Questions

Chapter 1 Questions and Answers

1. “Best practice in M&A requires that we augment the deterministic focus on structure with a

probabilistic focus on conduct.” What does this mean?

Structural factors drive success in M&A. These are distinct—they are the resources and

constraints one operates within—and can easily be rattled off: economic opportunity,

strategy, organization, brand, etc. We can have a deterministic mindset about these factors

and say, “If X structure is present, Y is the outcome.” However, M&A success is also driven

by conduct, which lends itself less easily to such clear boundaries and definition, and is

therefore more probabilistic. Best practice in M&A must therefore take in both a

deterministic focus on structure, and a probabilistic focus on conduct.

2. The chapter described six elements of structure that influence M&A transactions. What are

these and how do they influence success or failure in M&A?

The six elements of structure are:

Economics of the

opportunity

Ultimately, the success of an M&A deal is evaluated based on

whether it creates or destroys value—does the M&A investment

generate returns (cash) above the cost of capital? M&A

practitioners must therefore pay careful attention to the

economics of a deal – its cash flows, expected revenues and costs,

synergies, financial impact, capital costs, and returns.

Strategy The strategic dimension of structure refers to the firm’s resources

and competitive position within which it must operate. These are

summarized in terms of its strengths, weaknesses, opportunities

and threats (SWOT)—and whether and how these can be

addressed by M&A. Proactive and critical analysis of strategy is

crucial to success in M&A.

Organization The ability of merging firms to mesh well will depend in part on

organizational issues such as organization structure (who reports

to whom), culture, and leadership.

“Brand” The reputation and influence of buyer and target are key

influences on the conduct of the M&A effort, and can influence

post-merger success. Best practitioners seek to create and

preserve brand value. Personal brand (e.g. the aura of a CEO,

etc.) can also assist the development of a deal.

Law Laws and regulations constrain the actions of buyer and target

firms. But there are also opportunities to shape them. The M&A

practitioner must be alert to such opportunities while at the same

time managing legal exposure of the firm.

Ethics Best practitioners in M&A consciously address the ethical

dimension in deal development. It is not enough simply to stay

above the law.

3. Why is conduct important in due diligence?

Conduct is important in due diligence because it makes the difference between due diligence

that simply verifies facts and due diligence that identifies patterns, synthesizes facts into

usable information, and answers important ‘why’ questions. Conduct encompasses an

investigator’s care, stamina, and attitude toward critical thinking.

4. How might conduct play a role in the search for partners?

While the search for partners is usually based on careful, structured research, sometimes,

partners are discovered serendipitously. In such instances, social skills – networking skills –

play a role in bringing partners together, hence, the importance of conduct.

5. In what other areas of M&A might conduct have an influence?

Other areas of M&A in which conduct might have an influence are negotiation and bidding,

dealing with laws and regulations, deal design, post-merger integration, leadership and

communication, and managing the deal development process.

6. Why is process so important in deal development?

Process is important because it lends discipline to thinking and by doing so, helps ensure

that deals are pursued based on well-founded reasons. Process also helps build good M&A

practice – one that synthesizes lessons from past deals into a continually evolving body of

knowledge for future deals.

7. What are some benchmarks against which a deal’s outcomes might be measured?

A deal’s outcomes can be evaluated based on measures such as:

o Creation of market value

o Financial stability

o Improved strategic position

o Organizational strength

o Enhanced “brand”

o Observance of the letter and spirit of ethical norms and laws

o Improved process

8. Why is a deal a system? It being a system, what are the implications in terms of

unanticipated side effects? Explain.

Each deal reflects choices in several dimensions, such as price, form of payment, social

issues, etc. The choices interact with one another and cannot, therefore, be considered in

isolation. Hence, each deal is a system. This systemic nature suggests that tinkering with

one aspect of the deal will have an effect on some other aspect. As such, it behooves deal

designers to think through each action carefully in order to avoid unanticipated side effects.

9. Should one use the same blueprint for all M&A deals? Explain.

No. One should design deals according to the specific needs of the situation. For instance,

cross-border deals may warrant a different design from domestic deals. Or, some specific

circumstances (the target CEO nearing retirement, the need for equal standing between

buyer and target, etc.) may warrant different designs. Even for a specific deal, there cannot

be said to be a single best design, but rather, several feasible designs.

10. An “enhanced brand” in M&A should be one of the goals that deal makers aspire to. Why is

this important?

A firm and its deal maker’s “brand” can affect success in future M&A deals, which in turn

can affect the very survival of the firm. Therefore, a deal should improve not only the

reputation of the firm, but also that of its deal architects.


True or False

1. The field of business ethics is important because it provides detailed solutions to the

ethical dilemmas one encounters in M&A.

2. Ethical business practices build trust, but they do not yield economic gains.

3. Following and paying attention to the law are necessary, but not sufficient requisites for

acting ethically.

4. The U.S. legal framework generally requires directors and managers to operate a

company in the interest of its shareholders.

5. Edward Freeman argues that a firm’s activities should be primarily focused on

maximizing value for shareholders.

6. Utilitarianism is an ethical theory that believes actions should provide the greatest good

for a few people deemed to be the most important.

7. A focus on duties defines “right” versus “wrong” based on virtues. A person who

follows this ethical theory would consider what a virtuous person would do in a given

situation.

8. The tradition of ancient Greek philosophy, which defines “right” and “wrong” by virtues,

primarily focuses on personal pride and character—not duty.

9. Incorporating business ethics in the workplace builds stronger teams and leaders.

10. A company’s only defense against unethical business behavior is to institute a code of

ethics in the workplace.

Answers to True or False Questions

1. False. The field of business ethics is indeed important, but it does not provide the answers

to ethical dilemmas. What it does offer are some tools and frameworks with which an

M&A practitioner can identify and approach ethical dilemmas.

2. False. Trust and loyalty that a company can gain from its customers, consumers, and

counterparties can lead to successful branding of products and services. Companies with

strong brands (and brand images) can command price premiums in the marketplace.

3. True. The law only provides the lowest common denominator: a baseline measured by what

is not legal. However, it does not prescribe norms or standards of behavior. Even if

everyone abided by the law, there would still be ample opportunities for business managers

to behave unethically. The law tells you what you cannot do, but it does not provide

guidance for what you should do to act ethically. While the law may set clear-cut

boundaries around “illegal” managerial actions, it does not set any boundaries between

what constitutes ethical versus non-ethical behavior. The important takeaway here is that

the legal and ethical realms, however connected, are distinct and separate. Following the

law does not equate to acting ethically.

4. True. The stockholder view is dominant in the U.S.

5. False. Freeman offers a different view than Friedman’s notions of managerial capitalism.

Freeman argues that managers bear a fiduciary responsibility to all of its stakeholders:

groups of people who have a stake in or claim on the firm.

6. False. Utilitarianism holds that moral actions achieve the greatest good for the greatest

number.

7. False. “Duty ethics” is defined by duty or intentions.

8. True. Virtue ethics considers a person’s pride as an appropriate barometer for deciding if

an action is ethical. An ethical act would make a person proud to see his/her reflection in

the mirror. An unethical act would hurt a person’s pride if it were broadcast on the news

or printed on the front page of a newspaper.

9. True. Adopting ethical standards for behavior contributes to the strength of teams and

managerial leadership abilities by aligning a firm’s employees around shared values.

10. False. Instituting a corporate code of ethics is a good defense against unethical business

behavior in the workplace. Adopting a code of ethics, however, can easily be reduced to a

mentality of compliance, an observance of checklist of “Do’s and Don’ts.” A better

defense, which should complement and not substitute a corporation’s code of ethics, is to

create a culture of mindfulness. Companies can achieve this by discussing ethics in the

workplace within teams and within the enterprise. In addition, they can foster a culture of

mindfulness by offering seminars and training sessions in business ethics and ethical

decision-making.

Short Answer Questions

1. Describe and explain the role of ethics in Mergers and Acquisitions by providing some

key reasons for its importance in this field.

Ethics is important in the M&A field because it promotes best practices and positive

corporate cultures that in turn lead to sustainable business. Ethical behavior builds

teams and leadership, which underpin process excellence. Because ethics sets a higher

standard than laws and regulations, it provides incentives for managers to do more than

just comply with a baseline of norms; in essence, it motivates a positive spirit for business

practitioners to go above and beyond the call of duty. Ethical behavior rewards

business leaders by building strong individual reputation and good consciences. Ethical

behavior produces better-managed companies and engenders trust among

counterparties, which can lead to more effective and economically attractive mergers and

acquisitions.

2. If ethics is so important in M&A, why hasn’t it been given more attention?

People make excuses for why ethical standards and practice do not apply to their

business teams and enterprises. They claim that they are not trained to discuss ethical

matters, it is not a part of their job descriptions, they are in the business of making

money, being ethical is pointless and futile because many companies and business people

behave unethically.

3. Does Milton Friedman’s Stockholder school of thought promote (or not promote) ethical

decision-making in business? Why or why not? Please explain.

Perhaps one could argue that the main tenet of Milton Friedman’s Stockholder Theory,

“To maximize returns to stockholders,” has prompted some corporate managers to make

unethical decisions. In fact, Milton Friedman has been criticized for his famous article,

“The Social Responsibility of Business is to Increase its Profits,” which first appeared in

the New York Times Magazine in September 1979. In the text, however, Professor

Friedman points out several vital limits to the concentration on profit:

a. The company must obey the rules set by society (i.e., government).

b. It must engage in open and fair competition.

c. It must not practice deception or fraud.

Whether or not one agrees with Friedman’s Stockholder school of thought, one should

realize that it does not condone the aforementioned unethical business practices.

4. James, the Chief Learning Officer of Best Investments, has just been charged with the

task of implementing a structured program to promote ethical behavior at his company.

What would you recommend that he do?

James could begin by crafting or revising the company’s Code of Ethics: this is often best

done in teams of senior executives or employees of the company. The team-based

approach builds buy-in and yields a richer perspective. This effort should capture the

most appropriate norms and relevant standards of conduct that he believes employees

should uphold. In addition, James could look at the ethics codes of prominent companies

and professional associations for good examples.

In order to emphasize and teach employees the importance of the company’s Code of

Ethics, James could set up group training on the subject matter, with the support of CEO

and senior executives of the firm. Through training, employees could learn how to apply

the code of ethics to specific work-related scenarios and develop mindfulness for what

constitutes appropriate/inappropriate behavior. James and the other senior executives

must be aware that codes of ethics should be taught through informal examples and

social interaction. Leaders must “walk the talk.”

5. What is greenmail and why might it be considered unethical?

Greenmail is the payment of a premium share price by a takeover target to a hostile

buyer for the buyer’s accumulated shares in the target. Some consider it unethical

because:

a. It is discriminatory. Greenmail does not allow other Disney shareholders the

right/privilege of selling their shares at the premium price paid to hostile buyer.

b. It may promote self-serving behavior by managers.

c. It could transfer the wealth of other public shareholders to a more powerful raider

without their consent.

d. Greenmailers use intimidation (in a fashion similar to blackmailers) rather than

moral authority to attain their ends.


True or False

1. Despite the unique characteristics of M&A deals and their respective targets and buyers,

benchmarking against value creation permits generalizations to be drawn about factors

correlated with successful and failed deals.

2. Since the 1970s, event studies have dominated the field of M&A research; this technique

was considered a genuine innovation, theoretically well grounded, cheap to execute, and

able to evade the problem of holding constant other factors that plague ex post studies of

mergers’ effects.

3. Clinical studies can be characterized as inductive research, because researchers often

induce unanticipated insights by focusing on one transaction (or a small number of

transactions) in great depth.

4. Statistical significance is essentially the same thing as economic materiality, and each can

independently shed light on whether M&A transactions create or destroy value.

5. Average returns to target and buyer company shareholders are stable over time.


1. T

2. T

3. T

4. F: While statistical significance and economic materiality both collectively shed light on

whether M&A transactions create or destroy value, they are neither the same thing nor

an indicator of M&A value on a stand-alone basis. One needs both the proof of

statistical significance (that a result is not due to chance) and economic materiality (that

the wealth effect is large enough that shareholders or society should be concerned

about).

5. F: Returns from M&A vary over time, perhaps with changes in the economic cycle,

capital market conditions, or regulation.

Short Ans wer Questions

1. What does it mean to conserve value?

To conserve value is to earn the required rate of return from an investment, or the rate at

which the net present value for the investment is zero. Economically speaking, investors

earn “normal” returns when they conserve value.

2. Why shouldn’t the gains from M&A activity be evaluated using benchmarks other than

the economic one? Shouldn’t strategic benefits such as human capital, economies of

scale, and improved operations be considered?

There could be many grounds on which to evaluate M&A activity—economics is but one

of these. Executives and government policy-makers focus most on economics because it

affords a general measure of welfare. Also, economic measures of M&A results are the

most rigorous: one can observe market prices and financial accounting results.

Measuring outcomes of M&A transactions depends more on judgment.

3. Suppose you are an investor in Company A, which has just completed an acquisition.

The returns resulting from the event are 1.2% in the first week. Theoretically, how does

this compare to those of Company B, another stock in your portfolio that experienced a

75% annualized gain in the last year? What assumption underlies this comparison?

The annualized returns for Company A, based on the weekly return after the acquisition

is:

(1.012)^52 – 1 = 86%.

This stock offers a higher yield than Company B’s stock. This comparison assumes that

the 1.2% return can be repeated for the next 51 weeks.

4. What are some positive drivers of M&A profitability?

a. Relatedness and similarities between the assets to be purchased and the

buyer’s (core) business.

b. Expected synergies.

c. Hostile tender offers.

d. Investor confidence of higher future cash flows.

e. High stakes for managers = more value for investors.

f. M&A programs

g. Value-style acquiring

h. Restructuring

i. Rule of law and property rights in cross-border deals

j. Paying with cash

5. What are some negative drivers of M&A profitability?

a. Buying for market share.

b. M&A regulation.

c. Purchasing with stock versus cash.

d. Glamour buyers/glamour buying.

e. Purchase for diversification and vertical integration.

f. Deals transacted to use excess cash that is not successfully redeployed.

6. Why are hostile takeovers more profitable to buyers than friendly offers?

The positive returns from hostile deals may reflect bargain prices and/or the economic

benefits of replacing management and redirecting underperforming firms. The unwanted

suitors may have discovered special value-created synergies with target firms.

7. The main challenge of evaluating the profitability of M&A to combined entities (the

buyer and target firms combined) stems from the size differential between the buyer and

target. How have research studies addressed this issue?

Research studies conducted to address the size differential between buyer and target

firms examine weighted average returns, weighted by the relative sizes of the two firms,

or by examining the absolute dollars of the returns.

8. Suppose two business school students are asked to look at and evaluate the same

statistical study of M&A deals. The sample size is large and random; the data results are

clear. One student says that 60% of the M&A transactions failed, while the other says

that 60% of the M&A deals succeeded. Could they both be right? How might you

explain the difference in their responses?

Arguably, the students could both be right, depending on the assumptions they make

about deal success and failure, and how they define these two terms. The first student

may define success as the creation of value, whereas the second student may define

success as value creation and value conserved. Twenty-percent of deals conserved value,

which the first student includes in the “failure” group; whereas the second student

includes the deals in the “success” group.

This example should underscore the importance of scrutinizing the blanket statements

made “that most mergers fail.”

9. A popular notion is that the acquisition premiums that buyers pay represent expected

future value. How would you explain why buyers, on average, receive zero to slightly

negative returns?

Buyers pay premiums because they believe that acquiring target companies will

eventually yield returns in excess of those premiums, and thus create value for their

shareholders. Obtaining the estimated potential value, however, often hinges on

achieving financial and operational synergies and increasing revenue growth. Given the

great uncertainty surrounding mergers and acquisitions, a buyer may make projections

that are overly optimistic.


True or False

1. Despite the correlation between certain economic conditions and M&A activity, scholars

have cited the occurrences of M&A waves as one of the ten most important unresolved

questions in financial economics.

2. The second wave of M&A activity (1925-1929) was characterized by horizontal mergers

and produced the following firms: General Electric, Eastman Kodak, and U.S. Steel.

3. M&A waves are pro-cyclical to the stock market; they occur in line with increases in

stock prices.

4. Possible explanations for waves of M&A activity include bargaining power effects in

segments of supply chains, as well as managerial psychology.

5. Schumpeter stresses the importance of paying particular attention to entrepreneurs—not

only because of their important function in creative destruction but also because their

independence and tendency to appear singly makes them easy to miss in the crowd.

6. Holding the view that market manias always drive M&A activity is consistent with the

assumption that managers and markets are rational.


1. T

2. F: The second wave of M&A activity was characterized by vertical mergers. However,

the firms listed did originate during this period.

3. T

4. T

5. F: While Schumpeter stresses the importance of paying attention to entrepreneurs and

their role in creative destruction, it is not because “their tendency to appear singly makes

them easy to miss in the crowd.” On the contrary, Schumpeter explains why

entrepreneurs actually tend to appear in clusters: they swarm around opportunities. He

wrote that “The appearance of one or a few entrepreneurs facilitates the appearance of

others, and those the appearance of more in ever-increasing numbers.”

6. F: A belief that market manias always drive M&A activity is consistent with an

assumption of irrational managers and irrational markets.

Multiple Choice: Please pick the best answer.

1. Wave 1, from 1895 to 1904, was characterized by the following:

I. Economic and Capital Market Buoyancy

II. Technological Innovation

III. Vertical Mergers

a. I only

b. I & II only

c. II & III only

d. I, II, & III

2. In which of the following periods did M&A activity involve more hostile takeovers and

more going-private transactions?

a. 1965-1970

b. 1992-2000

c. 1981-1987

d. None of the above.

3. In the most recent merger wave, from 1992 to 2000:

I. M&A activity increased briskly in all segments of the economy.

II. M&A activity was high in the banking and high technology sectors.

III. Defense spending increased and led to high M&A activity in the defense sector.

a. I only

b. I & II only

c. II & III only

d. I, II & III

4. Merger activity appears to slow when:

I. Bond yields rise.

II. Bond prices rise.

III. The cost of capital increases.

a. III only

b. I & II only

c. II & III only

d. I & III only

5. According to Schumpeter, to understand M&A activity we should listen to turbulence

I. At the level of markets.

II. At the level of firms.

III. At the level of the economy.

a. I & II only

b. II & III only

c. I & III only

d. I, II & III

Answers to Multiple-Choice Questions

1. b

2. c

3. b

4. d

5. a

Short Answer

1. What are some common characteristics among the different merger waves between 1895

and 2000?

In each wave, the economy was expanding and capital markets were strong, with low or

falling rates of interest and rising stock prices. Technological innovation and the

overcapacity created by improved efficiencies were common drivers of M&A activity

throughout different decades.

2. Please provide examples of industry-specific drivers that spur M&A activity.

Industry-specific drivers include: innovation, changes in demographics, trade

liberalization, corporate restructurings, deregulation, technological changes, bargaining

power effects at different points of a supply chain, and the domino effect of

consolidations of peer firms.

3. Why does Schumpeter identify “turbulence” as the driver of M&A activity?

Schumpeter identifies “turbulence” as the driver of M&A activity; it is the force that

allows creative destruction to occur. In Schumpeter’s view, M&A deals are responses to

turbulence, which destructs and then renews the landscape of an industry or the

organization of a firm.

4. After 1989, Western firms were able to make toehold acquisitions in Central and Eastern

Europe. What was the turbulence that created this opportunity? How does Schumpeter’s

theory creative destruction apply here?

In 1989, the cold war came to an end. The turbulence that allowed for M&A activity was

the fall of the Iron Curtain, a major geopolitical change that transformed the landscape

in Europe. This example clearly delineates Schumpeter’s theory of Creative Destruction:

the fall of the Iron Curtain, crumbling of the Berlin Wall, disintegration of the Soviet

Union, and collapse of Communist party dictatorship in Central and Eastern Europe had

to take place before Europe could be renewed with new markets.

5. Describe an “inside out” approach and “outside in” approach for identifying turbulence

and monitoring M&A activity.

An “inside out” approach starts with looking at hard data: financials, market share, cost

information to derive conclusions about the performance results of firms and markets,

and to come up with stories, or general patterns and themes. An “inside out” approach

analyzes details to make larger generalizations.

An “outside in” approach starts with qualitative information: newspaper, magazine and

journal articles, securities analysts’ reports, CEO speeches, op-ed columns, etc.

Aggregate ideas provide cues for where to drill down for specific details.


1. The volume of cross-border M&A transactions has risen to record levels in recent years.

What, in your view, are some of the factors that have contributed to this trend?

Increased cross-border activity can be attributed to numerous factors, some of which

include:

• Technological advancements. Today’s communication and computing technologies

allow companies to run global operations efficiently and in real-time. That companies

can operate efficiently even on a global basis has certainly created incentives for

international expansion, and consequently led to increased M&A activity.

• Integration of financial markets. Unrestricted capital flows, currency convertibility, and

greater access to capital are among the benefits of financial market integration that have

encouraged international expansion and led to increased cross-border activity.

• Competition on a global scale. As businesses have expanded, competition has been

raised to that of the level of global titans. To compete effectively, many companies have

had to expand internationally, further increasing the volume of cross-border M&A.

2. In what ways do cross-border transactions usually differ from domestic acquisitions? What

might explain these differences?

• More related – cross-border acquisitions tend not to diversify far beyond the buyer’s

core industry. Expanding into a new country is risky enough; diversifying into a different

industry in unfamiliar territory may be viewed as too risky.

• Payments for cross-border acquisitions are mainly in cash as many cross-border buyers

are not listed in the target’s local markets.

• Cross-border targets are mainly manufacturing firms with low intangible assets,

providing evidence that acquirers look to developing nations as a source of cheap labor.

3. What motivations might drive companies to look for acquisition targets overseas?

The following might drive companies to expand overseas:

• Growth. Tapping offshore markets when domestic markets become saturated is a

common growth strategy. Teaming up with local players usually is a more cost effective

way of entering new markets.

• Competition. Competition has reached global scope in many industries. Businesses in

these industries (e.g. financial services) have needed to seek overseas alliances in order

to compete effectively.

• Profitability. Access to cheap labor and raw material may drive companies to seek

overseas alliances.

• Leverage. Companies may use overseas acquisitions as a means by which to extend the

reach of their brand names.

• Diversification. Companies may seek overseas partners as a means of diversifying both

product and geographic markets.

• Tax issues. Lower tax rates may entice companies to expand overseas.

4. For purposes of reducing risk through diversification, does it make more sense to invest in a

globally integrated market or one that isn’t? Explain.

For risk-diversification, it makes more sense to invest in a market that is less integrated

because such a market will have a lower correlation with movements of the global market.

5. How does free trade encourage cross-border merger activity?

Free trade reduces entry barriers, facilitates increased global and capital market

integration, and improves capital flows – making it easier for foreign companies to do

business locally. Free trade creates a level playing field between domestic and foreign

companies.

6. What factors must one look at to assess a country’s investment climate?

Macroeconomic factors such as GDP growth, per capita GDP, inflation, interest rates, and

currency are good starting points. Microeconomic factors such as costs of production,

demand characteristics, industry structure, and competition are important as well. The

degree and nature of government intervention must be considered too: what are the

strategies behind the government’s fiscal, monetary, currency and trade policies? How

actively does government manage activities? Is government pro- or anti- business?

Institutional factors, particularly the applicability of the rule of law, are also important.

Cultural and political factors are certain to have some impact on business, and must be

considered as well.

7. What factors, according to Porter’s Diamond Model, must an analyst consider when

evaluating a country’s competitive advantage?

Porter’s diamond model suggests looking at the following:

• Factor conditions. Porter argues that countries can gain competitive advantage by

nurturing institutions that create and then continually upgrade specialized factors of

production. A country analyst would therefore be well served to assess how specialized a

nation’s factors are, and whether they meet the needs of the target.

• Demand conditions. A country’s competitive advantage is influenced by demand

conditions at home, argues Porter. An analyst might therefore look into how

discriminating local consumers are – can they drive companies to strive for higher

standards?

• Related or supporting industries. Porter maintains that the presence of strong upstream

and downstream industries can create industry clusters that in turn enhance a nation’s

competitive advantage. The analyst could examine whether such clusters exist and to

what degree they spur innovation in related industries.

• Domestic rivalry. Competition breeds excellence – how open to competition is a country

in general? This can be examined by measuring concentration ratios, evaluating entry

barriers, and analyzing the patterns of competition within an industry/country.

8. What do researchers suggest is the reason behind cross-border acquisition targets being

mostly manufacturing companies?

Researchers suggest that companies acquiring manufacturing concerns do so as a way of

broadening the scale and use of intangible assets such as patents and brand name.


1. Describe the role of strategy in M&A.

Strategy in M&A flows from the company’s business strategy. Whether and how to grow

inorganically, or whether and how to restructure are the typical strategic decisions in that

motivate M&A deals.

2. Briefly describe the BCG Growth-Share Matrix, and cite its advantages and disadvantages.

This tool seeks to identify the relative positions of firms along three dimensions: size,

growth, and relative share of the market. Four positions are identified:

Cash cow – a business with high market share and low growth and hence low ongoing

investment to sustain the business

Star – a firm with high market share and high growth: it generates plenty of cash for its

ongoing expansion

Dog – a business with low growth and low market share

Problem child – a business with a high growth rate and low market share

The advantage of this matrix is that it is easy to use and is attractive visually. However, it

relies on historical rather than forecast data and says nothing about the capabilities

necessary for success in various businesses. In addition, this matrix seems to imply that

investment returns are solely a matter of market power.

3. According to Porter what are the five factors that drive economic attractiveness of an

industry? Please identify and briefly describe these factors.

Barriers to entry: Barriers to entry are forces or constructs that make it difficult for new

competitors to enter into an industry and then shield current industry players from higher

levels of competition. Some examples of entry barriers include regulatory restrictions, brand

names, and patents.

Customer Power: Because powerful customers can dictate prices, product quality, and

demand in an industry, their power directly affects the power of firms in industries that serve

those customers. Thus, the relative power between customers and the firms (and industries)

that serve them are inversely correlated: the greater the power of customers, the weaker the

power of firms (and attractiveness of the industry of those firms).

Supplier Power: Similar to customer power, the relative power of suppliers to firms in an

industry will dictate the strength of the firms and the industry in which they reside.

Threat of substitutes: Because product (goods and services) substitutes limit the pricing

power of firms in any given industry, firms and industries are better off when there are few to

no substitutes for those products that they sell and provide.

Rivalry Conduct: Because the forces in an industry (and the economy at large) are dynamic

and interdependent, the actions taken by any/all firms in an industry will affect the relative

power of other firms in that industry. Porter noted that rivalry conduct may be sharper in

industries where firms are similar in size, barriers to exit are high, fixed costs are high,

growth is slow, and products/services are not differentiated (commoditized).

4. What are the strategic map and the strategic canvas? What are they used for?

Both the strategic map and canvas profile the strategies of competitors. A strategic map

positions the players in an industry on the basis of size and two other dimensions that are

strategically meaningful. The map is helpful in identifying gaps in the competitive field. On

the other hand, a strategic canvas illustrates the similarity or difference among competitors’

strategies.

5. Briefly describe the attractiveness-strength matrix and its use. What is its chief drawback?

The attractiveness-strength matrix combines an assessment of the attractiveness of an

industry, and the attractiveness of the position within the industry. Industry attractiveness

would be assessed through an analysis of growth and prospective returns based on the

structure of the industry, and the drivers of change. The firm’s position would be assessed

through market share, costs to produce, qualitative assessments of resources, capabilities

and core competencies. The firms and their industries are then scored by a weighted

average of ratings on various dimensions. The chief drawback of this tool is that the ratings

for business and industry attractiveness may be arbitrary and not linked to financial returns.

6. Why is business definition so important?

A firm’s competitive position can only be properly assessed if the analysis can be defined

down to a level where the firm’s competitors and position within an industry can be clearly

drawn. As such, business definition is key: are there well-defined strategic sectors? Who

are the real peers of the business? Etc.

7. What are the three classic successful strategies? Describe each.

The three classic successful strategies are low-cost leadership, differentiation, and focus or

specialization. The low-cost leadership strategy seeks to create a sustainable cost advantage

over competitors. The differentiation strategy seeks to create a sustainable competitive

advantage through distinguishing the firm or its products sufficiently to command a higher

price and/or a strong customer franchise. The focused strategy sustains a competitive

advantage by finding and dominating a market niche.

8. What are some reasons why firms pursue inorganic growth?

a. Buying to sustain a growth trajectory despite a maturing product line

b. To circumvent regulatory or antitrust rules that limit growth

c. To improve economic efficiency through horizontal or vertical integration

d. To acquire unique resources and capabilities

e. To create value through diversification

9. How might diversification actually create value?

Diversification might create value if it promotes knowledge transfer, reduces costs, creates

critical mass, and exploits better transparency and monitoring through internal capital

markets. It may be successful where high relatedness in terms of industry focus between the

target and buyer, where the internal markets for talent and capital are truly disciplined, and

managers are properly rewarded, where the local capital market is less effective, where

product markets are experiencing an episode of deregulation or other turbulence, and when

one or both firms have significant information-based assets.

10. What are the alternatives to M&A for achieving inorganic growth? How do these avenues

differ from each other?

Contractual relationships, strategic alliances, joint ventures, and minority investments are

other paths to achieving inorganic growth. Contractual relationships are simply business

arrangements between two parties to perform certain services, or link certain business

processes. Common examples are licensing, co-marketing, co-development, joint

purchasing, franchising and long-term supply or toll agreements. A strategic alliance is

usually a more serious commitment than a contractual relationship, and involves the

exchange of managerial talent, resources, capabilities, and possibly even an equity

investment. A joint venture agreement creates a separate entity in which the two parties

invest, whereas in a minority investment, a firm invests directly into the counter-party firm.

11. What are some of the benefits that joint ventures and strategic alliances might bring?

Joint ventures and alliances can help reduce risk exposures – firms have been found to

engage in alliances or JVs where the risk of the venture is greater than its core businesses.

JVs and alliances can also increase focus for the buyer, as well as reduce agency costs. JVs

and alliances help commit the partners not to divert resources in inefficient ways.

12. What is Tobin’s Q?

Tobin’s Q is a measure of economic efficiency estimated as the ratio of market value of

assets divided by book value. A higher Q means higher efficiency.

13. What does a business manager need to consider for choosing a path for inorganic growth?

A business manager needs to consider: 1) benefits from a relationship: learning and

coordination gains, 2) Need for ownership and control and 3) Manage risk exposure. The

choice among alternatives is a result of balancing these important considerations.

14. What are some common motives for business managers to consider restructuring or exiting a

business?

Motives include: the adverse effects of industry turbulence -- the need to exit from

unattractive businesses, the need to sharpen strategic focus, correct “mistakes” and harvest

“learning”, to correct the market valuation of assets, to improve the internal capital market,

reduce tax expense, strengthen managerial incentives and align them with the interests of

shareholders, respond to capital market discipline, and gain financing when external funds

are limited.

15. What are some transactions to restructure, redeploy, or sell?

Transactions to restructure, redeploy, or sell might include the following:

o Sale of minority interest

o Sale of joint venture interest

o Divestiture or asset sale

o Carve-out

o Spin-off

o Split-off or exchange

o Tracking stock

o Financial recapitalization

16. What is a carve-out? A spin-off? A split-off? What is tracking stock?

A carve-out organizes the business unit as a separate entity and sells to the public an interest

in the equity of the unit through an initial public offering (IPO).

A spin-off, like a carve-out, creates a separate entity for the business and results in public

trading of its shares with majority ownership retained by the parent. But in the case of a

spin-off, the shares are given to the parent’s shareholders, in the form of a dividend. No

money is exchanged.

In a split-off, shares of the subsidiary business are swapped by shareholders of the parent for

shares in the subsidiary. This results in a freestanding firm, no longer a subsidiary of the

parent, owned initially by a subgroup of the former parent’s shareholders.

With tracking stock, a special equity claim on the subsidiary business is created, the dividend

of which is tied to the net earnings of the subsidiary.

17. What is financial recapitalization? What is a leveraged restructuring? An ESOP

restructuring?

In a financial recapitalization, the capital structure of a business is altered, usually to

optimize the mix of debt or equity, or to adjust the equity interests in the business. Leveraged

restructuring and ESOP restructuring are some ways to recapitalize. In a leveraged

restructuring, a firm might borrow debt to repurchase shares or pay an extraordinary

dividend. In an ESOP restructuring, the firm purchases its own shares for sale to an

Employee Stock Ownership plan.


1. Please list some characteristics of a good acquisition search process.

A good acquisition search process:

o focuses on process, not outcomes

o is proactive

o focuses on gathering usable information

o looks for information that is not widely dispersed or public

o has screening criteria that are consistent with the strategy of the buyer

o is flexible enough to respond quickly to a changing environment

o builds, optimizes and uses a search network to aid in information gathering

o reviews many deal opportunities

o reviews deal opportunities frequently

o relies on primary research

o has an information-gathering mindset over a transaction-forcing mindset

2. In the acquisition search phase, what might be some screening criteria used to evaluate

potential targets?

Screening criteria include:

o Industry and (buyer and target’s) position in it

o Strategic capabilities

o Size of the business (usually in terms of sales or assets)

o Profitability

o Risk exposure

o Asset type

o Management quality

o Prospective control

o Organizational fit

o Prospective control

o Organizational fit

3. Where can one find the “sweet spot” of acquisition searches?

The sweet spot of acquisition searches is in the realm of private information, where one can

discover little-known opportunities that offer potentially high returns on investment.

4. What is the “efficient markets hypothesis” and what are its implications for the acquisition

search process?

The efficient markets theory posits that public information is impounded into security prices

rapidly and without bias. What the market knows clearly is fully priced. Therefore, if the

acquisition search is to yield profitable investment opportunities, it must generate private

information before it becomes widely known.

5. Why are networks important in the acquisition search process? How can one be a “member”

of and enhance its position in a network?

Networks are important because they generate information, and can make the search process

efficient and effective. Membership in networks can be attained and enhanced by being part

of trade associations, attending trade shows, industry conferences and conventions,

subscribing to research reports, cultivating relationships with “gatekeepers” and “river

guides.”

6. What characteristics increase the value of a network?

A network is more valuable:

o the more the nodes (the points of connection, e.g. people)

o the higher the bandwidth (capacity to absorb information)

o the higher the speed (the efficacy with which information is distributed)

o the more diverse (the more “weak ties” it has)

o the more “stars” (or navigators)

7. What is the role of ‘navigators’ in the acquisition search field? Who are these navigators?

What were the two categories of navigators discussed in the chapter, and what functions do

they serve?

