5 + $117.65 = $148.15
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Determining Growth Rates
Key premise: A firms value can be approximated by thesum of the high growth plus a stable growth period.
Key risks: Sensitivity of terminal values to choice ofassumptions about stable growth rate and discount ratesused in both the terminal and annual cash flow periods.
Stable growth rate: The firms growth rate that isexpected to last forever. Generally equal to or less thanthe industry or overall economys growth rate. Formultinational firms, the growth rate is the world
economys rate of growth. Length of the high growth period: The greater the current
growth rate of a firms cash flow relative to the stablegrowth rate, the longer the high growth period.
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Adjusting Firm Value
Generally, the value of the firms equity is the sum of the present
value of the firms operating assets and liabilities plus terminal valueless market value of firms long-term debt.
However, value may be under or overstated if not adjusted forpresent value of non-operating assets and liabilities assumed by theacquirer.
PVFCFE = PVFCFF (incl. terminal value) PVD + PVNOA PVNOL
where PVFCFE = PV of free cash flow to equity investors
PVFCFF = PV of free cash flow to the firm
PVD = PV of debt
PVNOA = PV of non-operating assets
PVNOL = PV of non-operating liabilities
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Adjusting Firm Value Example
A target firm has the following characteristics:
An estimated enterprise value of $104 million
Long-term debt whose market value is $15 million
$3 million in excess cash balances
Estimated PV of currently unused licenses of $4million
Estimated PV of future litigation costs of $2.5 million
2 million common shares outstanding
What is the value of the target firm per common share?
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Adjusting Firm Value ExampleContd.
Enterprise Value $104
Plus: Non-Operating Assets
Excess Cash Balances
PV of Licenses
$3
$4
Less: Non-Operating Liabilities
PV of Potential Litigation $2.5
Less: Long-Term Debt $15
Equals: Equity Value $93.5
Equity Value Per Share $46.75
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Things to Remember
Zero growth model: Cash flow is expected to remain
constant in perpetuity. Constant growth model: Cash flow is expected to
grow at a constant rate.
Variable growth model: Cash flow exhibits both a
high and a stable growth period. Total present value represents the sum of thediscounted value of the cash flows over bothperiods.
The terminal value frequently accounts for most of
the total present value calculation and is highlysensitive to the choice of growth and discountrates.
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Applying Relative, Asset Oriented,
and Real Option Valuation Methods
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Applying Market-Based(Relative Valuation) Methods1
MVT = (MVC / IC) x IT
Where
MVC = Market value of the comparable company C
IC = Measure of value for comparable company C
IT = Measure of value for company T
(MVC/IC) = Market value multiple for the comparablecompany
1Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm.
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Market-Based Methods: Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MVC/VIC):
Comparable CompanyTrailing
P/E1Forward
P/E2Price/Sales Price/Book
Average
Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4
Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71
British Petroleum (BP) 9.18 7.68 0.69 2.17
Chevron Corp (CVX) 10.79 8.05 0.91 2.54Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86
ConocoPhillips (COP) 11.92 6.89 0.77 1.59
Total SA (TOT) 8.75 8.73 0.80 2.53
Eni SpA (E) 3.17 7.91 0.36 0.81
PetroChina Co. (PTR) 11.96 10.75 1.75 2.10
Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16
Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49
Equals Estimated Value of Target $40.72 $27.42 $81.77 $57.32 $51.81
1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars.
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Market-Based Methods:Recent Transactions Method1
Calculation similar to comparable companiesmethod, except multiples used to estimatetargets value based on purchase prices of
recently acquired comparable companies. Most accurate method whenever the transaction
is truly comparable and very recent.
Major limitation is that truly comparable recenttransactions are rare.
1Also called precedent method.
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Market-Based Methods:Same or Comparable Industry Method
Multiply targets earnings or revenues bymarket value to earnings or revenue ratiosfor the average firm in targets industry or
a comparable industry. Primary advantage is the ease of use and
availability of data.
Disadvantages include presumptionindustry multiples are actually comparableand analysts projections are unbiased.
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PEG Ratio
Used to adjust relative valuation methods for differences in growth
rates among comparable firms. Helpful in determining which of a number of different firms in same
industry exhibiting different growth rates may be the most attractive.
