Lecture 7

FIN703 MERGERS AND ACQUISITIONS LECTURE 7 VALUATION FOR MERGER AND ACQUISITIONS
28/06/2011 DR Vipin Jain Trimester 1, 2011 1
LECTURE OUTLINE

Introduction to valuation Comparables approaches Comparable companies analysis Comparable transactions analysis The DCF spreadsheet methodology Capital Budgeting Decisions Net Present Value (NPV) Real Options Analysis Spreadsheet Projections
DR Vipin Jain Trimester 1, 2011 2
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INTRODUCTION TO VALUATION

Valuation critical in M&As Acquisition failures can result from bidder paying too much Value of bidder tender offer may stimulate competing bidders In bidder contest, winner is firm with highest estimates of value of target Framework essential to discipline valuation estimates
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INTRODUCTION TO VALUATION

Valuation should be guided by a business economics analysis of the firm and its environment. Valuation methods Comparable companies or comparable transactions Discounted cash flow (DCF) spreadsheet approach Formula approach
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COMPARABLES APPROACHES
COMPARABLE COMPANIES ANALYSIS Group of companies comparable with respect to:
Size Similarity of products or production methods Age of company Recent trends and future prospects
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DR Vipin Jain Trimester 1, 2011
COMPARABLE COMPANIES ANALYSIS Key ratios are calculated for each company. For company. example: example: Market value of shareholders' equity to sales Market value of equity in relation to book value of equity (market/book) Market value of equity to earnings (price-to(price-toearnings ratio) Sales or revenue per employee Net income per employee Assets needed to produce $1 of sales or revenue
COMPARABLE COMPANIES ANALYSIS

Equity value of Company W = Average market-tomarket-to-sales ratio of comparables Company Ws Sales Ws

Valuation judgments are made
Key ratios are averaged for group Average ratios are applied to absolute data for company of interest to obtain its values. For example:

Advantages Common sense approach: similar companies should sell for similar prices Marketplace transactions are used Widely used in legal cases Used by investment bankers in fairness evaluation and opinions Can be used to establish valuation relationship for a company not publicly traded
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COMPARABLE COMPANIES ANALYSIS Limitations May be difficult to find companies that are actually comparable by key criteria Ratios may differ widely for comparable companies Different ratios may give widely different valuations

Limitations Companies in similar businesses and comparable in size may differ in track records and opportunities Growth rates in revenues Growth rates in cash flows Riskiness (beta) of companies Stages in life cycle of industry and company Competitive pressures Opportunities for expansion
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ILLUSTRATIVE EXAMPLE
Assume that we want to obtain the indicated market value of equity for company W. We find three companies that are comparable . To test for comparability , we consider size, similarity of products, age of company, and recent trends, among other variables. The actual data of variables. Company w is $100, $60, $5 sales, Book Value of 100, 60, Equity, and Net Income respectively. The key respectively. ratios for the three comparables are calculated as follows: follows:
ILLUSTRATIVE EXAMPLE (cont---) (cont---)
Ratio
Market/sales Market/Book Market/Net Income=price/ear nings ratio
Company A Company B Company C Average
1.2 1.3 20
1.0 1.2 15
0.8 2.0 25
1.0 1.5 20
Required: Calculate the indicated market value of equity for company W

SOLUTION
Variables Actual Recent data for Company W Average Market Ratio Indicated value of Equity (million)
Sales Book value of equity Net Income Average
$100 60 5
1.0 1.5 20
$100 90 100 $97

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COMPARABLE TRANSACTIONS ANALYSIS Valuation based on companies involved in the same kind of merger transactions Key ratios are calculated for each comparable deal based on actual transaction prices. For example: Total paid to targets sales Total paid to targets book value Total paid to targets net income Premium to targets pre-merger market value pre Premium to combined firm pre-merger market value pre28/06/2011 DR Vipin Jain Trimester 1, 2011 14

Key ratios are averaged for group and applied to merger transaction of interest to obtain its value. value. For example
Value Paid to Target W = Average total paid to-targets sales ratio Target Ws sales toWs
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Value Paid to Target W = Market value of Target W (1 + Average premium to targets)
Value Paid to Target W = Market value of combined company (1 + average premium To combined firms) Market value of buyer
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COMPARABLE TRANSACTIONS ANALYSIS
Advantages