Navigators are intermediaries of information, and can affect its dissemination. Examples of

navigators include investment bankers, consultants, lawyers, accountants, venture

capitalists, etc. Two categories of navigators are gatekeepers and river guides. Gatekeepers

give access to information and deals. River guides are industry or regional experts that

highlight emerging trends that might affect the availability of investment opportunities.

8. Is there a role for opportunism in acquisition searches? Why or why not?

Yes, there is a role for opportunism in acquisition searches. Although careful planning of

acquisition is always advisable, one must also allow for a certain degree of opportunism,

because acquisition search involves dynamic learning-by-doing. As Haspeslagh and

Jemison have written, “Most acquisitions involve an iteration between a strategy that is

clarified over time and the opportunistic consideration of acquisition possibilities.”

9. How can a searcher increase the probability of a ‘positive payoff’ from the acquisition search

process?

A searcher can increase the probability of a positive payoff by:

o Choosing promising arenas – those where there is uncertainty about who knows what

information

o Increasing the total number of deal opportunities reviewed

o Increasing the frequency of reviews

o Optimizing the network infrastructure to yield valuable information.

10. What lessons about the acquisition search process did the example of Kestrel Ventures

illustrate?

The managers of Kestrel Ventures went about their acquisition search very carefully, taking

care to observe the following:

• Having a clear objective – the Kestrel managers were clear that their goal was to offer

substantial returns to their investors.

• Use of screening criteria – Screening criteria for the target companies were well

thought-out and articulated, and were based on careful analysis not only of the potential

targets themselves, but also of various industries.

• Use of networks and river guides – The Kestrel managers relied on a network of contacts

that could help identify investment opportunities, and kept in regular contact with these

people. Kestrel’s managers also made it a point to cultivate relationships with industry

experts (river guides).

• Conducting primary research – While relying on network contacts, Kestrel also

undertook its own “grassroots” efforts – visiting target companies, talking to suppliers,

customers, competitors etc.

• Upstream positioning – Kestrel’s managers had the objective of “uncovering

transactions before they are formally represented by an intermediary”

11. A traditional view is that quality matters more than quantity. However, with social networks,

it may be quite the opposite: weaker ties may matter more than strong ties, and the breadth

(quantity) of contacts may be more meaningful than the quality. Please explain.

In social networks, the breadth (quantity of contacts) may matter more than the quality of

contacts because there is great strength in “weak ties.” According to Malcolm Gladwell, “Weak

ties tend to be more important than strong ties.” The reason for this is that your closest

connections occupy the same world that you do and share the same resources of information.

Weak ties, however, can offer more because they are more likely to know something, and have

access to information, that you don’t. In a sense, the information you share with your closest

circles is “public knowledge” within those circles, whereas weak ties (those outside your close

circles of family and friends) will tend to offer information that is not public knowledge (more

private) to you and your close contacts. Granovetter also argues that what matters in getting

ahead is not the quality of your relationship, but how many people you know with whom you

aren’t particularly close.

12. What does Metcalfe’s Law say and what implications does it have in the Acquisition Search

process?

The value of a network is proportional to the number of working nodes (points of connection) in

it. This emphasizes the importance of establishing and expanding the breadth of contacts (social

network) in the search process and in business practices in general. As research has shown,

social networks become more and more powerful when there are more points of connection.


Part I. True or False. If false, please explain why.

1. A compliance mentality will prepare for M&A success better than an investor mentality.

2. When conducting due diligence, it is advisable to focus on specific issues, particularly

accounting and legal issues, rather than to try to cover many areas.

3. Obtaining facts is the main objective of due diligence.

4. Professionals can be held liable for the failure to know of potential risks.

5. Due diligence should begin when the buyer approaches the target.

6. Cultural compatibility is no less important than financial, product or market compatibilities

between buyer and target.

Solutions:

1. False. Compliance is concerned narrowly with risk. The investor mentality is concerned

with risk and return, and is a better foundation for M&A success.

2. False. Broad due diligence will reveal more about risk and opportunity than will narrow due

diligence.

3. False. Obtaining facts is only a first step. Facts should then be translated to information

and knowledge.

4. True. Under U.S. securities laws, investment bankers and other intermediaries may be held

liable for damages resulting from the failure to disclose risks that a “duly diligent”

researcher should have known about.

5. False. Due diligence ought to begin well before the buyer approaches the target.

6. True.

Part II. Answer the following questions:

1. In what situations might a narrower scope of due diligence be justified?

A narrower scope of due diligence might be justified in highly competitive situations or where

the buyer already knows the target company extremely well.

2. In acquiring a target, when should the process of due diligence be begun?

Due diligence ought to begin well before the buyer approaches the target. It should begin as

soon as the possibility of a transaction arises. Public sources of information and knowledgeable

observers outside the target company (such as consultants, securities analysts, and retired

executives) can be a foundation for due diligence before the first contact.

3. How is investing in due diligence like buying an option?

Like an option, due diligence is a hedge against risk. One gains the right to learn things that are

not fully revealed to the outsider. As with an option, the due diligence research will be more

valuable the greater the uncertainty about the target, the longer the period of exposure, the

greater the value of the underlying asset (the target), and the lower the exercise price (the

purchase price for the target).

Part III.

For each of the following issues, write out some due diligence questions you would want to ask:

Legal issues

Accounting issues

Tax issues

Information

technology

Risk and insurance

issues

Environmental

issues

Market presence

and sales issues

Operations

Real and personal

property issues

Intellectual and

intangible assets

Finance

Cross-border

issues

Human resources

Cultural issues

Ethics

Possible Solutions:

Legal issues Is the target properly organized as a business and does it

enjoy proper legal standing? What is the shareholding/voting

structure? Are there any anti-takeover mechanisms? What

are the procedures for electing directors and appointing

officers? Has the target been involved in serious legal

proceedings? Is there any litigation in the near future?

Is the target in compliance with government regulations?

Accounting issues What are the target’s accounting procedures? Are they

adequate and in compliance with GAAP?

Are there any noticeable/unusual trends in the target’s

financial results? How do the target’s accounting processes

and results compare with its peers in the industry?

Tax issues Is the target in compliance with tax laws?

How much in unpaid taxes has the target accrued?

Are there opportunities for tax reduction?

Information

technology

Are the target’s management information systems adequate?

How compatible/incompatible are they with those of the

buyer? What investments are necessary to achieve

compatibility? How compatible are the IT cultures of target

and buyer?

Risk and insurance

issues

What is the condition of properties being acquired?

Are there possible exposures to natural hazards, business

interruption, technological change, change in government

policy, etc? How adequate are the target’s insurance policies

and liability coverage?

Environmental Is the target in compliance with environmental laws?

issues Are there possible exposures to environmental liabilities?

What is the extent of possible environmental liabilities?

Who should assume responsibility for cleanup if necessary?

Market presence

and sales issues

What is the general image of the firm?

How strong is its brand, franchise, or goodwill among

customers? Is the target’s market compatible with that of the

buyer’s? How strong are the target’s sales and marketing

organizations? Are they compatible with the buyer’s? In

what areas can sales and marketing processes be improved?

How can sales and marketing processes be streamlined to

achieve revenue synergies? What are the disruptive costs of

doing such? How do the target’s sales and marketing

processes compare to its industry peers? What is the outlook

for revenues and future trends?

Operations How strong are the target’s operational processes in terms of

cost, quality, efficiency, and flexibility? Are the target’s

operational processes and policies congruent with those of

the buyer? How can the target’s operations be streamlined in

order to achieve cost synergies? What investments will be

necessary to achieve the synergies? What are the possible

exposures to technological change? To labor issues?

Real and personal What is the condition of the properties being acquired?

property issues Are there potential exposures to claimants?

Intellectual and

intangible assets

Have all intangible assets been identified? How well are they

protected? Are there potential exposures to infringement

claims?

Finance Is the target creditworthy and solvent? How likely is it that

cash flow problems will occur? What is the target’s exposure

to covenants and guarantees? Does the target have sound

financial policies?

Cross-border

issues

What are the potential exposures to foreign currencies? To

foreign laws and regulations? What are the differences

between the target’s and the buyer’s business practices?

What impact would cultural differences have?

Human resources How deep is the talent and leadership pool at the target firm?

Which employees ought to be retained, and released?

What are the compensation/rewards policies? Are they

compatible with those of the buyer?

What are the levels of turnover and employee satisfaction?

Are there potential exposures to union issues? Pension

liabilities?

Cultural issues What are the target’s beliefs, mission, values, norms, and

traditions? What are the leadership and communication

styles? Are they compatible with those of the buyer?

Ethics Is the target in compliance with policies and laws relating to

ethics?

What are the potential exposures to liabilities arising from

ethics issues?

Are the ethics of the target firm compatible with the buyer’s?


1. What does it mean to “think like an investor”?

To think like an investor is to focus on economic reality, focus on future expectations,

focus on cash flow, get paid for risks, account for the time value of money and for

opportunity cost, consider any information advantages, and diversify efficiently.

2. Is intrinsic value something that can be measured precisely? Why or why not? How

does one arrive at intrinsic value through valuation?

Intrinsic value is unobservable. All valuation approaches measure intrinsic value

imperfectly. One can only estimate intrinsic value; therefore, one should work with a

range of values rather than a point estimate. One can arrive at a reasonable range of

values by triangulation.

3. What is the theory of value additivity? How does knowing this theory enable one to

create value?

The theory of value additivity states that enterprise value should be equal to the sum of

the parts of the enterprise:

Venterprise = sum of the values of the parts of the enterprise = debt and equity of the enterprise

An arbitrage opportunity exists when the equation doesn’t hold true, and value can be

created by taking advantage of that inequality, either by buying the asset that is

underpriced, or selling the asset that is overpriced.

4. Describe and define the nine estimators of value discussed in this chapter. List an

advantage and disadvantage for each and explain why they are advantages/disadvantages.

Describe situations in which certain valuation approaches are more useful than others.

Method Description Advantage Disadvantage Situation for

Use

Book value Book equity

divided by

shares

outstanding

• Easy to

calculate

• CPA

“blessing

”

• Not economic

reality; often

doesn’t reflect

current

market values

• Recently

founded

private firm

with no

intangible

assets as yet

Liquidation

value

Value of

business if it

were to be

• Focuses on

hard asset

values

• Ignores going

concern value

• Accuracy of

• Distressed

firm

discontinued and

the assets sold

piecemeal

divided by

shares

outstanding

• Conservative estimates

depends on

appraiser

• Liquidation

value of

certain assets

may be

difficult to

estimate

Replacement

cost value

Value of

business

calculated by

how much it

would cost to

replace the

business’ assets

at current prices

divided by

shares

outstanding

• Adjusts to

changing

capital market

and currency

conditions

• It may not be

possible to

clearly

identify which

assets need to

be replaced

and how they

should be

replaced, i.e.

in whole or by

parts

• Firm in high-

inflation/high

-devaluation

environment

Current trading

or market value

Current share

price

• Market-based;

ideal if the

• Information

not publicly

• Generally

useful if

market is

thought to

impound all

available

information

available is

not priced in

• Cannot be

used for

companies

whose debt

and equity

securities are

illiquid or not

publicly

traded

company is

publicly

traded

Trading

multiples

Business is

valued by

applying

multiples such as

Price/Earnings,

Price/Book and

Enterprise

Value/EBITDA

of comparable

companies to the

target company

• Market-based

• Easy to use

• Widely used

• Finding pure-

play peers

may be

difficult

• Vulnerable to

accounting

manipulation

• Generally

good if pure-

play peers

exist

Transaction

multiples

Target is valued

by applying

multiples of

comparable

transactions; a

control premium

is usually

involved

• Market-based

• Easy to use

• Widely used

• Finding

comparable

transactions

may be

difficult

• Control

premiums

vary widely

and depend on

many factors

• Generally

good if public

transactions

are

comparable

Discounted cash

flow

Target’s value is

determined by

the present value

of future cash

flows

• Based on

cash, not

accounting

flows

• Incorporates

the time value

of money

• Incorporates

“think-like-an-

investor”

principles

• Estimating

cash flows and

terminal

values may be

difficult,

particularly

for start-ups

and growth

companies

• Generally

good

• Especially

good for

private firms,

firms with no

peers, other

special

conditions

Adjusted present Value of • Value of debt • As with DCF, • Good for

value business is

determined in

two parts: a)

free cash flows

discounted at the

cost of equity,

and b) the

present value of

debt tax shields

tax shields is

clearly

defined. This

method is

particularly

suitable when

the target is to

be

recapitalized

with a highly

levered

structure.

• Incorporates

“think-like-an-

investor”

principles

estimating

cash flows

may be

difficult

highly-

leveraged

transactions

• Also

generally

good

Venture

Capital/Private

equity approach

Value of

business equals

the present value

of the target’s

exit value

• Simple

• Focuses on

exit

• Cash-flow

based

• Incorporates

• Accuracy of

exit value

oftentimes

cannot be

clearly

established or

• Good for

new, high-

risk firms

“think-like-an-

investor”

principles

proven, and

changes with

the “mood” of

the market

• The discount

rate is hard to

determine for

highly risky

prospects

Option valuation Value of

business is

determined by

treating equity

as a call option

on the business,

and valuing that

option

• Captures

uncertainty

and

optionality

• More

applicable

where firm has

large

optionality,

e.g. R&D, hi-

tech,

bankruptcy

• Valuation

inputs may not

be easy

estimate

• Situations

differ between

companies

such that

different kinds

of option

valuation

models may be

needed, some

• Good for

firms with

high

intangible

value, e.g.

biotech,

Internet firms

of which are

complicated

and time-

consuming.

5. Think through each of the eight “big-picture” rules on valuation discussed in this chapter.

What might happen if these rules are violated?

Valuation Rule If Violated…

Think like an investor. One might destroy value by thinking like

customers, employees, the government, and

other non-investor stakeholders.

Intrinsic value is unobservable; we can

only estimate it.

One might put too much faith in “the

answers.”

An opportunity to create value exists where

price and intrinsic value differ.

If you don’t look for differences, you might

not profit from a “golden” opportunity.

“Have a view” about the estimators. One might misuse estimates as conditions

vary.

Exercise estimators of intrinsic value to

find key value drivers, and the inherent

“bets” in the acquisition.

One might not embrace uncertainty

surrounding the estimates. Worse, one

may be unprepared for a change in

scenario.

Think critically; triangulate carefully. One might give too much weight to

estimates in which there is too much

uncertainty.

Focus on process, not product. One might tend to force the analysis into

“answers.”

If you get confused, see rule #1. One might get distracted by competing

modes of thinking.

6. Discuss the differences between the enterprise value and equity value approaches of

DCF.

The enterprise value approach values both debt and equity; free cash flows (i.e., before

interest payments) are discounted at WACC. The equity value approach values only the

company’s equity. Cash flows are net of interest payments, and are discounted at the

cost of equity.

7. What are the different ways of estimating the cost of equity? Describe the methods and

explain the rationale behind each of them.

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), or

the Dividend Growth Model.

Under the CAPM, one adds a risk premium to the risk-free rate to account for the

riskiness of equities, and to compensate investors for taking on such risk. The risk

premium can, and is usually, represented by the market’s historic returns over risk-free

rates, and is adjusted for the systematic risk of each company, using beta. There is no

premium for unsystematic or specific risk because such risk can be diversified away.

The Dividend Growth Model derives the cost of equity from the relationship between a

firm’s current stock price, and its future dividends. This model posits that a firm’s

current stock price represents the present value of all future dividends. As such, the

discount rate that equates the present value of all future dividends with the stock price is

the cost of equity. The formula for cost of equity using the Dividend Growth Model

implies that in equilibrium, with a firm’s dividends growing at a constant rate, the cost of

equity will equal the dividend yield plus the constant growth rate in dividends.

8. What factors might bound low-side and high-side bids of buyers?

The low-side boundary is often the target’s current market price. Sometimes, however,

the low-side boundary may go below the target’s market price, particularly if such

market price is subject to unreasonable future expectations. The high-side bid is bound

by the value of the target to the buyer. Such value should account for synergies and

possible benefits from recapitalization.

9. When is it necessary to unlever and relever betas?

Unlevering and relevering betas is necessary in the following instances:

• when the target’s debt-equity structure is going to change significantly

• when a company’s debt-equity structure changes significantly from year to year; and

• when the target being valued is not publicly traded and betas of peer public

companies reflect different debt-equity structures than that of the company under

consideration.

10. List and define the two approaches discussed in this chapter for estimating terminal value

growth rates. Which approach is better?

Terminal value growth rates can be estimated using the Sustainable Growth Model

and/or the Fisher Equation.

Under the Sustainable Growth Model, the terminal growth rate is a function of how large

a return the company makes on its equity, and how much of that return is reinvested in

the company. Hence the formula )1(* youtRatioDividendPaROEgss

−= .

On the other hand, when one uses the Fisher Equation, the assumption is that the

sustainable growth rate is a function of a real growth rate and inflation. Hence the

formula

The Fisher Equation is better because it is rooted in the external drivers of a firm’s

nominal rate of growth (inflation and real growth in the economy) rather than an internal

set of assumptions, as are embodied in the self-sustainable growth rate.

11. Suppose you are establishing the terminal value growth rate for a large industrial goods

manufacturer. In recent years, the company’s return on equity has averaged 10%, and it

has paid out roughly 10% of its annual profit in dividends. Economists project both the

real rate of growth and inflation to be 3%.

a. Calculate the terminal value growth rate using the Sustainable Growth Model and the

Fisher Equation.

b. Which of your two results do you think is more appropriate to use? Why?

Using the Sustainable Growth Model, the terminal value growth rate comes out to 9%:

gss = ROE * (1 – DPO)

= 10% * (1 – 10%)

= 9%

1 - ))g + (1 )g + ((1 = g InflationUnitsNominal∞∞∞ ×

Using the Fisher Equation, the terminal value growth rate comes out to 6.1%:

= ((1 + 3% ) * (1 + 3%)) - 1

= 6.1%

In this particular case, the result obtained from the Sustainable Growth Model implies

that the company can grow at a much faster pace than the economy. If carried to infinity,

the suggestion is that the firm will eventually own the world economy! The better choice,

therefore, is the result obtained from the Fisher Equation.

12. Why does the terminal value, rather than near-term forecasts of cash flows, often account

for a majority of the value of a firm? Why is the terminal value growth rate the “tail that

wags the dog?”

The terminal value has a significant impact because it capitalizes the growth of a firm to

perpetuity, whereas cash flows before the terminus are short and finite. The terminal

value growth rate has a major impact on terminal value because of its compounding

effect to perpetuity.

1 - ))g + (1 )g + ((1 = g InflationUnitsNominal∞∞∞ ×


1. Critique the following arguments:

a. An option is the right not the obligation to do something. For this reason, it is always less

risky to invest in options than in stocks.

b. When an option is out-of-money, it is worthless.

c. An American option may be exercised at any moment before expiration. Therefore, it has

a higher value than a European option with exactly the same terms.

d. Options are very risky instruments. Therefore, the addition of an option to your portfolio

will increase the risk of your holdings.

Solution:

a. Although an option is the right not the obligation to do something, it is riskier than

investing in stock due to its leverage nature.

b. Even when an option is out-of-money, it still has time value, which gives the underlying

asset time to rise or drop in value.

c. An American option may be exercised at any moment before expiration. Therefore, it has

an added option embedded in it compared to European option. As we know, options are

valuable. Therefore, an American option has a higher value than a European option with

exactly the same terms.

d. Although options themselves are very risky financial instruments, they can be used to

hedge open positions or reduce the overall risk of the portfolio by using corresponding

short or long and call or put positions.

2. Suppose that a stock trades at $50 today, and that you can buy call options that expire in one

month at exercise prices $40, $50, and $60.

a. Calculate your potential payoff one month later for these three options by assuming the

stock will trade at $30, $35, $45, $50, $55, $60, $65, and $70 at expiration.

b. Draw the payoffs on one graph and intuitively decide which option is more valuable.

Solution:

a.

Exercise price $ 40.00 $ 50.00 $ 60.00

Future stock price Option payoff Option payoff Option payoff 30.00$ -$ -$ -$ 35.00$ -$ -$ -$ 40.00$ -$ -$ -$ 45.00$ 5.00$ -$ -$ 50.00$ 10.00$ -$ -$ 55.00$ 15.00$ 5.00$ -$ 60.00$ 20.00$ 10.00$ -$ 65.00$ 25.00$ 15.00$ 5.00$ 70.00$ 30.00$ 20.00$ 10.00$

b.

Option payoff vs. Future stock price

$-

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

$35.0

$30.

0

$35.

0

$40.

0

$45.

0

$50.

0

$55.

0

$60.

0

$65.

0

$70.

0

Future stock price

Cal

l op

tion

pay

off

Call option (Ex: $40)



The option with a lower exercise price has a higher value because there is more chance for

the stock to be in the money at the expiration.

3. Briefly explain why does a call option price rise as stock price increases, exercise price

decreases, time to maturity increases, volatility increases, and risk-free rate increases.

Solution:

Stock price and exercise price can affect option prices directly by changing the underlying

value of the asset and the intrinsic value of the options. Both increase of stock price and

decrease of exercise price will increase the intrinsic value of the call options. Time to

maturity will increase the time value of the options. Volatility will also increase the time

value of options because it offers potential upside returns and no downside risk to investors.

Risk-free rate influences the values of the options indirectly by affecting the present value of

the exercise price and the expected value of the stock in the future. The increase of the risk-

free rate will lead to the decrease of present value of exercise price, which increases the

intrinsic value of the call options.

4. Briefly explain why it is never optimal for an investor to exercise an American call option for

a stock that does not pay dividends.

Solution:

Option value is composed of intrinsic value and time value. By exercising the option early,

one sacrifices the time value. Therefore, it is always better to sell an American option in the

market than to exercise it. For out-of-the-money options, this argument is even truer because

one will actually lose money by exercising the option.

5. By using various combinations of simple call and put options, one can implement different

trading strategies. Draw the payoff diagram for a portfolio that includes:

a. one short call at exercise price $15,

b. two long calls at exercise price $20 and

c. one short call at exercise price $25.

All the options expire at the same time and the stock trades at $20 today. Explain what

someone who holds this portfolio might be thinking about this stock; and conversely what

someone who is selling this portfolio might be thinking.

Solution:

a.

Call option A Call option B Call option CExercise price $ 15.00 $ 20.00 $ 25.00 Position short long short# of contracts 1 2 1

Stock price Option A payoff Option B payoff Option C payoff Total payoff

-$ -$ -$ -$ -$ 2.50$ -$ -$ -$ -$ 5.00$ -$ -$ -$ -$ 7.50$ -$ -$ -$ -$

10.00$ -$ -$ -$ -$ 12.50$ -$ -$ -$ -$ 15.00$ -$ -$ -$ -$ 17.50$ (2.50)$ -$ -$ (2.50)$ 20.00$ (5.00)$ -$ -$ (5.00)$ 22.50$ (7.50)$ 5.00$ -$ (2.50)$ 25.00$ (10.00)$ 10.00$ -$ -$ 27.50$ (12.50)$ 15.00$ (2.50)$ -$ 30.00$ (15.00)$ 20.00$ (5.00)$ -$ 32.50$ (17.50)$ 25.00$ (7.50)$ -$ 35.00$ (20.00)$ 30.00$ (10.00)$ -$ 37.50$ (22.50)$ 35.00$ (12.50)$ -$ 40.00$ (25.00)$ 40.00$ (15.00)$ -$

b.

Payoff diagram

$(30)

$(20)

$(10)

$-

$10

$20

$30

$40

$50

$- $3 $5 $8 $10

$13

$15

$18

$20

$23

$25

$28

$30

$33

$35

$38

$40

Stock price

Pay

off Option B payoff

Option C payoff

Total payoff

Option A payoff

From the graph, we can see that someone holding this portfolio is betting the volatility of

stock will increase, increasing the probability of a big move from $20 in either direction.

Therefore, he or she can capture the option premium difference between a long call and a

short call. Conversely, the seller of this portfolio might be thinking that the stock will not fall

below $15 or rise above $25. This portfolio is called a short butterfly. Therefore, the seller is

actually holding a long butterfly.

6. On May 21, 2003, the S&P 100 (OEX) closed at 463.58, the Dow Jones Industrials (DJX) at

84.91, and the NASDAQ 100 (NDX) at 1112.85. The following option prices were quoted

from The Wall Street Journal:

Expiration June 20 July 18 September 12

OEX 465 Call ($) $13.50 $14.90 $25.00

OEX 465 Put ($) $9.50 $14.50 $20.50

DJX 84 Call ($) $2.40 $3.10 $4.10

DJX 84 Put ($) $1.55 $2.45 $3.70

NDX 1125 Call ($) $31.00 $47.00

NDX 1125 Put ($) $39.00 $59.00 $82.50

Interest rate* 1.04% 1.00% 1.02%

* Rates are of Treasury bill rates maturing on the given dates.

Select three sets of data from the table and verify that put-call parity holds. Briefly explain

the underlying assumptions of put-call parity and why put-call parity might not always hold

in the real world.

Solution:

To verify put-call parity, you need to follow the following steps:

Step 1. Find the value of call option.

For example; Vc (OEX) 465 Jun 20 = $13.5

Step 2.

Exercise price: 465

Interest rate: 1.04%

OEX close price: 463.58

Put value = Vc - S + Ex *exp(-rt) = $14.52

Step 3. Compare the calculated price with quoted price.$14.52 > $9.50

Find appropriate parameter and calculate the implied put price using put-call parity.

Expiration 20-Jun 18-Jul 12-SepOEX 465 Call ($) $ 13.50 $ 14.90 $ 25.00 OEX 465 Put ($) $ 9.50 $ 14.50 $ 20.50 Implied Put price by put-call parity 14.52$ 15.58$ 24.94$

DJX 84 Call ($) $ 2.40 $ 3.10 $ 4.10 DJX 84 Put ($) $ 1.55 $ 2.45 $ 3.70 Implied Put price by put-call parity

$ 1.42 $ 2.06 $ 2.92

NDX 1125 Call ($) $ 31.00 $ 47.00 NDX 1125 Put ($) $ 39.00 $ 59.00 $ 82.50 Implied Put price by put-call parity

$ 42.19 $ 57.36

Interest rate* 1.04% 1.00% 1.02%

From the table, we can see put-call parity does not always hold in the real world. There are

several reasons: a. the quoted prices are transaction price for the last trade, therefore in the

volatile market the difference of timing will cause large deviation of put-call parity; b. the

transaction costs or slippage will also lead to deviation from put -call parity; c. different

option pricing models will lead to different price of call options, which consequently cause

the violation of put -call parity and d. many option prices are American options, for which

put-call parity does not hold.

7. Refer to problem 6. Select any index and calculate the intrinsic value and time value for the

options on that index. Compare the time values among the options on that index that expire

at different dates. What do you observe?

Solution:

Expiration 20-Jun 18-Jul 12-Sep To calculate the intrinsic value or time value:

OEX 465 Call ($) $ 13.50 $ 14.90 $ 25.00 Intrinsic value $ - $ - $ - Step 1. Find parameters.

Time value $ 13.50 $ 14.90 $ 25.00 For example: Vc OEX 465 Call June 20 = $13.50

OEX 465 Put ($) $ 9.50 $ 14.50 $ 20.50 Exercise price: 465

Intrinsic value $ 1.42 $ 1.42 $ 1.42 Stock price: 463.58

Time value $ 8.08 $ 13.08 $ 19.08 Step 2. Calculate intrinsic value of the option.

Expiration 20-Jun 18-Jul 12-Sep For call options: Intrinsic value = Max (S-EX, 0)

DJX 84 Call ($) $ 2.40 $ 3.10 $ 4.10 For put options: Intrinsic value = Max(Ex-S, 0)

Intrinsic value $ 0.91 $ 0.91 $ 0.91 Time value $ 1.49 $ 2.19 $ 3.19 For OEX 465 Call June 20: Max (463.58-465, 0) =0

DJX 84 Put ($) $ 1.55 $ 2.45 $ 3.70 Intrinsic value $ - $ - $ - Step 3. Calculte time value of the options:

Time value $ 1.55 $ 2.45 $ 3.70 Time value = Option value - Intrinsic value

Expiration 20-Jun 18-Jul 12-SepNDX 1125 Call ($) $ 31.00 $ 47.00 For OEX 465 Call June 20: $13.50 - $0.00 = $13.50

Intrinsic value $ - $ - $ - Time value $ 31.00 $ 47.00 NDX 1125 Put ($) $ 39.00 $ 59.00 $ 82.50 Intrinsic value $ 12.15 $ 12.15 $ 12.15 Time value $ 26.85 $ 46.85 $ 70.35

From the tables, it is clear that the time values of the options increase with the increase of

maturity of the options.

8. Why can the equity of a firm be viewed as an option on its assets? How would you calculate

the value of this option?

Solution:

An equity holder has the right to ride on the increase in asset value of a firm, but not the

obligation to repay the firm’s debt. Therefore, equity is analogous to an option on the assets

of the firm, with the exercise price equal to the par value of the debt, and expiration equal to

the maturity of the debt. By using corresponding volatility, one can value the equity of the

firm using various option-pricing models.

9. Briefly explain how the option analogy can be used to value loan guarantees and debts.

Solution:

Option-pricing theory provides the first rigorous approach to valuing loan guarantees. The

value of the put or default risk discount will be equal to the value of a loan guarantee

necessary to convert the debt from risky to default-risk free. The value of the contingent

liability the guarantor assumes will equal the value of a put option on the firm's assets.

Similar to loan guarantees, default risk discount of debts is also the value of a put option on

the firm’s asset. By adding the put option value to risk-free debt, one will have the value of

risky debts.

10. Suppose stock ABC trades at $40 today, and there is an equal chance of it going up to $60 or

down to $20 next year. The one-year risk-free rate is 10%.

a. Calculate the value of at-the-money call and put options. Does put-call parity hold in this

case? (Please use the binomial tree approach)

b. What probability of ABC going up to $60 next year will make the put-call parity hold?

Solution:

a. Step 1. Draw the tree and input probability and payoff of the options at the expiration.

Time Now One year later Probablity Call option payoff Put option payoffEx. Price: $40 Ex. Price: $40

60.00$ 50% 20.00$ -$

Stock price 40.00$

20.00$ 50% -$ 20.00$

Step 2. Calculate the expected value of option values and discount it back to now.

V option = PV [expected value of option payoff]

Discount rate 10%Call option value Put option value

$9.09 $9.09

b. To calculate the implied probability, you need to setup the put-call parity formula. Use Goal

Seek to backsolve the probability.

Step 1. Find parameters and setup put-call parity.

Step 2. Go to Tab tool, select goal seek. Set C-P equal to S-Ex*Exp(-rt) and changing cell as

probability.

Step 3. Enter OK and copy the solution from the changing cell.

New probability for ABC going up is 60%, as seen in the excel sheet attached.

Call option value Put option value11.00$ 7.19$

Put call parity C - P = S -Ex*exp(-rt)

Time (year) 1Stock price 40.00$ Exercise price 40.00$ Call value 11.00$ Put value 7.19$ C-P 3.81$ S-Ex*exp(-rt) 3.81$ Risk-free rate 10.00%

Another way to think about this question is to calculate the expected return of the stock and

derive what rate makes today's stock rise to that expected value.

11. For $20, you can buy a six-month call option on stock XYZ at exercise price $90. Stock

XYZ trades at $100 today. It has a 30% annual volatility. The annualized six-month risk-free

rate is 8%. Is the option overvalued or undervalued? How might you take advantage of this

opportunity? Please use Option Valuation.xls, the Black-Scholes option-pricing model

(found on the CD-ROM accompanying the textbook) to answer these questions.

Solution:

Stock price 100.00$ Black-ScholesVolatility 30% European: No DividendRisk-free rate 8%Dividend yield 0% Call value 16.41$ Time (year) 0.5 Call delta (hedge ratio) 0.785616193

Call elasticity 4.787585662

Call option Using put-call parityExercise price 90.00$ Put value 2.88$ Value 16.41$ Delta -0.214383807Quoted price 20.00$ Elasticity -7.442606543

S underlying asset price 100.00$ X exercise price 90.00$ rf risk-free rate 8%sd volatility 30%t years to expiration 0.5

Cumulative Standard Normal Functiond1 from Black-Scholes 0.791302059N(d1) 0.785616193

d2 from Black Scholes 0.579170025N(d2) 0.718762818

Therefore, the quoted price for the call option with an exercise price at $90 is higher than the

price calculated from the Black-Scholes formula. If we believe the B-S equation, we would

say the option is overvalued. One can sell this option at the market naked or cover by buying

the stock and wait for the price to go back to its fundamental value.

12. Mr. Thompson was a portfolio manager at a mid-sized asset management firm. Due to

current market turbulence, he wanted to diversify the risk in his portfolio by adding three

stocks. He picked three industries: financial, chemical, and computer services, and assigned

his associate to come up with some choices. After the associate handed him the folder with

the information about three stocks she picked, Mr. Thompson misplaced the folder and only

recovered three pages containing today’s stock option quotes. Could you use these data to

help Mr. Thompson identify which stock is in which industry from the implied volatilities in

these options? Please compute these implied volatilities using Option Valuation.xls and make

a judgment about which firm is which.

Stock A B C

Stock price

$

123.47

$

38.85

$

13.67

Exercise price

$

125.00

$

40.00

$

12.50

Expiration

date June, 20

June,

20

June,

20

Dividend

payout

$

2.64

$

0.80 $ -

Call option

value

$

2.25

$

0.65

$

1.40

Put option

value

$

3.70

$

1.85

$

0.20

Risk free rate 1.04% 1.04% 1.04%

Date: Wednesday, May 21, 2003

Solution:

To calculate the implied volatility, you need to Goal seek to find appropriate volatility that

will make the option price calculated from Black-Scholes equation equals to the quoted

price. First, input all parameters from stock price, exercise price, time to expiration,

volatility, risk-free rate, and dividend yield in the template. Then set the option price equal to

the quoted price, solve the implied volatility using Goal Seek in excel.

The results are shown below.

Implied Volatility (Call) 21.13% 25.43% 43.09%Implied Volatility (Put) 19.76% 25.88% 41.47%Average implied Volatility 20.45% 25.66% 42.28%

One example for calculating implied volatility.

