Refined de Pamphilis

8/8/2019 Refined de Pamphilis

1/83

Required Returns:Cost of Equity (ke)

Capital Asset Pricing Model:

ke = Rf+ (Rm Rf) + FSP

Where Rf = risk free rate of return

= beta

Rm = expected rate of return on equities

Rm Rf = 5.5% (i.e., its historical average since1963)

FSP = firm size premium


2/83

Estimates of Size Premium

Market Value (000,000)

>$12,400$5,250 to $12,400$2,600 to $5,250

$1,650 to $2,600.$700 to $1,650$450 to $700$250 to $450$100 to $250$50 to $100


3/83

Required Returns: Cost of Capital

Weighted Average Cost of Capital (WACC):

WACC = ke x E + i (1-t) x D + kpr x __PR__(E+D+PR) (E+D+PR) (E+D+PR)

Where E = the market value of equityD = the market value of debt

PR = the market value of preferred stockke = cost of equitykpr= cost of preferred stocki = the interest rate on debt

t = the firms marginal tax rate


4/83

Analyzing Risk

Risk consists of a diversifiable and non-diversifiablecomponent

Beta () is a measure of non-diversifiable risk

Beta is estimated by regressing stock returns (Rj)against market returns (Rm). The intercept provides a

measure of Rjs performance vs. market relative to whatCAPM would have predicted.

Rj = a + Rm (regression equation formulation)

Rj = Rf+ (Rm Rf) = Rf+RmRf= Rf(1-) + Rm(CAPM formulation)

If a > Rf(1-), Rj outperformed the CAPM estimate.


5/83

Effects of Leverage on Beta

Leveraged vs. Unleveraged Betas:

l = u (1 + (1-t) (D/E)) ( Leveraged beta)

u = Bl / (1 + (1-t) (D/E)) ( Unleveraged beta)

Where l and u are leveraged and unleveraged betas, respectively.

Implications:

--Increasing levels of debt relative to equity, which raise the firmsbreakeven point, increase shareholder risk associated with the firm.

--The tax shelter effects provided by the tax deductibility of interestreduce shareholder risk by increasing after-tax cash available forshareholders.


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Calculating Free Cash Flowto Equity Investors (FCFE)

FCFE (equity cash flow) represents cash flow available forpaying dividends or repurchasing common equity, aftertaxes, debt repayments, new issues, and allreinvestment requirements.

FCFE = (Net Income + Depreciation - Net WorkingCapital1)2 Gross Capital Expenditures3 + (NewPreferred Equity Issues Preferred Dividends + NewDebt Issues Principal Repayments)4

1Excludes cash in excess of normal operating requirements.2Cash from operating activities.3Cash from investing activities.4Cash from financing activities.


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Calculating Free Cash Flowto the Firm (FCFF)

FCFF (enterprise cash flow) is cash flow available to repaylenders and/or pay common and preferred dividends andrepurchase equity, after taxes and reinvestmentrequirements but before debt repayments.

FCFF = (Earnings before interest & taxes (1-tax rate) +Depreciation Net Working Capital1)2 Gross CapitalExpenditures3

1Excludes cash in excess of normal operating requirements.2Cash from operating activities.3Cash from investing activities.


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Comparing Free Cash Flowto the Firm and to Equity

Free Cash Flowto the Firm

Free Cash Flowto Equity

Cash from Operating

Activities

40 40

Cash from InvestingActivities

(22) (22)

Cash from FinancingActivities

(10)

Total Cash Flow 18 8


9/83

Things to Remember

CAPM is widely used to estimate COE Weights for WACC should reflect the acquiring firms

target capital structure

Pre-tax cost of debt for non-rated firms can be

approximated by comparison with similarly ratedfirms.

FCFF is widely used for valuing target firms becauseit does not require an estimate of financing needs.

FCFE is used primarily in the absence of debt or forvaluing equity in leveraged buyouts and financialservice firms.


10/83

Commonly Used Discounted Cash

Flow Valuation Methods

Zero Growth Model

Constant Growth Model

Variable Growth Model


11/83

Zero Growth Model

Free cash flow is constant in perpetuity.

P0 = FCFF0 / WACC, where FCFF0 is free cash

flow to the firm and WACC is the weightedaverage the cost of capital

P0 = FCFE0 / ke where FCFE0 is free cash flowto equity investors and ke is the cost of

equity


12/83

Zero Growth Model Example

What is the value of a firm, whose annualFCFF0 of $1 million is expected to remainconstant in perpetuity and whose weightedaverage cost of capital is 12%.

P0

= $1 / .12 = $8.3 million


13/83

Constant Growth Model

Cash flow next year (i.e., FCFF1, the first year of the

forecast period) is expected to grow at a constant rate.