(MVT/VIT) = A and
VITGR
MVT = A x VITGR x VIT
Where A = Market price to value indicator relative to the growth rateof
value indicator (e.g., (P/E)/ EPS growth rate)MVT = Market value of target
VIT = Value indicator for target (e.g., EPS)
VITGR = Projected growth rate in value indicator (e.g., EPS)
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Applying the PEG Ratio
An analyst is asked to determine whether Basic Energy Service (BAS) or CompositeProduction Services (CPS) is more attractive as an acquisition target. Both firms provideengineering, construction, and specialty services to the oil, gas, refinery, and petrochemicalindustries.BES and CPS have projected annual earnings per share growth rates of 15 percent and 9percent, respectively. BES and CPS current earnings per share are $2.05 and $3.15,respectively. The current share prices as of June 25, 2008 for BAS is $31.48 and for CPX is
$26. The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent,respectively. Based on this information, which firm is a more attractive takeover target as ofthe point in time the firms are being compared?
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Industry average PEG ratio:1 12.4/.11 = 112.73
BAS: Implied share price = 112.73 x .15 x $2.05 = $34.66CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96Answer: The difference between the implied and actual share prices for BAS and CPXis $3.18 (i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is moreundervalued than BAS at that moment in time.
1Solving MVT = A x VITGR x VIT using an individual firms PEG ratio provides the firms
current or share price in period T, since this formula is an identity. An industry averagePEG ratio may be used to provide an estimate of the firms intrinsic value. This implicitlyassumes that both firms exhibit the same relationship between price-to-earnings ratiosand earnings growth rates.
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Asset-Based Methods:Tangible Book Value
Tangible book value (TBV) = (total assets - totalliabilities - goodwill)
Targets estimated value = Targets TBV x[(industry average or comparable firm marketvalue) / (industry or comparable firm TBV)].
Often used for valuing Financial services firms where tangible book
value is primarily cash or liquid assets
Distribution firms where current assetsconstitute a large percentage of total assets
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Valuing Companies Using Asset Based Methods
Ingram Micro distributes information technology products worldwide. The firms share
price on 8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and thefirms beta is .89. Shareholders equity is $3.4 billion and goodwill is $.7 billion. Ingramhas 172 million (.172 billion) shares outstanding. The following firms represent Ingramsprimary competitors.
Market Value/Tangible Book Value
Beta Projected 5-Year NetIncome Growth Rate
(%)Tech Data .91 .90 11.6
Synnex Corporation .70 .40 6.9
Avnet 1.01 1.09 12.1
Arrow .93 .97 13.2Based on this information, what is Ingrams tangible book value per share (VIT)? What isthe appropriate industry average market value to tangible book value ratio (MVIND/VIIND)?Estimate the implied market value per share for Ingram (MVT) using tangible book valueas a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it8/21/08 share price?
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Asset-Based Methods: Liquidation Method
Value assets as if sold in an orderly fashion (e.g., 9-12months) and deduct value of liabilities and expensesassociated with asset disposition.
While varies with industry,
Receivables often sold for 80-90% of book value
Inventories might realize 80-90% of book book valuedepending on degree of obsolescence and condition
Equipment values vary widely depending on age andcondition and purpose (e.g., special purpose)
Book value of land may understate market value Prepaid assets such as insurance can be liquidatedwith a portion of the premium recovered.
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Asset-Based Method: Break-Up Value
Target viewed as series of independent operatingunits, whose income, cash flow, and balance sheetstatements reflect intra-company sales, fully-allocated costs, and operating liabilities specific toeach unit
After-tax cash flows are valued using market-basedmultiples or discounted cash flows analysis todetermine operating units current market value
The units equity value is determined by deducting
operating liabilities from current market value Aggregate equity value of the business is determined
by summing equity value of each operating unit lessunallocated liabilities and break-up costs
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Replacement Cost Method
All target operating assets are assigned avalue based on what it would cost to replacethem.
Each asset is treated as if no additional value
is created by operating the assets as part of agoing concern.
Each assets value is summed to determinethe aggregate value of the business.
This approach is limited if the firm is highlyprofitable (suggesting a high going concernvalue) or if many of the firms assets areintangible.
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Weighted Average ValuationMethod
An analyst has estimated the value ofa company using multiplevaluation methodologies. Thediscounted cash flow value is$220 million, comparabletransactions value is $234 million,the P/E-based value is $224million and the liquidation value is$150 million. The analyst hasgreater confidence in certainmethodologies than others.Estimate the weighted average
value of the firm using all valuationmethodologies and the weights orrelative importance the analystgives to each methodology.