Black-ScholesEuropean: No Dividend

Call value 1.38$ Call delta (hedge ratio) 0.793663Call elasticity 7.857107

Using put-call parityPut value 0.20$ Delta -0.206337Elasticity -14.09228

S underlying asset price 13.67$ X exercise price 12.50$ rf risk-free rate 1.04%sd volatility 41.47%t years to expiration 0.082192

Cumulative Standard Normal Functiond1 from Black-Scholes 0.819195N(d1) 0.793663


As seen in the above calculation, company A has the lowest volatility and company C has the

highest volatility. Based on knowledge of these three industries, one should find that the

chemical industry is a stable and mature industry, and therefore has low volatility.

Conversely, the computer services industry is a very volatile industry with high risk.

Therefore, one should be able to point out that Company A is in the chemical industry (3M),

B is in the financial industry (Citigroup) and C is in the computer services industry (AOL).


1. What is the defining feature of a synergistic transaction?

The defining feature of a synergistic transaction is that it creates value for shareholders by

harvesting benefits from merger that they would be unable to gain on their own.

2. Why must one “think like an investor” when evaluating synergies? What could go wrong

when one does not think like an investor?

To “think like an investor” is to focus on value creation. Some merger “benefits” might be

called synergies when in fact they do nothing to create value. Thinking like an investor helps

to separate true synergies from false ones and helps to ensure that the buyer won’t overpay.

To think like an investor includes focusing on future expectations, on cash flow, on risks and

returns, on accounting for time value of money and opportunity cost, on considering any

information advantages, and on diversifying efficiently.

3. In what instances will a buyer’s share price rise, fall, or remain the same in connection with

an acquisition announcement?

Buyer’s share price will: If this equation is satisfied

Rise Price < VTarget, Stand-alone + VSynergies

Not change Price = VTarget, Stand-alone + VSynergies

Fall Price > VTarget, Stand-alone + VSynergies

4. Explain in your own words the following equation, and provide definitions and examples of “in-place

synergies” and “real option synergies”:

The equation states that synergies can be valued as the sum of in-place synergies and real

option synergies. In-place synergies are those that can be reasonably predicted and

expected to happen. Real option synergies are those that pay off upon the occurrence of a

triggering event – usually a decision by management to exercise the right, not obligation, to

actualize a real option synergy. Such decisions are usually made in response to stimuli such

as new information, competitor’s moves, etc. Examples of in-place synergies include

revenue enhancements, cost reduction synergies, asset reduction synergies, tax reduction

synergies, and WACC reduction synergies. Examples of real option synergies include

growth options, exit options, options to defer, options to alter operating scale and options to

switch.

5. Is there an option embedded in each of these cases? If so, what type of option is it?

Case 1

OptionalSynergies

PlaceInSynergiesSynergies VVV Re+=

SuperSodas, an international soft drink manufacturing company of Latin American origin,

recently acquired a 40% interest in a Southeast Asian bottler. SuperSodas’ stake was limited

because laws in the Southeast Asian country prohibited companies that were more than 40%

foreign-owned from acquiring real estate. Among the synergies projected by SuperSodas was

$87 million in revenue enhancements if the Southeast Asian bottler were to build another plant in

the country’s southern region, which was currently underserved. Purchasing land and building a

new plant would require an initial investment of $2.8 million.

Answer: SuperSodas has a growth option (long call) in this case. The revenue enhancements

will only materialize if SuperSodas and its Southeast Asian affiliate exercise their option by

investing $2.8 million (strike price) in property, plant, and equipment.

Case 2

A large oil company has agreed to merge with a steel company. Their operations intersect nowhere. But

the CEO believes that the debt capacity of Newco will be larger than the sum of the debt capacity of the

two firms standing alone. The CEO has no plans to actually use this new debt capacity in the near term.

The creation of new debt capacity arises from the coinsurance effect described in the chapter.

But since there are no definite plans to use the new debt capacity, it cannot be valued as

illustrated in the chapter. However, the added financial flexibility of the unused debt capacity is

a long call option on future financing.

Case 3

Kinetic Utility, a company in the business of electricity generation, has agreed to acquire Alpine

Utility. Kinetic’s generation plants are all gas-fired, while Alpine’s plants are all oil- fired. They

serve the same market. Part of the rationale for acquiring Alpine was to achieve cost savings

through greater flexibility in responding to changes in the relative prices of the two fuels.

The merger creates a real option synergy through a switching option (long call) on fuel.

6. What are the two forms of WACC synergies described in the chapter? Define each form and

explain how each might create economic value. On what conditions are these truly

synergies?

The two forms of WACC synergies described in the chapter are 1) optimization in the use of debt

tax shields, and 2) coinsurance effects. The first has the potential to create economic value by

exploiting debt tax shields. This is only truly a synergy if investors cannot by themselves

optimize the use of leverage. The second has the potential to create economic value by enlarging

the debt capacity of the two firms beyond the sum of their debt capacities on a stand-alone

basis—this arises from the risk diversification effect of combining two cash flow streams with

low or less-than-perfect correlations. This is only truly a synergy if investors cannot diversify

across cash flow streams on their own.

7. For valuing each of the synergies described below, explain whether you would use a discount

rate equal to WACC, greater than WACC, or less than WACC. Explain the reasoning behind

your decision.

a. The French Government wants to promote the merger of two companies and

guarantees a yearly annuity if the two agree to merge.

b. PepsiCo management believed that by acquiring Quaker Oats, they would be able to

improve operating income growth from 8 percent to 10 percent through revenue

enhancements and cost savings.1

c. In the proposed merger between Hewlett Packard and Compaq in 2002, the CFO of

HP announced that $2.5 billion in cost synergies were expected from the Compaq

acquisition. Most of the cost synergies would come from layoffs and organizational

restructurings.2

d. Among the main arguments for the AOL-Time Warner merger was the potential

revenue enhancement to be gained from merging broadband delivery (AOL) with

content (Time Warner). By combining these offerings, it was expected that both

companies could achieve far greater market penetration.

Answers:

a. If the cash flow is truly government-guaranteed, then the French Government bond

yield should be used to value the annuity stream—this amounts to using the risk-free

rate.

1 Andrew Conway and Christopher O’ Donnell, “PepsiCo Acquires Quaker: Strengthening the Core,” Morgan Stanley Dean Witter, December 5, 2000.

b. The combination of revenue enhancements and cost savings into a single synergy

estimate blends more-risky and less-risky effects. WACC would be a reasonable

discount rate as it blends the spectrum of risks of the entity into one rate.

c. Since cost-synergies coming from layoffs and organizational restructuring are more

certain than other kinds of synergies, with a level of risk about as variable as EBIT, a

discount rate less than WACC could be used.

d. Revenue enhancement synergies are riskier than other types, and probably greater

than the average risk of the firm. A discount rate greater than WACC is probably

appropriate in this case. To the extent that they are considered even riskier, a higher

discount rate than WACC may be used.

8. Brown Paper Mills is planning to acquire Woodland Pulp and Paper. Michael Brown is

trying to determine an offer price and has asked you to estimate the value of synergies.

Brown expects that with greater market power, revenues will increase in nominal terms by

$50 million in the first year, by another 8% in years 2 and 3, by 5% in year 4, and zero in

year 5. Increased revenues will require an increase in working capital equivalent to 2% of the

first year’s sales. Thereafter, additional working capital needs will increase at the rate of

0.5% of revenues per year. Cost savings of $25 million are expected in the first year, $30

million in the second year, and $40 million thereafter. The cost savings after year 3 will have

2 Pui-Wing Tam, “Hewlett-Packard Tries to Gain Votes for Compaq Deal,” The Wall Street Journal, February 28,

to be adjusted to reflect inflation. An initial investment of $90 million is required to realize

the cost savings. Expected inflation is 2%, and expected operating margins are 10%. Brown

wants you to discount the synergies at 10%. The tax rate is 35%.

Answer:

The problem may be analyzed using the spreadsheet file, “Valuing Synergies.xls,” found on

the CD-ROM accompanying this book:

2002.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Revenue enhancements 50.0 54.0 58.3 61.2 61.2 Operating profit 5.0 5.4 5.8 6.1 6.1 Cost savings 25.0 30.0 40.0 40.8 41.6 Incremental profit 80.0 89.4 104.2 108.2 109.0 Taxes 28.0 31.3 36.5 37.9 38.1 Incremental profit after taxes 52.0 58.1 67.7 70.3 70.8 Increase in working capital (1.0) (0.3) (0.3) (0.3) (0.3) Initial investment (90.0) Subtotal (90.0) 51.0 57.8 67.4 70.0 70.5 Terminal value 899.2 Total free cash flows (90.0) 51.0 57.8 67.4 70.0 969.8 Value of synergies 640.7

The growth rate to perpetuity is assumed to be the expected inflation rate.


1. Cite some country factors that analysts must consider when evaluating cross-border acquisitions.

Analysts must consider factors such as inflation, exchange rates, tax rates, the timing of cash

remittance, political risk, market segmentation, governance, accounting principles, and

social/cultural issues.

2. How does a worldwide tax credit system differ from a territorial tax system? Which tax system does

your country use?

Under a worldwide tax credit system, the buyer’s country recognizes taxes paid in a foreign country

as a credit against tax liability at home. Under a territorial tax system, the buyer’s country exempts

foreign income from further taxation.

3. At the end of August 1998, the exchange rate between the US dollar and the Chilean peso stood at

US$ 1: CLP 473.5. The one-year Treasury rate in Chile stood at 15.84 percent, while the yield on the

one-year U.S. Treasury was 4.71 percent. Based on these numbers, what would be the peso-dollar

exchange rate one year hence?

Solution:

The one-year forward rate would be US$ 1: CLP 523.8.

One-year rate: (1 + .0471) = CLP 473.5 * (1 + .1584) * 1/FWD1-yr

FWD1-yr = CLP 523.8

(The actual rate one year later was US$ 1 : CLP 517.2, representing a 1.3 percent difference from

the projected rate.)

4. You are reviewing a DCF valuation for an overseas acquisition target. You feel that the valuation is

too optimistic given the high political risks of operating in the country. In what ways might you

adjust the DCF valuation?

To reflect your view of the political risk, the DCF calculations may be adjusted by 1) “haircutting”

the cash flow estimates, or 2) raising the discount rate.

5. Assume you have acquired manufacturing equipment for $800 million, and that it has a useful life of

10 years. Inflation is 2.5 percent, the real discount rate is 4.00 percent, and the tax rate is 40 percent.

a. What would be the present value of the depreciation tax shields from Year 1 to Year 5? Use the

nominal discount rate to calculate present value.

b. Now assume that you can inflate depreciation expense at a rate of 2.5 percent annually. Using the

same discount rate, what is the present value of depreciation tax shields from Year 1 to Year 5?

c. Go back to (a). This time, use the real discount rate to calculate the present value of the tax

shields. What do you observe? How would you interpret the results?

( )DollarPeso

PesoDollarPesoDollar FWD

RSPOTR1

*1**1$)1(*1$ +=+

Solution

a. Without inflation, at nominal rate Year 1 Year 2 Year 3 Year 4 Year 5Depreciation 80 80 80 80 80Depreciation tax-shield 32 32 32 32 32NPV of depreciation tax shields $132.62

b. With inflation, at nominal rateDepreciation 82.0 84.1 86.2 88.3 90.5Depreciation tax shield 32.8 33.6 34.5 35.3 36.2NPV of depreciation tax shields $142.46

c. Without inflation, at real rateDepreciation 80 80 80 80 80 Depreciation tax shield 32 32 32 32 32 NPV of depreciation tax shields $142.46

Note: The nominal discount rates in (a) and (b) were calculated using the Fisher equation: (1.025 *

1.04) -1 = 6.6%.

Notice that the NPVs in (b) and (c) are the same, consistent with the illustration in the

chapter. The NPV in scenario (a) is lower because the cost basis of the depreciating assets

is not allowed to increase with inflation, thus resulting in a lower depreciation tax shield.

This is one of the ways in which inflation transfers wealth from the private sector to the

public sector.

6. Below is a free cash flow estimate and valuation for a Taiwanese company. Values are given in

Taiwan dollars (NT$), and the NPV is translated into U.S. dollars at the current exchange rate of US$

1 : NT$ 34.96.

(NT$, in millions) 2003 2004 2005 2006 2007 2008Free cash flows 231 9,567 15,830 30,942 44,875 59,419 Terminal value 810,728 Cash flows including terminal value 231 9,567 15,830 30,942 855,603 Present value in Taiwan dollars 725,482 Present value in US dollars 20,752

Assume the following:

Inflation rate, US 2.4%Inflation rate, Taiwan -0.2%Exchange rate at time 0 (Taiwan dollars per US dollar) 34.96 Real discount rate 5.0%

a. Please translate the cash flows into U.S. dollars.

b. Please estimate the discounted cash flow value of the investment under the two forecasts (U.S.

dollars and Taiwan dollars). Did you come up with the same present value? What rate did you use to

discount the US dollar flows? What assumptions are necessary to obtain equivalency between

Approach A (converting local flows into dollars and discounting at a dollar rate), and B (forecasting

in local currency and discounting at a local rate?

Solution:

Year 0 1 2 3 4 5 6

(US$, in millions) 2003 2004 2005 2006 2007 2008

Exhange rate (Taiwan dollars per US dollar) 34.96 34.07 33.21 32.36 31.54 30.74 29.96

Free cash flows 7$ 288$ 489$ 981$ 1,460$ 1,983$ Terminal value 26,372$ Cash flows including terminal value 7$ 288$ 489$ 981$ 27,832$ Present value in US dollars 20,752

First, forecast forward exchange rates using the given inflation rates. Then, use the forecasted

forward rates to convert the Taiwanese cash flows into US dollar cash flows. To come up with the

same values between Approaches A and B, the dollar flows must be discounted at the nominal

discount rate in US dollars, which is equal to 7.52%, calculated as ((1+5%)*(1+2.4%)-1). The key

underlying assumptions are that inflation is the only differing variable between the US and

Taiwanese discount rates, and that the real discount rate in Taiwan dollars is the same as that in US

dollars. Inflation is already reflected in the exchange rate and in the US dollar cash f lows; therefore

it is necessary only to discount the US dollar cash flows using the real rate of return. These

assumptions are consistent with interest rate parity.

7. What factors might contribute to the segmentation of an economy? Would identical assets in separate

‘segmented’ markets command identical prices?

The following could lead to segmentation:

• Foreign exchange controls.

• Controls on investment by foreigners.

• High and variable inflation.

• Lack of a high-quality regulatory and accounting framework.

• Lack of country funds or cross-listed securities that provide benchmarks for arbitrage.

• Small size of market.

• Poor credit ratings or absence of credit ratings.

In the presence of segmentation, identical assets in different geographical areas would not

necessarily command the same prices.

8. You are trying to determine the cost of equity for a foreign target whose cash flows you have

projected in dollars. You have the following data:

10-year Treasury bond rate, US 5.50%10-year rate, US dollar denominated sovereign bonds 7.75%Beta of target versus foreign country stock index 0.96 Beta of foreign country stock index versus US index 1.30 Market risk premium, US 6.00%Market risk premium, foreign country 8.00%

What would your estimate of this firm’s cost of equity be?

Solution:

Based on the data provided, one could use the adjusted CAPM for calculating Ke:

( ) ( )[ ]freeriskmarketfirmcountryfreeriskriskcountryequity RRRK −++Π= ** ββ

Rf 5.50%Country credit spread 2.25%Beta of target versus foreign country stock index 0.96 Beta of foreign country stock index versus US index 1.30 Market risk premium, US 6.00%Ke 15.2%

9. Assume you are CEO of a US company evaluating three companies listed on the Hong Kong Stock

Exchange. China Mobile (Hong Kong) Ltd. provides cellular phone services in China. Hang Seng

Bank Ltd. provides banking and other financial services. Hutchison Whampoa Ltd. is a holding

company that operates in areas such as ports and related operations, telecommunications, property

and hotels, retail and manufacturing, infrastructure, finance and investments, etc. Their betas relative

to the global equity portfolio over the past 12 months were 1.31, 0.74, and 1.21 respectively. You

estimate, based on the last 10 years of data, that the equity market risk premium on the global

portfolio is approximately 6%. Currently, the long term US Treasury bond yields 1.4 percent. What

is your estimate of each company’s cost of equity based on the above data?

Solution:

This problem invites the reader to exercise the ICAPM:

a. China TelecomRf 1.4%Rm-Rf (world) 9.9%beta (world) 1.31 Ke 14.4%

b. Hang Seng BankRf 1.4%Rm-Rf (world) 9.9%beta (world) 0.74Ke 8.7%

d. Hutchison WhampoaRf 1.4%Rm-Rf (world) 9.9%beta (world) 1.21Ke 13.4%

10. Country A has a local market volatility of 36% and a country beta relative to the United States of 1.0.

Country B has a local market volatility of 20%, and also a beta of 1.0 versus the US market. The US

market has a volatility of 18%. Of the two countries, which is more segmented? Explain?

Solution:

Based on the data given, one can calculate the correlation between each country and the US. As the

calculations below show, Country A has the lower correlation. Because the US is the dominant

market in the global market, a low correlation with the US market suggests a low correlation with the

global market, and therefore greater segmentation. This example shows that although two countries

can have the same beta, they might have different natures of risk – with risk stemming from either

volatility or from correlation, or both.

Country A Country B USVolatility 36% 20% 18%Beta 1.00 1.00Correlation 0.50 0.90

11. List the different ways of calculating Ke discussed in the chapter and provide a brief explanation for

each.

Solution:

CAPM: Useful for cross-

border valuation where the

two countries are highly

integrated.

)(* RRRk fHomeife

Home

−+= β

International CAPM

(“ICAPM”): Similar to CAPM

but based on the global equity

portfolio. Assumes market

integration.

)(* RRRk f

w

m

w

ife−+= β

CAPM adjusted for

segmentation and polit ical

risk: Explicitly treats two

problems commonly

encountered in developing

countries. Economical use of

data, but may omit other

factors.

)(*)( * RRRk US

f

US

m

US

M

M

i

US

fe dom

dom

−++= ββπ

Multifactor model: considers

the exposure of a stock to

various factors, both macro-

economic and firm specific.

( ) ( ) ( )

( ) ( ) ( ) εβββ

ββα

+−+−+−+

+−+−+=−

HiL

LoLLAAA

DCPfExEx

fCCifWWiifi

RRRRRR

RRRRRR //

Probably has the highest

explanatory power and is

followed by best practitioners.

Has heavy data demands.

Credit model: relies on non-

equity measures of risk.

Economical data

requirements. Estimates cost

of equity for a country.

1101, )ln(* ++ ++= ititti RatingRiskCreditCountryK εγγ


Please review the following case and then answer the questions that follow.

CASE: GURU TECHNOLOGIES*

In 1984, Jay Forte, a deal maker well known for managing successful company turnarounds,

approached Debra Brown for advice on a proposed management buyout of an electronics

manufacturer, Guru Technologies Company (“GTC”) from its parent company, Allegro

Electronics Inc. Brown worked in the corporate finance division of Kuchler & Bevill (“K&B,”

or the “Bank”), at which Forte was a well-known customer. With the bank’s lending and

investment criteria in mind, Brown needed to consider making both a bridge loan and an equity

investment.

Forte was seeking to borrow $2.5 million from K&B, to be used towards the $3.5 million cash

purchase of GTC. He proposed that he and the Bank would make an equity investment of $1

million.

Brown created a financial structure that she anticipated following the buyout. She developed the

forecast of residual cash and the structure of the transaction flow based on specific assumptions

(found in Exhibits 1 and 2 below). She assumed that the credit agreement as finally negotiated

would prohibit the payment of dividends to common stockholders until the debt was

substantially reduced. She would repay the debt as fast as the required cash balance (2 % of

sales) would allow. Therefore, practically speaking, the only cash flow to be received by

common stockholders would receive would come from the terminal value. Brown also made the

assumption that the equity would begin at a value of $1 million (the total equity investment value

for Forte and K&B).

The management group originating the buyout would benefit from including K&B Bank as an

equity investor since the debt provided by the Bank would be priced approximately 250 basis

points less than had the deal been financed strictly with debt from another lender. Forte

indicated that any equity investment negotiated with the Bank would reduce the original

investors’ contribution by a similar amount, so new equity invested by Forte and the bank would

still total $1.0 million.

To successfully turn-around the company, Forte proposed a business plan for a sharp reduction

in overhead, a new incentive system for managers to meet their budget, and a restructured

marketing effort. His financial analysis projected that in a worst-case scenario, company sales

would rise to $5.5 million in fiscal year 1985.

_______________________________________________________________________

* This is a disguised case of an actual leveraged buyout.

Please refer to the following exhibits and notes before answering the questions below:

Exhibit 1GURU TECHNOLOGIES INC.Dollar Figures in thousands ($000)

Pro Forma AssumptionsTax rate 48%Shares outstanding 100,000Other net working capital/sales 23%Cash/sales 2.0% Bank requirment

1985 1986 1987 1988 1989Base rate 13.50% 13.50% 13.50% 13.50% 13.50%

Sales (000) $5,500 $7,500 $8,800 $10,000 $11,200

Operating margin 16.3% 19.0% 19.0% 19.0% 19.0%

Capital expenditures 260$ 550$ 750$ 750$ 750$

Depreciation 600$ 550$ 500$ 500$ 500$ Organizational expenses 200$ -$ -$ -$ -$

Cost of capital assumptions (as of April, 1984)Risk free rate 12.42%Internal rate (base + 3.5%) 17.00%Market risk premium 6.00%Beta-unlevered 1.45

Exhibit 2 Debra Brown's Forecast of Cash Flows and Economic Balance SheetsDollar Figures in thousands ($000)

1985 1986 1987 1988 1989 NotesSales 5,500$ 7,500$ 8,800$ 10,000$ 11,200$ Exh. 1EBIT 896.5 1,425.0 1,672.0 1,900.0 2,128.0 Exh. 1

Interest 339.2 310.2 294.2 262.0 207.6 Note 1

Org'l Expenses 200.0 0.0 0.0 0.0 0.0 Exh. 1

Pre-Tax Profit 357.3 1,114.8 1,377.8 1,638.0 1,920.4Taxes @ 48% 171.5 535.1 661.4 786.2 921.8 Exh. 1

Net Profit 186$ 580$ 716$ 852$ 999$

Depreciation 600.0 550.0 500.0 500.0 500.0 Exh. 1

Capital Expenditures 260.0 550.0 750.0 750.0 750.0 Exh. 1Additions to WC 95.0 460.0 299.0 276.0 276.0 Exh. 1

Additions to Cash 110.0 40.0 26.0 24.0 24.0 Exh. 1

Debt Amort. 320.8 79.7 141.5 301.7 448.6 Note 2

Residual Cash Flow -$ -$ -$ -$ -$ Note 3 0.0

Cash (Beginning) 0.0 110.0 150.0 176.0 200.0Changes 110.0 40.0 26.0 24.0 24.0 Note 4Cash (Ending) 110$ 150$ 176$ 200$ 224$ Cash (Required) 110.0 150.0 176.0 200.0 224.0

Debra Brown's Forecast of Economic Balance Sheet and Capital AccountsDollar Figures in thousands ($000)

@ Closing 1985 1986 1987 1988 1989 NotesCash -$ 110$ 150$ 176$ 200$ 224.00$ Other Net Working Cap. 1,170 1,265 1,725 2,024 2,300 2,576.0 Note 5

Net Fixed Assets 2,330 1,990 1,990 2,240 2,490 2,740.0Total Assets 3,500$ 3,365$ 3,865$ 4,440$ 4,990$ 5,540$

Debt 2,500 2,179.2 2,099.5 1,958.1 1,656.3 1,207.7Equity 1,000 1,185.8 1,765.5 2,481.9 3,333.7 4,332.3Debt & Equity 3,500$ 3,365$ 3,865$ 4,440$ 4,990$ 5,540$

Memo: Debt BalancesDebt (Beginning) 2,500 2,500.0 2,179 2,100 1,958 1,656.3Changes (321) (80) (141) (302) (449) Note 2

Debt (Ending) 2,179$ 2,100$ 1,958$ 1,656$ 1,208$ Debt (Average) 2,340$ 2,139$ 2,029$ 1,807$ 1,432$

Memo: Equity BalancesEquity (Beginning) 1,000 1,000.0 1,185.8 1,765.5 2,481.9 3,333.7Changes 185.8 579.7 716.5 851.7 998.6Ending 1,186$ 1,765$ 2,482$ 3,334$ 4,332$

NOTES:

Note 1:Interest expense is computed as the interest rate (base rate plus one percent where the

base rate is as given in Exhibit 1) times the average debt balance for the year.

Note 2:Assumes debt is repaid as fast as required cash balance will allow. (Requirement equals 2

percent of sales.)

Note 3:Because this residual cash flow nets out the repurchase of Global Electronics Inc.’s

shares, it is specifically the residual cash flow to Jay Forte and K&B Bank.

Note 4:The sum of residual cash flow plus additions to cash.

Note 5:Other net working capital is computed by multiplying the ratio of (Other Net Working

Capital/Sales) and sales.

Questions:

1. What do you estimate to be the equity value of Guru Technologies (GTC)? Please refer to

Exhibit 13.4 as a guide for your calculation of the terminal value and the appropriate annual

discount rates. Please use a perpetual growth rate of 7 percent.

Answer to Question 1DCF Analysis Using Circularity MethodDollar Figures in thousands ($000)

Now 1985 1986 1987 1988 1989 NotesRisk free rate 12.42% 12.42% 12.42% 12.42% 12.42%Market premium (equity) 6% 0.060 0.060 0.060 0.060 0.060Book value of the debt (at year-end) 2,179$ 2,100$ 1,958$ 1,656$ 1,208$

DCF value of equity (at year-end) 3,169$ 3,915$ 4,813$ 5,891$ 7,180$ D/E (Market) 68.78% 53.63% 40.68% 28.12% 16.82%Unlevered Beta 1.45 1.45 1.45 1.45 1.45

Levered Beta 1.97 1.85 1.76 1.66 1.58

Cost of Equity 24.23% 23.55% 22.96% 22.39% 21.88%

CumulativeDiscount Factor 0.80 0.65 0.53 0.43 0.36

Residual Cash Flows -$ -$ -$ -$ -$

Terminal Value 7,180$ Note 1

Net Present Value $2,550 Perpetual Growth: 7%

Note 1: Assumes no more debt is repaid. The terminal value for 1989 was calulated as the residual cash flow in 1990 capitalized

at Ke - g. The residual cash flow in 1990 was assumed equal to the net income in 1989 times (1+g) (or $999,000 * 1.07).

To calculate GTC’s terminal value, you first need to calculate the residual cash flows. The

terminal value for 1989 is derived from the residual cash flow in 1990 capitalized at Ke - g.

Assume the residual cash flow in 1990 is equal to the net income in 1989 multiplied by (1+g) (or

$999,000 x 1.07).

Using the circularity method illustrated in Exhibit 4 of the chapter, you can start with a fixed

approximate equity value (hard-code in cell) and then derive the debt-to-equity ratio. Then,

using the D/E ratio you calculated and the unlevered beta of 1.45 (given in Exhibit 1), you can

determine the levered beta (BL) for the equity as well as the cost of equity.

BL = BU * [1+ (1-t) * (Debt book / Equity market )]

With the levered beta, you can now calculate the cost of equity using the CAPM model.

After determining the cost of equity, you can now re-calculate the terminal value by inputting the

equation:

Emarket = Cash Flow1989 * (1+g) / (ke-g)

Then you can start the circularity iterations to calculate the approximate solution for the equity

value of the firm. With this calculation, you can back-solve to determine the various years’

discount rates and annual equity values. Finally, you can arrive at the Net Present Value of the

equity valuation = $ 2.55 million.

2. From the bank’s point of view, what is the Net Present Value of the $2.5 million loan? Hint:

Please lay out the amortization and payment structure to calculate the NPV.

What percentage of the equity should the bank request as part of its commitment to lend in order

to break even on its required return?

Answer to Question 2 Net Present Value of LoanDollar Figures in thousands ($000)

1985 1986 1987 1988 1989 NotesBalance of Bank DebtDebt (Beginning) 2,500$ 2,179$ 2,100$ 1,958$ 1,656$ Changes (321)$ (80)$ (141)$ (302)$ (449)$ Debt (Ending) 2,179$ 2,100$ 1,958$ 1,656$ 1,208$

Cash Flow to BankInterest 339$ 310$ 294$ 262$ 208$ Princ. (2,500)$ 321$ 80$ 141$ 302$ 1,656$ Note 1

Total (2,500)$ 660$ 390$ 436$ 564$ 1,864$

Required Return Base Rate 13.50% 13.50% 13.50% 13.50% 13.50% Base + 3.5% 17.00% 17.00% 17.00% 17.00% 17.00% Discount Factor 0.85 0.73 0.62 0.53 0.46 Present Values (2,500)$ 564$ 285$ 272$ 301$ 850$ Net Present Value (228)$

Note 1: Assumes bank debt is repaid in full at end of 1989.

To determine the NPV of the bank loan, you need to lay out the debt amortization and payment

schedule for the five-year projection. The debt payment schedule is derived from the cash flows,

and the interest expense is calculated on an annual basis by using the following formula:

Average debt balance for the year * Interest rate

The proposed interest rate on the loan (equal to the base rate plus 1.0 percent) is clearly below

the going rate on credits of similar risk (i.e., base plus 3.5 percent). You need to use this going

rate (the required rate of return for comparable investments) as your discount rate to then

calculate the NPV of the loan: ($228,009).

In order to break-even on the loan shortfall, the bank should acquire an appropriate percentage

of the equity:

($228,009) = X * ($1,000,000 – $2,550,480)

X = 14.71%

3. Please perform a sensitivity analysis on the terminal growth rate. How sensitive is your

valuation to the growth rate? With this information, please analyze this deal structure from the

point of view of Debra Brown and K&B bank.

Growth Rate PV of Cash Flows

0% $1,513

1% $1,617

2% $1,732

3% $1,859

4% $2,002

5% $2,162

6% $2,343

7% $2,550

8% $2,789

9% $3,068

10% $3,396

11% $3,789

12% $4,269

13% $4,867

14% $5,633

15% $6,650

The equity forecast may be varied in numerous ways to test the sensitivity of this result.

For instance, with a data table, varying the perpetual growth rate embedded in the terminal

value produces these present values.

The present value of equity appears to be reasonably robust to variations in the

perpetual-growth-rate assumption. The reasons are that most of the value is created by growth

in the 1985-89 period and that the cost of equity in 1989 is still very high, 21.88%. Thus, small

variations in perpetual growth produce a small effect.

It is important to contemplate and understand this problem from the two parties’ point of view.

From each party’s positions, there must be some balance between equity and debt. Jay Forte

gives up some equity in order to get a better interest rate from the bank. In turn, the bank

benefits from taking some equity so it can satisfy its required rate of return.


1. Real options are pervasive everywhere even in daily life. Please identify which of the

following alternatives are real options.

a. Automobile insurance,

b. Defined benefit retirement plan,

c. Cash or credit cards in your wallet,

d. Training a work force to do multiple tasks,

e. Taking swimming lessons.

Solution:

a. Insurance is a put option. You “put” your wrecked car to the insurance company

to get the exercise value.

b. A defined benefit retirement plan is not an option because you know how much

you will get in the future. There is no contingency in this case.

c. Cash or credit cards in your wallet are options to you because cash and unused

debt capacity offer you financial flexibility. Generally, the cash balance and

unused debt capacity of corporations carry some real option value for

shareholders because of the financial flexibility they create.

d. Training a work force to do multiple tasks creates an option because it provides

operational flexibility under future business uncertainty. The cost of the training

is the price of the option.

e. Taking swimming lessons is buying an option because it will give you a skill that

provides flexibility in your personal life.

2. How do options differ from “opportunities”?

Solution:

Opportunities and options tend to differ on five dimensions: exclusivity, cost to acquire, finite

life, distinguishability from the underlying asset, and contingency.

3. Suppose you go to an automobile dealer to buy a car. After you pick the right model, the

salesperson recommends four alternatives to you. They are metallic painting, adjustable

passenger side seat, automatic transmission, and adjustable steering wheel. Among these

four, which one seems like an option to you? Why?

Solution:

Among the four choices, the adjustable passenger side seat and adjustable steering wheel give

you because they offer you the flexibility to change and switch after the purchase. The other two

offer no flexibility and cannot be changed after the purchase.

4. Automakers are beginning to develop a hybrid car, which can use gasoline or electricity

as power sources. Assume one such car sells for $2,000 more than a normal gasoline-

powered car. Based on your estimation, a normal gas-powered car will consume present

value of $10,000 of over its lifetime if gas prices stay at the current level. If you only use

electricity for the hybrid car, it will cost you $15,000 now. But if a new source of energy

is developed soon, the cost of electricity for the lifetime of the car may drop to $10,000 in

present value term and gas price may double in the future. The probability of status quo is

predicted at 60%. Does the hybrid car represent an option to you? How much of its

premium is accounted for by the option value?

Solution:

ProbabilityPV of cost ($10,000) 60%

EMV of cost (10,000)$ Gas is cheaper, you use gas.Buy Hybrid car

PV of cost ($10,000) 40%Electricity is cheaper, you use electricity.

DecisionPV of cost ($10,000) 60%

EMV of cost (14,000)$ Gas is cheaper, you use gas.Buy Normal Car

PV of cost ($20,000) 40%Saving of switching option: 4,000$ Gas is more expensive, you use gas.

Premium for hybrid $2,000

Option value > Premium

The EMV of the cost is calculated by averaging costs based on their probabilities. The total

expected cost for hybrid car is $10,000 and is $14,000 for normal car. It implies a $4,000

saving by buying hybrid car. Compared to $2,000 premium, it makes the choice to buy hybrid

car a good investment in term of expected value.

5. You can purchase the right to drill in a natural gas field for $6 million. If you have a dry well,

the present value of future payoffs is zero. If you find natural gas, the PV of future payoffs

will be $10 million. After consulting with a geologist, you estimate that there is roughly a

70% chance of finding gas. He also told you that you can spend a certain amount of money to

drill a test well in the field so that you can be sure whether you will find gas or not. Please

draw a decision tree that determines the value of the test. What kind of option is the test?