FCFF1=FCFF0(1+g)

P0 = FCFF1 / (WACC-g), where g is the expected rate of

growth of FCFF1.

P0 = FCFE1 / (ke g), where g is the expected rate of

growth of FCFE1.


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Constant Growth Model Example

Estimate the value of a firm (P0) whose cost ofequity is 15% and whose cash flow in the prioryear is projected to grow 20% in the current yearand then at a constant 10% annual ratethereafter. Cash flow in the prior year is $2million.

P0 = ($2 x 1.2)(1.1) / (.15 - .10) = $52.8 million


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Variable Growth Model

Cash flow exhibits both a high and a stable growthperiod.

High growth period: The firms growth rate exceeds arate that can be sustained long-term.

Stable growth period: The firm is expected to grow at arate that can be sustained indefinitely (e.g., industryaverage growth rate).

Discount rates: Reflecting the slower growth rate duringthe stable growth period, the discount rate during the

stable period should be lower than doing the high growthperiod (e.g., industry average discount rate).


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Variable Growth Model Example

Estimate the value of a firm (P0) whosecash flow is projected to grow at acompound annual average rate of 35% forthe next five years and then assume a

more normal 5% annual growth rate. Thecurrent years cash flow is $4 million. Thefirms weighted average cost of capitalduring the high growth period is 18% and

then drops to the industry average rate of12% beyond the fifth year.


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Variable Growth Model ExampleSolution

PV1-5 = $4 x 1.35 + $4 x (1.35)2 + $4 x (1.35)3 +

(1.18) (1.18)2 (1.18)3

$4 x (1.35)4 + $4 x (1.35)5

(1.18)4 (1.18)5

= $30.5

PV5 = (($4 x (1.35)5 x 1.05)) / (.12 - .05) = $117.65

(1.18)5

P0 = PV1-5 + PV5 = $30.5 + $117.65 = $148.15


18/83

Determining Growth Rates

Key premise: A firms value can be approximated by thesum of the high growth plus a stable growth period.

Key risks: Sensitivity of terminal values to choice ofassumptions about stable growth rate and discount ratesused in both the terminal and annual cash flow periods.

Stable growth rate: The firms growth rate that isexpected to last forever. Generally equal to or less thanthe industry or overall economys growth rate. Formultinational firms, the growth rate is the world

economys rate of growth. Length of the high growth period: The greater the current

growth rate of a firms cash flow relative to the stablegrowth rate, the longer the high growth period.


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Adjusting Firm Value

Generally, the value of the firms equity is the sum of the present

value of the firms operating assets and liabilities plus terminal valueless market value of firms long-term debt.

However, value may be under or overstated if not adjusted forpresent value of non-operating assets and liabilities assumed by theacquirer.

PVFCFE = PVFCFF (incl. terminal value) PVD + PVNOA PVNOL

where PVFCFE = PV of free cash flow to equity investors

PVFCFF = PV of free cash flow to the firm

PVD = PV of debt

PVNOA = PV of non-operating assets

PVNOL = PV of non-operating liabilities


20/83

Adjusting Firm Value Example

A target firm has the following characteristics:

An estimated enterprise value of $104 million

Long-term debt whose market value is $15 million

$3 million in excess cash balances

Estimated PV of currently unused licenses of $4million

Estimated PV of future litigation costs of $2.5 million

2 million common shares outstanding

What is the value of the target firm per common share?


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Adjusting Firm Value ExampleContd.

Enterprise Value $104

Plus: Non-Operating Assets

Excess Cash Balances

PV of Licenses

$3

$4

Less: Non-Operating Liabilities

PV of Potential Litigation $2.5

Less: Long-Term Debt $15

Equals: Equity Value $93.5

Equity Value Per Share $46.75


22/83

Things to Remember

Zero growth model: Cash flow is expected to remain

constant in perpetuity. Constant growth model: Cash flow is expected to

grow at a constant rate.

Variable growth model: Cash flow exhibits both a

high and a stable growth period. Total present value represents the sum of thediscounted value of the cash flows over bothperiods.

The terminal value frequently accounts for most of

the total present value calculation and is highlysensitive to the choice of growth and discountrates.


23/83

Applying Relative, Asset Oriented,

and Real Option Valuation Methods


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Applying Market-Based(Relative Valuation) Methods1

MVT = (MVC / IC) x IT

Where

MVC = Market value of the comparable company C

IC = Measure of value for comparable company C

IT = Measure of value for company T

(MVC/IC) = Market value multiple for the comparablecompany

1Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm.