Estimated
Value ($M)
Relative
Weight
Weighted
Avg. ($M)
220 .30 66.0
234 .40 93.6
224 .20 44.8
150 .10 15.0
1.00 219.4
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Real Options as Applied to M&As
Real options refer to managements ability to adopt and later revisecorporate investment decisions (e.g., acquisitions)
Options to expand (i.e., accelerate investment)
Acquirer accelerates investment in target after acquisitioncompleted due to better than anticipated performance of the
target Options to delay (i.e., postpone timing of initial investment)
Acquirer delays completion of acquisition until a patent pendingreceives approval
Options to abandon (i.e., divest or liquidate initial investment)
Acquirer divests target firm due to underperformance andrecovers a portion of its initial investment
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Alternative Real OptionValuation Methods
Develop a decision tree for which the NPV of eachbranch represents the value of alternative real options.The options value is equal to difference between its
NPV and the NPV without the real option. Treat the real options as financial options and valueusing the Black-Scholes method.
Option to expand or delay are valued as call optionsand added to the NPV of the investment without theoption.
Option to abandon is valued as a put option andadded to the NPV of the investment without theoption.
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Base Case:Microsoft offers tobuy all outstandingshares of Yahoo
Option to postponecontingent onYahoos rejectionof offer
Option to abandoncontingent onfailure to integrateYahoo & MSN
Option to expandcontingent on
successfulintegration ofYahoo & MSN
Purchase Yahooonline searchbusiness only. Buyremaining
businesses later.
Offer same/lowerprice for all ofYahoo if boardcompositionchanges
Spin-off combinedYahoo & MSN to
Microsoftshareholders
Divest combinedYahoo & MSN.Use proceeds topay dividend orbuy back stock.
Analyzing Microsofts Real Options inIts Attempted Takeover of Yahoo
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Things to Remember
Alternatives to discounted cash flow analysis include the
following: Market based methods
Comparable companies
Recent transactions
Same or comparable industries
Asset based methods Tangible book value
Liquidation value
Break-up value
Replacement cost method
Weighted average method Firm value must be adjusted for both non-operating assets and
liabilities.
Real options should be considered in M&A valuation whenclearly identifiable and when would add significantly toinvestments value
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Using Financial ModelingTechniques to Value and
StructureMergers & Acquisitions
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M&A Model Building Process
Step 1: Value acquirer and target as standalone
firms
Step 2: Value acquirer and target firms including
synergy
Step 3: Determine initial offer price for target
firm
Step 4: Determine the combined firms ability tofinance the transaction
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Step 1: Value Acquirer & Target asStandalone Firms
Understand determinants of profits and cash flow, i.e.,bargaining strength of
Customers (size, number, price sensitivity)
Current competitors (market share, differentiation)
Potential entrants (entry barriers, relative costs) Substitutes (availability, prices, switching costs)
Suppliers (size, number, uniqueness)
relative to industry participants.
Normalize 3-5 years of historical financial information Project normalized cash flow based on expected market
growth and changes in profits/cash flow determinants.
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Step 2: Value Acquirer & Target FirmsIncluding Synergy
Estimate
Sources and destroyers of value
Implementation costs incurred to realizesynergy
Consolidate acquirer and target projectedfinancials including the effects of synergy
Estimate net synergy (consolidated firms lessvalues of target and acquirer)
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Adjusting Combined Acquirer/Target CompanyProjections For Estimated Synergy
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales1 $200 $220 $242 $266 $293
Cost of sales2 $160 $176 $194 $213 $234
Anticipated Cost Savings
Direct labor $2 $4 $6 $8 $8Indirect labor $1 $2 $4 $4 $4
Purchased materials $2 $3 $5 $5 $5
Selling expenses $1 $3 $5 $5 $5
Total $6 $12 $20 $22 $22
Cost of sales (incl. synergy) $154 $164 $174 $191 $212
Cost of sales/Net sales 77.0% 74.6% 71.9% 71.8% 72.4%
1Combined company net sales projected to grow 10% annually during forecast period.2Cost of sales before synergy assumed to be 80% of net sales during forecast period.