Solution:

Cost of right $6,000,000 Net Payoff ProbabilityPV $4,000,000 70%

EMV 4,000,000$ Test

PV -$ 30%

DecisionPV $4,000,000 70%

EMV 1,000,000$ No test

PV ($6,000,000) 30%Value of the test 3,000,000$ The value of the test: $4 million - $1 million = $3 million

The test is an “R&D” option that allows the buyer to obtain accurate information to determine

whether to exercise the right to buy drilling right or not. Therefore, even without changing the

possibilities of events, while the test indicates a dry well, the buyer will not buy the right to drill.

Therefore, the net payoff for that branch is $0 not -$6,000,000 in the case of no test. The option

creates value by giving the buyer the right to withdraw from the purchase of drilling right.

6. The CEO of MegaSoftware Inc. considers investing in a software development project.

R&D will cost $5 million right now. The software development can be finished in one year.

Forecasted profit from the sales of software follows a lognormal distribution with a mean of

$10 million and a standard deviation of 50%. Marketing and advertising expenses for the

sales are estimated at $5 million. The one-year risk-free rate is 7%. In your opinion, is the

investment in R&D an option? If so, what kind, and what is its value? (Calculate the option

value using template given in the disk)

Solution:

The investment in R&D is essentially the purchase of a call option on an uncertain future

discovery. For simplicity, you could consider this to be a European call option, of the sort that

the Black-Scholes Option Pricing Model is ideally suited for valuing. Using “Option

Valuation.xls,” insert the assumptions and estimate the option value. As these results show, the

price of the option ($5 million) is less than its estimated value ($5.43 million). The CEO should

proceed to invest in R&D.

Black-ScholesStep 1 Insert parameters into the model European: No Dividend

Stock price $10,000,000 Call value 5,430,122$ * The expected mean of project is also the current price. Call delta (hedge ratio) 0.962Exercise price $5,000,000 Call elasticity 1.772* The cost to exercise the option.Risk-free rate 7% Using put-call parityVolatility 50% Put value 92,091$ Time (years) 1 Delta -0.038

Elasticity -4.109Step 2 Calculate the option value using template.

S underlying asset price $10,000,000Call value 5,430,122$ X exercise price $5,000,000

rf risk-free rate 7%Step 3 Compare to the price of option sd volatility 50%

t years to expiration 1Option price $5,000,000* Cost of investment. Cumulative Standard Normal FunctionOption value 5,430,122$ d1 from Black-Scholes 1.776

N(d1) 0.962


Option value > option price, it is a good investment from Eepected Monetary Value stand point

7. Suppose you are negotiating an agreement with a start-up company that allows you to buy 50

percent of its equity 3 years from now at $10 million. The market value of the equity today is $8

million. The annual historical volatility of this company’s equity is 25%. The three-year

government bond yield is 6%. Assuming risk neutrality, please estimate the value of this option

using the binomial method: a) draw the lattice; b) fold it back to determine the present value.

Solution:

Step 1 Grow the tree Now Year 1 Year 2 Year 3

Parameters needed: A 16,936,000$ 13,189,770$

Volatility (Annualized) 25% 10,272,203$ 10,272,203$ Length of period (year) 1 8,000,000$ 8,000,000$

6,230,406$ 6,230,406$ Up percentage u 1.284025417 4,852,245$ Down percentage d 0.778800783 3,778,932$ A -- $10,272,203 = $8,000,000 * U (1.284)

Step 2 Assess the probabilities of an up or down movement ----- These will be used in step 5 to fold back the tree.

Pu = [(1+Rf)-d)]/(u-d) 55.66% --- 56.66% chance of moving upPd = [u-(1+Rf)]/(u-d) 44.34% --- 44.34% chance of moving downRf = 6%Rf 6%

Step 3 Assess the states in which the options will be exercised

Step 4 Estimate the payoffs associated with these end-states.

Exercise price $10,000,000

Now Year 1 Year 2 Year 3

6,936,000$ -

- 272,203$ - -

- - -

- Step 5 Calculate the present value of expected future payoffs.

Now Year 1 Year 2 Year 3 B

6,936,000$ 3,755,808$

2,031,881$ 272,203$ 1,098,290$ 142,928$

75,048$ - -

- B --- $3,755,808 = ($6,936,000 * Pu + $272,203 * Pd)/(1+Rf)

Binomial approach assumes that each year, the value of the equity will move up by u (u = e(1*25%) = 1.284) or down by d (d = e^(-1*25%) = 1/u = 0.779). This means that at the end of the first year, the value of the equity will be either $10,272,203 (u *$8,000,000) or $6,230,406 (d *$8,000,000)

In the above table, the boldface numbers indicate when you will exercise the option. In these cases, the payoff is greater than the exercise price, $10,000,000

By folding back the tree to now, the value of the option is obtained in the term of present value. Therefore, although the current value of the firm is $8 million. This agreement still has a positive value of $1,098,290.

Take the example of $3,755,808, one would take the expected value of the Pu*$6,936,000+Pd*$272,203, or (.5666*$6,936,000)+(0.4434*$272,203) to yield $3,981,156—discounting this by one year at the risk-free rate, 0.06 yields $3,755,808. This process is repeated for the other cells, folding back to the present, to find a value of $1,098,290 for the agreement.

8. A big pharmaceutical company XYZ is considering a joint venture deal with biotech

company ABC. Company ABC has a promising drug candidate in the pipeline, which just

passed the Phase II Clinical trials. ABC needs cash to push the clinical trials forward and

apply for FDA approval. Therefore, it approached company XYZ to offer XYZ the right to

share the future profits from this drug in exchange for a cash payment now. (Assume no time

value of money in this problem).

a. Company ABC asks for $5 million cash payment now in exchange for fifty percent of the

future profits from the drugs. There is an 80% chance for this drug to pass the Phase III

clinical trial and get FDA approval. If FDA approves its use, the forecasted sales will

most likely be $200 million with a minimum of $100 million and a maximum of $300

million. The profit margin on the sales is estimated at 20%. To obtain fifty percent of the

profit, Company XYZ also needs to share fifty percent of the marketing expense of $20

million. Should company XYZ take this offer?

b. After reexamining the possibility of passing FDA approval, company XYZ found that

there is a 90% chance for this drug to have a positive result from the Phase III Clinical

trial and there is a 90% chance for it to obtain FDA approval. Company XYZ proposes to

ABC that it can pay $2 million if the drug passes the Phase III test and pay a certain

amount now. Suppose the sales forecast, profit margin and other terms stay the same.

How much should company ABC ask for the initial payment?

Solution:

a. First, we draw a tree to illustrate how XYZ should process this decision: XYZ needs to

estimate the expected value of ABC based on probabilities of FDA approval, and projected sales

figures and profit margins. Then, we build a Monte Carlo simulation model incorporating the

uncertainties as defined in the problem. Running 5,000 simulations, we get a mean expected net

value for the investment of $3 million.

Step 1. Draw the tree

80% chance of getting FDA approval

Cost of the right: $10,000,000

20% chance fail

Profit margin: 20%Marketing expense: $20Share of profit: 50%Initial cost: $5

Step 2. Build an Excel spreadsheet model (See the model on CDROM accompanying the book: CHPT9A.xls.

Chance of approval: Discrete distribution 0

Payoff: Triangular distribution 100

Expected payoff: 0

Net payoff: ($5)

Step 3.

Step 4. Run crystal ball 5000 times, get the results in the following.

Go to cells with uncertaint distributions and specify the distribution. In this problem, this is done for you: the chance of approval is a customerized discrete distribution with 80% probability to be 1 and 20% probability to be 0; the payoff is a triangle distribution with high at $300, low at $100 and the best guess at $200.

Distribution of Sales: Triangle with a maximum at $300 million, a minimum at $100 million and the most possible value at $200 million

20% of Sales - Marketing expense

($20 million)

Zero

Payoff

Summary:Display Range is from ($5) to $14 MillionEntire Range is from ($5) to $15 MillionAfter 5,000 Trials, the Std. Error of the Mean is $0

Statistics: ValueTrials 5000Mean $3Median $4Mode ($5)Standard Deviation $5Variance $29Skewness -0.10Kurtosis 1.95Coeff. of Variability 1.83Range Minimum ($5)Range Maximum $15Range Width $20Mean Std. Error $0.08

Frequency Chart

Million

.000

.050

.101

.151

.201

0

251.7

503.5

755.2

1007

($5) ($0) $5 $10 $14

5,000 Trials 4,994 Displayed

Forecast: Net payoff

b.

Step 1. Draw the tree

10% chance of getting FDA approval

Cost of the right: $2

Initial cost: ??? 10% chance fail

Profit margin: 20%Marketing expense: $20Share of profit: 50%Stage two cost: $2Initial cost: $0

Step 2. Build an Excel spreadsheet model (See the model on CDROM accompanying the book: CHPT9B.xls.

Chance of pass: Discrete distribution 0

Chance of approval: Discrete distribution 0

Payoff: Triangular distribution 100

Expected payoff after Pass of phase III: 0

Net payoff after the payment of $2 ($2)

Total Net payoff: 0

Step 3.

Step 4. Run crystal ball 5000 times, get the results in the following.

Go to cells with uncertaint distributions and specify the distribution. In this problem, this is done for you: the chance of passing Phase III trial is a customerized discrete distribution with 90% probability to be 1 and 10% probability to be 0; the chance of FDA approval is a customerized discrete distribution with 90% probability to be 1 and 10% probability to be 0 and the payoff is a triangle distribution with high at $300, low at $100 and the best guess at $200.

10% chance fail

90% chance of passing Phase III

Zero

Payoff

Distribution of Sales: Triangle with a maximum at $300 million, a minimum at $100 million and the most possible value at $200 million

20% of Sales - Marketing expense

($20 million)

Zero

Summary:Display Range is from -2.00 to 17.10 millionEntire Range is from -2.00 to 17.70 millionAfter 5,000 Trials, the Std. Error of the Mean is 0.07

Statistics: ValueTrials 5000Mean 6.45Median 7.02Mode 0.00Standard Deviation 5.16Variance 26.62Skewness -0.06Kurtosis 1.99Coeff. of Variability 0.80Range Minimum -2.00Range Maximum 17.70Range Width 19.70Mean Std. Error 0.07

Frequency Chart

mi l l ion

.000

.025

.049

.074

.098

0

123

246

369

492

-2.00 2.77 7.55 12.32 17.10


Forecast: Total net payoff

From the Monte Carlo simulation, it is noted that a mean of $6.45 million is obtained. Therefore,

it is the maximum amount company ABC can charge for. The risk profile of this project indicates

it is fairly risky. There are two major spikes at -$2 million and $0. So, company ABC may want

to lower the ask price to compensate the risk. What is also worth to mention is that the total

amount company ABC can charge for this deal increases from $8 million to $8.45 million due to

the staging of the payment.

9. Why it is hard to value real options?

Solution:

There are no simple approaches to value real options because of the following:

• The exercise price and data may be contingent rather than fixed

• The value of the underlying asset may not be very uncertain, and the uncertainty may be

hard to estimate.

• Transaction costs may be high and/or contingent.

• The option may actually consist of a cluster of options, or a series of options, or options

on options.


1. What is liquidity? Why is it valuable?

Solution:

Liquidity refers to the ability to find a ready price and counterparty for a transaction to

purchase or sell an asset. It is valuable because it offers both the buyer and the seller an

option to buy or sell. It is a right not an obligation.

2. You are considering an acquisition of a private company, ABC. Based on a stand-alone

valuation, ABC is worth $10 million. The total synergy, if the merger is completed, is

estimated to be $4 million. Suppose that in this case, the discount for liquidity for public

companies similar to ABC is around 45%. Please estimate the maximum payment for this

company.

Solution:

ControlandLiquiditySynergiesAlonedS VVetTforPaymentMaximum π++= tanarg

V (Standalone) = $10 million; V (Synergies) = $4 million; and p (discount for liquidity) =

45% * V standalone = $4.5 million.

Maximum payment = $10 + $4 - $4.5 = $9.5 million.

3. Give some examples of some illiquid securities in financial markets. Briefly explain why it

is important to consider them in the analysis of M&A transactions.

Solution:

Examples include: Letter stock; entrepreneurs’ restricted shares; private placements before

public transactions; and private equity investments. In M&A activities involving any the

above, liquidity will play a pivotal role in determining the deal value or structure.

4. Briefly explain why “control” is valuable to business managers. How does one value

control?

Solution:

“Control” is the power and right to direct the strategy and activities of the firm, to allocate

resources, and to distribute the economic wealth of the firm. Because having control grants

owners the right to determine the future strategy of the firm, control is analogous to having

a switching option. As described in the Real Options chapter (Chapter 14), you can use

different methods to value this option. However, it is important to estimate key drivers such

as volatility and duration of the option if one is using the binomial model or the decision

tree methods. If one is using the Black-Scholes model, one needs to accurately estimate the

underlying asset value and exercise price as well.

5. Suppose there is a retailer company that has two major shareholders: Mr. Jones and Mrs.

Emily. Other owners of the firm are oceanic voters. Mr. Jones is the first major shareholder

and Mrs. Emily is the second major shareholder. Assuming the following three scenarios,

please use the Excel model “Power.xls” to calculate the Shapley Value for all the parties.

If power determines the value of votes, whose votes will be worth the most in each

situation?

Scenario 1: Jones has 30% of votes; Emily has 20% of votes and the other 50% of votes are

held by oceanic voters.





Solution:

Using Power.xls, you should come up with the following results:

Scenario 1 Scenario 2 Scenario 3

Structure: 30/20/50 40/10/50 40/20/40

Power Power Power

Index Index Index

Mr. Jones 0.36 0.64 0.56

Mrs. Emily 0.16 0.04 0.06

Oceanic voters 0.48 0.32 0.38

Below we use the example of scenario 3 to illustrate the calculations:

Power Power# Votes # Voters Index Ratio

Control shareholder #1 40 1 0.563 0.014Control shareholder #2 20 1 0.063 0.003Ocean 40 50 0.375 0.009Total 100 12 1.000

# votes needed to pass = 50

Assumptions Milnor-Shapley

Looking at the results across-the-board from the point of view of the first major

shareholder, we observe that Mr. Jones’s power index rises to 0.64 when he acquires an

additional 10 percent stake from another major shareholder versus 0.56 when the stake is

from oceanic shareholders. Although he acquires the same number of shares in either case,

the balance of power between him and the second major shareholder becomes much more

tilted in his favor when the additional shares are taken from the second major shareholder.

Likewise, from the point of view of the second major shareholder, Mrs. Emily’s power index

is much greater if she acquires an additional 10 percent share from the first major

shareholder as compared to when he acquires the same stake from the oceanic

shareholders.

The most interesting observation, however, is found when looking at what happens to the

power index of the oceanic shareholders. Comparing (1) and (2) we see that their stakes

remains constant but the power index rises significantly when the balance of power between

the first and second major shareholders is more evenly distributed. Even more interesting,

when comparing (2) and (3), we see that the power index of the oceanic shareholders is

greater in (3), even though their stake has actually decreased! This is because selling 10

percent of their stake to the second major shareholder allows them to effectively

redistribute the power balance – the first major shareholder now becomes less powerful

relative to the second major shareholder, making the balance of power more even and

thereby increasing the relative power of the oceanic shareholders.

6. Suppose you are the principal at a private equity firm and are considering an opportunity to

purchase the majority of shares in a publicly traded machinery tool company. You think the

company is mismanaged and you would like to expand its product lines and to sell them

abroad. The purchase of 60% of shares will give you control over implementing your

expansion project. The base value for this company is estimated at $100 million. The

expansion project will cost about $10 million and has an 80% chance of succeeding. If the

project succeeds, you believe it will generate a business worth $20 million in present value

terms. If it fails, the present value will be zero. Can control in this case be seen as an

option? If so, what kind of option is it and what is the value of this option? How much of a

premium, in percentage terms, are you willing to pay in this case?

Solution:

Buying the company will give you the right to switch from an old strategy to a new one. In

this sense, the investment in the company represents a real option, specifically a switching

option. The decision tree below illustrates the optionality created by the purchase of the

company. The different branches of the tree illustrate the payoffs under different

circumstances. Using the estimated payoffs and probabilities, the expected value of the

payoff can be calculated – this is the value of the option. The premium that one would be

willing to pay can be calculated by comparing the value of the option to the base case

estimate of the firm value.

ProbabilityPV of Benefit $20,000,000 80%

$6,000,000Expand

Cost of Project 10,000,000$ PV of Benefit $0 20%

Decision

$0Not expand

Additional profit from switching option: 6,000,000$ Base value: 100,000,000$ Percentage premium: 6%

Net EMV of project

Net EMV of project

7. Suppose you are the CEO of a firm, and a public company want s to purchase your

company. There are several major shareholders that cumulatively/together hold 60% of

your firm’s share. The other 40% are oceanic voters. The base value for your firm--the

DCF value excluding any value for illiquidity or control--is $100 million. Assume that the

public company is willing to pay a 30% premium for control. Assume your opponent uses

the base price as his bid price and that there are a total of one hundred shares. How much

will the individual share price be for block shareho lders and for oceanic shareholders?

Solution:

Base case value of the equity (1) 100.00$ Adjustment for illquidity (2) 0%Value of equity adjusted for possible illiquidity (3) 100.00$

%premium for control 30%

Size of controlling bloc (4) 60%Value of controlling bloc (5) 78.00$ Value of minority bloc (6) 22.00$ Value of equity adjusted for control asymmetry and illquidity (7) 100.00$

Controlling bloc price per share (8) 1.30$ Minority bloc price per share (9) 0.55$

(2) Illiquidity is assumed to affect all shares equally. Here, there is no illiquidity adjustment.(3) Value after illiquidity adjustment = Base value * (1-%Discount for illiquidity)(4) Percentage ownership of controlling bloc.

(7) The law of conservation of value requires that the value of minority and control blocs sum up to the value of equity adjusted for possible illiquidity.(8) Controlling bloc price per share equals the value of the controlling bloc divided by the number of shares for the controlling bloc.(9) Minority bloc price per share equals the value of the minority bloc divided by the number of shares for the minority bloc.

(1) The base value of the company is the value of the firm with marketable shares but no control blocs or the value of the firm calculated from the DCF model.

(5) Value of the control bloc = Value of equity adjusted for possible illiquidity * (1+Control premium) * Size of the controlling bloc(6) The value of the minority bloc equals the difference between the value of equity adjusted for possible illiquidity and the value of the control bloc.

The price per share for the controlling block is $1.3 million. And the price per share for the

minority block is $0.55 million. The difference between the two is caused by the total

control premium asked by the controlling bloc.

8. You are an M&A advisor, facing an interesting deal. One of your clients is preparing to

purchase an oil- refining company, which does not have any long-term debt on its balance

sheet. The company is worth $100 million today on a stand-alone basis. The deal proposed

by both parties is structured so that the buyer will purchase 60% of the seller’s shares today

and is restricted from selling its holdings in the next five years. After your client gains

majority control, he plans to hire outside consultants to initiate a cost-cutting program to

make the company more profitable. If the program succeeds, you believe it will generate total

savings of $20 million in one year. If it fails, the PV will be zero. The cost of the program is

around $5 million and the chance of success is estimated at 70%. The historical volatility for

the assets of this firm is about 20%. What kinds of options are embedded in this deal?

Assuming the risk-free rate is at 8% annually, how much are the options worth in value?

What is your recommended purchase price for this deal?

Solution:

There are two options in this deal: a long switching (call) option from the control and a short

put option from illiquidity. The total value of the firm equals the total of the base value for

the firm and the value of all options.

Discount rate: 8% ProbabilityPayoff $20,000,000 70%

EMV for payoff 12,962,963$ SuccessControl

Cost : $5,000,000 Payoff -$ 30%Net Payoff: 7,962,963$ Fail

Decision

EMVNo control Payoff -$

Value of switching option: 7,962,963$

The put value could be estimated using the Black-Scholes Option Pricing model:

Stock price: $100,000,000

Exercise price: $100,000,000

Risk free rate: 8%

Volatility: 20%

Time: 5 years

Total value of firm: 71,336,341.25$

Price for 60% of equity 42,801,804.75$

Total value of the firm = base value of the firm + value of switch option - value of put option =$100,000,000+$7,962,963-$36,626,622 = $71,336,341.25


1. What is purchase accounting?

Purchase accounting is a method of recording the acquisition of a firm. The central feature

of this approach is that the target is recorded on the buyer’s books at the purchase price.

2. Define “goodwill” in the context of purchase accounting. Can goodwill be amortized? How

does FAS 142 require that goodwill be treated?

Goodwill is the difference between the purchase price and the fair market value of the

target’s identifiable assets. Under the new rules, goodwill cannot be amortized, but must be

tested at least annually for impairment.

3. What criteria determine whether an asset should be classified as intangible, rather than as

part of goodwill? Explain each.

The contractual-legal criterion and the separability criterion. By the first criterion, an

acquired asset is considered intangible and distinct from goodwill if it arises from

contractual or other legal rights. By the second criterion, an acquired asset is considered

intangible and distinct from goodwill if it is capable of being separated from the acquired

entity and sold, transferred, licensed, rented, or exchanged.

4. Should acquired intangible assets be amortized?

Yes, if the tangible asset has a finite life.

5. Describe the Consolidation Method of accounting for acquisitions. For what percentage of

share ownership acquired is this method suggested, and why? How are balance sheet and

income statement items of the target reflected? How are balance sheet and income statement

items for minority investors reflected?

The Consolidation Method is suggested for acquisitions involving 50% or more of target

stock, which typically gives the acquirer control over the assets. This situation is captured

by the consolidation method’s subsuming the target’s accounts into the buyer’s accounts.

Profits (losses) attributable to minority investors are subtracted from (added to) the income

statement.

6. Describe the Equity Method of accounting for acquisitions. When is this method used? How

are the target’s balance sheet and income statement items reflected?

The Equity Method is used when a firm acquires a significant interest in – but not majority

control of – a target. Such transactions are often characterized by acquisition stakes of

between 20 to 50 percent. Balance sheet and income statement items of the target are not

reflected individually in the buyer’s financial statements. Rather, an account, “Investment in

Target Company,” is created when the buyer makes the initial investment, upon which this

account will record the investment at the buyer’s purchase price. This account will be

increased or decreased by the buyer’s proportionate share in the target’s profits and losses.

The buyer is also obligated to report profits and losses of the target on its (the buyer’s)

income statement. These profits and losses then make their way to the balance sheet through

the retained earnings account.

7. How is a receipt of dividends from the target recorded under the Equity Method?

Dividends received by the buyer are reflected as a reduction in the account “Investment in

Target Company,” with an accompanying entry for an increase in cash.

8. Describe the Cost Method of accounting for acquisitions. When is this method used? What

are the three methods of recording acquisitions that fall under the Cost Method? Explain

each.

The Cost Method is used when the buyer does not acquire significant control of the target.

Such acquisitions typically involve the purchase of less than a 20 percent stake in the target.

The investment is recorded on the balance sheet as an “Investment in Affiliate.”

9. How do the Consolidation Method and the Equity Method of accounting differ in their

treatment of cash flows of the target?

Under consolidation, the target’s cash flows are subsumed into those of the buyer; therefore,

many of the buyer’s cash flow items can be affected by the target’s performance. Under the

equity method, only the actual cash flows between the target and buyer will be reflected in

the cash flow statement.

True or False. If false, provide the correct answer.

1. In purchase accounting, the buyer records assets acquired at their historical cost rather than at

their acquisition price.

2. Purchase accounting requires that the purchase price be allocated among the various asset

accounts to the FMV of each.

3. In purchase accounting, liabilities are not recorded at fair market value.

4. In purchase accounting, the buyer’s past financial results can be retroactively restated.

5. The Consolidation Method is used when material voting power but not majority control is

acquired.

6. Under the Consolidation Method, balance sheet items attributable to minority investors are

carried on the acquirer’s books.

7. Under the Consolidation Method, balance sheet items attributable to minority investors are

carried at fair market value.

8. Under the Equity Method, the buyer recognizes its investment in a target through a balance

sheet account, “Investment in Target Company.”

9. Under the Equity Method, the target’s profits and losses are not reflected on the buyer’s

income statement.

10. The Equity Method recognizes dividends received from the target as an addition to the

“Investment in Target Company” account.

11. The Cost Method is typically used when the buyer acquires less than a 20% share in the

target.

Answers:

1. False. Assets are recorded at purchase price.

2. True.

3. False. Liabilities are recorded at fair market value.

4. False. The buyer’s past financial results cannot be retroactively restated.

5. False. Use of the consolidation method implies that the acquirer exercises majority

control.

6. True.

7. True.

8. True.

9. False. The target’s profits and losses are reflected in the buyer’s income statement,

usually in an account called “Income from equity investments.”

10. False. Dividends are recognized as a reduction to the “Investment in Target Company”

account.

11. True.


1. In the chapter, four cases are discussed to illustrate the concept of momentum acquisition

strategies. What are the common features of this strategy?

The cases on “Automatic” Sprinkler, Ling-Temco-Vought, U.S. Office Products, and Tyco

International suggest a number of features in common among momentum acquirers:

• “Feedback effect” from the stock market: high share valuation that creates an attractive

acquisition currency.

• Low organic rate of growth offset by rapid growth from acquisition

• Earnings management.

• Early successful growth that becomes increasingly difficult to sustain.

• Unexpected events happened to halt the growth.

• Sudden reverse of investors’ sentiment; dramatic stock price decline.

• Change of management.

2. Among different momentum strategies, EPS momentum and revenue momentum are the

most common approaches. Please briefly describe both strategies.

The EPS momentum holds that stock prices are driven by changes in EPS and that therefore

steady and aggressive growth in EPS will result in high stock prices (and high P/E

multiples). EPS can be managed by designing deals in ways that avoid EPS dilution. In some

industries, the momentum focus is on revenues instead of earnings per share due to the fact

that a significant portion of the market values of firms in these industries derives from their

growth options; therefore some analysts advocate using revenue multiples as a basis for

valuing these firms.

3. In the chapter, Scott Sterling Johnson, a momentum investor, said, “I want to be in the sweet

spot of the ‘S curve,’ which is the point of maximum rate-of-change, acceleration,

momentum… There are five things I specifically look for...dramatically accelerating

earnings...strong balance sheet...strong relative price strength...industries that are doing

well...low institutional ownership...dynamic trends…” What is the “key bet” of an investing

strategy such as this?

First of all, the momentum investor believes that a “hot hand” or a winning streak is

sustainable over some period of time. One tries to be the first to identify the trend and the

first to withdraw when the trend stops. If one is able to do this, the strategy will provide high

returns; however, timing-based strategies have not proved an ability to beat benchmarks

consistently. It is doubtful whether any momentum investor can consistently foresee the

future, and in particular, whether they can answer the question “When will the momentum

stop?”

4. Momentum advocates believe that firms with momentum enjoy higher earnings (or revenue)

multiples than firms without. Please critique this belief.

Research on investment momentum offers a number of insights and implications for M&A

practitioners. First, momentum investment strategies may indeed pay, though the effect may

not be consistent or sizable enough to overcome taxes and transaction costs. Second, the

finding is not uniform across national markets. Third, the profitability of momentum

investment strategies is almost entirely explained by industry momentum rather than firm

momentum.

5. Why is momentum acquiring unsustainable indefinitely? How might analysts incorporate this

unsustainability in their va luations?

Momentum acquiring is not sustainable indefinitely for at least three reasons: 1) the annual

acquisition volume cannot get bigger forever; 2) the world is finite and 3) unexpected events

can happen at any time in the future to halt growth. To reflect the unsustainability of

momentum acquiring, analysts should adjust their long-term growth prospects for firms that

apply momentum-acquiring strategies downward and be extremely careful about the

underlying assumptions pertaining to the terminal value calculation.

6. Assume that buyer and target agree to a stock-for-stock acquisition. The buyer has 2 million

shares outstanding and $2 million in earnings. Its current P/E ratio is 20. The target has 1

million shares outstanding and $500,000 in earnings. The target’s current P/E ratio is 16.

Suppose the buyer is willing to offer a 20 percent premium for the target and a purchase

related transaction charge of $50,000 is expected. Calculate the earnings per share for Newco

after the merger and the percentage change in the buyer’s EPS.

Solution:

Buyer Target Newco % ChangeFinancial Data on Merging Firms

1 Purchase-related charges (50) 2 Net Income 2,000$ 500$ 2,450$ 23%3 Number of shares 2000 1000 2480 24%4 Earnings Per Share (EPS) 1.00$ 0.50$ 0.99$ -1.2%5 Current stock price 20.00$ 8.00$ 6 Price/Earnings Ratio 20.00 16.00 7 Ratio of earnings of Target to Buyer 0.25

Terms of share-for-share offer8 Dollar value of bid 9.60$ 9 Premium over Target´s pre-bid price 20%

10 Ratio of P/E Paid to P/E of Buyer 0.96

Dilution to the buyer resulting from the deal11 Dollar accretion (dilution) in Buyer E.P.S. (0.01)$ 12 Percentage accretion (dilution) -1.2%

Before After merger

As seen in the above table, the earnings per share for Newco after the merger is $0.99. This

implies dilution of 1.2% from the buyer’s EPS before the merger.

7. Refer to problem 6. By changing the bid price for the target, the buyer can avoid dilution.

Please calculate the percentage dilution or accretion for purchase premiums of 0%, 10%,

20%, 30% and 40%, and for target earnings of $250,000, $500,000, $750,000, $1,000,000 to

$1,250,000, assuming the target still has same P/E ratio. Explain the results.

Solution:

-1.2% 0% 10% 20% 30% 40%$250 0.0% -0.9% -1.8% -2.7% -3.5%$500 2.1% 0.4% -1.2% -2.8% -4.3%$750 3.8% 1.5% -0.7% -2.9% -4.9%

$1,000 5.4% 2.4% -0.3% -3.0% -5.4%$1,250 6.7% 3.2% 0.0% -3.0% -5.9%E

arn

ing

s o

f th

e ta

rget

Premium over target's per-bid price

From the above table, it is clear that an increase in the target’s earnings will reduce dilution

and enhance accretion. At the same time, when the premium required for the purchase

decreases, the dilution effect is smaller.

8. Assume you as the CEO of a publicly listed company are considering a purchase in a related

industry. There are two opportunities available. Company A is more technologically

advanced, which implies a high growth potential. But it also demands a higher premium than

company B, which has lower growth opportunities. Both companies have 2 million shares

outstanding and projected earnings for this year for both companies are the same at $2

million. Company A’s stock trades at $20 and company B’s stock trades at $15. After a

careful study of their businesses, you estimate that earnings of company A will grow at a rate

of 12% and those of company B will grow at 3%. You estimate your own firm’s earnings

will grow at 8%. Assume that the earnings of Newco after the merger will be just the simple

arithmetic addition of the forecasted earnings of your firm and the target. There are 3 million

shares outstanding for your firm; projected earnings for this year are $3 million. Your firm’s

stock trades at $25. If company A asks for a 60% premium over its market price and

company B only asks for a 20% premium, which company would you acquire? Please use

quantitative evidence to back up your decision.

Solution:

Buyer Target A Target BBefore Before Before

Financial Data on Merging FirmsNumber of Shares 3,000 4,500 6,780 2,000 5,160Net income $3,000 $2,500 $5,500 $3,000 $6,000Earnings per share $1.00 $0.56 $0.81 $1.50 $1.16Current stock price $25.00 $15.00 $21.00 $22.50 $27.00Price/earnings ratio 25 27 25.89 15 23.22Ratio of earnings of target to buyer 0.833 1.000Earnings growth rate 8% 15% 3%

Terms of share-to-share offerDollar value of bid $21.00 $27.00Premium over Target's pre-bid price 40% 20%Ratio of P/E paid to P/E of buyer 1.512 0.72

Resulting Accretion (Dilution)Dollar accretion (dilution) in Buyer E.P.S. ($0.19) $0.16Percentage accretion (dilution) -18.9% 16.3%

Buyer after acquiring target A

Buyer after acquiring target B

Earning forecasts:Now Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Buyer before $3,000 $3,240 $3,499 $3,779 $4,081 $4,408 $4,761 $5,141 $5,553 $5,997 $6,477$1.00 $1.08 $1.17 $1.26 $1.36 $1.47 $1.59 $1.71 $1.85 $2.00 $2.16

Target A before $2,500 $2,875 $3,306 $3,802 $4,373 $5,028 $5,783 $6,650 $7,648 $8,795 $10,114

$0.81 $0.90 $1.00 $1.12 $1.25 $1.39 $1.56 $1.74 $1.95 $2.18 $2.45 Growth rate for Newco 11.18% 11.29% 11.40% 11.51% 11.62% 11.73% 11.84% 11.95% 12.06% 12.16%Target B before $3,000 $3,090 $3,183 $3,278 $3,377 $3,478 $3,582 $3,690 $3,800 $3,914 $4,032

$1.16 $1.23 $1.29 $1.37 $1.45 $1.53 $1.62 $1.71 $1.81 $1.92 $2.04 Growth rate for Newco 5.50% 5.56% 5.62% 5.68% 5.74% 5.79% 5.85% 5.91% 5.97% 6.03%

$6,682

EPS for Buyer after acquiring target A

EPS for Buyer after acquiring target B

$5,500

EPS after merger

$14,792 $16,591 $7,581 $8,454 $9,436 $10,543

$9,911 $10,509 $7,057 $7,458 $7,886 $8,343

EPS after merger

EPS for Buyer alone

$8,831 $9,353

$11,792 $13,200 $6,115

$6,000 $6,330

$6,805

EPS growth with a dilutive target and an accretive target

$0.60

$0.80

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

$2.60

0 1 2 3 4 5 6 7 8 9 10Years from closing of the acquisition

Ear

nin

gs

per

sh

are

($)

Buyeralone

Buyer withtarget A

Buyer withtarget B

From the above table and figure, it can be seen that a deal with company A is immediately

dilutive (-10.1%) and a deal with company B is immediately accretive (12.6%). But the deal

with company A offers faster growth in earnings after the merger. Looking at near-term

dilution ignores possible long-term benefits. Ultimately, however, a choice between the two

companies should be based on total economic analysis, culminating in an estimated NPV of

the two potential investments.

9. Why is value creation a superior approach compared to momentum acquisition strategies? As

a manager, what are the implications of each approach for you?

Value creation is the best criterion for acquisition strategies because it focuses on the

longer-term future, accounts for the time value of money, focuses on economic reality,

focuses on risk and return, and accounts for opportunity costs. Further, the use of NPV

directly measures changes in investors’ welfare. Although difficult to apply, value-based

acquisition strategies have the ultimate virtue of weeding out bad deals more effectively than

other approaches. As a business manager, taking a value-based acquisition approach means

focusing on value, the future, and cash flow.