25/83

Market-Based Methods: Comparable Company Example

Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies

Target Valuation Based on Following Multiples (MVC/VIC):

Comparable CompanyTrailing

P/E1Forward

P/E2Price/Sales Price/Book

Average

Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4

Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71

British Petroleum (BP) 9.18 7.68 0.69 2.17

Chevron Corp (CVX) 10.79 8.05 0.91 2.54Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86

ConocoPhillips (COP) 11.92 6.89 0.77 1.59

Total SA (TOT) 8.75 8.73 0.80 2.53

Eni SpA (E) 3.17 7.91 0.36 0.81

PetroChina Co. (PTR) 11.96 10.75 1.75 2.10

Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16

Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49

Equals Estimated Value of Target $40.72 $27.42 $81.77 $57.32 $51.81

1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars.


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Market-Based Methods:Recent Transactions Method1

Calculation similar to comparable companiesmethod, except multiples used to estimatetargets value based on purchase prices of

recently acquired comparable companies. Most accurate method whenever the transaction

is truly comparable and very recent.

Major limitation is that truly comparable recenttransactions are rare.

1Also called precedent method.


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Market-Based Methods:Same or Comparable Industry Method

Multiply targets earnings or revenues bymarket value to earnings or revenue ratiosfor the average firm in targets industry or

a comparable industry. Primary advantage is the ease of use and

availability of data.

Disadvantages include presumptionindustry multiples are actually comparableand analysts projections are unbiased.


28/83

PEG Ratio

Used to adjust relative valuation methods for differences in growth

rates among comparable firms. Helpful in determining which of a number of different firms in same

industry exhibiting different growth rates may be the most attractive.

(MVT/VIT) = A and

VITGR

MVT = A x VITGR x VIT

Where A = Market price to value indicator relative to the growth rateof

value indicator (e.g., (P/E)/ EPS growth rate)MVT = Market value of target

VIT = Value indicator for target (e.g., EPS)

VITGR = Projected growth rate in value indicator (e.g., EPS)


29/83

Applying the PEG Ratio

An analyst is asked to determine whether Basic Energy Service (BAS) or CompositeProduction Services (CPS) is more attractive as an acquisition target. Both firms provideengineering, construction, and specialty services to the oil, gas, refinery, and petrochemicalindustries.BES and CPS have projected annual earnings per share growth rates of 15 percent and 9percent, respectively. BES and CPS current earnings per share are $2.05 and $3.15,respectively. The current share prices as of June 25, 2008 for BAS is $31.48 and for CPX is

$26. The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent,respectively. Based on this information, which firm is a more attractive takeover target as ofthe point in time the firms are being compared?


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Industry average PEG ratio:1 12.4/.11 = 112.73

BAS: Implied share price = 112.73 x .15 x $2.05 = $34.66CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96Answer: The difference between the implied and actual share prices for BAS and CPXis $3.18 (i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is moreundervalued than BAS at that moment in time.

1Solving MVT = A x VITGR x VIT using an individual firms PEG ratio provides the firms

current or share price in period T, since this formula is an identity. An industry averagePEG ratio may be used to provide an estimate of the firms intrinsic value. This implicitlyassumes that both firms exhibit the same relationship between price-to-earnings ratiosand earnings growth rates.


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Asset-Based Methods:Tangible Book Value

Tangible book value (TBV) = (total assets - totalliabilities - goodwill)

Targets estimated value = Targets TBV x[(industry average or comparable firm marketvalue) / (industry or comparable firm TBV)].

Often used for valuing Financial services firms where tangible book

value is primarily cash or liquid assets

Distribution firms where current assetsconstitute a large percentage of total assets


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Valuing Companies Using Asset Based Methods

Ingram Micro distributes information technology products worldwide. The firms share

price on 8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and thefirms beta is .89. Shareholders equity is $3.4 billion and goodwill is $.7 billion. Ingramhas 172 million (.172 billion) shares outstanding. The following firms represent Ingramsprimary competitors.

Market Value/Tangible Book Value

Beta Projected 5-Year NetIncome Growth Rate

(%)Tech Data .91 .90 11.6

Synnex Corporation .70 .40 6.9

Avnet 1.01 1.09 12.1

Arrow .93 .97 13.2Based on this information, what is Ingrams tangible book value per share (VIT)? What isthe appropriate industry average market value to tangible book value ratio (MVIND/VIIND)?Estimate the implied market value per share for Ingram (MVT) using tangible book valueas a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it8/21/08 share price?


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Asset-Based Methods: Liquidation Method

Value assets as if sold in an orderly fashion (e.g., 9-12months) and deduct value of liabilities and expensesassociated with asset disposition.

While varies with industry,

Receivables often sold for 80-90% of book value

Inventories might realize 80-90% of book book valuedepending on degree of obsolescence and condition

Equipment values vary widely depending on age andcondition and purpose (e.g., special purpose)

Book value of land may understate market value Prepaid assets such as insurance can be liquidatedwith a portion of the premium recovered.