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Step 3: Determine Initial Offer Pricefor Target Firm
Estimate minimum and maximumpurchase price range
Determine amount of synergy willing toshare with target shareholders
Determine appropriate composition of offerprice
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Calculating Initial Offer Price (PVIOP)
1. PVMIN = PVT or PVMV, whichever is greater for a stock purchase
(liquidation value of net acquired assets for an asset purchase)2. PVMAX = PVMIN + PVNS, where PVNS = PVSOV PVDOV3. PVMAX = PVMIN + PVNS4. PVIOP = PVMIN + PVNS, where 0 1
Offer price range = (PVT or MVT) < PVIOP < (PVT or MVT) + PVNS
Where PVMIN = PV minimum purchase price
PVT = PV standalone value of target firm
PVMV = Market value target firm
PVMAX = PV maximum purchase price
PVNS = PV of net synergy
PVSOV = PV of sources of value
PVDOV = PV of destroyers of value = Portion of net synergy shared with target company shareholders
How is determined?
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Step 4: Determine Combined FirmsAbility to Finance Transaction
Estimate impact of alternative financingstructures
Select financing structure that
Meets acquirers required financial returnsand desired financial structure;
Meets targets primary financial and non-financial needs;
Does not raise borrowing costs; and
Is supportable by the combined firms.
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Calculating EPS andPost-Merger Share Price
Acquiring Company is consideringthe acquisition of TargetCompany in a share for sharetransaction in which TargetCompany would receive$84.30 for each share of itscommon stock. AcquiringCompany does not expect anychange in its price/earningsmultiple after the merger.
Selected data are presentedas follows:
AcquiringCompany
TargetCompany
NetEarnings
$281,500 $62,500
SharesOutstanding
112,000 18,750
MarketPrice PerShare
$56.25 $62.50
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Calculating EPS andPost-Merger Share Price: Solution
1. Exchange ratio = Price per share offered for Target Company/ Priceper share for Acquiring Company = $84.30 / $56.25 = 1.5
2. New shares issued by Acquiring Company = 18,750 (shares of TargetCompany) x 1.5 (share exchange ratio) = 28,125
3. Total shares outstanding of the combined firms = 112,000 + 28,125 =
140,1254. Post merger EPS of the combined firms = ($281,500 + $62,500) /
140,125 = $2.46
5. Pre merger P/E = Pre-merger price per share / pre-merger EPS =56.25 /($281,500/112,000) =$56.25/$2.51 = 22.4
6. Post-merger share price = Post-merger EPS x Pre-merger P/E = $2.46x 22.4 = $55.10 (as compared to $56.25 pre-merger share price)
Note: Example assumes no increase in EPS due to synergy for simplicity.
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Model Worksheet Layout1
Assumptions Section
Historical Period Forecast Period
1Refers to model template contained on CDROM accompanying textbook.
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Using M&A Model Template1
Model worksheet layout: Assumptions (top panel); historical perioddata (lower left panel); forecast period data (lower right panel).
Displaying Microsoft Excel formula results on a worksheet:
On Tools menu, click Options, and then click the View Tab.
To display formulas in cells, select the formulas check box; to
display the formulas results, clear the check box. In place of existing historical data, fill in the data in cells notcontaining formulas. Do not delete existing formulas in historicalperiod unless you wish to customize the model.
Do not delete or change formulas in the forecast period cellsunless you wish to customize the model. To replace existing data,change the forecast assumptions at the top of the spreadsheet.
1Refers to model template found on CDROM accompanying textbook.
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Model Historical Data Input Requirements:Income Statement1
Net sales
Depreciation expense
Total cost of sales
Sales expense
General and administrative expense
Amortization of intangibles
Other expense (income) net
Interest income
Interest expense
Taxes1Note these income statement line items may not correspond exactly to those shown on the acquirers or targets
financial statements. The analyst should insert new rows in the model on the CDROM accompanying thistextbook to reflect the data categories that are available.
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Model Historical Data Input Requirements:Balance Sheet1
Cash Other current assets Gross fixed assets Accumulated depreciation and amortization Other assets Current liabilities Existing long-term debt Other liabilities Common Stock
Retained earnings Shares outstanding1Note these balance sheet line items may not correspond exactly to those shown on the acquirers or targets financial
statements. The analyst should insert new rows in the model on the CDROM accompanying this textbook toreflect the data categories that are available.
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Model Balance Sheet AdjustmentMechanism Methodology
Separate current assets into operating and non-operatingassets.
Operating assets include minimum operating cashbalances and other operating assets (e.g., receivables,inventories, and assets such as prepaid items).1
Current non-operating assets are investments (i.e., cashgenerated in excess of minimum operating balancesinvested in short-term marketable securities).
