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Using Financial Modeling

Techniques to Value and


Structure Mergers &
Acquisitions

Tact is for people


not witty enough to be sarcastic.
--Anonymous

Course Layout: M&A & Other


Restructuring Activities

Part I: M&A
Environment

Part II: M&A


Process

Part III: M&A


Valuation &
Modeling

Part IV: Deal


Structuring &
Financing

Part V:
Alternative
Strategies

Motivations for
M&A

Business &
Acquisition
Plans

Public Company
Valuation

Payment &
Legal
Considerations

Business
Alliances

Regulatory
Considerations

Search through
Closing
Activities

Private
Company
Valuation

Accounting &
Tax
Considerations

Divestitures,
Spin-Offs &
Carve-Outs

Takeover Tactics
and Defenses

M&A Integration

Financial
Modeling
Techniques

Financing
Strategies

Bankruptcy &
Liquidation

Cross-Border
Transactions

Learning Objectives
Primary learning objective: Provide students with a basic
understanding of how to use financial models to value and
structure M&As
Secondary learning objectives: Provide students with a
knowledge of
How to estimate the value of synergy;
Commonly used relationships in building M&A valuation
models; and
How to use models to estimate the purchase price
range, initial offer price for a target firm, and to evaluate
the feasibility of financing the proposed offer price.

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 to
finance the transaction

Step 1: Value Acquirer & Target as


Standalone Firms
Use the 5-forces model to 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.

Applying the 5-Forces Model to Project Acquirer and


Target Firm Financial Performance
How have the following factors
affected revenue growth and profit
margins in the acquirer and target
firms industry historically?
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)

How will these factors change (if


at all) to impact future revenue
growth and profit margins of
these firms?
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)

Key questions:
1.

How might changes in the bargaining power of customers and suppliers


relative to the acquirer and target firms impact product pricing, costs, and
profit margins?

2.

How might substitutes and new entrants affect product pricing and profit
margins?

Step 2: Value Acquirer & Target Firms


Including Synergy
Estimate
Sources and destroyers of value
Implementation costs incurred to realize
synergy
Consolidate acquirer and target projected
financials including the effects of synergy
Estimate net synergy (consolidated firms less
values of target and acquirer)

Adjusting Combined Acquirer/Target Company


Projections 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

$8

Indirect labor

$1

$2

$4

$4

$4

Purchased materials

$2

$3

$5

$5

$5

Selling expenses

$1

$3

$5

$5

$5

$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%

Total

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

Discussion Questions
1. How would you adjust the combined firms income
statement for cost savings due to improved worker
productivity? (Hint: Determine the line item most
directly affected by the improvement in productivity.)
2. How would you adjust the combined firms income
statement for additional revenue generated from crossselling (i.e., Acquirer selling its products to the targets
customers and vice versa)?
3. How would you reflect the expenses incurred in
implementing the worker productivity improvement and
cross-selling programs on the combined firms income
statement?

Step 3: Determine Initial Offer Price


for Target Firm
Estimate minimum and maximum
purchase price range
Determine amount of synergy willing to
share with target shareholders
Determine appropriate composition of
offer price

Calculating Initial Offer Price (PVIOP)


1.
2.
3.

PVMIN = PVT or PVMV, whichever is greater for a stock purchase (liquidation value of net
acquired assets for an asset purchase)
PVMAX = PVMIN + PVNS, where PVNS = PVSOV PVDOV
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


Offer price per share = PVIOP / Targets fully diluted shares outstanding1
How is determined?
Fully diluted shares outstanding includes basic shares plus shares resulting from exercising in the money options and conversion of convertible debt and preferred
stock.