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Asset-Based Method: Break-Up Value

Target viewed as series of independent operatingunits, whose income, cash flow, and balance sheetstatements reflect intra-company sales, fully-allocated costs, and operating liabilities specific toeach unit

After-tax cash flows are valued using market-basedmultiples or discounted cash flows analysis todetermine operating units current market value

The units equity value is determined by deducting

operating liabilities from current market value Aggregate equity value of the business is determined

by summing equity value of each operating unit lessunallocated liabilities and break-up costs


35/83

Replacement Cost Method

All target operating assets are assigned avalue based on what it would cost to replacethem.

Each asset is treated as if no additional value

is created by operating the assets as part of agoing concern.

Each assets value is summed to determinethe aggregate value of the business.

This approach is limited if the firm is highlyprofitable (suggesting a high going concernvalue) or if many of the firms assets areintangible.


36/83

Weighted Average ValuationMethod

An analyst has estimated the value ofa company using multiplevaluation methodologies. Thediscounted cash flow value is$220 million, comparabletransactions value is $234 million,the P/E-based value is $224million and the liquidation value is$150 million. The analyst hasgreater confidence in certainmethodologies than others.Estimate the weighted average

value of the firm using all valuationmethodologies and the weights orrelative importance the analystgives to each methodology.

Estimated

Value ($M)

Relative

Weight

Weighted

Avg. ($M)

220 .30 66.0

234 .40 93.6

224 .20 44.8

150 .10 15.0

1.00 219.4


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Real Options as Applied to M&As

Real options refer to managements ability to adopt and later revisecorporate investment decisions (e.g., acquisitions)

Options to expand (i.e., accelerate investment)

Acquirer accelerates investment in target after acquisitioncompleted due to better than anticipated performance of the

target Options to delay (i.e., postpone timing of initial investment)

Acquirer delays completion of acquisition until a patent pendingreceives approval

Options to abandon (i.e., divest or liquidate initial investment)

Acquirer divests target firm due to underperformance andrecovers a portion of its initial investment


38/83

Alternative Real OptionValuation Methods

Develop a decision tree for which the NPV of eachbranch represents the value of alternative real options.The options value is equal to difference between its

NPV and the NPV without the real option. Treat the real options as financial options and valueusing the Black-Scholes method.

Option to expand or delay are valued as call optionsand added to the NPV of the investment without theoption.

Option to abandon is valued as a put option andadded to the NPV of the investment without theoption.


39/83

Base Case:Microsoft offers tobuy all outstandingshares of Yahoo

Option to postponecontingent onYahoos rejectionof offer

Option to abandoncontingent onfailure to integrateYahoo & MSN

Option to expandcontingent on

successfulintegration ofYahoo & MSN

Purchase Yahooonline searchbusiness only. Buyremaining

businesses later.

Offer same/lowerprice for all ofYahoo if boardcompositionchanges

Spin-off combinedYahoo & MSN to

Microsoftshareholders

Divest combinedYahoo & MSN.Use proceeds topay dividend orbuy back stock.

Analyzing Microsofts Real Options inIts Attempted Takeover of Yahoo


40/83

Things to Remember

Alternatives to discounted cash flow analysis include the

following: Market based methods

Comparable companies

Recent transactions

Same or comparable industries

Asset based methods Tangible book value

Liquidation value

Break-up value

Replacement cost method

Weighted average method Firm value must be adjusted for both non-operating assets and

liabilities.

Real options should be considered in M&A valuation whenclearly identifiable and when would add significantly toinvestments value


41/83

Using Financial ModelingTechniques to Value and

StructureMergers & Acquisitions


42/83

M&A Model Building Process

Step 1: Value acquirer and target as standalone

firms

Step 2: Value acquirer and target firms including

synergy

Step 3: Determine initial offer price for target

firm

Step 4: Determine the combined firms ability tofinance the transaction


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Step 1: Value Acquirer & Target asStandalone Firms

Understand determinants of profits and cash flow, i.e.,bargaining strength of

Customers (size, number, price sensitivity)

Current competitors (market share, differentiation)

Potential entrants (entry barriers, relative costs) Substitutes (availability, prices, switching costs)

Suppliers (size, number, uniqueness)

relative to industry participants.

Normalize 3-5 years of historical financial information Project normalized cash flow based on expected market

growth and changes in profits/cash flow determinants.