The firm issues new debt whenever cash outflows exceedcash inflows.
The firms investments increase whenever cash outflowsare less than cash inflows.1Minimum cash balances determined by analyzing the firms cash conversion cycle or by
computing the average ratio of cash balances to net revenue over some prior periodtimes current net revenue..
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Model Balance Sheet AdjustmentMechanism Illustration
Assets Liabilities
Current Operating Assets
Cash Needed for Operations (C)
Other Current Assets (OCA)
Total Current Operating Assets (TCOA)
Short-Term (Non-Oper.) Investments (I)Net Fixed Assets (NFA)
Other Assets (OA)
Total Assets (TA)
Current Liabilities (CL)
Other Liabilities (OL)
Long-Term Debt (LTD)Existing Debt (ED)
New Debt (ND)
Total Liabilities (TL)
Shareholders Equity (SE)
Cash Outflows Exceed Cash Inflows: If (TA I)>(TL ND) + SE, ND > 0 (i.e., thefirm must borrow), otherwise ND = 0
Cash Outflows Less Than Cash Inflows: If (TA I) < (TL ND) + SE, I > 0 (i.e.,the firms non-operating cash increases), otherwise I = 0
Cash Outflows Equal Cash Inflows: If (TA I) = (TL ND) + SE = 0, ND=I= 0
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Estimating Interest Expense
IEXP = (DEOY + DBOY)/2 x i, where DEOY = DBOY - DPRP
where
DEOY = End of year debt balanceDBOY = Beginning of year debt balance
DPRP = Annual principal repayment
IEXP = Dollar value of annual interest expense
i = Weighted average interest rate
D bt R t S h d l
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Debt Repayment Schedule
Total Debt
12/31/05
2006 2007
MaturitySchedule MaturingAmount Interest Rate MaturingAmount Interest Rate
Long-TermDebt
$690,710 0 0 $190,710 5.5%
Medium Term $540,500 $30,500 7.5% $30,000 7.5%
Mortgage Debt $42,380 $694 10.15% $767 10.15%
Total $1,273,590 $31,194 7.559% $221,477 5.787%
RemainingBalance
1/1/06 EndingBalance
Interest Rate EndingBalance
Interest Rate
Long-Term
Debt
$690,710 $690,710 5.5% $500,000 5.5%
Medium Term $540,500 $510,000 7.5% $480,000 7.5%
Mortgage Debt $42,380 $41,686 10.150% $40,919 10.15%
Total $1,273,590 $1,242,396 6.477% $1,020,919 6.627%
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Hints on Using Financial Models
Ensure Excels Iteration Command is on toaccommodate circular references inherent in themodel.
For example, cash and investments affects interestincome, which in turn impacts net income and cashand investments.
To turn on the iteration command,
On the menu bar, click on Tools >>> Options >>>Calculations
Select iteration and specify the maximum number ofiterations and the amount of change.
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Things to Remember Financial modeling facilitates the process of
valuation, deal structuring, and selection of theappropriate financing plan.
The process entails the following four steps:
Valuing the acquirer and target firms asstandalone businesses using multiple valuation
methods Valuing consolidated acquirer and target firms
including the effects of net synergy
Determining the initial offer price for the target firmfrom within the price range defined by theminimum and maximum purchase prices
Determining the combined firms ability to financeinitial offer price
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Analyzing Privately
Held Companies
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What is a Private Firm?
A firm whose securities are not registeredwith state or federal authorities
Without registration, their shares cannotbe traded in the public securities markets.
Share ownership usually heavily
concentrated (i.e., firms closely held)
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Key Characteristics ofPrivately Held U.S. Firms
There are more than 28 million firms in the U.S.
Of these, 7.4 million have employees, with therest largely self-employed, unincorporatedbusinesses
M&A market in U.S concentrated amongsmaller, family-owned firms
-- Firms with 99 or fewer employees account for98% of all firms with employees
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Percent Distribution of U.S. Firms FilingIncome Taxes in 2004
Proprietorships
Partnerships
Corporations
72%
9%
19%
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Family-Owned Firms
89% of U.S. businesses family owned
Major challenges include:
succession,
lack of corporate governance,
informal management structure,
less skilled lower level management, and
a preference for ownership over growth.