Calculating Offer Price Per Share and Targets Equity


Value Under Alternative Payment Scenarios
All Stock Transaction:
Offer Price Per Share = Share Exchange Ratio 1 x Acquirers Share Price
= Offer Price Per Target Share x Acquirers Share Price
Acquirers Share Price
Equity Value
= Offer Price Per Share x Targets Fully Diluted Shares Outstanding
All Cash Transaction:
Offer Price Per Share = Cash Offer Per Target Share
Equity Value
= Cash Offer Per Target Share x Targets Fully Diluted Shares
Outstanding
Cash and Stock Transaction:
Offer Price Per Share = Cash Offer Per Share + (Share Exchange Ratio x Acquirers
Share Price)
Equity Value
= [Cash Offer Per Share + (Share Exchange Ratio x Acquirers Share
Price)] x Targets Fully Diluted Shares Outstanding
1

When share exchange ratios (SERs) are fixed, the value of the transaction can change due to fluctuations in the acquirers share price. Assume the
SER is 2 and the acquirers share price is $50, the offer price per share is $100. However, if the acquirers share price falls to $40 or increases to
$60 before closing, the offer price is $80 and $120, respectively. Under a floating SER, the dollar value of the offer price per share is fixed and
the number of shares exchanged varies with the value of the acquirers share price. Acquirer share price changes require re-estimating the SER.
For example, if the acquirers share price falls to $40, the number of new acquirer shares issued to preserve the $100 offer price is 2.5 (i.e.,
$100/$40); if the acquirers share price rises to $60, the new SER would be 1.6667 (i.e., $100/$60). Fixed SERS are most common because the
risk of changes in the offer price is shared equally by the acquirer (i.e., if acquirers share price rises) and the target (i.e., if the acquirers share
price falls).

Calculating the Targets Fully Diluted Shares Outstanding


and Adjusting Equity Value (If Converted Method)
Assumptions about Target

Comment

Basic Shares Outstanding

2,000,000

In-the-Money Options1

150,000

Exercise Price = $15/share

Convertible Debt (Face value = $1000;


convertible into 50 shares of common
stock)
Preferred Stock (Par value = $20;
convertible into one share of common at
$24 per share

$10,000,000

Implied conversion price = $20 (i.e.,


$1000/50)

$5,000,000

Preferred shares outstanding =


$5,000,000 / $20 = 250,000

Offer Price Per Share

$30

Purchase price for each target share


outstanding

Total Shares Outstanding2 = 2,000,000 + 150,000 + ($10,000,000/$1000) x 50 + 250,000


= 2,000,000 + 150,000 + 500,000 +250,000
= 2,900,000
Adjusted Target Equity Value3 = 2,900,000 x $30 -150,000 x $15
= $87,000,000 - $2,250,000
= $84,750,000
An option whose exercise price is below the market value of the firms share price.
Total shares Outstanding = Issued Shares + Shares from in the money options and convertible securities.
3
Purchase price adjusted for new acquirer shares issued for convertible shares or debt less cash received from in the money option holders.
1
2

Step 4: Determine Combined Firms


Ability to Finance Transaction
Estimate impact of alternative financing
structures (e.g., debt/ratio ratios)
Select financing structure that
Meets acquirers required financial returns
and desired financial structure;
Meets targets primary financial and nonfinancial needs;
Does not raise borrowing costs; and
Is supportable by the combined firms
operating cash flows.

Calculating Post-Merger
Earnings Per Share (EPS)
Will the transaction be
transaction be dilutive or
accretive to the acquirers
EPS?
Acquirer is considering the
acquisition of Target in which
Target would receive $84.30
for each share of its common
stock. Acquirer wishes to
assess the impact of
alternative forms of payment
on post-merger EPS.
Acquirer believes that any
synergies in the first year
following closing would be
fully offset by costs incurred
in combining the two
businesses. Selected data
are presented as follows:

Pre-Merger
Data
Net
Earnings

Acquirer

Target

$281,500,000 $62,500,000

Shares
112,000,000
Outstanding

18,750,000

EPS

$2.51

$3.33

Market
Price Per
Share

$56.25

$62.50

Calculating Post-Merger EPS in a


Share for Share Exchange1
Share exchange ratio = Price per share offered for Target /
Price per share for Acquirer = $84.30 / $56.25 = 1.5
2. New shares issued by Acquirer = 18,750,000 (shares of
Target) x 1.5 (share exchange ratio) = 28,125,000
3. Total shares outstanding of the combined firms =
112,000,000 + 28,125,000 = 140,125,000
4. Post-merger EPS of the combined firms = ($281,500,000
+ $62,500,000) / 140,125,000 = $2.46 (versus $2.51 for
Acquirer prior to the merger)
1.

Implication: EPS for the combined firms is diluted $.05 during


the first full year following closing.
1

Target has no convertible preferred stock or debt outstanding, and its employees have no in the money options..