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Step 2: Value Acquirer & Target FirmsIncluding Synergy

Estimate

Sources and destroyers of value

Implementation costs incurred to realizesynergy

Consolidate acquirer and target projectedfinancials including the effects of synergy

Estimate net synergy (consolidated firms lessvalues of target and acquirer)


45/83

Adjusting Combined Acquirer/Target CompanyProjections For Estimated Synergy

Year 1 Year 2 Year 3 Year 4 Year 5

Net Sales1 $200 $220 $242 $266 $293

Cost of sales2 $160 $176 $194 $213 $234

Anticipated Cost Savings

Direct labor $2 $4 $6 $8 $8Indirect labor $1 $2 $4 $4 $4

Purchased materials $2 $3 $5 $5 $5

Selling expenses $1 $3 $5 $5 $5

Total $6 $12 $20 $22 $22

Cost of sales (incl. synergy) $154 $164 $174 $191 $212

Cost of sales/Net sales 77.0% 74.6% 71.9% 71.8% 72.4%

1Combined company net sales projected to grow 10% annually during forecast period.2Cost of sales before synergy assumed to be 80% of net sales during forecast period.


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Step 3: Determine Initial Offer Pricefor Target Firm

Estimate minimum and maximumpurchase price range

Determine amount of synergy willing toshare with target shareholders

Determine appropriate composition of offerprice


47/83

Calculating Initial Offer Price (PVIOP)

1. PVMIN = PVT or PVMV, whichever is greater for a stock purchase

(liquidation value of net acquired assets for an asset purchase)2. PVMAX = PVMIN + PVNS, where PVNS = PVSOV PVDOV3. PVMAX = PVMIN + PVNS4. PVIOP = PVMIN + PVNS, where 0 1

Offer price range = (PVT or MVT) < PVIOP < (PVT or MVT) + PVNS

Where PVMIN = PV minimum purchase price

PVT = PV standalone value of target firm

PVMV = Market value target firm

PVMAX = PV maximum purchase price

PVNS = PV of net synergy

PVSOV = PV of sources of value

PVDOV = PV of destroyers of value = Portion of net synergy shared with target company shareholders

How is determined?


48/83

Step 4: Determine Combined FirmsAbility to Finance Transaction

Estimate impact of alternative financingstructures

Select financing structure that

Meets acquirers required financial returnsand desired financial structure;

Meets targets primary financial and non-financial needs;

Does not raise borrowing costs; and

Is supportable by the combined firms.


49/83

Calculating EPS andPost-Merger Share Price

Acquiring Company is consideringthe acquisition of TargetCompany in a share for sharetransaction in which TargetCompany would receive$84.30 for each share of itscommon stock. AcquiringCompany does not expect anychange in its price/earningsmultiple after the merger.

Selected data are presentedas follows:

AcquiringCompany

TargetCompany

NetEarnings

$281,500 $62,500

SharesOutstanding

112,000 18,750

MarketPrice PerShare

$56.25 $62.50


50/83

Calculating EPS andPost-Merger Share Price: Solution

1. Exchange ratio = Price per share offered for Target Company/ Priceper share for Acquiring Company = $84.30 / $56.25 = 1.5

2. New shares issued by Acquiring Company = 18,750 (shares of TargetCompany) x 1.5 (share exchange ratio) = 28,125

3. Total shares outstanding of the combined firms = 112,000 + 28,125 =

140,1254. Post merger EPS of the combined firms = ($281,500 + $62,500) /

140,125 = $2.46

5. Pre merger P/E = Pre-merger price per share / pre-merger EPS =56.25 /($281,500/112,000) =$56.25/$2.51 = 22.4

6. Post-merger share price = Post-merger EPS x Pre-merger P/E = $2.46x 22.4 = $55.10 (as compared to $56.25 pre-merger share price)

Note: Example assumes no increase in EPS due to synergy for simplicity.


51/83

Model Worksheet Layout1

Assumptions Section

Historical Period Forecast Period

1Refers to model template contained on CDROM accompanying textbook.


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Using M&A Model Template1

Model worksheet layout: Assumptions (top panel); historical perioddata (lower left panel); forecast period data (lower right panel).

Displaying Microsoft Excel formula results on a worksheet:

On Tools menu, click Options, and then click the View Tab.

To display formulas in cells, select the formulas check box; to

display the formulas results, clear the check box. In place of existing historical data, fill in the data in cells notcontaining formulas. Do not delete existing formulas in historicalperiod unless you wish to customize the model.

Do not delete or change formulas in the forecast period cellsunless you wish to customize the model. To replace existing data,change the forecast assumptions at the top of the spreadsheet.

1Refers to model template found on CDROM accompanying textbook.


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Model Historical Data Input Requirements:Income Statement1

Net sales

Depreciation expense

Total cost of sales

Sales expense

General and administrative expense

Amortization of intangibles

Other expense (income) net

Interest income

Interest expense

Taxes1Note these income statement line items may not correspond exactly to those shown on the acquirers or targets

financial statements. The analyst should insert new rows in the model on the CDROM accompanying thistextbook to reflect the data categories that are available.