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Governance Issues
What works for public firms may not for privatecompanies
Market model relies on dispersed ownership
with ownership & control separate Control model more applicable where
ownership tends to be concentrated and theright to control the business is not fully separate
from ownership (e.g., small businesses)
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Steps Involved in Valuing PrivatelyHeld Businesses
1. Adjust target firm data to reflect truecurrent profitability and cash flow
2. Determine appropriate valuation
methodology (e.g., DCF, relativevaluation, etc.)
3. Estimate appropriate discount(capitalization) rate
4. Adjust firm value for liquidity risk, valueof control, or minority risk if applicable
S
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Step 1: Adjusting the IncomeStatement
Owner/officers salaries
Benefits
Travel and entertainment
Auto expenses and personal life insurance
Family members
Rent or lease payments in excess of fair marketvalue
Professional service fees
Depreciation expense
Reserves
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Areas Commonly Understated
When a business is being sold, the following expensecategories are often understated by the seller:
The marketing and advertising expenditures required
to support an aggressive revenue growth forecast Training sales forces to market new products
Environmental clean-up (long-tailed liabilities)
Employee safety
Pending litigation
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Areas Commonly Overlooked When a business is being sold, the following asset
categories are often overlooked by the buyer aspotential sources of value:1
Customer lists
Intellectual property
Licenses
Distributorship agreements
Leases
Regulatory approvals
Employment contracts
Non-compete agreements
How might you value each of the above items?1For these items to represent sources of incremental value they must represent sources of revenue or
cost reduction not already reflected in the targets cash flows.
Adjusting the Targets Financial Statements
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Adjusting the Target s Financial Statements
TargetsStatements
NetAdjustments
AdjustedStatements
Comments
Revenue 8000 8000
Cost of Sales 5000 (400) 4600 Convert LIFO to FIFO
Depreciation 100 (40) 60 Convert accelerated tostraight line
Selling: Salaries/Benefits 1000 (100) 900 Eliminate family member
Selling: Rent 200 (100) 100 Eliminate sales offices
Selling: Insurance 20 (5) 15 Reduce premiums
Selling: Advertising 20 10 30 Increase advertising
Selling: Travel & Enter 250 50 300 Increase travel
Admin.: Salaries/Benefits 600 (100) 500 Reduce owners pay
Admin: Rent 150 (30) 120 Reduce office space
Admin: Directors/Prof. Fees 280 (40) 240 Reduce fees
Total Expenses 7620 (755) 6865
EBIT 380 1135
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Discussion Questions
1. Why is it often more difficult to value privatelyowned companies than publicly traded firms?Give specific examples.
2. Why is it important to restate financialstatements provided to the acquirer by thetarget firm? Be specific.
3. How could an analyst determine if the target
firms cost and revenues are understated oroverstated? Give specific examples.
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Step 2: Determine AppropriateValuation Methodology
Income or DCF approach
Relative or market-based approach
Replacement cost approach
Asset-oriented approach
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Capitalization Multiples
Methods: Perpetuity or constant growth Assume discount rate is 8% and firms current
cash flow is $1.5 million. Multiples in brackets.
--If cash flow expected to remain level inperpetuity, the implied valuation is
[1/.08] x $1.5 = $18.75 million
--if cash flow expected to grow 4 percent
annually in perpetuity, the implied valuation is
[(1.04) / (.08 - .04)] x $1.5 = $39.0 million
St 3 S l t A i t Di t
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Step 3: Select Appropriate Discount(Capitalization) Rates
Capital asset pricing model (CAPM) Estimate firms beta based on comparable publicly
listed firms1
Adjust for specific business risk2
Cost of capital
Cost of debt based on what public firms of comparablerisk are paying3
Weights reflect managements target debt to equityratio or industry average ratio4
1Assuming private firm leveraged, estimate private firms leveraged beta based on unlevered beta forcomparable publicly firms adjusted for private firms target debt to equity ratio. Alternatively, use
industry average ratio assuming firms target D/E will move to industry average..2Difference between junk bond rate and risk-free rate, return on OTC small stock index and risk-freerate, or Ibbotsons suggested firm size adjustments3Assuming firms with similar interest coverage ratios will have similar credit ratings, estimate what
private firms credit rating would be and base its pre-tax cost of borrowing on a comparably ratedpublic firms cost of borrowing.4Dividing D/E by 1/(1+D/E) converts D/E into a debt to total capital ratio, which subtracted from onegives the equity to total capital ratio
St 4 Adj t Fi V l f Li idit
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Step 4: Adjust Firm Value for LiquidityRisk, Value of Control, or Minority Risk
Discount Applied to Firm Value
Liquidity risk: Reflects potential loss in value when anasset is sold in an illiquid market
Minority risk: Reflects lack of control associated withminority ownership. Risk varies with size of ownershipposition
Premium Applied to Firm Value Value of control: Ability to direct activities of the firm
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Liquidity Discount
Liquidity is the ease with which investors can sell theirstock without a serious loss in the value of theirinvestment.