More directly applicable than company comparisons Companies may combine diverse activities. activities. M&A transactions involve premiums so results from comparable companies need to be adjusted upward
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COMPARABLE TRANSACTIONS ANALYSIS
Limitations

May be difficult to find transactions within a relevant time frame Transactions may not be truly similar Resulting ratios may vary widely Considerable judgment may be required Does not take into account the estimated synergies that may vary between different transactions
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This example looks into the comparable transactions analysis for the Exxon Mobil merger. The table given on merger. the next slide shows the data for the three major oil mergers in the 1990s as comparable transactions. 1990s transactions.
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Mobil
Details LTM Sales Mobil 63.0 Book Value 19.0 LTM net income 2.9 Market Value of Target 58.7 Market value of combined 233.7
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Ratio
Total paid/sales Total paid/book Total paid/net income Premium paid,% target Premium paid,% combined
Amoco
Texaco
Conoco Average
1.38 3.00 22.46 22.3% 7.7%
0.77 2.79 15.46 17.7% 6.3%
0.37 2.29 7.60 0.0% 0.0%
0.84 2.69 15.18 13.3% 4.7%
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Required: Required:

Use the average ratio to determine the equity value of Mobil. Mobil. Use the Amoco transaction multiple to determine the equity value of Mobil. Mobil.
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SOLUTION
Application of Valuation Ratios to Mobil (Dollar amounts in billions) Mobil Average Transaction Multiple Value of Equity
LTM Sales Book Value LTM net income Market Value of Target Market value of combined Average
$63.0 19.0 2.9 58.7 233.7
0.84 2.69 15.18 13.3% 4.7%
$53.0 51.2 43.8 66.6 69.6 56.8
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SOLUTION
Application of Valuation Ratios to Mobil (Dollar amounts in billions) Mobil Amoco Transaction Multiple Value of Equity
LTM Sales Book Value LTM net income Market Value of Target Market value of combined Average
$63.0 19.0 2.9 58.7 233.7
1.38 3.00 22.46 22.3% 7.7%
$86.7 57.0 64.9 71.8 76.7 71.4
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SOLUTION

The result from the average transaction multiple indicates that the price that Exxon should have paid for Mobil is $56.8 billion. This is substantially 56. billion. below the $74.2 paid by Exxon. 74. Exxon. In the second table, where BP-Amoco transaction BPmultiple is used , the indicate price is $71.4 billion. 71. billion.
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THE DCF SPREADSHEET METHODOLOGY

Procedure Historical data for each element of balance sheet, income statement, and cash flow statement are presented 5 to 10 years Detailed financial ratio analysis is performed to discover financial patterns Additional critical analysis Business economics of industry in which company operates
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THE DCF SPREADSHEET METHODOLOGY Company's competitive position Assessments of financial patterns, strategies, and actions of competitors Based on analysis, relevant cash flows are projected Procedures similar to capital budgeting analysis

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CAPITAL BUDGETING DECISIONS

Definition Process of planning expenditures whose returns extend over a period of time. time. Generally in relation to investment in fixed assets, but concept applicable to investment in cash, receivables, inventory, as well as M&A activities. activities.
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CAPITAL BUDGETING DECISIONS

Importance of capital budgeting decisions: decisions: Consequences of decisions continue for number of years Require effective planning to assure proper timing Size of outlay may require financing to be arranged in advance Size of outlay means decisions and their timing can make or break the firm
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NET PRESENT VALUE (NPV)

Present value of all future cash flows discounted at the cost of capital minus the cost of investments made over time compounded at the opportunity cost of funds
n CFt It wh ere : NPV o ! t t t !1 (1 k ) t !1 (1 k ) NPV o = net present va lue at period 0 n
CFt ! cash lows in period t k = cost o capital n = number o periods I t ! investment outlays in period t

ILLUSTRATIVE EXAMPLE An acquiring company (A) has the opportunity to buy a target company (T). (T). The target company can be purchased for $180 million. million. The relevant net cash flows that will be received from the investment in the target company will be $40 million for the next ten yeas, after which no cash flows will be forthcoming. forthcoming. The relevant cost of capital for analyzing the target is 14%. 14%

ILLUSTRATIVE EXAMPLE (cont---) (cont---) Required:
Calculate the NPV and explain whether the Merger looks favourable. favourable. Assuming that the acquirer pays $250 million, Calculate the NPV and explain whether the Merger looks favourable. favourable.
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SOLUTION NPV = $40[PVIFA (14%,10yr)]-180 (14%,10yr)]= $40 (5.2161)- $180 (5.2161)= $28.644 million Or NPV = GPV I 0 = $208.644-$180 $208.644= $28.644 million