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Model Historical Data Input Requirements:Balance Sheet1

Cash Other current assets Gross fixed assets Accumulated depreciation and amortization Other assets Current liabilities Existing long-term debt Other liabilities Common Stock

Retained earnings Shares outstanding1Note these balance sheet line items may not correspond exactly to those shown on the acquirers or targets financial

statements. The analyst should insert new rows in the model on the CDROM accompanying this textbook toreflect the data categories that are available.


55/83

Model Balance Sheet AdjustmentMechanism Methodology

Separate current assets into operating and non-operatingassets.

Operating assets include minimum operating cashbalances and other operating assets (e.g., receivables,inventories, and assets such as prepaid items).1

Current non-operating assets are investments (i.e., cashgenerated in excess of minimum operating balancesinvested in short-term marketable securities).

The firm issues new debt whenever cash outflows exceedcash inflows.

The firms investments increase whenever cash outflowsare less than cash inflows.1Minimum cash balances determined by analyzing the firms cash conversion cycle or by

computing the average ratio of cash balances to net revenue over some prior periodtimes current net revenue..


56/83

Model Balance Sheet AdjustmentMechanism Illustration

Assets Liabilities

Current Operating Assets

Cash Needed for Operations (C)

Other Current Assets (OCA)

Total Current Operating Assets (TCOA)

Short-Term (Non-Oper.) Investments (I)Net Fixed Assets (NFA)

Other Assets (OA)

Total Assets (TA)

Current Liabilities (CL)

Other Liabilities (OL)

Long-Term Debt (LTD)Existing Debt (ED)

New Debt (ND)

Total Liabilities (TL)

Shareholders Equity (SE)

Cash Outflows Exceed Cash Inflows: If (TA I)>(TL ND) + SE, ND > 0 (i.e., thefirm must borrow), otherwise ND = 0

Cash Outflows Less Than Cash Inflows: If (TA I) < (TL ND) + SE, I > 0 (i.e.,the firms non-operating cash increases), otherwise I = 0

Cash Outflows Equal Cash Inflows: If (TA I) = (TL ND) + SE = 0, ND=I= 0


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Estimating Interest Expense

IEXP = (DEOY + DBOY)/2 x i, where DEOY = DBOY - DPRP

where

DEOY = End of year debt balanceDBOY = Beginning of year debt balance

DPRP = Annual principal repayment

IEXP = Dollar value of annual interest expense

i = Weighted average interest rate

D bt R t S h d l


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Debt Repayment Schedule

Total Debt

12/31/05

2006 2007

MaturitySchedule MaturingAmount Interest Rate MaturingAmount Interest Rate

Long-TermDebt

$690,710 0 0 $190,710 5.5%

Medium Term $540,500 $30,500 7.5% $30,000 7.5%

Mortgage Debt $42,380 $694 10.15% $767 10.15%

Total $1,273,590 $31,194 7.559% $221,477 5.787%

RemainingBalance

1/1/06 EndingBalance

Interest Rate EndingBalance

Interest Rate

Long-Term

Debt

$690,710 $690,710 5.5% $500,000 5.5%

Medium Term $540,500 $510,000 7.5% $480,000 7.5%

Mortgage Debt $42,380 $41,686 10.150% $40,919 10.15%

Total $1,273,590 $1,242,396 6.477% $1,020,919 6.627%


59/83

Hints on Using Financial Models

Ensure Excels Iteration Command is on toaccommodate circular references inherent in themodel.

For example, cash and investments affects interestincome, which in turn impacts net income and cashand investments.

To turn on the iteration command,

On the menu bar, click on Tools >>> Options >>>Calculations

Select iteration and specify the maximum number ofiterations and the amount of change.


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Things to Remember Financial modeling facilitates the process of

valuation, deal structuring, and selection of theappropriate financing plan.

The process entails the following four steps:

Valuing the acquirer and target firms asstandalone businesses using multiple valuation

methods Valuing consolidated acquirer and target firms

including the effects of net synergy

Determining the initial offer price for the target firmfrom within the price range defined by theminimum and maximum purchase prices

Determining the combined firms ability to financeinitial offer price


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Analyzing Privately

Held Companies


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What is a Private Firm?

A firm whose securities are not registeredwith state or federal authorities

Without registration, their shares cannotbe traded in the public securities markets.

Share ownership usually heavily

concentrated (i.e., firms closely held)


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Key Characteristics ofPrivately Held U.S. Firms

There are more than 28 million firms in the U.S.