1. Why is a deal a “system”?

Each deal reflects choices in several dimensions, such as price, form of payment, social

issues, etc. The choices interact with one another. For instance, the more value a buyer

gives to the target company management, the less the buyer will likely give to the target’s

shareholders. Therefore, individual deal design choices cannot be considered in isolation.

One must assess them simultaneously, as a bundle of terms. Hence, deal design is a system.

2. What are some of the classic objectives of deal design in M&A?

Some classic objectives are to:

o Create value

o Improve reported financial results and avoid EPS dilution

o Improve control and avoid voting dilution

o Build financial flexibility

o Hedge security price risk

o Improve competitive standing

o Manage signals to the capital markets

o Manage incentives

o Frame governance and management

o Shape impact on employees and communities

3. What are some of the terms that are usually negotiated in an M&A deal?

Commonly negotiated deal terms include price, form of payment, form of reorganization and

tax implications, deadlines, timing, control and governance, commitments and warranties,

social issues, etc.

4. What are some issues to be considered when deciding on a form of payment? What are the

general forms of payment? And what are some circumstances under which each might be

used?

Some issues to be considered when deciding on a form of payment include:

o The target’s preference (cash or stock?)

o The buyer’s funding capacity

o Tax implications

o Motivational objectives (e.g. management performance)

Types of payments include fixed payments, semi-fixed payments, contingent payments, and

side payments:

o Fixed payments employ cash and senior debt securities, and can be used when there

is little uncertainty about the value of the target.

o Semi-fixed payments involve common and preferred stock, and sometimes, mezzanine

securities. Semi-fixed payments might be used when the buyer does not have the cash

or debt capacity to finance the acquisition. They may also be used to allow target

investors to participate in the upside for the combined firm.

o Contingent payments are used to hedge against uncertainties about the value of the

firm or about the future. For instance, earn-outs and convertible bonds might be

used when buyer and target disagree on the value of the firm. Caps, floors, and

collars might be used to protect target and buyer against fluctuations in the buyer’s

share price.

o Side payments are payments to parties other than the owners of the target firm,

parties that may have some influence in the success of the post-merger firm. These

might include managers, unions, bank lenders, and governments. Examples of side

payments are “golden parachutes,” bonuses, employment and consulting contracts,

etc.

5. Why might fixed payments have an adverse signaling effect?

The use of fixed payments could be interpreted as a lack of confidence by target shareholders

in the buyer’s future management of the enterprise, thus prompting them to demand fixed

payments.

6. How might deal terms be designed to deter either party from backing out of an M&A deal?

Deals can include terms that impose penalties on the party that backs out of an M&A deal.

For instance, the buyer and target can agree on a walk-away fee to be paid by whichever

party backs out. The parties might also agree on lock-up options, which automatically allow

one party the right to buy shares in the counterparty at a given price if the latter enters into

an agreement with an outside party.

7. What is an earn-out? In what deal situations might it especially be useful?

An earn-out is an arrangement where a portion of the purchase price for a company would

only be paid by the buyer upon attainment of agreed-upon performance goals. It is

especially useful in situations where the buyer and target cannot come to agreement on the

value of the target.

8. Describe how Price might be influenced by the Form of Payment.

A cash payment, for instance, would result in an immediately taxable deal, which in turn

could cause the target to demand a higher price from the buyer. Research suggests that

where selling shareholders are exposed to a higher tax payment in the near term, the

premium paid is higher.

9. How can a deal be tailored to hedge against security price risk in a share-for-share exchange?

A collar can be incorporated into the deal terms in order to hedge against security price risk. A

collar places both a cap and a floor on the effective purchase price. In the buyer’s case, a cap

might adjust the exchange ratio downward when the buyer’s stock rises above a certain price.

In the seller’s case, a floor could adjust the exchange ratio upward when the buyer’s stock falls

below a certain price.

10. What impact might the Form of Payment have on the Timing of a deal?

The Form of Payment would impact the Closing Date of a deal. For instance, cash deals

typically are quicker to finance and to pay. On the other hand, stock deals might draw out

the closing date for a deal, as stock issuance often entails registration and may require a

shareholder vote.

11. Is there a single best feasible deal? Explain.

No, it is unlikely that there will be one “best” single feasible deal. Rather, there is likely to

be an area within which feasible deals may be achieved. Deal design involves tradeoffs

among the various objectives of the buyer and seller. Both parties must decide on which

tradeoffs are acceptable and which are non-negotiable. Often, there are several acceptable

solutions arrived at through a process of optimization where the desirability of one set of

terms is compared against another set of terms. As such, there is no single best feasible deal.


1. What three possible kinds of tax benefits are M&A transactions usually associated with?

o A reduction in tax expense through the exploitation of net operating loss tax carry

forwards (NOLs) and other tax credits.

o A reduction in tax expense through the “step-up,” or increase, in the basis or value of

assets on which tax shields such as depreciation expense are computed.

o The exploitation of debt tax shields through increased financial leverage.

2. Which main issues must a deal designer consider when deciding on the form of acquisitive

reorganization? Explain.

o Tax impact: will the form of reorganization create a tax liability that is immediate or

deferred?

o Target’s liabilities: how can the reorganization be structured to shield the buyer from

the target’s liabilities?

o Shareholder vote: will the deal design require a shareholder vote?

o Surviving entity: should the buyer or the target be the surviving entity? How will this

affect third party contracts?

o Form of payment: what form of payment will result in the most tax -efficient structure?

o Limitations on other actions: which form of reorganization allows the buyer most

flexibility?

3. From a tax standpoint, which alternative is more desirable to the seller, the sale of a

company’s assets, or the sale of its stock? Explain.

A sale of stock is preferable to selling assets. This is because a sale of assets incurs tax

liabilities at two levels (one, a capital gain at the corporate level, and the other at the

shareholder level when securities are sold or liquidated). A sale of stock incurs tax only at

the shareholder level. Also, the liabilities of the target carry over to the buyer with a sale of

the entity.

4. Explain how a buyer might realize a tax benefit from purchasing an asset for cash.

If the asset purchased is depreciable or amortizable, and if the purchase premium can be

allocated to the asset, the buyer benefits from the step-up in basis. This increases

depreciation or amortization expense and therefore reduces tax expense.

5. In a purchase of assets for cash, how might a conflict of interest due to tax consequences

arise between buyer and seller?

A possible allocation conflict might ensue between buyer and seller in tax jurisdictions where

capital gains tax rates are lower than income tax rates. The buyer will want to allocate the

fair market value of the purchase in ways to shield taxes on ordinary income (e.g., toward

inventory), while the seller will want to allocate the fair market value to capital items such as

plant and equipment to create capital gains rather than ordinary income.

6. What happens in a triangular cash merger?

In a triangular cash merger, the buyer forms a subsidiary (Subco) and capitalizes it with

enough cash to purchase the target’s stock. The target then merges with Subco.

7. What is a reverse triangular cash merger? How does the IRS view this transaction?

A reverse triangular cash merger is one where the buyer forms a subsidiary (Subco) to

acquire a target’s stock. Subco then merges into the target. The target company survives, as

do its tax attributes and liabilities. The IRS views this transaction as a cash purchase of

target shares.

8. What is a forward triangular cash merger? How does the IRS view this transaction?

A forward triangular cash merger is one where the buyer forms a subsidiary (Subco) to

acquire a target’s shares. The target then merges into Subco, which becomes the surviving

entity. The target company’s liabilities are transferred to Subco and its tax attributes cease

to exist. The IRS views this transaction as a purchase of assets.

9. What advantage does a cash merger have over a cash purchase of stock?

In a cash merger no minority shareholders remain in the target; all target shareholders have

been paid cash and the target ceases to be an independent entity. As long as the buyer can

attract a voting majority of the target’s shareholders, the merger can be effected and the

dissenting shareholders forced to exit. This is a minority “freeze-out.”

10. Describe what happens in a statutory merger and in a statutory consolidation.

In a statutory merger, one company absorbs the other. The target company ceases to exist.

The buyer assumes the liabilities of the target. All shares in the target company become

buyer shares. No minority target shareholders remain.

In a statutory consolidation, two or more corporations combine into one new corporation.

The pre-existing corporations cease to exist as legal entities.

In both cases, at least part of the consideration is made up of the buyer’s stock. While the

two transactions are legally different, common language of finance refers to both as

“mergers.”

11. What condition does the IRS require for statutory mergers and consolidations to be tax-free?

Statutory mergers and consolidations can be considered tax-free if there is sufficient

“continuity of interest” by the selling shareholders, which requires that at least 50 percent of

the merger consideration is paid in stock of the acquiring company.

12. What happens in a forward triangular merger under an “A” type reorganization? What is

needed in order for this kind of transaction to qualify as tax-free?

In this transaction, the target company is merged into a subsidiary of the buyer (Subco). To

qualify as a tax-free transaction, the subsidiary must acquire substantially all of the target’s

assets (e.g., at least 70 percent of the fair market value of gross assets and 90 percent of the

FMV of net assets).

13. What happens in a reverse triangular merger under an “A” type reorganization? What

requirements must be met for this kind of transaction to qualify as tax-free?

In a reverse triangular merger, the buyer’s subsidiary (Subco) is merged into the target, with

the target as the surviving subsidiary of the buyer. In order to qualify as a tax-free

transaction, at least 80 percent of the consideration must be paid in the buyer’s parent

corporation voting stock. Also, the buyer must control “substantially all” of the target’s

assets.

14. What happens in a voting stock-for-stock acquisition (“B” type reorganization)? How can

this transaction qualify as tax-free?

No merger occurs in a voting stock-for-stock acquisition. Instead, the target is retained as a

wholly (or partially)-owned subsidiary of the buyer. To qualify as a tax-free transaction, the

buyer must exchange only voting common or preferred stock, and afterwards, control at least

80 percent of the votes of the target.

15. What happens in a voting stock-for-assets acquisition (“C” type reorganization)? How can

this transaction qualify as tax-free?

In a voting stock -for-assets acquisition, the buyer offers shares of its voting stock for

substantially all of the assets of the target company. The target company must liquidate after

the transaction, and distribute the shares in the buyer to the target shareholders in liquidation.

Tax-free status requires that at least 70 percent of the fair market value of the gross assets,

and 90 percent of the FMV of net assets of t he target company be transferred to the buyer.

16. A CEO wants to acquire a target but faces dissident shareholders in his own company. In

addition, he must seek shareholder authorization if he pays for the target with stock. Which

among the reorganization structures saves the CEO from a confrontation with dissidents?

A cash purchase of stock saves the CEO from a confrontation because it does not require

shareholder approval from either target or buyer shareholders.


1. For each of the following, identify whether stock or cash tends to be the prevalent form of

payment. Explain why.

a. buoyant period in the stock market cycle

b. hostile takeover

c. jumbo deal

d. ownership is concentrated

Solution:

a. During buoyant periods in the stock market cycle, stock tends to be the prevalent form of

payment, probably due to opportunism – companies tend to use stock as payment when

they believe their shares are richly valued.

b. In hostile takeovers, cash is the preferred medium because it can preempt competitors.

Cash payments remove any contingency about the value of the bid. In addition, cash

does not involve complications that come with a stock deal, such as shareholder approval

requirements. Finally, cash payments are more effective at winning arbitrageurs over:

c. Stock payments tend to be used in jumbo deals – this may be due simply to the inability to

“write a check”; paying for jumbo deals in cash may overly strain financial reserves.

d. Cash deals tend to be used when ownership of the target and/or buyer is concentrated.

By not paying with stock, the buyer possibly avoids bringing in a new significant

shareholder that might destabilize the internal politics of the equity ownership group.

2. A study on shareholder returns found that over the five years following the deal, share-for-

share transactions yielded average excess returns of +14.5%, while cash deals yielded

+90.1%. What might explain this?

The opportunistic use of stock during times of overvaluation might explain this phenomenon

– inflated stock prices may result in overpayment or higher payments, leading to a lower

return on the investment.

3. Why do the following seem to affect the choice of form of payment: minimization of costs,

agency costs, and information asymmetry?

a. Minimization of costs. Forms of payment can have very different effects on costs;

managers will want to reduce the overall cost of capital and other costs such as taxes,

securities registration and issuance costs, and transaction costs.

b. Agency costs. Some managers may choose to barricade themselves from the rigors of

the marketplace by using cash to pay for acquisitions. Using debt or equity exposes

managers to the discipline imposed by creditors and shareholders.

c. Information asymmetry. Managers may have a clearer view of the true value of the firm

than do outsiders, and may thus take advantage of stock as a medium of payment in times

of overvaluation.

4. Research indicates that for buyer shareholders, payment in cash is associated with close to

zero returns, while payment in stock is associated with significantly negative returns. What

might explain this phenomenon?

This phenomenon might be explained by a tendency to overpay when stock is used, because

of its nature as “soft” currency, as opposed to cash. The use of hard currency may enforce

stricter discipline in the price paid. In addition, these findings suggest that the use of stock

could be opportunistic—buyers may exploit overvaluation in their shares to conclude deals.

5. What are the tax implications of a cash deal for the target? What about a stock deal?

In a cash deal, target shareholders must immediately pay taxes on their capital gain. In a

stock deal, the target shareholders’ taxes are deferred until the shares of Newco are sold.

6. Do abnormal returns to target shareholders tend to be larger in stock or in cash deals? Why?

Abnormal returns to targets tend to be larger in cash deals perhaps because target

shareholders expect the buyer to compensate them for their tax exposure—in cash deals,

target shareholders have an obligation to pay taxes immediately on their capital gain. Also,

in cash deals the buyer may be able to offer a higher price because of the larger tax shield

resulting from the “step-up” in the basis of depreciable assets.

7. How is it that some forms of payment might consume financial slack, and others might create

it?

Paying with cash uses financial slack (cash and/or unused debt capacity) unless the cash

payment is financed with a sale of equity; paying with equity increases Newco’s debt

capacity.

8. Are there any signaling implications when the target insists on a cash payment?

Yes. If a target insists on a cash payment, it may signal pessimism about the prospects of the

target and/or Newco.

9. Explain how issuing equity to fund an acquisition might send negative signals to the markets.

There is some evidence of a ‘pecking order’ when managers choose among funding

alternatives – issuing equity is usually less preferred to using internal funds or raising debt.

This leads to the hypothesis that managers will issue new equity only when the firm is

overvalued. The abundance of stock -for-stock deals when the stock market is buoyant

supports this hypothesis. Issuing stock, therefore, might be a signal to the markets that the

firm is overvalued.

10. Do stock prices of bidders react positively or negatively upon the announcement of a cash

deal? What about a stock deal? Explain.

Stock prices of bidders tend to react neutrally or positively at the announcement of cash

deals, and negatively at the announcement of stock deals. This is because bidders who are

optimistic about the value of merger synergies will tend to offer cash; therefore, a stock offer

may be perceived to be a signal of pessimism, or at least, of less optimism, hence the negative

reaction to stock deals.

11. Explain the difference in price, form of payment, and financing between a pre-emptive and a

contingent strategy. How does the choice of strategy affect the form of payment and

financing chosen?

A preemptive strategy is intended to thwart competing bidders; therefore, it is designed to be

an offer that target shareholders “cannot refuse.” If a buyer chooses to follow this strategy,

the form of payment often has to be cash, and the funding source internal, leaving no doubt

about the value of securities or about financing. On the other hand, a contingent strategy is

used when the probability of competing offers is low. If a buyer chooses this strategy, the

form of payment is often only partially or not even at all in cash, and the financing chosen

may be external.

12. The chapter discussed seven dimensions of M&A transaction financing: mix, maturity, yield

basis, currency, exotic terms, control features, and distribution. Explain how each plays into

a decision maker’s choice of financing.

o Mix. The decision maker will want to choose a form of financing that preserves a firm’s

financial flexibility, minimizes its cost of capital, and is compatible with its asset base.

o Maturity structure. Decision makers can choose a maturity structure for liabilities that

will expose the firm to reinvestment risk, refinancing risk, or not expose the firm to either.

o Basis for the yields. A decision maker’s outlook for interest rates will affect whether a

fixed or floating rate debt instrument is chosen.

o Currency. A firm’s exposure to foreign exchange rate fluctuations and the possibility of

exploiting unusual financing opportunities in global capital markets will influence the

currency in which the firm chooses to raise acquisition funding.

o Exotic terms. A firm may choose to issue exotic securities if these can lower the cost of

capital and/or reduce risk. Exotic securities may also be used in cases where there is

some disagreement between issuers and investors about a firm’s prospects.

o Control features. Decision makers will choose forms of financing that best preserve

control.

o Distribution. The form of financing chosen will affect the way a firm markets its

securities, and the way it delivers value to investors. Decision makers will want to

consider these factors when choosing a form of financing.

13. What is a risk-neutral maturity structure? Reinvestment risk? Refinancing risk?

A risk-neutral maturity structure is one that equates the life of a firm’s assets with the life of

its liabilities. A structure in which the maturity of liabilities is greater than the maturity of

the firm’s assets creates reinvestment risk, the risk that management will not be able to

deploy the cash released by the firm’s assets to achieve returns sufficient to service the

liabilities. In the opposite case, where the maturity of assets is greater than the maturity of

liabilities, the firm is exposed to refinancing risk, the risk that the firm will not be able to roll

over its maturing liabilities on favorable terms.

14. What are the Six C’s of Credit?

The six C’s are cash flow, collateral, capital, conditions, course, and character.

15. What is the FRICTO framework?

FRICTO is a framework that is used to evaluate financing alternatives. FRICTO stands for

flexibility, risk, income, control, timing, and other—dimensions used by the framework to

assess different funding alternatives.


1. What is the “exchange ratio”?

The exchange ratio is the number of shares of the buyer’s stock to be exchanged for each

share of the target firm’s stock.

2. Which party does not want to go above a certain ‘maximum’ exchange ratio? Which party

does not want to go below a certain ‘minimum’ exchange ratio?

The buyer does not want to go beyond a maximum, and the seller does not want to go beyond

a minimum exchange ratio.

3. Why does the value of Newco matter in exchange ratio determination? Put another way, why

does the exchange ratio not depend only on the current ratio of the buyer’s va lue to the

target’s value?

The value of Newco matters because it is the shares of Newco, not the buyer’s shares, that

will determine the value created or destroyed for the shareholders of both companies.

4. In every deal, it is possible to arrive at a sweet spot. True or False? Explain.

It is not always possible to arrive at a sweet spot. The buyer’s and seller’s estimates of the

value of Newco may differ so much that there is no exchange ratio that satisfies both the

buyer’s maximum and the seller’s minimum.

5. What three factors tend to determine how the middle ground is carved up in cases where

there is a large zone of potential agreement between buyer and seller? Explain.

The three factors are:

• Bargaining power. The party with greater bargaining power—either in the form of

financial slack or in more personal attributes such as credibility, charisma, influence, or

negotiating skill—gets to claim a greater portion of the “middle ground.”

• Focal points such as control premiums in comparable transactions. Sellers may bargain

for an exchange ratio that is consistent with peer deals.

• Relative contributions of the two firms. The middle ground may be carved up according

to each party’s relative contribution, which may be measured in terms of relative share

prices, operating profits, assets, revenues, unit sales, etc.

Use the spreadsheet file “Deal Boundaries.xls” in answering the questions below.

6. An electric utility company is in a stock-for-stock negotiation with an acquirer. The buyer’s

and target’s share prices are currently trading at $35 and $20, respectively. The buyer is

projected to earn $200 million, and the target, $150 million. Synergies of $10 million are

expected from the deal. Each party has 80 million shares outstanding. Both buyer and target

expect Newco to trade at a price-earnings ratio of 11 times. What is the range of feasible

exchange ratios for this deal?

Solution:

There is no acceptable exchange ratio – the target’s minimum requirement is higher than the

maximum the buyer is willing to pay: the negotiators are in Zone III.

P/E Model AssumptionsBuyer's Share Price P1 35.00$ Target's Share Price P2 20.00$ Buyer's Net Income E1 200$ Target's Net Income E2 150$ Net Income from Synergies Es 10$ Buyer's Shares Outstanding S1 80Target's Shares Outstanding S2 80Expected P/E Ratio of Newco PE12 11

Maximum Acceptable

Minimum Acceptable

ER1 ER20.414 0.678

Results Based on the P/E of Newco

7. Refer to the problem above. How high must Newco’s price-earnings ratio be for a deal to be

possible? What does your answer tell you in general about price-earnings expectations of

parties that enter into M&A transactions?

Solution:


Maximum Acceptable

Minimum Acceptable

ER1 ER2PE12

11 0.41 0.6812 0.54 0.5913 0.67 0.5214 0.80 0.4715 0.93 0.4216 1.06 0.3817 1.19 0.35


By running a data table, we see that Newco’s price-earnings ratio must be around 13 times

or more for a deal to be possible. In general, parties that enter into M&A transactions

expect the P/E ratio of t he combined firm to improve—it makes no sense to enter into a

transaction if the resulting P/E ratio will be lower than before the merger.

8. Referring to the same problem, suppose that buyer and target both estimate Newco’s DCF

value to be $5 billion. What would be the range of feasible exchange ratios for the deal?

Solution:

Using the DCF model of exchange ratio determination, the feasible exchange ratios are

between 0.47 and 0.79:

DCF Model AssumptionsP1 35.00$ P2 20.00$ S1 80$ S2 80$

DCF12 5,000$

Maximum Acceptable

Minimum Acceptable

ER1 ER2DCF 0.7857 0.4706

9. Now run a sensitivity analysis using projected DCF values from $3 billion to $7 billion.

What are the resulting maximum and minimum exchange ratios? Graph your solution and

interpret the results.

Solution:


DCF12 5,000$

Maximum Acceptable

Minimum Acceptable

ER1 ER2DCF 0.7857 0.4706

3,000$ 0.0714 1.14293,500$ 0.2500 0.84214,000$ 0.4286 0.66674,500$ 0.6071 0.55175,000$ 0.7857 0.47065,500$ 0.9643 0.41036,000$ 1.1429 0.36366,500$ 1.3214 0.32657,000$ 1.5000 0.2963

Win-Loss Boundaries: DCF Analysis

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00

$6,0

00

$6,5

00

$7,0

00

DCF Value of "Newco"E

xcha

nge

Rat

ioBuyer's Maximum ERTarget's Minimum ER

II. Target Wins,Buyer Loses

I. Both WinIII. BothLose

IV. Buyer WinsTarget Loses

The DCF value of Newco has to be at least $4.4 billion for a deal to be feasible.

10. Now suppose the parties agree to a cash-for-stock transaction instead. Assuming again that

the expected P/E ratio for Newco is 11 times, is there a feasible deal? Why or why not?

Solution:


Maximum Acceptable

Minimum Acceptable

$ per shr $ per shrPE12

11 14.50 20.00


As in #1 above, there is no feasible deal if the anticipated P/E ratio is 11 times, regardless of

the currency used in the exchange.

11. Run a sensitivity analysis using a range of P/E ratios from 11 to 17 times—what should the

expected minimum P/E ratio be in order for a deal to be feasible? Graph your solution and

interpret the results.

Solution:


Maximum Acceptable

Minimum Acceptable

$ per shr $ per shr

PE12

11 14.50 20.0012 19.00 20.0013 23.50 20.0014 28.00 20.0015 32.50 20.0016 37.00 20.0017 41.50 20.00


Win-Loss Boundaries: P/E Analysis

0

20

40

11 12 13 14 15 16 17P/E Ratio of "Newco"

$ per share

Buyer's Maximum ERTarget's Minimum ER

I. Both Win

II. Target Wins,Buyer Loses

III. BothLose

IV. Buyer WinsTarget Loses

This is the same deal, so as in # 2 above, the P/E should be around 13 times in order for a

deal to be feasible.

12. Assume again that the expected DCF value for Newco is $5 billion. What would be the

range of feasible cash payments?

Solution:

The range of feasible cash payments is from $20 to $27.50 per share:


DCF12 5,000$

Maximum Acceptable

Minimum Acceptable

ER1 ER2DCF 27.50 20.00$

13. Now run a sensitivity analysis using projected DCF values from $3 billion to $7 billion.

Graph your solution and interpret the results.


DCF12 5,000$

Maximum Acceptable

Minimum Acceptable

ER1 ER2DCF 27.50 20.00$

3,000$ 2.50$ 20.00$ 3,500$ 8.75$ 20.00$ 4,000$ 15.00$ 20.00$ 4,500$ 21.25$ 20.00$ 5,000$ 27.50$ 20.00$ 5,500$ 33.75$ 20.00$ 6,000$ 40.00$ 20.00$ 6,500$ 46.25$ 20.00$ 7,000$ 52.50$ 20.00$

Win-Loss Boundaries: P/E Analysis

$-

$10

$20

$30

$40

$3,0

00

$3,5

00

$4,0

00

$4,5

00

$5,0

00

$5,5

00

$6,0

00

$6,5

00

$7,0

00

P/E Ratio of "Newco"

Exc

hang

e R

atio

Buyer's Maximum ER

Target's Minimum ER

I. Both WinII. Target Wins,Buyer Loses

III. BothLose IV. Buyer Wins

Target Loses

As in problem 4 above, regardless of the form of payment, the DCF value of Newco has to be at

least $4.4 billion in order for a deal to make sense.


1. If earnouts are useful, why are they not pervasive in big public deals?

Solution:

Earnouts are less useful where there is higher certainty about a target’s performance and

where the merging firms are from similar industries. Also, where the firms are large, the

earnout may be very complex to structure. The level of uncertainty for private companies

and high technology industries is much higher than that for public companies and firms in

less volatile industries due to information disparities and market conditions.

2. Earnouts are options, but there are also some differences between earnouts and options.

Please describe the differences and explain their implications for value of earnouts.

Solution:

Similar to call options, earnouts are financial derivatives with an underlying asset. But

financial options are standardized exchange-traded contracts. And the underlying assets for

financial options are stocks, fixed-income instruments and other publicly traded securities,

whereas for earnouts, the underlying assets are actual operational performances measured

by revenues, earnings, cash flow etc. Compared to publicly traded securities, these assets are

much more difficult to value, and their uncertainties much more difficult to assess. These

difficulties create many implications for value of earnouts because earnouts are normally

valued from option valuation methods such as the binomial model or Monte Carlo simulation

method, in which the accurate estimation of drivers is essential.

3. You are the CEO of a local beverage firm that is negotiating a deal with a large national food

company. The deal is structured as follows: the acquirer will pay $20 million in cash now.

However, if the revenues of your firm reach $200 million after three years, the acquirer will

pay another $20 million. In addition, the management team will be awarded a 10% bonus on

any extra revenues exceeding $200 million. Checking your firm’s financial statement over

the past several years, you estimate that its revenues have a volatility of 18%. You expect

$180 million in revenues this year. Assuming a 6% of risk-free rate, what is the probability

that your firm’s shareholders will get a $20 million payment three years later? How much is

the bonus plan to the management team worth? Try using the binomial option-pricing model

to value this bonus plan.

Solution:

Your firm’s shareholders will have a 67.78 percent chance of getting a $20 million payment

three years later. And the bonus plan is worth $4.33 million to the management team.

Step 1 Grow the tree Now Year 1 Year 2 Year 3

Parameters needed: (A) 343$ 287$

Volatility (Annualized) 18% 239$ 239$ Length of period (year) 1 $200 200$

167$ 167$ Up percentage (u) 1.197217 140$ Down percentage (d) 0.83527 117$ (A) -- $239 = $200 * U (1.197)

Step 2 Assess the probabilities of an up or down movement ----- These will be used in step 5 to fold back the tree.

Pu = [(1+Rf)-d)]/(u-d) 62.09% = chance of the firm value moving upPd = [u-(1+Rf)]/(u-d) 37.91% = chance of the firm value moving downRf = 6%Rf 6%

Step 3 Assess the states in which the earnouts will be paid

Step 4 Estimate the probabilities and payments associated with these end-states.

Trigger price $200 Bonus percent: 10%

Now Year 1 Year 2 Year 3 Probability

$14.32 23.94%-

- $3.94 43.84%- -

- - -

- Total probability: 67.78%

Step 5 Calculate the present value of expected future payoffs.

Now Year 1 Year 2 Year 3 (B)

$14.32$9.80

$6.57 $3.94$4.33 $2.31

$1.35 - -

- (B) --- $9.80 = ($14.32 * Pu + $3.94 * Pd)/(1+Rf)

In the above table, the shaded numbers indicate when the earnouts will be paid. In these cases, the sales is greater than the trigger, $200 million

For instance, to arrive at (B), $9.80 million, one would take the expected value of (Pu*$14.32+Pd*$3.94), or (.6209*$14.32)+(0.3791*$3.94) to yield $10.39. Discounting this by one year at the risk-free rate, 0.06 yields $9.80. This process is repeated for the other cells. Folding the expected values back to the present, we arrive at a value of $4.33 million for this bonus plan.

By adding all probabilities of events when sales exceed $200 million, the probability of shareholders' getting $20 million payment three years later is 67.78 percent. By folding back the tree to now, the value of the bonus plan is obtained in the term of present value.

The Binomial approach assumes that each year, the firm's revenues will move up by u (u= e^(1*18%) = 1.197) or down by d (d = e^(-1*18%) = 1/u = 0.835). This means that at the end of the first year, the firm's revenues will be either $239 million (u *$200 milllion) or $167 (d *$200 million).

From the binomial series calculation, one should know:23.94% = Pu^3 = (62.09%)^343.84% = 3*Pu^2*Pd = 3*(62.09%)^2*37.91%

4. Refer to problem 3. After consulting with an outside marketing firm your estimation of the

volatility of revenues for the next three years increases from 18% to 30%.

a. How much is the bonus plan to management team worth now?

b. Moreover, if the three year time period is reduced to two years, are you better off

in terms of the chances of getting the bonus as well as the value of the bonus

plan?

Solution:

As with problem number 3, build a binomial lattice laying out the outcomes. Then calculate

the payoffs for each outcome. Fold back the expected value of the payoffs to arrive at the

value of the option. The answers are given below, and the complete solutions can be found

in the CD-ROM accompanying this book.

a. After increasing the volatility of the firm’s revenue to 30%, your firm’s shareholders will

have a 53.61% chance of getting $20 million payment three year later. And, the bonus plan is

worth $5.83 million to the management team.

b. If the three year time period is reduced to two years, the probability of getting $20 million

payment increases to 77.35 percent and the value of the bonus plan decreases to $4.02

million.

5. Refer to problem 3 again. After careful consideration, the buyer changes the bonus plan.

The management team will still get 10% of any revenues exceeding $200 million but

there will be a $5 million cap on the amount of the bonus. This means that the

management team will only get $5 million even if the revenues exceed $250 million.

Keeping other parameters the same, how much is the bonus plan worth now?

Solution:



value of the option. The answer is given below, and the complete solution can be found in

the CD-ROM accompanying this book.

If there is a $5 million cap on the amount of the bonus, the value of bonus plan will drop to

$2.46 million, which implies a 43.2 percent decrease compared to the result of problem 3.

6. Refer to problem 5.

1. Using volatility of 12%, 15%, 18%, 21%, 24% and 27% for the revenues,

recalculate the value of the bonus plan.

2. Then, changing the agreement from three years to two years, recalculate the value

of the bonus plan for the above range of volatilities. Plot the values and time

periods in one table and explain the results.

Solution:



value of the option. The answers are given below, and the complete solutions can be found

in the CD-ROM accompanying this book.

a. By changing the volatility cell, one can obtain a series of the data for the values of bonus

plan and probability of payment as shown above. It is noted that with the increase of

volatility, the value of bonus plan decreases at first, and then increases. After it reaches 21%,

the value of the bonus plan decreases again. This is matched with the nature of the

optionality of the bonus plan with a cap—a collar assembled by a long call at a low strike

price and a short call at a high exercise price.

Volatility 12% 15% 18% 21% 24% 27%Value of bonus plan $2.46 $2.50 $2.42 $2.46 $2.54 $2.50 $2.37Probability of payment 67.78% 80.80% 73.43% 67.78% 63.28% 59.56% 56.39%

b. By comparing the results of a three-year period and those of a two-year period, it is clear

that the longer the time period, the more valuable the bonus plan is. Furthermore, due to the

unique nature of the collar, in which the dependence of its value on volatility of the

underlying asset is not linear, the value of the bonus plan for the two-year time period

decreases all the way with the increase of the volatility.

Volatility 12% 15% 18% 21% 24% 27%Value of bonus plan (Two years) $1.72 $2.30 $1.95 $1.72 $1.55 $1.42 $1.31Value of bonus plan (Three years) $2.50 $2.42 $2.46 $2.54 $2.50 $2.37

7. A buyer approached you and expressed his interest to buy your firm for $10 million.

Your estimation of the value of your firm is $12 million. To bridge the gap between you and

the buyer, both of you agree on an earnout plan with the following terms: you will get $5

million now; the earnout, which is based on the EBITDA of your firm, will last for three

years. An earnout trigger will start at $2 million and increase by that amount each year.

Currently, the sales of your firm are $55 million. Based on your knowledge, sales growth is

most likely to be 12% with a minimum at 6% and a maximum at 15%. Your best guess for

the EBITDA to sales ratio is 10% with a minimum of 5% and a maximum of 15%. The three-

year risk-free rate is at 6%. Given the above information, is this deal economically attractive

to you?

Solution:

After building the three-year forecast as follows, the uncertainties about sales and EBITDA

ratio are input in the model as a triangular distribution. Running CrystalBall 5,000 times,

the result is shown below. From the seller’s point of view, the enterprise valuation of the

proposed earnout has a mean of $12.79 million, which is higher than your asking price.

Therefore, it is an attractive deal to you.

Base Year Sales 55$ Earnout Period, in Years 3 Year 1 Year 2 Year 3

Sales 61.64$ 67.57$ 76.36$ min 6%

Growth Rate most likely 12% 12% 10% 13%max 15%

EBITDA 8.08$ 8.48$ 7.52$ min 5%

EBITDA/Sales most likely 10% 13% 13% 10%max 15%

Earnout Target 2.00$ 4.00$ 6.00$ Annual Earnout Value 6.08$ 4.48$ 1.52$

Present Value of the Earnout,Discounted at 6% 11.00$

Dollars at Closing 5.00$

Enterprise Valuation of Proposed Earnout 16.00$

Seller Valuation

Summary:Display Range is from $7.53 to $18.08 millionEntire Range is from $6.59 to $19.74 millionAfter 5,000 Trials, the Std. Error of the Mean is $0.03

Statistics: ValueTrials 5000Mean $12.79Median $12.77Mode ---Standard Deviation $2.06Variance $4.25Skewness 0.07Kurtosis 2.77Coeff. of Variability 0.16Range Minimum $6.59Range Maximum $19.74Range Width $13.15Mean Std. Error $0.03

Frequency Chart

million

.000

.006

.011

.017

.023

0

28.25

56.5

84.75

113

$7.53 $10.16 $12.80 $15.44 $18.08


Forecast: Enterprise value

8. Refer to problem 7. The buyer estimates that sales growth will follow a normal

distribution with a mean of 10% and a standard deviation of 5%. He expects the EBITDA to

sales ratio to likewise follow a normal distribution with a mean of 8% and a standard

deviation of 3%. From his perspective, is this deal attractive?