Calculating Post-Merger EPS


in an All Cash Transaction
1. Purchase price = $84.30 x 18,750,000 = $1,580,625,000
2. Assume Acquirer borrowed the entire purchase price at
8% interest with the principal repaid in 10 years
3. Annual interest expense = .08 x $1,580,625,000 =
$126,450,000
4. Post merger EPS of the combined firms = ($281,500,000
+ $62,500,000 - $126,450,000 (1 - .4)) / 112,000,000 =
$2.39 (versus $2.51 for Acquirer before the merger)
Implication: EPS of the combined firms is diluted by $.12
during the first full year following closing due to the annual
interest expense
1

Assumes the firms marginal tax rate is 40 percent.

Calculating Post-Merger EPS


in a Cash & Stock Transaction
Assume purchase price equals 1 share of Acquirer stock (@
$56.25) and $28.05 ($84.30 offer price - $56.25) in cash and
that the cash portion of the purchase price is financed at 8%
annual interest with the principal due in 10 years 1
1. New shares issued by Acquirer = 18,750,000 (shares of
Target)
2. Total shares outstanding of the combined firms =
112,000,000 + 18,750,000 = 130,750,000
3. Post-merger EPS of the combined firms = ($281,500,000 +
$62,500,000 - $42,075,000 (1 - .4)) / 130,750,000 = $2.44
(versus $2.51 for Acquirer before the merger)
Implication: EPS of the combined firms is diluted by $.07 during
the first full year following closing. Therefore, under these
assumptions, EPS dilution is smallest in an all stock deal.
1

Annual interest is computed as follows: .08 x $28.05 x 18,750,000 (Target shares) = $42,075,000

Model Worksheet Layout

Assumptions Section
Historical Period

Forecast Period

Refers to model template contained on CDROM accompanying textbook.

Using M&A Model Template1

Model worksheet layout: Assumptions (top panel); historical period


data (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 not
containing formulas. Do not delete existing formulas in historical
period unless you wish to customize the model.
Do not delete or change formulas in the forecast period cells
unless you wish to customize the model. To replace existing data,
change the forecast assumptions at the top of the spreadsheet.
1

Refers to model template found on CDROM accompanying textbook.

Model Balance Sheet Adjustment


Mechanism Methodology
Separate current assets into operating and non-operating
assets.
Operating assets include minimum operating cash balances
and other operating assets (e.g., receivables, inventories,
and assets such as prepaid items). 1
Current non-operating assets are investments (i.e., cash
generated in excess of minimum operating balances
invested in short-term marketable securities).
The firm issues new debt whenever cash outflows exceed
cash inflows.
The firms investments increase whenever cash outflows
are less than cash inflows.
1

Minimum 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 period times
current net revenue..

Model Balance Sheet Adjustment


Mechanism Illustration
Assets
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)

Liabilities
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., the
firm 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

Estimating Interest Expense


IEXP = ((DEOY + DBOY)/2) x i, where DEOY = DBOY - DPRP
where
DEOY = End of year debt balance
DBOY = Beginning of year debt balance
DPRP = Annual principal repayment
IEXP = Dollar value of annual interest expense
i

= Weighted average interest rate

Debt Repayment Schedule


Total Debt
12/31/05

2006

Maturity
Schedule

Maturing
Amount

Interest Rate

2007
Maturing
Amount

Interest Rate

Long-Term
Debt

$690,710

$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%

Remaining
Balance

1/1/06

Ending
Balance

Interest Rate

Ending
Balance

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%

Hints on Using Financial Models

Ensure Excels Iteration Command is on to accommodate circular


references inherent in financial models.
For example,
Cash & Investments x Interest Rate Affects Net Income
Net income Affects Cash & Investments

To turn on the iteration command,


On the menu bar, click on Tools >>> Options >>> Calculations
Select Automatic and Iteration
Set maximum number of iterations to 100 and the maximum
amount of change to .01.

Things to Remember
Financial modeling facilitates the process of
valuation, deal structuring, and selection of the
appropriate financing plan.
The process entails the following four steps:
Valuing the acquirer and target firms as
standalone 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 firm
from within the price range defined by the
minimum and maximum purchase prices
Determining the combined firms ability to finance
initial offer price

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