Of these, 7.4 million have employees, with therest largely self-employed, unincorporatedbusinesses

M&A market in U.S concentrated amongsmaller, family-owned firms

-- Firms with 99 or fewer employees account for98% of all firms with employees


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Percent Distribution of U.S. Firms FilingIncome Taxes in 2004

Proprietorships

Partnerships

Corporations

72%

9%

19%


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Family-Owned Firms

89% of U.S. businesses family owned

Major challenges include:

succession,

lack of corporate governance,

informal management structure,

less skilled lower level management, and

a preference for ownership over growth.


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Governance Issues

What works for public firms may not for privatecompanies

Market model relies on dispersed ownership

with ownership & control separate Control model more applicable where

ownership tends to be concentrated and theright to control the business is not fully separate

from ownership (e.g., small businesses)


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Steps Involved in Valuing PrivatelyHeld Businesses

1. Adjust target firm data to reflect truecurrent profitability and cash flow

2. Determine appropriate valuation

methodology (e.g., DCF, relativevaluation, etc.)

3. Estimate appropriate discount(capitalization) rate

4. Adjust firm value for liquidity risk, valueof control, or minority risk if applicable

S


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Step 1: Adjusting the IncomeStatement

Owner/officers salaries

Benefits

Travel and entertainment

Auto expenses and personal life insurance

Family members

Rent or lease payments in excess of fair marketvalue

Professional service fees

Depreciation expense

Reserves


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Areas Commonly Understated

When a business is being sold, the following expensecategories are often understated by the seller:

The marketing and advertising expenditures required

to support an aggressive revenue growth forecast Training sales forces to market new products

Environmental clean-up (long-tailed liabilities)

Employee safety

Pending litigation


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Areas Commonly Overlooked When a business is being sold, the following asset

categories are often overlooked by the buyer aspotential sources of value:1

Customer lists

Intellectual property

Licenses

Distributorship agreements

Leases

Regulatory approvals

Employment contracts

Non-compete agreements

How might you value each of the above items?1For these items to represent sources of incremental value they must represent sources of revenue or

cost reduction not already reflected in the targets cash flows.

Adjusting the Targets Financial Statements


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Adjusting the Target s Financial Statements

TargetsStatements

NetAdjustments

AdjustedStatements

Comments

Revenue 8000 8000

Cost of Sales 5000 (400) 4600 Convert LIFO to FIFO

Depreciation 100 (40) 60 Convert accelerated tostraight line

Selling: Salaries/Benefits 1000 (100) 900 Eliminate family member

Selling: Rent 200 (100) 100 Eliminate sales offices

Selling: Insurance 20 (5) 15 Reduce premiums

Selling: Advertising 20 10 30 Increase advertising

Selling: Travel & Enter 250 50 300 Increase travel

Admin.: Salaries/Benefits 600 (100) 500 Reduce owners pay

Admin: Rent 150 (30) 120 Reduce office space

Admin: Directors/Prof. Fees 280 (40) 240 Reduce fees

Total Expenses 7620 (755) 6865

EBIT 380 1135


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Discussion Questions

1. Why is it often more difficult to value privatelyowned companies than publicly traded firms?Give specific examples.

2. Why is it important to restate financialstatements provided to the acquirer by thetarget firm? Be specific.

3. How could an analyst determine if the target

firms cost and revenues are understated oroverstated? Give specific examples.


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Step 2: Determine AppropriateValuation Methodology

Income or DCF approach

Relative or market-based approach

Replacement cost approach

Asset-oriented approach


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Capitalization Multiples

Methods: Perpetuity or constant growth Assume discount rate is 8% and firms current

cash flow is $1.5 million. Multiples in brackets.

--If cash flow expected to remain level inperpetuity, the implied valuation is

[1/.08] x $1.5 = $18.75 million

--if cash flow expected to grow 4 percent

annually in perpetuity, the implied valuation is

[(1.04) / (.08 - .04)] x $1.5 = $39.0 million

St 3 S l t A i t Di t


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Step 3: Select Appropriate Discount(Capitalization) Rates

Capital asset pricing model (CAPM) Estimate firms beta based on comparable publicly

listed firms1

Adjust for specific business risk2

Cost of capital

Cost of debt based on what public firms of comparablerisk are paying3

Weights reflect managements target debt to equityratio or industry average ratio4

1Assuming private firm leveraged, estimate private firms leveraged beta based on unlevered beta forcomparable publicly firms adjusted for private firms target debt to equity ratio. Alternatively, use

industry average ratio assuming firms target D/E will move to industry average..2Difference between junk bond rate and risk-free rate, return on OTC small stock index and risk-freerate, or Ibbotsons suggested firm size adjustments3Assuming firms with similar interest coverage ratios will have similar credit ratings, estimate what

private firms credit rating would be and base its pre-tax cost of borrowing on a comparably ratedpublic firms cost of borrowing.4Dividing D/E by 1/(1+D/E) converts D/E into a debt to total capital ratio, which subtracted from onegives the equity to total capital ratio