A liquidity discount is a reduction in the offer price for thetarget firm by an amount equal to the potential loss ofvalue when sold due to the lack of liquidity in the market.
Recent studies suggest a median liquidity discount ofapproximately 20% in the U.S.
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Control Premium
Purchase price premium represents amount a buyer pays seller inexcess of the sellers current share price and includes both asynergy and control premium
Control and synergy premiums are distinctly different
--Value of synergy represents revenue increases and cost savings
resulting from combining two firms, usually in the same line of
business--Value of control provides right to direct the activities of the target
firm (e.g., change business strategy, declare dividends, and
extract private benefits)
Country comparisons indicate huge variation in median control
premiums from 2-5% in countries with relatively effective investorprotections (e.g., U.S. and U.K.) to as much as 60-65% in countrieswith poor governance practices (e.g., Brazil and Czech Republic).
Median estimates across countries are 10 to 12 percent.
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Minority Discount
Minority discounts reflect loss of influence due tothe power of controlling block shareholder.
Investors pay a higher price for control of a
company and a lesser amount for a minoritystake.
Implied Median Minority Discount =
1 [1/(1 + median control premium paid)]
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Adjustments to Firm Value
PVMAX = (PVMIN + PVNS)(1 + CP%)(1 LD%) and
PVMAX = (PVMIN + PVNS)(1 LD% CP% CP% x LD%)
Where PVMAX = Maximum purchase price
PVMIN = Minimum firm valuePVNS = Net synergy
LD% = Liquidity discount (%)
CP% = Control premium or minority discount (%)
CP% x LD% = Interaction of these factors11As a stock becomes less liquid, investors see greater value in more control. Therefore, larger liquidity
discounts are associated with larger control premiums.
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Incorporating Liquidity Risk, Control Premiums,and Minority Discounts in Valuing a Private Business
LGI wants to acquire a controlling interest in Acuity Lighting, whose estimated standalone equityvalue equals $18,699,493. LGI believes that the present value of synergies is $2,250,000. LGIbelieves that the value of Acuity, including synergy, can be increased by at least 10 percent byapplying professional management methods and by reducing the cost of borrowing by financingthe operations through the holding company. To achieve these efficiencies, LGI must gain controlof Acuity. LGI is willing to pay a control premium of as much as 10 percent. LGI reduces themedian 20% liquidity discount by 4% to reflect Acuitys high financial returns and cash flow growthrate. What is the maximum purchase price LGI should pay for a 51 percent controlling interest inthe business? For a minority 20 percent interest in the business?
To adjust for presumed liquidity risk of the target firm due to lack of a liquid market, LGI discountsthe amount it is willing to offer to purchase 50.1 percent of the firms equity by 16 percent.
PVMAX = ($18,699,493 + $2,250,000)(1 - .16)(1 + .10)) x .501= $20,949,493 x .924 x .501= $9,698,023
If LGI were to acquire only a 20 percent stake in Acuity, it is unlikely that there would be any
synergy, because LGL would lack the authority to implement potential cost saving measureswithout the approval of the controlling shareholders. Because it is a minority investment, there isno control premium, but a minority discount for lack of control should be estimated. The minoritydiscount is estimated using Equation 10-3 in the textbook (i.e., 1 (1/(1 + .10)) = 9.1).
PVMAX = ($18,699,493 x (1- .16)(1 -.091)) x .2 = $2,855,637
Thi R b
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Things to Remember The U.S. M&A market is concentrated among small,
family-owned firms. Valuing private firms is more challenging than public
firms because of the dearth of reliable, timely data.
The purpose of recasting private company
statements is to calculate an accurate current profitor cash flow number.
Maximum offer prices should be adjusted for aliquidity discount and control premium If the marketfor the firms equity is illiquid and a controlling interest
is desired
Maximum offer prices for a minority interest in a firmshould be adjusted for a minority discount.