Solution:

After building the three-year forecast as follows, the uncertainties about sales and EBITDA

ratio are input in the model as triangular distribution. Running Crystal Ball 5,000 times, the

result is shown below. From the seller’s point of view, the enterprise valuation of the

proposed earnout has a mean of $9.86 million, which is lower than his bid price. Therefore,

it is an attractive deal to you.

Base Year Sales 55$ Earnout Period, in Years 3 Year 1 Year 2 Year 3

Sales 54.35$ 61.20$ 66.94$ Growth Rate Mean 10%

Standard deviation 5% -1% 13% 9%

EBITDA 4.51$ 5.39$ 6.16$ EBITDA/Sales Mean 8%

Standard deviation 3% 8% 9% 9%

Earnout Target 2.00$ 4.00$ 6.00$ Annual Earnout Value 2.51$ 1.39$ 0.16$

Present Value of the Earnout,Discounted at 6% 3.74$

Dollars at Closing 5.00$

Enterprise Valuation of Proposed Earnout 8.74$

Buyer Valuation

Summary:Display Range is from $5.00 to $16.02 millionEntire Range is from $5.00 to $22.64 millionAfter 5,000 Trials, the Std. Error of the Mean is $0.03

Statistics: ValueTrials 5000Mean $9.86Median $9.66Mode $5.00Standard Deviation $2.44Variance $5.98Skewness 0.55Kurtosis 3.41Coeff. of Variability 0.25Range Minimum $5.00Range Maximum $22.64Range Width $17.64Mean Std. Error $0.03

Frequency Chart

million

.000

.005

.011

.016

.021

0

26.5

53

79.5

106

$5.00 $7.76 $10.51 $13.27 $16.02


Forecast: Enterprise value for buyer

9. As a prominent media company, FREESPEECH is considering an expansion into an

online media niche. During negotiations with a start-up internet service company

JUMPONLINE, the two sides had a heated debate on the assumptions about future revenue

growth and profit margins, which led to different valuation of the firm based on DCF model.

FREESPEECH thinks the start-up company is worth $30 million while the investment banker

for company JUMPONLINE thinks that it is worth at least $50 million based on the rapid

growth of internet related businesses over the past several years. To resolve the

disagreement, the two sides agree to a payment schedule as follows:

a. FREESPEECH will pay $15 million in cash to acquire JUMPONLINE now;

b. After the acquisition, FREESPEECH will pay JUMPONLINE’s shareholders cash equal

to 20 percent of JUMPONLINE’s gross annual revenues, minus a deductible amount which

is $10 million now will increase at a compound annual rate of 50 percent for the next five

years;

c. In addition, FREESPEECH will pay JUMPONLINE’s shareholders cash equal to 50

percent of JUMPONLINE’s gross profits, minus a deductible amount of $1 million now but

which would increase at a compound rate of 50 percent annually for the next five years.

Currently, the sales of JUMPONLINE are $10 million. Sales growth is most likely to be at

40% with a minimum of 30% and a maximum of 55%. The profit margin will improve

gradually over the next five years. Currently the profit margin is 10%, but FREESPEECH’s

estimation of profit margin of the next five years follows a normal distribution with means of

12%, 15%, 20%, 25%, and 30% respectively and with standard deviations of 20 percent of

these numbers respectively. Assuming a risk-free rate of 8%, what is the value of

JUMPONLINE from FREESPEECH’s perspective? Please use the excel sheet given to you

and run the crystal ball model.

Solution:

After building the five-year forecast model as follows, the uncertainties about sales and profit

margin are input in the model as triangular distribution and normal distribution. Running

crystal ball 5,000 times, the result is shown below. From FREESPEECH’s perspective,

enterprise valuation of proposed earnout has a mean of $28,337 million, which is lower than

his bid price.

Base Year Sales 10,000$ Earnout Period, in Years 5 Year 1 Year 2 Year 3 Year 4 Year 5

Sales 14,021$ 20,494$ 29,309$ 40,607$ 55,884$ min 30%

Growth Rate most likely 40% 40% 46% 43% 39% 38%max 55%

Operating Income 1,416$ 3,169$ 6,808$ 5,975$ 20,722$

Profit Margin 10% 15% 23% 15% 37%

Mean 12% 15% 20% 25% 30%Standard deviation 2.4% 3.0% 4.0% 5.0% 6.0%

Earnout Target for sales Increase per year 50% 10,000$ 15,000$ 22,500$ 33,750$ 50,625$ Annual Earnout Value 804$ 1,099$ 1,362$ 1,371$ 1,052$ Earnout Target for Profit Increase per year 50% 1,000$ 1,500$ 2,250$ 3,375$ 5,063$ Annual Earnout Value 208$ 835$ 2,279$ 1,300$ 7,830$ Total annual earnout values 1,012$ 1,933$ 3,641$ 2,672$ 8,882$

Present Value of the Earnout,Discounted at 8% 13,493$

Dollars at Closing 15,000$

Enterprise Valuation of Proposed Earnout 28,493$

Buyer Valuation

Summary:Display Range is from $21,308 to $35,502 thousandsEntire Range is from $18,700 to $38,971 thousandsAfter 5,000 Trials, the Std. Error of the Mean is $39

Statistics: ValueTrials 5000Mean $28,337Median $28,279Mode ---Standard Deviation $2,748Variance $7,548,967Skewness 0.26Kurtosis 2.96Coeff. of Variability 0.10Range Minimum $18,700Range Maximum $38,971Range Width $20,271Mean Std. Error $38.86

Frequency Chart

thousands

.000

.006

.012

.019

.025

0

31

62

93

124

$21,308 $24,857 $28,405 $31,953 $35,502


Forecast: Enterprise Value of Earnout for BBB

10. Refer to problem 9. Suppose you are the financial advisor for company JUMPONLINE.

Based on your knowledge, sales growth is most likely to be 45% with the minimum at 60%

and the maximum at 70%. The profit margin will improve gradually in the next five years.

Currently the profit margin is 10%. Your estimations for profit margins during the next five

years follow normal distributions with means of 15%, 20%, 25%, 30%, and 35% respectively

and with standard deviations of 15 percent of means. Please use the excel sheet given to you

and run the crystal ball model. Compare the result with problem 9 and explain.

Solution:

After building the five-year forecast model as follows, the uncertainties about sales and profit

margin are input in the model as triangular distribution and normal distribution. Running

crystal ball 5,000 times, the result is shown below. In your point of view, enterprise valuation

of proposed earnout has a mean of $52,548 million, which is lower than his bid price. By

comparing to problem 9, it is clear that the earnout plan works for both parties. Therefore,

this earnout plan successfully bridges the $20 million valuation gap between buyer and

seller.

Base Year Sales 10,000$ Earnout Period, in Years 5 Year 1 Year 2 Year 3 Year 4 Year 5

Sales 15,783$ 25,122$ 41,712$ 66,847$ 105,561$ min 45%

Growth Rate most likely 60% 58% 59% 66% 60% 58%max 70%

Operating Income 2,256$ 5,768$ 10,734$ 20,472$ 44,334$

Profit Margin 14% 23% 26% 31% 42%

Mean 15% 20% 25% 30% 35%Standard deviation 2.3% 3.0% 3.8% 4.5% 5.3%

Earnout Target for sales Increase per year 50% 10,000$ 15,000$ 22,500$ 33,750$ 50,625$ Annual Earnout Value 1,157$ 2,024$ 3,842$ 6,619$ 10,987$ Earnout Target for profits Increase per year 50% 1,000$ 1,500$ 2,250$ 3,375$ 5,063$ Annual Earnout Value 628$ 2,134$ 4,242$ 8,548$ 19,636$ Total annual earnout values 1,785$ 4,158$ 8,084$ 15,168$ 30,623$

Present Value of the Earnout,Discounted at 8% 43,625$

Dollars at Closing 15,000$

Enterprise Valuation of Proposed Earnout 58,625$

Seller Valuation

Summary:Display Range is from $42,135 to $63,195 thousandsEntire Range is from $39,084 to $67,205 thousandsAfter 5,000 Trials, the Std. Error of the Mean is $59

Statistics: ValueTrials 5000Mean $52,548Median $52,505Mode ---Standard Deviation $4,148Variance $17,209,296Skewness 0.09Kurtosis 2.85Coeff. of Variability 0.08Range Minimum $39,084Range Maximum $67,205Range Width $28,122Mean Std. Error $58.67

Frequency Chart

thousands

.000

.006

.011

.017

.022

0

28

56

84

112

$42,135 $47,400 $52,665 $57,930 $63,195


Forecast: Enterprise value of earnout for CCC


1. How can one price risk management features in M&A?

M&A deals are negotiated transactions; there is no competitive bidding with which to set an

equilibrium price for risk management features in a deal. Therefore, one needs to estimate

independently whether the whole package of the deal (cash or stock payment plus the cost of

risk management) is appropriate. Option valuation techniques such as Monte Carlo

simulation are the most common ways to price risk management features.

2. What is the true value of a bid?

The true value of a bid is the sum of the consideration paid and the value of ancillaries such

as risk management features.

3. M&A is a risky activity. What costs are associated with deal failure? What value is at risk

when a deal fails?

The costs associated with deal failure before consummation include: research expenses,

legal, accounting, and financial advisory fees, management time, damage to reputation, and

the cost of the lost opportunity. The opportunity cost can be massive where there are solid

synergies or strategic options that might have been created. When a deal fails, a

participant’s reputation is at risk, too. The value at risk also grows over the time period of

deal development, reaching its maximum at the closing.

4. What are the four classic profiles of payments in M&A? What are the differences between a

floating collar and fixed collar?

The four classic profiles of payments in M&A are a fixed exchange ratio deal, fixed value

deal, floating collar and fixed collar. With a floating collar, payment can vary a between a

maximum and minimum, downside losses are limited (which pleases target shareholders) and

upside gains are capped (which pleases buyer shareholders). The resulting payoff diagram

from a floating collar resembles the well-known “bull spread” used by options traders. With

a fixed collar, the payment is fixed as long as the buyer’s share price remains within a

reasonable range, but beyond that range, the gains and losses will be shared. The following

figures illustrate the nature of a floating collar and a fixed collar.

Floating collar Fixed collar

5. Suppose the fixed exchange ratio in a deal is 1.2:1, and that at the time of agreement, the

buyer’s share price is $25.00. The buyer and seller agree to a floating collar, which has a low

trigger of $15.00 and a high trigger of $35.00. Thus, the exchange ratio is 1.2 to 1, unless the

$ Buyer’s Stock Price

$ Buyer’s Stock Price

buyer’s stock price falls below $15.00, in which case the exchange ratio will be equal to

$18.00 divided by the buyer’s share price, or unless the buyer’s share price is greater than

$35.00, in which case the exchange ratio will equal $42.00 divided by the buyer’s share

price. Please calculate and graph the number of shares issued for one share of the seller’s

stock, assuming the following share prices for the buyer: $0.01, $5.00, $10.00, $15.00,

$20.00, $25.00, $30.00, $35.00, $40.00, $45.00, and $50.00. Also, calculate and graph the

value of the bid with the collar at these prices. (Please use the spreadsheet, “Collars

Analysis.xls.”)

Insert the parameters into the model “Collars Analysis.xls.” You should obtain the following

results:

Buyer's Stock Value of BidPrice With Collar With Stock Collar

"Fixed" Exchange Ratio 1.20 0.01$ 18.00$ 1,800.00 Collar upper strike 35.00$ 5.00$ 18.00$ 3.60

10.00$ 18.00$ 1.80 15.00$ 18.00$ 1.20

Collar lower strike 15.00$ 20.00$ 24.00$ 1.20 25.00$ 30.00$ 1.20 30.00$ 36.00$ 1.20 35.00$ 42.00$ 1.20 40.00$ 42.00$ 1.05 45.00$ 42.00$ 0.93 50.00$ 42.00$ 0.84

Number of Buyer Shares Issued Per

Target Share

Exch. Ratio above upper strike

Exch Ratio below lower strike

Upper strike/Buyer's Stock Price

Lower strike/Buyer's Stock Price

From the standpoint of the target investor, the collar for this fixed exchange rate deal

essentially consists of a long put option (with a strike price of $15.00) and a short call option

(with a strike price of $35.00). When combined with the stock position the payoff presented

to the target shareholders corresponds to the floating collar.

Value Received by Target Investor, Stock Plus Collar

$-

$10

$20

$30

$40

$50

$0 $10 $20 $30 $40 $50

Buyer´s Share Price

Val

ue

of

Bid

per

Tar

get

S

har

e

Number of Shares Issued, Stock Plus Collar

0.000.501.001.502.002.503.003.504.00

$5 $10 $15 $20 $25 $30 $35 $40 $45 $50

Buyer´s Share Price

Buy

er S

hare

s pe

r Ta

rget

S

har

e

6. Suppose a seller agrees to receive a payment in buyer’s stock worth $30.00 per target

share. Buyer and seller agree to a collar, which has a low trigger of $15.00 and a high

trigger of $40.00. Thus, the cash payment will be $30.00 for each share of the seller’s

stock, unless the buyer’s stock price falls below $15.00, in which case the exchange ratio

would be equal to 2 shares of stock; or unless the buyer’s share price is greater than

$40.00 in which case the exchange ratio will equal 0.75 shares of stock. Please calculate

and graph the number of shares issued for each share of the seller’s stock, assuming the

following share prices for the buyer: $0.01, $5.00, $10.00, $15.00, $30.00, $40.00,

$50.00, and $60.00. Also, calculate and graph the value of the bid with the collar at these

prices. (Please use the spreadsheet program “Collars Analysis.xls.”)

Insert the parameters into the model. You should obtain the following results:

Buyer's Stock Value of BidPrice With Collar With Stock Collar

"Fixed" Value per Target Share $30.00 0.01$ 0.020$ 2.00 Collar upper strike $40.00 5.00$ 10.00$ 2.00 Exch. Ratio above upper strike 0.75 10.00$ 20.00$ 2.00 Collar lower strike $15.00 15.00$ 30.00$ 2.00 Exch Ratio below lower strike 2.00 30.00$ 30.00$ 1.00

40.00$ 30.00$ 0.75 50.00$ 37.50$ 0.75 60.00$ 45.00$ 0.75

Number of Buyer Shares Issued Per

Target Share

Value Received by Target Investor, Stock Plus Collar

$10

$20

$30

$40

$50

Val

ue

of

Bid

per

Tar

get

S

hare

Number of Shares Issued, Stock Plus Collar

0.5

1.0

1.5

2.0

2.5

Bu

yer

Sh

ares

per

T

arg

et S

har

e

The diagrams of the combined position given in the above figures correspond to the fixed

collar.

7. Assume you as the CEO of a publicly listed company have just agreed to acquire a target.

You agree on an exchange ratio of two shares of your firm’s stock for one share of the

target’s stock, based on today’s market prices of both companies: $25 for your firm and $40

for the target. The deal needs to be approved by a government regulatory agency – this

process will take one year. To reduce the risk for the target arising from possible fluctuations

in your stock price, you agree to a collar. The collar would give the target’s shareholders cash

equal to the difference between $22 and your firm’s share price one year later, with a

maximum cash payment of $5 for each share of buyer’s stock. The annualized volatility for

the risk-free rate is 15%. Given a risk-free rate of 5% and 22% volatility for your stock, how

much is this offer truly worth to the target’s shareholders in term of share price? (For

simplicity, start by using the Black-Scholes Option Pricing model found in “Option

Valuation.xls” to get an approximate figure, then see what the simulation analysis reports in

“Collars Analysis.xls.”

To arrive at the true value of the deal, one needs to calculate the value of the collar. This

collar is assembled by a long put with the strike price at $22 and a short put with the strike

price at $17, which allows a maximum cash payment of $5 -- $22-$17. By using Option

Valuation.xls, one can arrive at the option value of the individual put options. The net value

of one collar comes out to $0.55. Since each target share will be exchanged for two shares of

your firm’s stock, the offer in terms of one target’s share is worth $51.10, which is equal to

$50.00 + $1.10.

Black-Scholes Black-ScholesStep 1 Insert parameters into the model European: No Dividend European: No Dividend

Stock price $25 Call value 4.67$ Call value 8.87$ Call delta (hedge ratio) 0.820778 Call delta (hedge ratio) 0.981704

Exercise price $22 Call elasticity 4.396824 Call elasticity 2.767389

Risk-free rate 5% Using put-call parity Using put-call parityVolatility 22% Put value 0.59$ Put value 0.04$ Time (years) 1 Delta -0.179222 Delta -0.018296

Elasticity -7.543953 Elasticity -11.60848Step 2 Calculate the option value using template.

S underlying asset price $25 S underlying asset price $25Put value (Long) 0.59$ X exercise price $22 X exercise price $17

rf risk-free rate 5% rf risk-free rate 5%Put value (Short) 0.04$ sd volatility 22% sd volatility 22%

t years to expiration 1 t years to expiration 1Value of this collar: 0.55$

Cumulative Standard Normal Function Cumulative Standard Normal Functiond1 from Black-Scholes 0.918334 d1 from Black-Scholes 2.090284N(d1) 0.820778 N(d1) 0.981704

d2 from Black Scholes 0.698334 d2 from Black Scholes 1.870284N(d2) 0.757516 N(d2) 0.969278

Long put Short put

The results from “Collars Analysis. XLS” suggest that the collar has an expected value of

$0.51. this is close to the value estimated using the Black-Scholes model, $0.55 per share.

The difference between the two values is likely due to the interdependence between the two

embedded options. The interdependence exists because when one option is “in-the-money,”

the other option is certainly “out-of-the-money.” The Black-Scholes model assumes

independence of value, whereas the simulation analysis permits a modeling of the

interdependence.

Life of the collar:Life of collar: 365

Structure of the collar:If one component is a long call:Strike price: -$ Payoff formula (text): Maximum of (stock price minus strike price) or zeroPayoff calculated: 0If one component is a short call:Strike price: -$ Payoff formula (text): Zero minus the maximum of (stock price minus strike price) or zeroPayoff calculated: -$ If one component is a long put:Strike price: 22.00$ Payoff formula (text): Maximum of (strike price minus stock price) or zeroPayoff calculated: -$ If one component is a short put:Strike price: 17.00$ Payoff formula (text): Zero minus the maximum of (strike price minus stock price) or zeroPayoff calculated: -$

Buyer's share price today: 25.00$ Annualized v olatility of buyer's share price: 22.0%Forecast of return of buyer's share price at closing of deal: -12.5%Forecast of buyer's share price at closing of deal: 22.06$ Risk-free rate of return today 5%Annualized volatility of risk-free rate of return 15%Standard deviation of annualized risk-free rate of return 0.8%Forecast of risk-free rate of return: 5%

Calculated value of the collar (sum of four payoffs): -$

Forecast: Problem_7 Value of collar


Frequency Chart

dollars

.000

.199

.398

.596

.795

0

993.7

3975

$0.00 $1.13 $2.25 $3.38 $4.50


Forecast: Problem_7 Value of collar

8. Refer to question 7. Suppose the approval period is not certain. Your best guess is that the

approval process will take one year, with a minimum time of half a year and a maximum

time of two years. The annualized volatility for the risk-free rate is 15%. Please use the

Monte Carlo simulation method to calculate the probability of a cash payment and the

expected value of one share of the target’s stock in the deal.

Solution:

By defining a triangular distribution for the expected time period, one can value the collar

using “Collars Anaylsis.xls” and Crystal Ball software.

Life of the collar:Best guess days 365Maximum days 730Minimum days 182.5Forecast of life of collar: 289.9948


Buyer's share price today: 25.00$ Annualized volatility of buyer's share price: 22.0%Forecast of return of buyer's share price at closing of deal: -0.95%Forecast of buyer's share price at closing of deal: 24.76$ Risk-free rate of return today 5%Annualized volatility of risk-free rate of return 15%Standard deviation of annualized risk-free rate of return 0.8%Forecast of risk-free rate of return: 6%


Summary:Display Range is from $0.00 to $4.96 dollarEntire Range is from $0.00 to $11.96 dollarAfter 1,000 Trials, the Std. Error of the Mean is $0.05


Frequency Chart

dollar

.000

.195

.389

.584

.778

0

194.5

389

583.5

778

$0.00 $1.24 $2.48 $3.72 $4.96

1,000 Trials 970 Displayed

Forecast: Cost of the collar to the firm

A trial run of 1,000 times results in a mean value of the collar of $0.64 per buyer’s share.

Therefore, the total worth of one share of the target’s stock is $51.28 ($50 + (2 * $0.64)).

The probability of zero cash payment in the future can be read from the risk profile as

77.8%, therefore the probability of any cash payment can be computed by subtracting 77.8%

from 1 to arrive at 22.2%, which may motivate the buyer to accept this deal.

9. Assume you are negotiating a deal with company ABC. Your current bid price is $56 per

share but ABC asks for $60 per share. To resolve the difference, company ABC proposes

that besides the $56 cash payment, there will be a contingent va lue right that will give ABC’s

shareholders the right to some cash payment at the end of three years if Newco’s stocks do

not perform well during this period. Assume one share of Newco is worth $40 today. The

contingent value right will permit a holder of Newco to receive a cash payment equal to the

difference between $50 and the stock price of Newco after three years, if Newco’s stock

trades below $50. The cash payment will be capped at $15. The annualized volatility for the

risk-free rate is 20%. Given a risk free rate of 6% and estimated volatility of 18% for

Newco’s stock, what does the deal cost the buyer in terms of each share of ABC’s stock?

(Again, as an experiment, use the Black-Scholes Option Pricing model to estimate the value

of the collar. Then estimate the answer using the simulation model in “Collars

Analysis.xls.”)

To arrive at the true cost of the deal, one needs to calculate the value of the collar. This

collar is assembled by a long put with the strike price at $ 50 and a short put with the strike

price at $35, for a maximum cash payment of $15 – within the boundaries of $50-$35. By

using the spreadsheet Option Valuation.xls, one can arrive at the option value of the

individual put options. The net value of one collar is computed at $5.12. Since shareholders

will receive $56.00 for each target share now, the offer in terms of one target’s share is

worth $61.12, which is equal to $56.00 + $5.12.

Black-Scholes Black-ScholesStep 1 Insert parameters into the model European: No Dividend European: No Dividend

Stock price $40 Call value 4.23$ Call value 11.64$ Call delta (hedge ratio) 0.506982 Call delta (hedge ratio) 0.877288

Exercise price $50 Call elasticity 4.79356 Call elasticity 3.015381

Risk-free rate 6% Using put-call parity Using put-call parityVolatility 18% Put value 5.99$ Put value 0.87$ Time (years) 3 Delta -0.493018 Delta -0.122712

Elasticity -3.290059 Elasticity -5.629187Step 2 Calculate the option value using template.

S underlying asset price $40 S underlying asset price $40Put value (Long) 5.99$ X exercise price $50 X exercise price $35

rf risk-free rate 6% rf risk-free rate 6%Put value (Short) 0.87$ sd volatility 18% sd volatility 18%

t years to expiration 3 t years to expiration 3Cost of this collar: 5.12$

Cumulative Standard Normal Function Cumulative Standard Normal FunctionTotal cost of one share ABC: 61.12$ d1 from Black-Scholes 0.017502 d1 from Black-Scholes 1.161537

N(d1) 0.506982 N(d1) 0.877288

d2 from Black Scholes -0.294268 d2 from Black Scholes 0.849768N(d2) 0.384277 N(d2) 0.802273

Long put Short put

Turning to the simulation analysis, the results reveal that the collar is worth $4.33 per

share—again, the lower estimate compared to the Black-Scholes result is probably due to the

interdependence of the two embedded options, which the simulation captures, but which the

Black-Scholes estimate ignores.

Life of the collar:Life of collar: 1095


Buyer's share price today: 40.00$ Annualized volatility of buyer's share price: 18.0%Forecast of return of buyer's share price at closing of deal: 23.6%Forecast of buyer's share price at closing of deal: 50.67$ Risk-free rate of return today 6%Annualized volatility of risk-free rate of return 20%Standard deviation of annualized risk-free rate of return 1.2%Forecast of risk-free rate of return: 7%



Frequency Chart

dollars

Mean = $4.33.000

.116

.232

.348

.463

0

579.2

2317

$0.00 $3.75 $7.50 $11.25 $15.00


Forecast: Problem_9 Value of Collar

10. Refer to question 9. Assume you would like to renegotiate with ABC the time period for this

contingent value right. Your best guess is that the final agreement will be 2.5 years with a

minimum of 2 years and maximum of 3 years. The volatility of interest rates is 20%. Please

use the Monte Carlo simulation method to calculate the expected value of this right and the

probability that you will have to make another cash payment in the future.

Solution:

By defining a triangular distribution for the expected time period, one can value the collar

using “Collars Anaylsis.xls” and Crystal Ball software.

Life of the collar:Best guess days 912.5Maximum days 1095Minimum days 730Forecast of life of collar: 799.5722


Buyer's share price today: 40.00$ Annualized volatility of buyer's share price: 18.0%Forecast of return of buyer's share price at closing of deal: 30.02%Forecast of buyer's share price at closing of deal: 54.00$ Risk-free rate of return today 6%Annualized volatility of risk-free rate of return 20%Standard deviation of annualized risk-free rate of return 1.2%Forecast of risk-free rate of return: 6%



Frequency Chart

Dollars

Mean = $4.76.000

.104

.208

.311

.415

0

519

2076

$0.00 $3.37 $6.74 $10.12 $13.49


Forecast: Value of collar (CTR)

A trial run of 5,000 draws results in a mean value of the collar of $4.76 per share. Therefore,

the total worth of one share of the target’s stock is $60.76 ($56 + $4.76). The probability of

zero cash payment in the future can be read from the risk profile as 41.5%, therefore the

probability of any cash payment can be computed by subtracting 41.5% from 1 to arrive at

58.5%.


True or False

1. Social issues usually relate only to a narrow group of people, which includes senior

management, boards of directors, and influential middle managers.

2. Highly visible executives, such as CEOs, turn over more quickly than less visible ones,

such as division heads and managers.

3. While important, social issues do not directly affect the probability of successfully

reaching agreement on an M&A transaction.

4. The “Merger of Equals” (MOE) structure is designed to combine partners of roughly

equal influence. Industry specialists, however, often claim that the structure of MOEs

yields a clear dominance of the buyer over the target firm.

5. The MOE structure is believed to increase the resistance of target managers to a merger,

and thus decreases the probability of successfully consummating a deal.

6. Research studies reveal that there is no significant difference in top management turnover

between friendly and unfriendly deals.

7. Corporate name changes often involve serious consideration and debate because the

management team of the new company will want to create a strong brand identity;

luckily, the actual economic costs are negligible.

8. Social issues often stimulate deal-related transactions such as side payments and complex

trade-offs.

9. There is a strong positive correlation between the size of firms and the compensation they

pay to senior executives (such as CEOs): the larger the firm, the greater the executive

compensation.

10. Social issues do not surface in early discussions of M&A; rather, executives wait until

after they have discussed the economics of a deal to see if it is even worth considering.


1. T. While various social issues engendered by a merger or acquisition eventually may

affect a vast number of stakeholders, this narrow group of people has the decisive role in

accepting or rejecting merger proposals.

2. T.

3. F. Settlement of social issues does directly affect the probability of reaching agreement

on an M&A deal. Social issues help to obtain the support of the target firm’s

management.

4. T.

5. F. The MOE structure is believed to decrease the resistance of target managers to a

merger, and thus increases the chances of successfully consummating a deal.

6. T. True, according to a research finding of Martin and McConnell (1991).

7. F: The costs of a corporate name change can be material. These costs could include: new

signage and stationery, corporate identity advertising, and legal expenses associated

with redrawing contracts under the name of the new entity.

8. T.

9. T.

10. F. Actually, social issues are routinely discussed first in negotiations of mergers and

acquisitions.


1. What are retention payments? In what form are they paid? What determines the size and

period of time in which they are paid?

Retention payments are the terms of compensation for managers continuing with the new

company. They come in varying forms: ordinary salary and bonuses, and extraordinary

retention bonuses that pay managers for fulfilling specific terms of employment set over a

period of time. The market value of the executive’s skills outside the firm (i.e. what he/she

might be paid or offered by a competing firm) often determines the choice of payment size

and the period of time in which it will be paid.

2. What are Golden Parachute payments and when are they paid? Who determines and pays

for them? What key function do they hold?

Golden Parachute payments are lump sum payments made to key executives in excess of

their usual compensation when ownership or control of the corporation changes. A

target company’s board of directors determines the golden parachute payments; but the

entity surviving from the merger is obliged to make the payments under the parachute.

Thus, the payments amount to an added cost or premium to the acquisition.

The key functions of the golden parachute payments with respect to a target company are

1) to motivate managers to act in the best interests of shareholders, 2) to add an

expensive hurdle for any buyer who might contemplate acquiring the target, and 3) to

hinder competing firms from making employment offers to their employees and dissuade

employees from leaving the firm if and when competing firms do present them with

attractive offers.

3. If target shareholders bear the cost of the MOE structure, how can one calculate an

approximation of this cost?

To approximate the cost, one would take the difference between the acquisition premium

of a company under the MOE structure and the acquisition premium that would have

been necessary to complete the deal without the MOE structure, and then multiply by the

market capitalization of the target ex ante—this estimates the cost of the lost opportunity

for the target shareholders.

4. What is the benefit of determining CEO leadership succession early in the merger

agreement? Are there any drawbacks?

The benefit of determining the leadership succession early in the merger agreement is

that it can encourage the named successor to stay with the firm. However, a drawback to

early determination is that the other potential contenders for the CEO position that were

not chosen may leave the firm prior to the deal closing.

5. In a merger transaction, what are three key considerations for determining the new

company’s workforce (i.e. “who stays and who leaves”)?

a. The financial performance record of the buyer and target management

teams.

b. Managers’ core competencies and potential to help realize economic

synergies at Newco.

c. The strategic fit of business units and individuals within the new

organization structure.

6. In a merger transaction, the buyer or target’s corporate name can be retained or a blended

name can be created. What message does each option convey about the ongoing firm?

Retaining the target’s name conveys a sense of continuity of the target, even if major

changes are taking place within the firm. Retaining the buyer’s name conveys both

continuity and dominance of the acquirer. This might not be appropriate or feasible in

an MOE transaction. Creating a blended name portrays equality between the target and

buyer firms and would be consistent with an MOE.

7. Explain why Daimler and Chrysler decided that a new public parent company should be

organized under the laws of the Federal Republic of Germany.

The parties realized that if they created the combined parent as a German corporation,

they would be better positioned to win the approval of important German constituencies,

such as German stockholders, managers, and employees. Furthermore, the management

teams of the two firms believed that organizing the new company under the laws of the

Federal Republic of Germany would help in their endeavor to structure the deal as a

Merger of Equals.

8. In the Hewlett-Packard (HP) and Compaq merger contest, how did Walter Hewlett use

information about the prospective compensation of Fiorina and Capellas?

He sought to portray the deal as a means of self-enrichment of the senior executives.

This case shows that social terms could create a negative backlash among the firms’

shareholders, who may not see the payment terms as fair or appropriate.

9. Consider the vignette on Wachovia Bank’s acquisition plans in 2001, provided in the

chapter. Wachovia agreed to a Merger of Equals with First Union Corporation for $12.5

billion, but then SunTrust bank appealed directly to Wachovia’s shareholders with an

unsolicited offer of $13.7 billion. Why did the Wachovia-SunTrust negotiations not

succeed?

Wachovia’s management opposed the SunTrust bid on the grounds that the two firms had

different reporting structures: Wachovia’s wealth management business reported to a

centralized business unit while SunTrust’s wealth management business reported to

various regional units on a geographical basis.

Journalists and securities analysts suspected that the attractive social terms offered by

First Union influenced the stance of Wachovia management.

10. Regarding the 1998 Fleet Bank and BankBoston merger:

a. Why was there a retention plan for employees of BankBoston Robertson Stephens?

b. What were the terms of the retention plan?

c. How and why did they differ from the retention plans created when BankBoston

merged with Robertson Stephens in 1996?

a. The retention plan for employees of BankBoston Robertson Stephens was a deal term

of the Fleet Bank and BankBoston merger that was created to retain the various top-

performing executives, up to and after the deal closing. The plan was particularly

intended to retain the key executives who were instrumental in the continued success of

BankBoston Robertson Stephens.

b. The retention plan was worth $800 million, which would be paid to the key

BankBoston Robertson Stephens employees if they remained with the firm though the

third anniversary of that merger.

c. The value of this retention plan was significantly greater than the $200 million

retention plan created for 1996 merger between BankBoston and Robertson Stephens.

Since payment of the 1996 retention plan was scheduled to pay off within 18 months of

the 1998 Fleet BankBoston merger, the new retention plan was structured to extend the

tenure of key Robertson Stephens employees to 2001, three years after the closing of the

Fleet BankBoston merger. The sizable increase in the retention plan reflected the

importance of not only retaining the key employees who would benefit under the 1996

plan, but also fostering the rapid growth of Robertson Stephens and its continued

success.


1. Walk through the usual timeline of a deal.

a. A deal usually originates from a search process identifying targets that will fit the

strategic goals of a buyer. The search process may take place from within the

acquirer’s company, or from an advisor such as an investment banker and/or

consultant.

b. Once a target is identified, the buyer approaches the target to “pitch” the

proposal.

c. If the target is willing to consider the proposed deal, the broad outlines of the

deal are sketched. Financial and legal advisors are called in. Information is

exchanged, due diligence conducted, and first-round documents such as

confidentiality and exclusivity agreements, term sheets, engagement letters, etc. are

drafted.

d. At this point, the CEOs may brief their boards about negotiations, and a letter of

intent may or may not be drafted.

e. When the due diligence process is fairly complete, detailed negotiations of the

terms of the deal takes place, and the definitive agreement is drafted. The boards

vote on the deal, and the merger agreement is signed.

f. A public announcement is issued, all necessary statements such as proxy and

registration statements are filed, and a Hart-Scott-Rodino filing is submitted.

g. The merger is submitted to a vote by shareholders.

h. The merger is executed and completed, usually over several months.