St 4 Adj t Fi V l f Li idit


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Step 4: Adjust Firm Value for LiquidityRisk, Value of Control, or Minority Risk

Discount Applied to Firm Value

Liquidity risk: Reflects potential loss in value when anasset is sold in an illiquid market

Minority risk: Reflects lack of control associated withminority ownership. Risk varies with size of ownershipposition

Premium Applied to Firm Value Value of control: Ability to direct activities of the firm


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Liquidity Discount

Liquidity is the ease with which investors can sell theirstock without a serious loss in the value of theirinvestment.

A liquidity discount is a reduction in the offer price for thetarget firm by an amount equal to the potential loss ofvalue when sold due to the lack of liquidity in the market.

Recent studies suggest a median liquidity discount ofapproximately 20% in the U.S.


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Control Premium

Purchase price premium represents amount a buyer pays seller inexcess of the sellers current share price and includes both asynergy and control premium

Control and synergy premiums are distinctly different

--Value of synergy represents revenue increases and cost savings

resulting from combining two firms, usually in the same line of

business--Value of control provides right to direct the activities of the target

firm (e.g., change business strategy, declare dividends, and

extract private benefits)

Country comparisons indicate huge variation in median control

premiums from 2-5% in countries with relatively effective investorprotections (e.g., U.S. and U.K.) to as much as 60-65% in countrieswith poor governance practices (e.g., Brazil and Czech Republic).

Median estimates across countries are 10 to 12 percent.


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Minority Discount

Minority discounts reflect loss of influence due tothe power of controlling block shareholder.

Investors pay a higher price for control of a

company and a lesser amount for a minoritystake.

Implied Median Minority Discount =

1 [1/(1 + median control premium paid)]


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Adjustments to Firm Value

PVMAX = (PVMIN + PVNS)(1 + CP%)(1 LD%) and

PVMAX = (PVMIN + PVNS)(1 LD% CP% CP% x LD%)

Where PVMAX = Maximum purchase price

PVMIN = Minimum firm valuePVNS = Net synergy

LD% = Liquidity discount (%)

CP% = Control premium or minority discount (%)

CP% x LD% = Interaction of these factors11As a stock becomes less liquid, investors see greater value in more control. Therefore, larger liquidity

discounts are associated with larger control premiums.


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Incorporating Liquidity Risk, Control Premiums,and Minority Discounts in Valuing a Private Business

LGI wants to acquire a controlling interest in Acuity Lighting, whose estimated standalone equityvalue equals $18,699,493. LGI believes that the present value of synergies is $2,250,000. LGIbelieves that the value of Acuity, including synergy, can be increased by at least 10 percent byapplying professional management methods and by reducing the cost of borrowing by financingthe operations through the holding company. To achieve these efficiencies, LGI must gain controlof Acuity. LGI is willing to pay a control premium of as much as 10 percent. LGI reduces themedian 20% liquidity discount by 4% to reflect Acuitys high financial returns and cash flow growthrate. What is the maximum purchase price LGI should pay for a 51 percent controlling interest inthe business? For a minority 20 percent interest in the business?

To adjust for presumed liquidity risk of the target firm due to lack of a liquid market, LGI discountsthe amount it is willing to offer to purchase 50.1 percent of the firms equity by 16 percent.

PVMAX = ($18,699,493 + $2,250,000)(1 - .16)(1 + .10)) x .501= $20,949,493 x .924 x .501= $9,698,023

If LGI were to acquire only a 20 percent stake in Acuity, it is unlikely that there would be any

synergy, because LGL would lack the authority to implement potential cost saving measureswithout the approval of the controlling shareholders. Because it is a minority investment, there isno control premium, but a minority discount for lack of control should be estimated. The minoritydiscount is estimated using Equation 10-3 in the textbook (i.e., 1 (1/(1 + .10)) = 9.1).

PVMAX = ($18,699,493 x (1- .16)(1 -.091)) x .2 = $2,855,637

Thi R b


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Things to Remember The U.S. M&A market is concentrated among small,

family-owned firms. Valuing private firms is more challenging than public

firms because of the dearth of reliable, timely data.

The purpose of recasting private company

statements is to calculate an accurate current profitor cash flow number.

Maximum offer prices should be adjusted for aliquidity discount and control premium If the marketfor the firms equity is illiquid and a controlling interest

is desired

Maximum offer prices for a minority interest in a firmshould be adjusted for a minority discount.

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