SOLUTION (cont---) (cont---) NPV = $40[PVIFA (14%,10yr)]-250 (14%,10yr)]= $40 (5.2161)- $250 (5.2161)= -$41.356 million Or NPV = GPV I 0 = $208.644-$250 $208.644=-$41.356 million
STANDARD METHOD FOR EVALUATION AND RANKING OF INVESTMENTS

NPV method correctly assumes reinvestment at cost of capital Value additivity principle Sum of project NPVs is the same regardless of how they are combined Can consider projects independently Firm value is sum of component project NPVs NPV is amount project adds to firm value maximizing NPV maximizes firm value An acquisition is fundamentally a capital budgeting problem: problem: Mergers do not make sense if buyer pays too much resulting in negative NPVs
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REAL OPTIONS ANALYSIS

NPV approach does not recognize flexibility in investment decisions. decisions. Postponement Abandonment Modification Negative NPV investment may be positive if value of flexibility is included. included.
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Company R needs to expand its distribution system. system. It seeks to analyze the returns if it postpones the investment until year 2. If the present value of the incremental cash flow is $40 million and the cost of capital is 10%, calculate the 10% NPV. NPV.
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SOLUTION
Postpone investment until Year 2 Investment in Year 2 = $50 million Present value of incremental cash flows = $40 million Cost of capital = 10%
NPV analysis:
$50 $50 NPV ! $40 ! $40 2 (1.10) 1.21 ! $40 $50(0.8264) ! 40 $41.322 NPV ! $ 1.322 million

Postponement option can be view as a call option in the Black-Scholes (1973) option pricing model: Black-
C ! S N (d1 ) Xe
Where:
rF T
N (d 2)
d1 !
ln(S / X ) rF T
W T
1 W T 2
d 2 ! d1 W T

N(d1 N(d1) represents a probability term measuring the change in C in response to a change in S. N(d2) is N(d2 the probability that the option will be exercised. exercised.
Key
variables are: are:
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I TEST MYSELF
Solve for C in this case using the following additional information: Risk free rate = 3.70% Standard Deviation = 0.15 Strike price = $50.00 Time to Maturity = 2 years
(Remember, Black-Scholes model has Blackalready been covered in FIN705).

SPREADSHEET PROJECTIONS

Provides great flexibility in projections growth rate for each item in spreadsheet could be different from one another and from year to year Important to understand underlying growth patterns Growth rate consistent with forecast for economy Growth rate consistent with industry Growth rate consistent with market share in relation to competitors
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NPV of acquisition obtained from sum of free cash flows discounted at applicable cost of capital.
n
NPV !
t !1
FCFt (1 k ) t
here :
FCFt = free cash flo s in period t = X t ( 1 T) I t X t ! before - tax cash flo s in period t T k
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tax rate cost of capital

I t ! investment outlays in period t
FREE CASH FLOWS

Net Revenues Operating Expenses Net Operating Income (NOI) (NOI) Income Taxes Net Operating Profits after Taxes (NOPAT or NOI(1-T)) NOI( + Depreciation Gross Cash Flows Change in working capital Capital expenditures Investments Change in other assets net Free Cash Flows

Company A is considering the purchase of a target company T. The projected initial revenue is $1000 , and this is projected to grow at a 20% rate. 20% rate. From the historical patterns and economic outlook, investment bankers project costs of sales to be 80% of the revenue. 80% revenue. Corporate tax are postulated at 40%. 40%
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Net working capital is 4% of the revenues, and net property, plant and equipment are 6% of revenues. revenues. For the target company, total capital investment of 10 cents is required for each dollar of revenues. revenues. Company T represents an investment opportunity in which revenues will grow at 20% 20% for 3 years and than level off. off.
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ILLUSTRATIVE EXAMPLE (cont---) (cont---) Required:

Prepare the Spreadsheet projects of Company T and determine the FCF. Compute the NPV to determine the value of the target.
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SOLUTION
Percent of revenue 1.Revenues(R t) 2. Costs 3. Net Operating income (X t) 4. Taxes (T) 5. Net operating income after Tax [Xt (1-t)] (1Investment Requirements 6. Newt working capital (I wt) 7. Net property , plant and equip( I ft) 8. Total (I t) 9. FCF [Xt (1-T) It] (14 6 10 48 72 120 24 68 86 144 29 69 104 173 35 0 0 0 207 100 80 20 40 12 0 $1,000 1 1,200 960 240 96 144 2 1,440 1152 288 115 173 3 1,728 1382 346 138 207 4 to to 1,728 1382 346 138 207
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VALUATION OF THE TARGET
YEAR 3 1 1. Before Tax cash Flows (Xt) 2. Taxes at 40% (T) 3. After Tax Cash Flows [Xt (1-t)] (14. Investment (It) 5. Free Cash Flows [Xt (1-T) It] (16. Discount factor a. Discount factor 7. Present Value
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2 288 115 173 144 29 (1+k)2 1/1.21 $23.97
Beginning 346 138 207 173 35 (1+k)3 1/1.331 $26.30
End 346 138 207 0 207.4 k(1+k) 3 10/1.331 $1558.23

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240 96 144 120 24 (1+k) 1/1.10 $21.82
EVALUATION OF SPREADSHEET APPROACH

Advantages Expressed in financial statements familiar to business community Data are year by year with any desired detail of individual balance sheet or income statement accounts Flexibility and judgment in formulating projections
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EVALUATION OF SPREADSHEET APPROACH

Disadvantages Numbers used in projections may create illusion that they are actual or correct numbers Link between projected numbers and economic or business logic may not be clear May become highly complex Details may obscure driving factors important in making projections
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END OF THIS LECTURE
LECTURE 7 WILL BE CONTINUED IN THE NEXT CLASS
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FIN703 MERGERS AND ACQUISITIONS LECTURE 7 VALUATION FOR MERGER AND ACQUISITIONS

28/06/2011 DR Vipin Jain Trimester 1, 2011 1

DR Vipin Jain Trimester 1, 2011

Equity value of Company W = Average market-tomarket-to-sales ratio of comparables Company Ws Sales Ws

Company A Company B Company C Average

Required: Calculate the indicated market value of equity for company W

Sales Book value of equity Net Income Average

$100 90 100 $97

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 58.7 1, 2011

1.38 3.00 22.46 22.3% 7.7%

0.77 2.79 15.46 17.7% 6.3%

0.37 2.29 7.60 0.0% 0.0%

0.84 2.69 15.18 13.3% 4.7%

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

$63.0 19.0 2.9 58.7 233.7

0.84 2.69 15.18 13.3% 4.7%

$53.0 51.2 43.8 66.6 69.6 56.8

DR Vipin Jain Trimester 1, 2011

$63.0 19.0 2.9 58.7 233.7

1.38 3.00 22.46 22.3% 7.7%

$86.7 57.0 64.9 71.8 76.7 71.4

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

THE DCF SPREADSHEET METHODOLOGY

DR Vipin Jain Trimester 1, 2011

CAPITAL BUDGETING DECISIONS

DR Vipin Jain Trimester 1, 2011

CAPITAL BUDGETING DECISIONS

NET PRESENT VALUE (NPV)

NET PRESENT VALUE (NPV)

NET PRESENT VALUE (NPV)

DR Vipin Jain Trimester 1, 2011

NET PRESENT VALUE (NPV)

NET PRESENT VALUE (NPV)

STANDARD METHOD FOR EVALUATION AND RANKING OF INVESTMENTS

REAL OPTIONS ANALYSIS

DR Vipin Jain Trimester 1, 2011

REAL OPTIONS ANALYSIS

DR Vipin Jain Trimester 1, 2011

REAL OPTIONS ANALYSIS

REAL OPTIONS ANALYSIS

REAL OPTIONS ANALYSIS

variables are: are:

DR Vipin Jain Trimester 1, 2011

REAL OPTIONS ANALYSIS

(Remember, Black-Scholes model has Blackalready been covered in FIN705).

tax rate cost of capital

I t ! investment outlays in period t

FREE CASH FLOWS

DR Vipin Jain Trimester 1, 2011

DR Vipin Jain Trimester 1, 2011

2 288 115 173 144 29 (1+k)2 1/1.21 $23.97

Beginning 346 138 207 173 35 (1+k)3 1/1.331 $26.30

End 346 138 207 0 207.4 k(1+k) 3 10/1.331 $1558.23

240 96 144 120 24 (1+k) 1/1.10 $21.82

DR Vipin Jain Trimester 1, 2011

EVALUATION OF SPREADSHEET APPROACH