2. Are parties to a deal obligated to issue a Letter of Intent during merger negotiations?

Does the Letter of Intent represent a binding agreement? Why are LOIs used?

No to both questions—parties are not obligated to issue LOIs, and LOIs are not binding

agreements. Despite this, LOIs are used to create momentum between the two sides and help

push the development of a definitive agreement.

3. What are some of the first-round documents that may be drafted in a merger? In general,

when and why are first-round documents issued?

Examples of first-round documents include the term sheet, the exclusivity agreement, the

engagement letter, the confidentiality agreement, the standstill agreement, and the letter of

intent. First-round documents are usually issued after the buyer and target have initiated

talks and are open to the possibility of a merger, but before a definitive agreement is

reached. Thus, these documents are risk-management devices that are usually meant to

ensure confidentiality and exclusivity while the parties are gathering and verifying

information, and in the midst of negotiating.

4. What factors might parties to a deal consider when deciding whether or not to issue a

Letter of Intent or other first-round documents?

Trust, speed and the probability of leakage are the factors that parties will want to consider

when making this decision. If trust between parties is low and the probability of leakage is

high, it is best to draft first-round documents. If trust is high, the probability of leakage is

low, and speed and secrecy are crucial, some first-round documents may be unnecessary.

Executing the first-round documents may trigger public disclosure obligations, the news from

which might solicit competing bidders or investor reactions.

5. What, according to the Supreme Court, are the factors a company must consider in

deciding whether and when to disclose a transaction?

The factors that must be considered are a) the significance of the transaction to the company,

and b), the probability of the transaction occurring.

6. What is a standstill agreement and what risks does it manage?

A standstill agreement is one in which the buyer commits to not purchasing shares of the

target for a specified period of time. Loss of control is the risk that it helps the target

manage. By limiting the buyer’s shares, a standstill agreement helps prevent the buyer from

accumulating voting power.

7. Give an example of a material adverse change. How might it derail the deal process?

A change in business conditions is an example of a material adverse change. For instance, if

oil prices suddenly drop, two oil companies that are in merger discussions might postpone or

cancel merger talks.

8. How might a sudden change in share prices derail the deal process? Explain.

If shares are used as the medium of exchange in a merger, a sudden change in share prices

may derail the deal process by affecting the value of the transaction. For instance, if the

acquirer’s share price drops, the seller may view the acquirer’s effective purchase price as

inadequate, and demand a higher exchange ratio. The buyer may refuse to accede to the

seller’s demand to avoid severely diluting its equity stake. For more on this, see Chapter 23.


1. What is governance? Through what processes do boards of directors exercise governance?

Governance is the action of controlling or directing. A company’s board of directors

exercises governance through the processes of executive hiring and firing, compensation,

auditing, review of financial performance, and approval of major decisions.

2. What are agency costs? Why do they arise?

Agency costs destroy value and arise when an agent (e.g. management) acts in conflict with

the interests of the fiduciary (e.g. shareholders). Conflicts arise because of breakdowns in

governance, monitoring, and control systems due to asymmetries of information between

insiders and outsiders, and to low fractional ownership among managers.

3. What is jawboning? How is different from “exit”?

Jawboning, or “voice,” is a process of exhortation to management and coalition-building

among investors and directors to influence a firm’s board and managers. “Exit” simply

entails selling one’s shares in response to “an objectionable state of affairs.”

4. How does governance reduce agency costs?

Governance reduces agency costs by:

• Designing compensation structures that align the interests of managers and

shareholders

• Monitoring financial performance and taking actions necessary to improve

shareholder wealth

• Binding managers through contracts aimed at achieving goals. This is known as

financial contracting.

• Building a coalition among directors and shareholders to influence managers. This

is known as jawboning.

5. Does good governance pay? How?

Yes. In general, firms with stronger governance practices are more highly valued by the

market. Strong governance pays by reducing agency costs.

6. Through what mechanisms can investors influence managers and directors?

Investors can influence managers and directors through mechanisms such as proxy fights,

shareholder resolutions, lawsuits, jawboning, and cumulative voting.

7. Describe what happens in a typical dual-class recapitalization.

In a typical dual-class recapitalization, the shareholder would swap an ordinary share (with

votes) for a non-voting share that pays a higher dividend. A few special shareholders retain

their superior-voting shares.

8. Define the duties of loyalty and care.

The duty of loyalty states that directors must make decisions in the interest of shareholders

and must avoid conflicts with other interested parties. Directors should not participate in

any self-dealing.

The duty of care states that directors must be careful in considering all aspects of issues

before them; they must be well informed. Directors must not shirk from their responsibilities.

9. What is the business judgment rule?

Under the business judgment rule, courts are unlikely to intervene if directors and officers

fulfill their duties in good faith, i.e. if they are not conflicted, are informed, and act in

rational belief.

10. What is the enhanced business judgment rule? When does the enhanced business judgment

rule get triggered?

The enhanced business judgment rule gets triggered when a company becomes the target of a

takeover bid. In cases where the business judgment rule is applicable, courts are unlikely to

intervene as long as directors exercise their duties in good faith. In contrast, when the

enhanced business judgment rule gets triggered, directors are held to a higher standard of

scrutiny before the protections of the business judgment rule are conferred on directors.

Steps taken to evaluate directors’ actions may include obtaining opinion letters, forming an

independent committee of directors, and discussing and reviewing directors’ actions in

detail.

11. What two tests must be met for courts to rule that directors have performed their duties in

accordance with the enhanced business judgment rule?

a. The board must show it had reasonable grounds for believing a danger existed to the

firm, arising from the hostile bid.

b. The defensive response must be reasonable in relation to the threat posed.

12. What is the Revlon Rule? When does it get triggered?

The “Revlon Rule” requires boards to maximize shareholder value (e.g., by auctioning the

firm) when it is evident that the firm is to be sold and there are multiple bidders. The Revlon

rule gets triggered when a sale of the firm is inevitable. The directors’ role changes “…from

defenders of the corporate bastion to auctioneers charged with getting the best price for the

stockholders at a sale of the company…”3

3 Revlon, Inc. v. MacAndrews & Forbes Holdings, Supreme Court of Delaware, 1986 506 A. 2d 173.


1. What is the aim of securities laws?

The aim of securities laws is to inform investors, prevent manipulation, produce more

efficient markets, and achieve a level playing field.

2. How does one determine whether a fact is material?

One determines whether a fact is material by asking the question, “Would you want to know

about it if you were in the investor’s shoes?”

3. What is the significance of the Securities Act of 1933?

The Securities Act of 1933 requires that new securities be registered with the SEC. Through

registration, the SEC can impose standards of disclosure.

4. What is a registration statement? A prospectus? A red herring?

The registration statement is a document submitted to the SEC that contains the prospectus

and other forms. The prospectus describes the business of the issuer, the issuer’s financial

condition, the capitalization, the purposes for raising the new funds, etc. A red herring is a

preliminary prospectus meant to inform investors while the registration is being approved by

the SEC.

5. When is a registration deemed to be “effective”?

A registration is declared to be effective by the SEC when it is satisfied with the completeness

of disclosure in the prospectus.

6. What is the Securities Act of 1934?

The Securities Act of 1934 lays out rules regulating securities exchanges and the securities

traded in the public markets. It also requires corporations with assets greater than $10

million and more than 500 shareholders to register with the SEC. These companies are

called reporting companies.

7. What is the Williams Amendment to the Securities Exchange Act of 1934? What are the

four important “rules of the road” imposed by the Williams Amendment?

The Williams Amendment requires hostile bidders to disclose any information to target

shareholders in connection with a bid. The four “rules of the road” are:

• Early warning. A buyer must notify the SEC within 10 days upon the accumulation of 5

percent or more of a target’s shares.

• Open for 20 days. The buyer’s tender offer must be open for 20 business days before

shares may be purchased.

• Equal treatment. All target shareholders must be treated equally by the buyer.

• Cash offers too. Cash tender offers are also subject to the anti-fraud and registration

requirements that govern share for share exchanges.

8. Do states have jurisdiction over securities registration? What are “blue sky” laws?

States are permitted to have jurisdiction over securities registration as long as they don’t

conflict directly with the provisions of the ’34 Act. The “blue sky” laws allow states to bar

transactions that federal laws would permit. Still, the SEC/federal laws are the supreme

authority – one must register stock for sale in every state where the stock is to be marketed.

9. What are the two theories of insider trading liability? Explain each.

The two theories of insider trading liability are the classical theory and the misappropriation

theory. The basis for prosecution in classical theory is deception, defined as a failure to

disclose information, or to abstain from trading. Under misappropriation theory, the basis

for prosecution is theft of confidential information for the purpose of trading.

10. Can one buy or sell securities during the waiting period of filing a registration statement with

the SEC?

The waiting period is the time between the filing of a registration statement, and the date

when the registration becomes effective. One cannot buy or sell securities during this period,

but can make oral offers and receive preliminary indications of interest in buying the

securities.


1. What is a trust? Why are trusts harmful to consumers?

A trust is a grouping of competitors in an industry gathered through mergers or informal

production agreements. Trusts might harm consumers by charging prices higher than those

that would prevail in a competitive market.

2. What is a contestable market?

A contestable market is one in which only a few firms exist in an industry, yet oligopoly

pricing does not result because the firms behave competitively in anticipation of easy entry

by firms outside of the market. Prices are kept low enough so that potential new entrants do

not have an opportunity to enter the market by offering low prices.

3. What two conditions are necessary for a merger to have an anticompetitive effect?

The two conditions necessary for a merger to have an anticompetitive effect are:

a. the market must be substantially concentrated after the merger; and

b. the merger must raise barriers to entry by new firms into the market in the near term,

new players that would stimulate competition.

4. What is the Sherman Act?

The Sherman Act outlaws anticompetitive behavior. It considers the following illegal:

a. contracts that attempt to restrain trade or commerce among the different states and

foreign countries; and

b. attempts to monopolize trade among the states or with foreign nations.

Violations of the Sherman Act are punished by fines and/or imprisonment.

5. What is the Clayton Act?

The Clayton Act specifically addresses mergers and acquisitions, preventing combinations

that would restrain trade. The Clayton Act forbids acquisitions whose effect may be

“…substantially to lessen competition or tend to create a monopoly…”

6. What is the Hart-Scott-Rodino Act?

The Hart-Scott-Rodino Act requires combinations above a certain size threshold to submit

information to the DOJ and FTC in advance of consummating the deal. This law grants the

federal government a right of advance regulatory review of M&A deals.

7. Which government agencies enforce antitrust laws? What are their respective functions?

The agencies that enforce antitrust laws are the Antitrust Division of the Department of

Justice (DOJ) and the Federal Trade Commission (FTC). The DOJ prosecutes violations of

the Sherman Act as criminal felonies. The FTC enforces the Federal Trade Commission Act

and parts of the Clayton Act, both of which do not entail criminal sanctions.

8. Define what horizontal, vertical, and conglomerate mergers are. What motivates each type of

merger?

o Horizontal mergers occur among peer competitors in an industry (such as two shoe store

chains for example). Horizontal mergers can help firms achieve greater market power

and increase economies of scale.

o Vertical mergers occur among firms within the value chain (such as a supplier and a

customer). They may help firms increase revenue through greater product offerings and

reduce costs through greater control of the supply chain.

o Conglomerate mergers occur among firms unrelated by value chain or peer competition.

They help firms increase sales within the conglomerate. They may also be motivated by

the belief that the central office has key know-how in allocating capital and running the

disparate businesses better than they can be run independently.

9. What are the two quantitative measures used to determine degree of market concentration in

horizontal mergers? Explain conceptually what each aims to measure.

The two quantitative measures are the cross elasticity of demand and the Herfindahl-

Hirschman Index. The cross elasticity of demand measures how closely related demand is

for two different goods. The relationship is measured as the change in demand for one good

in response to a change in the price of another good. The Herfindahl-Hirschman Index

measures market concentration based on market shares of players in the relevant market.

10. Firm A, a manufacturer of butter, wants to acquire Firm B, a manufacturer of margarine. The

Federal Trade Commission wants to determine the economic relationship between butter and

margarine. A review of prices over the last 20 years reveals that the demand for margarine

rises 3% for every 1% increase in the price of butter. Calculate the cross elasticity of demand

and interpret the results.

Values greater than 1 indicate elastic demand. In this case, demand for margarine is highly

sensitive to the price of butter.

11. Listed below are the top ten book publishers, ranked according to fiscal year 2000 revenue:4

% Change in demand for margarine (a) 0.03% Change in price of butter (b) 0.01Cross elasticity of demand (a/b) 3

Suppose Scholastic Corp. wanted to acquire Marvel Enterprises. Descriptions of both

companies are given below. Calculate the HHI indices pre-merger and post-merger. Do you

think the FTC would approve this transaction?

Scholastic Corporation

“Selling more than 325 million books annually, Scholastic Corporation is a leading

publisher of children’s books. Its success is based on traditional favorites, including

the Babysitter’s Club and Clifford the Big Red Dog series, as well as on newcomers,

most notably the wildly popular Harry Potter series…Scholastic also specializes in

educational materials, publishing 35 magazines that are read by more than 20 million

elementary and high school students in the United States alone.”5

Marvel Enterprises, Inc.

“Marvel Enterprises, Inc. is one of the world’s most prominent character-based

entertainment companies, with a proprietary library of over 4,700 characters. The

4 Jack W. Plunkett, Plunkett’s Entertainment & Media Industry Almanac 2002-2003, p.87.

2000 Revenue (in $ MM)

McGraw Hill Cos. Inc. 4,281.0 Scholastic Corp. 1,402.5 Houghton Mifflin Co. 1,027.6 John Wiley & Sons Inc. 594.8 Thomas Nelson Inc. 265.5 Hungry Minds Inc. 243.3 Marvel Enterprises Inc. 231.7 Golden Books Family Ent. 148.9 Information Holdings Inc. 73.3 Millbrook Press Inc. 21.4

company operates in the licensing, comic book publishing and toy businesses in both

domestic and international markets. Marvel’s library of characters includes

Spiderman, X-Men, Captain America, Fantastic Four and the Incredible Hulk…”6

The calculation of pre- and post-transaction HHI indices is shown below:

5 Ibid., p. 411

Summary Market HHI before the deal 3,188.9 Market HHI after the deal 3,283.4 Change in market HHI 94.6

HHI Indexes before the contemplated transaction

FY 2000 Revenue (in

$ MM) % Market Share (Market Share)2

Market PlayersMcGraw Hill Cos. Inc. 4,281.0 51.6 2666.7Scholastic Corp. 1,402.5 16.9 286.2Houghton Mifflin Co. 1,027.6 12.4 153.7John Wiley & Sons Inc. 594.8 7.2 51.5Thomas Nelson Inc. 265.5 3.2 10.3Hungry Minds Inc. 243.3 2.9 8.6Marvel Enterprises Inc. 231.7 2.8 7.8Golden Books Family Ent. 148.9 1.8 3.2Information Holdings Inc. 73.3 0.9 0.8Millbrook Press Inc. 21.4 0.3 0.1Total 8,290.0 100.0 3188.9 HHI

Based on Revenues

There may be valid reasons for both permitting and not permitting this transaction.

Although both pre- and post-transaction HHIs suggest a high degree of concentration, it

could be argued that information is provided only on the top ten book publishers whereas in

reality there may be many more book publishers such that the HHIs when all book publishers

are considered might reflect a much lower degree of concentration. In addition, while

Scholastic and Marvel overlap somewhat in their target markets (i.e., the children’s market),

their product offerings are markedly different. Marvel’s target market segment seems much

broader than just the children’s market. Perhaps the most important takeaway from this

exercise is that one cannot make a decision to approve or disapprove a transaction based

only on HHIs.

12. What other guidelines do the regulatory agencies use to determine whether to approve or

disapprove a horizontal merger?

6 Ibid, p. 326.

HHI Indexes after the contemplated transaction

Revenues % Market Share (Market Share)2

Market PlayersMcGraw Hill Cos. Inc. 4,281.0 51.6 2666.7Houghton Mifflin Co. 1,027.6 12.4 153.7John Wiley & Sons Inc. 594.8 7.2 51.5Thomas Nelson Inc. 265.5 3.2 10.3Hungry Minds Inc. 243.3 2.9 8.6Golden Books Family Ent. 148.9 1.8 3.2Information Holdings Inc. 73.3 0.9 0.8Millbrook Press Inc. 21.4 0.3 0.1Scholastic + Marvel 1,634.20 19.7 388.6Total 8,290.0 100.0 3283.4 HHI

Based on Revenues

Other guidelines used by the regulatory agencies are:

a. whether the merger will forestall entry by other firms

b. whether the merger efficiency gains are credible; and

c. whether either of the merger partners is a failing firm.


1. What is the role of first-round documents in merger negotiations?

First-round documents lay out terms of engagement/agreement/norms among parties privy to

a deal. The purpose of first-round documents is to deal with risks that may arise before a

definitive agreement can be reached.

2. What is a confidentiality agreement?

A confidentiality agreement commits the buyer to hold in confidence all non-public

information received from the target and to use it for no other purpose than consummating

the transaction. The agreement also lays out the information to be provided and the

channels through which it is to be accessed. The target may seek relief in the event that the

agreement is violated.

3. What does an exclusivity agreement do?

An exclusivity agreement binds a target to not share information or seek discussions with

other potential buyers over a specified period of time during which the merger agreement is

being negotiated and the buyer is performing due diligence.

4. What is a standstill agreement? What is its objective?

A standstill agreement prevents a buyer from purchasing more target shares without

approval from the target’s board of directors. Its objective is to prevent the buyer from

pressuring the target by short-circuiting merger negotiations through open market purchases

or a direct tender offer to shareholders.

5. What information does a term sheet contain? What is the purpose of having a term sheet?

A term sheet contains a brief summary of terms of the deal such as price, form of payment,

structure, social issues, etc. Although not a binding agreement, the term sheet establishes a

sense of alignment between the two parties, and provides a framework upon which to draft

the definitive agreement.

6. What is a letter of intent? Why do some M&A advisors advise against issuing an LOI?

A letter of intent is an agreement to agree on the intent of the deal negotiations up to that

point. Some M&A advisors advise against signing an LOI because it is not contractually

binding, and because it may trigger some disclosure obligations.

7. What is a definitive agreement? How is it a “risk management” device?

A definitive agreement is the legal document that lays out all the necessary details relevant to

consummating a deal. It is a risk management device that binds both parties to carry out

steps leading to the consummation of a deal, and to abide by certain rules of conduct.

Breaches of the terms of agreement subject the offending party to penalties, and may bring

about litigation. Unlike the Letter of Intent, a definitive agreement is binding (subject to

conditions such as shareholder approval).

8. What is the importance of the “Parties to the Deal” component?

The “Parties to the Deal” component clearly indicates who the parties to the transaction

are. Defining who is in the deal is important for delineating who exactly has commitments to

perform under the contract. Also, defining who is in the deal establishes exclusivity, the

result of which, hopefully, is the deterrence of competitors.

9. What is the “Recitals” component?

The “Recitals” component conveys what the parties to the deal want to accomplish. This

component helps readers understand the motivations for the deal. It sometimes also provides

a general idea of the transaction by offering information such as the structure of the merger,

the form of exchange, and the price or exchange ratio.

10. Why is the “Definition of Terms” component important?

The definition of terms is important because it prevents misunderstanding. It also helps to

reduce the length and complexity of the document.

11. What information is contained in the “Description of the Basic Transaction” section?

Why is this section important?

The “Description of the Basic Transaction” section contains information about how the deal

will be consummated. Details provided in this section will usually include the form of

exchange, the price or the exchange ratio, information about the treatment of options and

warrants, the merger structure, the targeted closing date and social issues. This section

might also specify the future registration rights of any non-registered shares issued by the

buyer in payment for the target.

12. What are the three ways in which the sellers’ rights to register shares might appear?

Provide an explanation for each of the ways. Why is it important to include a provision in

the definitive agreement for registering shares?

The three ways to register shares are 1) on demand, 2) shelf, and 3) piggy-back. On demand

registration permits the seller to require the buyer to register shares when the seller wants.

Shelf registration requires Newco to maintain an effective registration statement with the

SEC for a relatively long time period, and permits the target shareholders to register under

these documents. Piggyback registration allows the seller to demand registration only when

Newco is registering other shares. Provisions for registering shares are important because

they affect the exit strategy of selling shareholders.

13. What is in the “Representations and Warranties” section? What is the difference between

a representation and a warranty? Why is the Representations and Warranties section

important?

The “Representations and Warranties” section contains disclosures about the condition of

the buyer and seller at the time of the transaction. In effect, this section provides a snapshot

of the buyer and seller as of a certain date. A representation is a statement of fact while a

warranty is a commitment that a fact is or will be true. The reps and warranties can trigger

an exit with no liability if the other party’s representations and warranties are shown to be

false. By the same token, this section gives a foundation for indemnities after the closing of

the deal.

14. True or False. Explain.

a. Sellers are less concerned about the condition of the buyer if the buyer pays in

stock rather than in cash.

b. If a representation or warranty is found to be false after the closing of the deal, the

injured party can always sue for damages.

a. False. Sellers are more concerned about the condition of the buyer if the buyer pays

in stock, because the stock price can fluctuate.

b. False. Reps and warranties expire at the closing of the transaction, unless explicitly

stated otherwise in the agreement.

15. What purpose does the “Covenants” section serve?

In the covenants section, the buyer and seller promise to do or not do certain things between

the signing of the agreement and the closing date. Covenants prevent opportunistic behavior

by either party.

16. What purpose does the “Conditions to Closing” section serve?

This section lists the conditions that each side must observe in order to consummate the

transaction. Standard closing conditions include shareholder approvals, regulatory

approvals, absence of material litigation, consents from third parties, and opinions from

professional advisors. The failure of one party to meet the closing conditions allows the

other party to walk away from the deal without recourse.

17. What is a “bring-down”?

A “bring-down” is the act of reaffirming the truthfulness of representations and warranties

at the time of closing.

18. What does the “Termination” Section contain?

The termination section lists the circumstances under which the parties can unilaterally or

mutually terminate the transaction. Some provisions may include termination fees.

19. What purpose does the “Indemnifications” section serve?

The indemnifications section specifies damage payments in the event of losses discovered

after closing, or of a breach of provisions in the agreement.

20. What is a proxy statement?

A proxy is an authorization to act for another. Corporations send out proxy statements to

solicit authorization to vote the shares at a meeting as the shareholders instruct.

21. What is a merger proxy statement? What information does a merger proxy statement

usually contain?

In most cases a merger proxy statement is a document that asks shareholders to vote for (or

against) a merger. At their most basic level, merger proxy statements contain information

about terms of the proposed deal (e.g. price, form of exchange, organizational structure),

rationale and background of the deal, financial and tax impact of the deal, requirements for

consummation, proof of financing on acquirer’s part, fairness opinions, regulatory matters

and conditions of termination.

22. Infant World and Busy Bee have agreed to a merger of equals. Busy Bee has an

Employees Stock Option Plan (ESOP) with options unexercised on 923,000 shares, 2.0% of

the company’s total outstanding shares. The ESOP had a clause that would allow shares to

vest automatically if Busy Bee were acquired or became party to a merger. The merger

proxy statement made no mention of the unexercised options on the shares. Should this

information have been disclosed in the proxy statement? Explain.

The unexercised shares could have a material impact on the accretion or dilution of the deal

This information is important to investors and should have been disclosed. If the two firms

are publicly held corporations, the SEC would review the proxy statement and probably

require disclosure.

23. Does having a fairness opinion from a financial advisor mean that a deal is good for

shareholders? Explain.

Not necessarily. All that a fairness opinion suggests is that the consideration paid is “fair”

from the standpoint of shareholder welfare, not that this deal is “best” in comparison to

other actual or potential proposals.

24. Why do proxy statements disclose the number of shares held by directors and officers?

This is to disclose fully the potential personal interest of officers and directors in a deal.

25. Why do proxy statements often contain information on financing arrangements for the

buyer? Or alternatively, why are commitment letters (for funding) so important?

Assurance of funding is an important signal that the deal can be consummated and of the

credibility of the bid. Acquirers will want to prove that the funding necessary to back up the

deal is readily available.

26. Why are the target’s Articles of Incorporation and By-Laws often amended in connection

with a merger?

A target’s articles of incorporation and by-laws are often amended to remove obstacles (such

as anti-takeover defenses) to a merger. By-laws are often amended to reduce the size of the

board, to change voting procedures and terms of directorship, and to eliminate other defense

mechanisms.

27. Companies often have what is called a “Rights Agreement.” What is this and what is its

purpose?

A rights agreement gives shareholders the right to buy shares at a given exercise price

(usually below market) in the event of a takeover. It is also known as a poison pill. Poison

pills are meant to discourage unwanted offers by making the acquisition more expensive for

the buyer, and by diluting whatever equity stake the buyer has already accumulated.

28. What is a “Keepwell Covenant”? Why is it important?

A keepwell covenant is a promise by the acquirer to meet all obligations of the target as they

come due should the target be unable to meet them. This pledge is important for assuaging

fears of creditors, thus preventing them from blocking the acquisition.

29. What is the purpose of the “Conditions to the Offer” section of a proxy statement?

The Conditions to the Offer section enumerates the conditions under which the acquirer has

no obligation to make good on its offer to acquire shares. This section therefore is a risk

management tool for the acquirer.


1. What is ZOPA? When does it exist?

ZOPA stands for “Zone Of Potential Agreement.” It exists when there is an overlap between

the ranges of values a buyer is willing to pay and a seller is willing to accept.

2. What is BATNA? Why is it important to have one during negotiations? Please give an

example of BATNA.

BATNA stands for “Best Alternative to a Negotiated Agreement.” Having a BATNA is

important because it helps set the walk-away price for buyer and seller, and therefore

prevents either party from getting caught up in deal frenzy when the price is outside of either

party’s feasible range. A classic example of BATNA would be one that involves a make

versus buy, or lease versus buy, decision.

3. What is anchoring? In terms of strategy, is it a good idea to anchor?

As buyer (seller), to anchor is to open with a price high enough (low enough) to motivate the

counterparty to lower (raise) expectations about the likely settlement price. It is generally an

effective strategy to anchor, although one must be careful not to do so with an unreasonably

high or low price in order not to derail the negotiations.

4. What is the endowment effect? What is status quo bias? What causes both phenomena?

What does the occurrence of these two phenomena suggest about behavior in deal making?

The endowment effect is a phenomenon where people tend to ask more in selling an asset

than they would offer to buy it. The status quo bias is involved in situations where people

stick to their current situation because the disadvantages of changing seem larger than the

advantages. Both phenomena are due to loss aversion. The occurrence of these phenomena

suggests that parties to a negotiation do not always behave “rationally” in economic terms

because other factors (e.g. psychological) come into play.

5. What steps must one take to prepare for a negotiation?

o Assess the current strategic position and alternative strategic actions for buyer and

target.

o Value the target using a variety of approaches.

o Explore your BATNA.

o Decide on an opening and a walk-away price.

o Identify the relevant players and their interests.

o Anticipate tradeoffs.

o Consider motivations and aspirations.

o Work through possible negotiation scenarios in advance.

o Assess the impact of bargaining costs.

o Check the reputation of your counterparty.

o Reflect on persuasion.

6. How might sunk costs negatively affect a party to a negotiation?

If either buyer or seller (or both) invests significant amounts of time and money to prepare

for negotiations, they may feel compelled to complete a deal at all costs. Another example,

in the seller’s case, is being unwilling to take a loss on the asset being sold. For instance, if

a seller is disposing of an asset in which it invested $100 million but which is worth only $20

million today, the seller may insist on being able to reclaim the $100 million.

7. Why is it advisable to conduct multi- issue, parallel bargaining rather than single- issue, serial

bargaining?

Multi-issue, parallel bargaining allows both parties to give and take on different issues,

thereby increasing the chances of success. In contrast, single-issue, serial bargaining is

likely to cause a stalemate when the parties are completely at odds about the issue.

8. What does it mean to create, rather than claim, value?

Creating, rather than claiming, value means to enlarge the pie for the benefit of all parties

rather than to aim for as large a slice of a fixed pie as possible at the expense of other

parties. In other words, creating value means transforming a situation from a zero-sum

game to a positive-sum game.

9. What are three ways to address a stalemate during negotiations?

Three ways to address a stalemate are to change the rules of the game, change the players,

and change the value-added offered in the deal.


1. What are the five methods of sale discussed in the chapter? Describe each method and

discuss advantages and disadvantages associated with each.

Method Description Advantages Disadvantages

Beauty contest Interested buyers

are invited to

present themselves

to the target.

Choice of buyer is

made behind closed

doors.

Judges have greater

ability to obtain

information from

buyers.

Slow, opaque, and

vulnerable to

lobbying.

Lottery Seller specifies sale

price; winner is

selected by random

drawing.

Speed. No price discovery

by seller. No

chance to evaluate

buyer on other

criteria such as fit,

competence, etc.

First come first

served

First buyer to show

up gets to acquire

Speed. No price discovery

or chance to

target. evaluate buyer on

other criteria.

Auction Sale is awarded to

highest bidder.

Reveals prices,

transparent, fast,

draws more

potential buyers.

Likely to be costly

Friendly, non-

competitive

negotiation

Buyer persuades

target to sell in

friendly

negotiations.

No hostility or

nettlesome events

that might hinder

integration. Target

has greater say in

structuring the deal.

No price discovery.

2. Auctions can be classified as open versus sealed, single versus double, common value versus

private value. Briefly describe each.

In an open auction bids are made public while in a sealed-bid auction, only the seller sees

the bids. In a single auction only the buyers bid, while in a double auction buyers bid and

sellers offer prices at which they would be willing to consummate a deal. In a common value

auction, the asset being sold has similar use to all buyers. In a private value auction values

differ depending on their use to the buyer.

3. What is an English Auction? A Dutch Auction? A first price sealed bid auction? A second

price sealed bid auction? What are the advantages and disadvantages of each method?

Method Description Advantages Disadvantages

English

auction

Open bidding.

Asset is sold to the

highest bidder.

• Price discovery

and revenue

maximization for

seller.

• Transparency.

• Speed.

• Bidding frenzy

may result in

overpayment by

buyer.

• Reduces

flexibility for

seller. No

chance to

evaluate buyer

on other criteria

such as fit,

competence, etc.

• Vulnerable to

collusion.

• “Winner’s

curse”

Dutch auction Seller begins with

arbitrarily high

• Does not “leave

money on the

• Reduces

flexibility for

price and reduces

it until a bidder

accepts.

table.”

• Speed.

seller. No

chance to

evaluate buyer

on other

criteria.

First price

sealed bid

auction

Each bidder has

only one chance to

offer – and outside

the view of other

bidders.

• Price discovery.

• Speed.

• Bidders have no

chance to

counteroffer.

• Revenues to

seller are not

maximized.

Second price

sealed bid

auction.

Same as first price

sealed bid auction,

but winner pays

second-highest

price rather than

the winning price.

• May encourage

more bidders

and higher

prices.

• Speed.

• Bidders have no

chance to

counteroffer.

• Revenues to

seller are not

maximized.

4. Which auction method would maximize revenues to the seller?

The English auction would maximize revenues to the seller.

5. What are the main advantages of using auctions for asset sales? What are its main

disadvantages?

Auctions allow sellers to maximize revenue, motivate buyers to bid with speed and at higher

prices, and are relatively faster, fairer and more transparent. But auctions reduce the

flexibility and discretion of the seller by committing the seller to decide on a process.

Auctions may also be subject to manipulation by buyers. Finally, auctions may discourage

entry by prospective bidders because auctions are so successful in maximizing revenue to the

seller.

6. What is the “Winner’s Curse”?

The “Winner’s Curse” refers to overpayment by a winning bidder for an asset put up for sale

in an auction. Since the winner makes the highest estimate for the asset, the implication is

that everyone else had a lower estimate of the asset’s value. Deal frenzy often gives rise to

the “winner’s curse.”

7. Why must the effective M&A practitioner master the art of multi-attribute bidding in

auctions?

The effective M&A practitioner must master the art of multi-attribute bidding because

auctions are not always settled solely by price. Price is just one consideration within the

bundle of attributes that constitutes the M&A deal.

8. If an asset for sale is unique, is it advisable for the seller to use an auction process? Explain.

Yes – if an asset is unique, selling by auction is advisable. Since a unique asset is scarcer,

bidders are likely to compete more fiercely – an auction will pit bidders against each other

and will be likely to drive up the price, maximizing revenue for the seller.


1. What is a hostile takeover?

A hostile takeover is one in which an unfriendly buyer offers an unsolicited bid for a majority

of the shares in a target firm. The operative word is unsolicited.

2. The investment opportunities hypothesis says that takeovers are motivated by the buyer’s

desire to purchase a target at a low valuation, improve its operations and gains in efficiency,

and profit from the gains in investment.

The inefficiency hypothesis, which holds that takeovers are motivated by a desire to improve

operational inefficiencies and profit from them. The investment opportunities hypothesis

suggests that targets simply present attractive investment opportunities owing to strong

growth prospects and synergies, not inefficiencies.

3. What is an M&A arbitrageur? How might M&A arbitrageurs define the outcome of a

takeover contest?

An arbitrageur is a professional investor who seeks to exploit small pricing inefficiencies

within or across markets associated with events or transactions. By exploiting pricing

inefficiencies, arbitrageurs drive markets toward efficiency. The arb takes a long position on

the target’s shares and a short position on the seller’s shares. This hedged position exposes

the arb only to the risk that the deal will not be completed, i.e. the risk that the arb sees to

take. Arbitrageurs may define the outcome of a takeover contest if they accumulate a large

enough number of the target’s shares to “swing the vote.”

4. To what factors are an M&A arbitrageur’s returns most sensitive? Explain.

An M&A arbitrageur’s returns are most sensitive to the price offered per share, and to the

length of the holding period. The price offered determines the payoffs on the investment, and

therefore affects the returns. The length of the holding period affects the arb’s returns

because of the time value of money. The longer the holding period is, the greater the interest

expense the arb incurs, negatively affecting returns.

5. What is a leveraged recapitalization? Why might a target resort to it?

A leveraged recapitalization entails borrowing a substantial amount of money and using it

for a large one-time dividend to all shareholders and/or a large one-time share repurchase.

A target may use a leveraged recapitalization as an anti-takeover defense, in the hope that

the added leverage and payment of cash to shareholders will make the target less attractive

to a hostile bidder.

6. All things equal, should a bidder make a tender offer with a shorter or longer holding

period? Explain.

The bidder has a greater chance of winning if it chooses a shorter holding period. A longer

holding period gives the target time to execute anti-takeover defenses or to look for other

buyers. In addition, a shorter holding period is favored by arbs since it increases their

returns. The vote of the arbs could determine the outcome of the deal. Therefore, a shorter

holding period works in the bidder’s favor.

7. What should a bidder consider in determining its highest or walk-away bid and its lowest

bid?

The walk-away price should be determined by the bidder’s reasonable estimate of the “high”

end of the target’s intrinsic value. For the low bid, the bidder may need to consider factors

other than the target’s current market price. For instance, the bidder needs to consider the

possibility of competing bids, or of self-initiated restructuring that the target might take on.

8. What is a minority shareholder freeze-out?

This is a merger of the target with the buyer (or subsidiary of the buyer) that forces an

unwilling remainder of shareholders in the target company to give up their shares in return

for payment from the target. Target shareholders are said to be “frozen out” of the target by

the compulsory nature of a merger in which the majority of target shareholders approve the

merger.

9. What is EVNT? How is it calculated?

EVNT stands for the “Expected Value of Not Tendering” (i.e., the value to target

shareholders if they do not tender shares to the hostile bidder). Share prices are estimated

under two scenarios: (a) if no shares are tendered to the raider and share prices subside to

the ex ante price; and (b) if no shares are tendered to the raider, but they are tendered to a

higher competing bidder who buys the firm. These prices are then multiplied by their

probability of occurrence, and summed.

10. In economic terms, what needs to happen for target shareholders to tender their shares?

The value of tendering (i.e. the bid price) must be greater than the expected value of not

tendering (EVNT).

11. What are stub shares?

Like the stub of a movie ticket that remains with a viewer after entering a theatre, stub shares

are the shares of a company that remain in the hands of shareholders after a

recapitalization.

12. What is a bear hug? What is the advantage of using this strategy?

A “bear hug” refers to a high initial bid. This strategy deters competitors and pressures the

target’s directors to accept the offer. Knowing this, arbs will tend to support the bid.

Accordingly, the high bid strategy raises the probability of winning the contest.

13. When would a low bid strategy be appropriate?

A low bid strategy would be appropriate when the bidder is patient and/or confident that

there will be no or few other competing bidders.

14. Scott Siegel, manager of an M&A hedge fund, watched the tape go across his Bloomberg

screen at 4:00 p.m. on June 13, 2001. Celera Genomics, a Rockville company known for

mapping the human genome, announced it would acquire AXYS Pharmaceuticals Inc., an

integrated small molecule drug discovery and development company. The deal was

structured as a stock swap in which AXYS shareholders would receive 0.1016 Celera

share for each AXYS share. Celera had closed the previous day at $41.75, and AXYS at

$3.45. What would Siegel do as an M&A arbitrageur? Explain.

Based on Celera’s last closing, the effective purchase price for AXYS would be $4.24. As an

M&A arb, Siegel would immediately take a long position in AXYS and a short position in

Celera on the bet that the seller’s share price would decline while the buyer’s share price

would rise.

15. Assume that the acquisition was completed in 5 months (150 days). Assume further that

Siegel purchased 300,000 shares of AXYS at an average cost of $4.15, and shorted

29,800 shares of Celera. Siegel funded 70% of his purchase with debt. Celera’s share

price on the closing date was $27.43. Assuming a borrowing cost of 8%, calculate the

return on Siegel’s investment for the holding period and on an annualized basis.

Days in Holding Period

Assumptions 150 Position and Payoff in Target SharesBuy Target shares at 4.15$ Payoff on Target shares at end 2.79$ Gross Spread Per Share on Target shares (1.36)$ Total value of Gross spread on Target Shares (Times # shares =) 300,000 (408,933.60)$

Position and Payoff in Buyer SharesShort Buyer shares at 41.75$ Payoff on Buyer shares at end 27.43$ Gross Spread Per Share on Buyer shares 14.32$ Total Value of Gross Spread on Buyer shares 29,800 4,296,000.00$

Total Assets of the Arbitrage Position 1,245,000.00$

Short Position in Buyer Shares 1,244,150.00$ Borrowed shares of Buyer (1,244,150.00)$ Debt @ % Assets 70% 871,500.00$ Capital Employed 373,500.00$ Total Liabilities and Capital of the Arbitrage Position 1,245,000.00$

Net Spread CalculationGross Spread 3,887,066.40$ -Interest @ 8% (28,652.05)$ - Short Dividends Foregone -$ + Long Dividends Received -$ Net spread 3,858,414.35$

Days in holding period 150

ResultsReturn on capital for holding period only 1033%Return on capital annualized 2514%

16. Healthy Land, Inc. (HLI), a waste management services company, wants to acquire

Spitzer’s Environmental Services (SES). HLI has determined that its purchase price

should not exceed $44 per Spitzer share. The shares currently trade at $28.50 apiece.

Members of the Spitzer family (which owns 40% of the company) occupy all board seats

and are determined to keep the company within their control. Their consultants have

drawn up a restructuring plan that, by their estimates, could raise the value of Spitzer to

$42 a share. An aggressive raider named Mathias Martin is reportedly going to join the

bidding contest. HLI thinks Mathias will place a bid of $35.00. HLI estimates a 50%

chance that the Spitzer family will win the bid, a 30% chance that Martin will win, and a

20% chance that neither scenario will materialize. Should HLI put in a bid? If so, how

much should HLI bid? Please draw a decision diagram facing the investor.

To decide on its bid price, HLI should consider things from the investor’s point of view. The

investor has to decide whether to tender to HLI or not. If the investor decides not to tender to

HLI, he/she is faced with three scenarios, as illustrated in the investor’s decision diagram below:

The expected value of not tendering (EVNT) = (.50*$42) + (.30*35) +(.20 *28.50) = $37.20.

Therefore, HLI must bid a price above $37.20 to increase its chances of winning, and below

$44.00.

Tender to HLI

Don’t tender to HLI

Spitzer bid $42

Mathias Martin $35

No bid $28.50

.50

.30

.20


True or False

1. Whether defensive tactics create or destroy value for target shareholders depends on both

corporate governance and uncertainty.

2. Research evidence shows that targets of hostile bids have higher debt and inside

ownership and lower liquidity and debt capacity.

3. Defense tactics are particularly discouraging to arbitrageurs.

4. The “Saturday Night Special” is a surprising offer to the target board that is left open

for only a brief period of time.

5. A godfather offer is a cash offer that is accompanied with an implied threat, which

makes directors feel pressured to accept.

6. Golden parachutes grant target managers generous payments if they decide to stay at the

combined firm following an acquisition.

7. A board of directors has the power to rescind a poison pill.

8. The poison pill is a non-detachable shareholder right to obtain shares at nominal cost

upon the occurrence of a triggering event.

9. Governments can give external presentation to targets through the implementation of

discriminatory laws and regulations.


1. T. The effectiveness of defense tactics depends on the degree of uncertainty regarding the

target’s intrinsic value, as well as the quality of the target firm’s corporate governance.

2. F. As mentioned in the chapter, the research findings reported in the August 1985 issue

of Securities Regulation and Law Reporter (page 1479, “Merger, Takeovers Increasing

Pressure on Outside Directors”) show that targets of hostile bids have lower debt and

inside ownership and higher liquidity and debt capacity.

3. T.

4. T.

5. F. A godfather offer is a cash offer that is so high that the directors feel unable to refuse

it.

6. F. Golden parachutes are generous severance payments granted to target managers if

they are terminated following an acquisition that changes control. If managers are given

generous payments to stay at the firm, those are probably “retention payments.”

7. T.

8. F. The poison pill is a detachable shareholder right to obtain shares at nominal cost

upon the occurrence of a triggering event.

9. T.


1. If most public corporations have not been subject to a hostile takeover contest, why are

takeover defenses so prevalent?

• It offers flexibility to a company’s board and management in the case that the

company becomes a target for a takeover. By having the defenses already in

place ahead of an attack, it allows the directors and management to better

maximize value to shareholders during the takeover attempt/process.

• These defenses raise the bar for potential bidders, and thus effectively “weeds

out” all but the most serious and determined bidders.

2. What is a “street sweep”? What is a “drop and sweep”?

A “street sweep” is the purchase of a target (and thus control of the target) via the open

market. A “drop and sweep” is a street sweep that follows a withdrawal of a buyer’s

tender offer.

3. What do toehold purchases attempt to do?

Toehold purchases seek to obtain a material position of the target’s equity shares in order to:

a. Signal the seriousness of the bidder’s intent.

b. Influence the target board.

c. Fend off other possible bidders.

d. Earn a consolidation profit in the event that the target is won by another

higher bidder.

4. What is the Williams Act and why is it important?

The Williams Act stipulates that a bidder must notify the SEC upon surpassing a five

percent stage in the target. It is important because it takes out the element of surprise of

sizable open market block purchasing of shares, and puts an effective “cap” on using the

open market purchase approach to buy a target company.

5. What is the key difference between a proxy contest and consent solicitation?

A proxy contest is one in which a buyer submits an acquisition approval request to the

target’s shareholders, in advance of the target’s annual shareholder meeting. (A proxy is

literally a legal document by which shareholders can vote an absentee ballot). A proxy

contest can be run in a fashion similar to that of a political campaign, with investment

bankers and proxy solicitation firms.

6. What are four things to consider in choosing a form of takeover attack?

a. Attitude of target management and board. The strength with which the target

management and board of directors will resist an unsolicited bid will dictate how much

time and effort a bidder will need to devote to win their support.

b. Distribution of voting power. Whether shares are held by a powerful few

(institutional investors and founding families) or a disparate group will dictate the

effectiveness of different tactics. For example, a tender offer would probably work better

on a dispersed group of shareholders than a small select few.

c. Strength of target defenses in place. Different target defenses have different degrees

of defensive power. For example, the poison pill is typically viewed as a “showstopper.”

d. Presence of competing bidders and/or a “white knight.” Competition will always

make it more difficult for a company to make a successful takeover attack. When there

are competing bidders and a white knight, (any of whom may be favored by target

management), a hostile buyer will need to appeal directly to shareholders through a

tender offer, proxy fight, or consent solicitation.

7. Where do deal-embedded defenses appear and what are they intended to do? Do they

discriminate among specific bidders?

Deal-embedded defenses appear as features of definitive agreements and they are

intended to raise the ante for a hostile bidder. In addition, they are also intended to deter

other potential competing bidders.

Deal-embedded defenses may or may not discriminate among bidders.

8. What is the fair price provision and does it have much of a presence in the U.S. markets?

The fair price provision is an amendment requiring that all selling shareholders receive

the same offer price from a buyer. This prevents a discriminatory offer from a bidder

(i.e. greenmail) that seeks to induce target shareholders to sell. Many states in the U.S.

now require that takeover bids carry a “fair price” for shareholders.

9. What is the difference between a white knight and a white squire?

A white knight is a company sought by a target company for the purpose and intention of

a friendly merger (often as a defense against an unsolicited bid from a hostile raider).

Unlike a white knight, a white squire merely purchases a large block of stock in the

target company and does not take control.

10. A target’s litigation can cover a number of possible claims regarding M&A bids and

transactions. Please give a few examples.

a. Failure to comply with tender offer disclosure requirements, especially regarding

the bidder’s plans or proposals for operation or restructuring of the target

company, the bidder’s financial condition and source of financing.

b. Use of inside information and/or breach of confidentiality commitments to the

target.

c. Violation of anti-trust law, or rules and laws specific to regulated industries.

d. Failure to promptly disclose a share interest greater than 5 percent, an intent to

control, and full membership of a group of investors.


True or False

1. A crash in the stock market might serve to temporarily remove a takeover threat for a

company.

2. A stock undervaluation can make a company susceptible to a hostile takeover attack.

3. A consent solicitation is similar to a proxy fight in that it requires a shareholder meeting,

in which shareholder approval must be obtained.

4. The special rights afforded by a poison pill can be amended and rescinded by a board of

directors with shareholder approval.

5. Leveraged recapitalizations can be structured as a going-private transaction or as a

restructuring in which the target will remain a public company.

6. With the MBO, managers are absolved from having to concern themselves with the

reactions of public shareholders.

7. “The Revlon Standard” stems from a 1986 case in which the court ruled that when a

company puts itself up for sale, stakeholder interests can be considered only in light of

increasing shareholder value.

8. For a leveraged recapitalization, the target company needs to be one that is “levered”

with a high debt to total capital ratio.

9. A leveraged recap can be particularly effective when the initial hostile bid is high.

10. Management must be able to finance the equity portion of a recapitalization.


1. T.

2. T.

3. F. A consent solicitation is similar to a proxy fight in that shareholder approval is

required. A shareholder meeting, however, is NOT mandatory for a consent solicitation.

4. F. The special rights afforded by a poison pill can be amended and also rescinded by a

board of directors without shareholder approval.

5. F. In a leveraged recapitalization, the equity remains in the hands of the original owners

and thus, the company will remain a public entity. An MBO results in a privately owned

company.

6. T.

7. T.

8. F. The target company needs to have low leverage: with very little debt and substantial

unused debt capacity.

9. F. Only the contrary, a leveraged recap can be particularly effective when the initial

hostile bid is low. In the case of American Standard, the company performed valuation

analysis based on an LBO that showed a higher valuation than the initial low bid made

by Black and Decker. Because Black and Decker’s initial hostile bid was low, it was

clear to the company that the bid was unacceptable based on its leveraged recap

financial analysis.

10. T.


1. The diverse nature of American Standard was thought to be a deterrent to many potential

buyers. Why can business diversity make a company less attractive for acquisition?

Business diversity can make a company less attractive for acquisition because the

company may have little to no concentrated focus from which the acquirer could obtain

synergies. Even if the target does have a core business, the potential buyer may not be

interested in acquiring non-core business assets that it would end up divesting after

acquiring the target company in its entirety.

As discussed in Chapter 3, more value is created when a buyer makes a focused

acquisition.

It is also true, however, that a highly diversified firm might be acquired at a price less

than the sum of the values of its parts. Thus, a hostile bidder might acquire the target,

sell the pieces, and pocket a gain—such is the theory of the “bust up” acquisition.

2. What does the Delaware Anti-Takeover Statute stipulate? Why was it designed?

The Delaware Anti-Takeover Statute makes the following provision: Companies

incorporated in Delaware may not combine with any “interested stockholder” for a

period of three years (from date of incorporation) unless:

a. The Board of Directors approves the combination

b. The interested stockholder owns at least 85% of the common stock outstanding

c. At least 66.67 percent of the shares outstanding not owned by the interested

stockholder are voted in favor of a combination.

The Statute was designed to encourage full and fair offers and to discourage abusive

takeover tactics.

3. Aqua Toys Inc. wanted to acquire Toy Land Company (“TLC”) and thus made a tender

offer to the shareholders of Toy Land at $45, a price that represented a significant

premium to TLC’s current stock price. The offer was set to expire on January 31.

Aqua Toys then decided to raise its bid to $60 and extend the deadline because only a

small fraction of shares had been tendered as of January 30. How might you explain why

so few shares were tendered?

The low response rate could be an indication that arbitrageurs were buying up large

blocks of Toy Land in expectation of subsequent higher bids made by Aqua Toys or other

interested buyers.

4. If there has been no instance in which a company’s golden parachute has defeated a

hostile bid, why do over 350 firms of the Fortune 500 have golden parachutes in place?

Even though a golden parachute has never defeated a hostile bid to date, golden

parachutes still offer a couple of key benefits to companies. They raise the takeover costs

for buyers while also providing the incentive to keep key employees at a target firm.

Like other defenses, the provision will not completely protect a company from

attack, but it will demand a greater premium to be paid by the buyer.

5. Why might a white knight pay for a hostile bidder’s tender offer expenses?

A white knight might pay for a hostile bidder’s tender offer expenses in exchange

for the bidder’s agreement to make no subsequent takeover attempts of the target

company.

6. How can a company employ a “double attack” against a poison pill?

a. Making a consent solicitation to change the composition of the target’s board of

directors

b. Filing a lawsuit

Black and Decker made this two-pronged assault on American Standard’s poison pill.

7. What are some benefits and drawbacks of an MBO?

Benefits: Increased management control due to private ownership; cost savings

due to exemption from public reporting; liberation from public shareholder concerns and

scrutiny; premiums paid to shareholders.

Drawbacks: Equity shares become illiquid since they are no longer traded in the

capital markets; conflicts of interest can force a board of directors to represent

shareholders in the buyout negotiations and to seek a third-party fairness opinion for

evaluation of the buyout terms.

8. How can the substantial increase in corporate leverage resulting from a restructuring

increase value for the firm?

Increased debt can:

a. Deliver substantial increased tax savings from the debt shield.

b. Send a positive signal to the capital markets about the company management and

lenders’ confidence that future cash flows will be able to service the new debt

load.

c. Induce management to increase operational efficiency.

9. What are some key differences between an MBO and a leveraged recapitalization?

a. An MBO is a “going-private” transaction while a recap does not change a public

corporation to a private company.

b. The recap preserves equity liquidity while the MBO shares remain illiquid

securities.

c. An MBO allows a company to realize significant savings because it is no longer

necessary to publicly report its financial results.

d. Under the MBO, all owners are insiders. With a recap, some equity investors are

outsiders to the firm.

e. There is greater potential for conflicts with an MBO than for a leveraged recap,

because there is a change in equity ownership. The buyout negotiations may be

more difficult given the change in ownership and control of the “going-private”

company.

10. What is the main drawback of leveraged restructurings?

Restructurings are inherently complicated and difficult to develop. Moreover, they are

challenging to implement. Restructurings are time-consuming and require significant

resources, including specialized expertise.


1. Why is it important to prepare carefully for a deal presentation?

Poor presentation can break a deal. The presentation shapes understanding and

expectations, which if done poorly, can haunt a manager later on. A deal that is not

presented well to a CEO and/or board of directors may be rejected. Or, a deal that is not

presented well to shareholders and capital markets may fail to receive shareholder approval.

Finally, a deal may fail to pass government scrutiny if it is not presented well to regulators.

2. Reflecting on the classic challenges to preparing an effective presentation, what steps should

the presenter take in advance to meet those challenges?

First, establish clear objectives for your presentation. What are you trying to accomplish

with it? Second, clarify the perspective and “bandwidth” of the audience. Knowing your

audience is a foundation for designing an effective presentation. Third, reflect carefully on

the balance between secrecy and disclosure. Fourth, consider the mixture of objectivity and

advocacy—what does the mission of the presentation call for? And finally, consider the

adjustment in expectations that may be required. Executives and markets do not like

negative surprises. Consider carefully the signals your presentation might give and whether

they serve your objectives.

3. What would you say are some characteristics of a good deal presentation? How does good

deal presentation facilitate corporate governance?

Good deal presentation is objective, focuses on what is important, addresses strategic issues,

highlights key drivers of success, explores “what-if” scenarios, presents only the needed

information, and is tailored to meet the demands of the specific audience. By being all of the

above, a good deal presentation gives senior management and directors tools to ask the right

questions and to effectively assess the deal.

4. What are the four classic kinds of deal presentations discussed in the chapter? For each type,

what should be the deal presenter’s main objective?

5. When first announcing a deal to the public, is it advisable to say as little as possible? Why or

why not?

The first public announcement represents an opportunity to shape the thinking of investors

and to advocate the deal; therefore, the announcement should provide enough information

for investors to evaluate the deal. Saying too little could turn investors away. It is advisable

Kinds of deal presentations Main objective

“Concept” presentation to a

senior executive/s seeking

approval to begin negotiations

To obtain a mandate to proceed with

research and negotiations

Presentation to a firm’s board of

directors seeking approval for

negotiated terms

Gain final approval from the board

for the proposed terms, to announce

the deal publicly, and to move to

consummate the transaction

Communication to employees Resolve uncertainty; build support;

motivate.

Announcement of the deal to the

financial markets and the general

public

To inform the lead steer, and to

advocate the deal

to include in the first public announcement details about payment terms, timing of the deal,

strategic motives, financial impact, risk factors, and contingencies.

6. Explain how an investor estimates the new share prices for target and buyer upon the

announcement of a deal. In this context, what is the specific objective that the deal presenter

hopes to achieve?

Upon announcement of a deal, the investor will form a probabilistically weighted average of

the share prices of both target and buyer based on assessments of the bid price and the

probability that the deal will be consummated:

New Target Price = prob (Bid value) + (1-prob) (target share price if bid fails)

New Buyer Price = prob(buyer price if bid succeeds) + (1-prob)(buyer share price if bid

fails)

The deal presenter seeks to increase the investor’s estimate of “prob,” justify the bid value to

the target and investors, and explain benefits of the bid to the buyer.

7. What kind of decision is a CEO making when he/she evaluates a deal? In this light, how

must a deal presentation be framed in order to gain CEO approval?

A CEO is making an investment decision or a resource-allocation decision when evaluating

a deal. The CEO seeks to determine whether the returns from the deal will be worth its

financial and social costs. Therefore, deal presenters must argue their case based on a cost-

benefit analysis.

8. Explain the guiding principles by which board directors make their decisions. In view of

these, what should be the focus of a deal presentation to the board?

Directors seek to fulfill the duties of care and loyalty. The duty of care requires directors to

be as fully informed as possible, and the duty of loyalty requires the first loyalty of directors

to be to the shareholders. Directors will seek to justify deals based on these standards.

Therefore, deal presentations to boards must anticipate the kinds of questions directors will

ask in order to fulfill their duties. Usually these questions concern high-level issues around

deal rationale, valuation, post-merger strategy, assessment of synergies, analysis of key

value drivers, and consequences of the deal for shareholders.


1. When should planning for post-merger integration begin?

Planning for post-merger integration should begin early, even before a definitive agreement

has been reached. In fact, it is advisable to do some post-merger integration planning in the

analytic phase of the transaction, before getting to the bargaining table. Integration

planning formally begins with the appointment of an integration process leader.

2. From where should post-merger integration strategies originate?

The integration strategy should flow from the business rationale for the deal. It should be

consistent with and supportive of all the strategic choices that motivated the deal in the first

place. In other words, integration strategy should follow business strategy.

3. How are autonomy, interdependence, and control defined in the chapter, in the context of

post-merger integration?

Autonomy refers to the preservation of a culture, the continuation of a leadership team, and

independence of decision-making. Interdependence refers to the melding of the target’s

operations and value chain with that of the buyer. Control refers to the imposition of rules,

procedures, and operating systems (such as financial and quality control systems) on the

target.

4. What are the four types of integration strategy presented in the chapter? Describe the degree

of autonomy, independence, and control required by each strategy. In what kinds of

situations might each be appropriate?

The four strategies are:

Absorption Low Autonomy

High Control

High

Interdependence

As implied by its name, this strategy allows

the target little or no independence.

Absorption is usually appropriate in

horizontal acquisitions, where one company

acquires another company in the same

industry. It is especially appropriate when

cost savings are the key rationale for the deal.

Confederatio

n

High Autonomy

High Control

Low

Interdependence

Confederation is often seen where buyer and

target are in the same industry. But special

needs may make it desirable to preserve

autonomy and independence. These needs

might originate from specialized know-how,

creative or research skills, or the desire to

preserve key customer relationships.

Linkage High Autonomy

High Control

High

Interdependence

Linking is observed where the acquirer and

target are in the same industry but focus on

different parts of the production chain.

Again, special needs may require granting the

target high autonomy. But the integration

into the buyer’s value chain demands high

interdependence of business processes.

Preservation High Autonomy

Low Control

Low

Interdependence

Preservation is often seen in conglomerate

acquisitions, where there is lower relatedness

in business activities among firms.

5. When might none of the four models be advisable but instead might a totally new

organization culture be superior? In what types of deals is it advisable to impose / merge

cultures? In what types of deals is it advisable to keep distinct cultures? Explain.

It is advisable to impose or merge cultures when the success of the merger hinges upon

complete or near-complete integration between target and buyer. This is usually true in

scale-driven deals, i.e. those that are efficiency-driven. On the other hand, it is usually

advisable to keep cultures separate or devise a totally new culture in scope-driven deals –

those that broaden a product range – particularly when there is limited overlap between

businesses of the target and buyer.

6. What business areas should integration planning cover?

Integration planning should cover areas such as communication, production, logistics,

supply chain management, financial controls and management information systems,

employee issues, retention of talent, organizational structure—virtually all business areas of

the target and of Newco.

7. Should post-merger integration be done piece-wise or in a systemic fashion? Explain.

Piece-wise integration risks internal inconsistency in strategy and implementation. Post-

merger integration planners should realize that modifying one part of the system will

invariably have consequences on another; therefore, integration should be approached

systemically.

8. Can integration execution begin before a deal is consummated?

Generally, no. To begin the implementation process before consummation would be to

“jump the gun” and risk exposure to regulatory penalties. Regulatory approval should be

obtained for the deal before integration can be implemented.

9. What are some crucial elements for success in integration execution?

Speed, decisiveness, determination, and communication are crucial to success in execution.

Employees of the buyer and target firms will be most in need of direction in the early days of

a merger, so it is important to “strike while the iron is hot” – to set clear direction and to

implement changes while momentum is running. Many mergers have failed to achieve stated

goals because integration was not executed speedily. Along with speed, communication is a

key determinant of success. Communication needs to go beyond the typical short memo – a

real effort must be made to bring employees on board. Communication needs to set high

aspirations, to specifically identify sources of value, and to be truly inclusive.

10. What are some pitfalls to be avoided in post-merger integration?

Some pitfalls to be avoided are:

• Excessive planning

• Obsessive list making (simply identifying tasks)

• Delaying the start of integration and dragging out the finish

• Allowing divergent initiatives

• Under-communicating/content-free communications

• Putting no one in charge

• Empty talk about lofty ideals

• Ignoring project management disciplines

• Ignoring employees’ “me” issues


True or False

1. A strategic capability is difficult to imitate.

2. A company’s larger business units are always the least acquisitive; the smaller business

units are often the most acquisitive because of their need for growth and expansion.

3. Employing a “bottom-up” deal pipeline is the best approach for developing M&A

business.

4. The first contact between a potential buyer and target should be a cold call from a sales or

marketing professional in the division.

5. Lawyers are the only functional experts that become a part of a business development

team.

6. Antitrust and other regulatory filings are submitted to the U.S. federal and state

governments, (and as required in certain cases, to foreign governments) upon entering the

LOI (Letter of Intent) stage.

7. Merger integration planning becomes rigorous between the signing of the definitive

agreement and closing of the deal.

8. The electronic digitization of company information can enhance effective merger process

flow.

9. It is beneficial when integration teams get involved early on in the due diligence because

they can access information that will help steer the integration planning process.


1. T.

2. F. As of 2003, GEPS was one of the largest business units of General Electric,

accounting for $23 billion in revenues in 2002, as well as the most acquisitive division.

3. F. According to Jerry Miller, GEPS’ Business Development Leader, a bottom-up

approach only yields a limited set of ideas. However, by implementing a top-down deal

pipeline in addition to the bottom-up deal pipeline, the division produces a wider range

of diverse, rich ideas.

4. F. The first contact by a potential buyer is indeed usually a cold call, but by a business

development leader or the CEO, not by a sales or marketing professional.

5. F. All functional experts are a part of the business development team. Experts in

intellectual property, environmental issues, human resources, finance, law, sales,

technology, etc. take part in the due diligence process.

6. F. Antitrust and regulatory filings are submitted upon completion of the merger

definitive agreement, which occurs after the initiation of the LOI stage.

7. T.

8. T.

9. F. As depicted at GEPS, an integration team can “get in the way” during due diligence

process. While they ask for information that may help them with the integration process,

they can distract the focus of the due diligence process and negatively impact the merger

negotiations.


1. Identify the two sources from which GEPS discovers new acquisition opportunities.

a. Workout meetings: internal business meetings in which the Business Development

staff come together with operating unit managers to assess the unit and design a

broad new vision for it. Together, Business Development and operating unit

professionals identify business segments with potential growth opportunities,

generate a list of potential target firms, and then prioritize the list.

b. Annual Planning Cycle commitments: At the beginning of every calendar year, GEPS

operating managers create a “business plan” for the year: a lengthy document that

identifies and outlines the organic and growth goals for revenues and profits.

2. What are GEPS’ four key criteria for screening acquisition opportunities?

a. Strategic Fit: The target was expected to be in a current or related market

segment of GEPS, with objectives that were aligned or complementary to those of

GEPS. The target was expected to show focused competitive leadership in a

niche segment as an indication that it would be an enhancement to GEPS, not just

a mere addition.

b. Technology: GEPS sought targets with a strategic rationale for employing and

developing new technology products and/or services.

c. People: The target’s quality of people—their talents, skills and know-how—was a

serious factor in GEPS’ decision to make an acquisition.

d. Financial Considerations: The target had to meet certain quantitative criteria in order

to be considered. Examples include: EBIT operating margin of 15 percent or more,

double-digit revenue growth rate, sales greater than $50 million annually, etc.

3. What are the three “buckets” of information that GEPS sought from a target firm?

a. Initial business overview and summary: GEPS’ initial request was for a one page

summary and overview of the company.

b. Due diligence: During the due diligence state, GEPS would request substantial

in-depth information.

c. Post-merger integration related: After the definitive agreement was signed, GEPS

would request information that was specifically targeted for post-merger

integration planning.

4. Why did GEPS develop and organize Centers of Excellence (COE)?

The Centers of Excellence were small teams developed to guide the integration

process of specific functions, such as getting on the GE payroll and intranet, connecting

with firm benefits, etc. As with other processes, GEPS found that there were repetitive

activities that could be streamlined and coordinated by the organization of small teams.

5. Why does the Business Development unit of GEPS perform post-acquisition audits on all

of their deals? What is the main purpose and focus of the post-audit?

The post-audit is crucial in evaluating whether post -merger integration was

structured well and is completed. The audit includes an examination of whether the new

unit is following GEPS policies and procedures. Of particular importance is GE’s

Integrity Policy, which requires training, understanding, and adherence. The post-audit

is also focused on ensuring reporting transparency.

6. – 15. For the following questions, please identify the corporate development stage in

which the stated GEPS activity takes place: Initial planning stage (IS), LOI development

stage (LOI), Definitive Agreement phase (DA), and Post-Merger Integration (PMI).

6. _____GEPS appoints leadership of the Post Merger Integration plan.

7. _____GE Operating Unit Leader and Business Development Leader review recent GEPS

acquisitions and discuss their success.

8. _____ GE and the target firm sign a confidentiality agreement.

9. _____GEPS evaluates the target firm to see if it meets certain quantitative criteria.

10. _____GEPS Business Development Leader, a GE M&A lawyer and outside counsel

begin drafting a standard contract and tailoring it to the particular needs of the

transaction.

11. _____The comprehensive due diligence report is near completion.

12. _____Integration plans become rigorous at this stage.

13. _____An Integrity Briefing is scheduled.

14. _____GE Senior Counsel and lawyers become involved.

15. _____The CEO of GEPS gives his internal support for the deal.

Answers

6. LOI

7. IS

8. IS

9. IS

10. DA

11. LOI

12. DA

13. PMI

14. IS

15. IS


True or False

1. Given the inherent variability in M&A, it may not be worthwhile to formulate an opinion

about the future of M&A activity.

2. The increasing automation of analytical techniques will allow deal designers to focus less

on number crunching and more on the creative task of shaping good deals.

3. Any potential advantage gained from real option valuation will likely diminish over time.

4. Learning from current events is passive and easy.

5. Research has answered all the important questions in M&A.


1. F. It is worthwhile to formulate an opinion about future M&A activity; to not have a

forward-looking view is to risk always looking behind, and thus being left behind as

others move forward.

2. T. It is important to note that increasing automation does not preclude the deal designer

from focusing (more) on number crunching. If the deal designer chooses to involve

himself in quantitatively modeling, he is at liberty to do so. What increasing automation

creates is the option to focus less on number crunching. It frees up time for the deal

designer to engage in other activities.

3. T. As innovations spread, their competitive advantage declines.

4. F. Learning from current events is active learning—you must do your own analysis on

announced deals in order to form your own “view.”

5. F. The more that research reveals, the more questions that get raised.


1. Why is it imperative to develop one’s view about the future of M&A?

In developing a view on M&A, one is forced to think critically and to analyze

information in a proactive manner. To simply contemplate the past and present, one

risks falling behind while others move forward. To follow other people’s opinions over

developing one’s own carries the great risk of making other people’s mistakes and

furthermore, taking accountability for other people’s shortcomings.

2. How will continuous technological change and progress affect M&A practitioners and

how they conduct business?

To keep pace with ongoing improvements in the field of technology, M&A professionals

must continually invest not only in new kinds of technology but also in technology

training. There will be an increasing need for all employees to have higher proficiencies

in technological applications. Reliance on full-time “firm technology specialists” will

become more and more of a disadvantage for M&A business practitioners.

3. Why can the application of real option valuation in the field of M&A be both a “curse”

and a “blessing”?

Applying real option valuation is fairly un-charted territory in M&A. Thus, it could be a

blessing in allowing talented deal makers to successfully “blaze their own trails” but a

curse if practitioners attempt to trail blaze but get lost, stuck without an established path

to follow.

To translate the metaphor above into more concrete terms: real option valuation is a

blessing if it enables practitioners to model and quantify terms aspects of deals that

previously could not be valued. Business practitioners who can adeptly incorporate real

option valuation into deals may gain competitive advantage.

As a young field, however, option theory presents many challenges and uncertainties. It is

mathematically complex and inaccessible to many business practitioners. Furthermore,

the importance and relevance of options is not well known or understood in many

business practices or the media.

4. Why is it a good idea for serious M&A professionals to get “professional help”?

Given the breadth, depth, and complexity of the field, it is hard to be a specialist in all

areas of M&A. This is the reason why it is a good idea to leverage business contacts and

to develop professional relationships with top advisors and specialists in various areas of

M&A.

5. How do you define or characterize an M&A deal leader?

An M&A deal leader is someone who knows how to manage not only the individual parts

of a merger transaction, but also the entire process: a deal leader knows how to bind and

fit the pieces together into a harmonic whole. The deal leader has an elevated view: the

deal leader can see the forest through the trees.

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