VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS

OKAN BAYRAK

Definitions
 A merger is a combination of two or more

corporations in which only one corporation survives and the merged corporations go out of business.  Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies  A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company

Types of Mergers
 Horizontal Mergers

- between competing companies  Vertical Mergers - Between buyer-seller relation-ship companies  Conglomerate Mergers - Neither competitors nor buyer-seller relationship

History of Mergers and Acquisitions Activity in United States

 The First Wave 1897-1904
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After 1883 depression Horizontal mergers Create monopolies Oligopolies The Clayton Act of 1914 Conglomerate Mergers Booming Economy Hostile Takeovers Mega-mergers Strategic mega-mergers

 The Second Wave 1916-1929

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 The Third Wave 1965-1969

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 The Fourth Wave 1981-1989

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 Mergers of 1990s
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Motives and Determinants of Mergers



Synergy Effect
NAV= Vab (Va+Vb) P E Where Vab = combined value of the 2 firms

Vb = market value of the shares of firm B. Va = As measure of its own value P E = premium paid for B = expenses of the operation

Operating Synergy Financial Synergy

 
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Diversification Economic Motives

Horizontal Integration Vertical Integration Tax Motives

FIRM VALUATION IN MERGERS AND ACQUISITIONS

 Equity Valuation Models
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Balance Sheet Valuation Models

Book Value: the net worth of a company as shown on the

balance sheet.

Liquidation Value: the value that would be derived if the firms

assets were liquidated.

Replacement Cost:
its liabilities.

the replacement cost of its assets less

FIRM VALUATION IN MERGERS AND ACQUISITIONS-2

 Dividend Discount Models

D1 D2 D3 V0 !    ....... 2 3 1  k (1  k ) (1  k )
Where Vo = value of the firm Di k = dividend in year I = discount rate

FIRM VALUATION IN MERGERS AND ACQUISITIONS-3

 The Constant Growth DDM
D0 (1  g ) D0 (1  g )2 V0 !   ...... 1 k (1  k )2

And this equation can be simplified to:

V0 ! D0 (1  g ) D1 ! kg kg

where g = growth rate of dividends.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-4

 Price-Earnings Ratio
P0 1 PVGO ! 1 E1 k E/k
where PVGO = Present Value of Growth Opportunity

P0 E1 (1  b ) ! E1 k  ROExb
Implying P/E ratio

P0 1 b ! E1 k  ROExb
where ROE = Return On Equity

FIRM VALUATION IN MERGERS AND ACQUISITIONS-5

 Cash Flow Valuation Models
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The Entity DCF Model : The entity DCF model values the value of a company as
the value of a companys operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity

Value of Operations: The value of operations equals the discounted value of expected future free cash flow.

Continuing Value =
. Value of Debt
. Value of Equity

Net Operating Profit - Adjusted Taxes WACC

FIRM VALUATION IN MERGERS AND ACQUISITIONS-6

 What Drives Cash Flow and Value?

- Fundamentally to increase its value a company must do one or more of the following: . Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital). . Increase the return on new capital investment. . Increase its growth rate but only as long as the return on new capital exceeds WACC. . Reduce its cost of capital.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-7

 The Economic Profit Model: The value of a
company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.
Economic Pr ofit ! Invested Capital x ( ROIC  WACC )
where ROIC = Return on Invested Capital WACC = Weighted Average Cost of Capital

Economic Pr ofit ! NOPLAT  ( Invested Capital x WACC )

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

STEPS IN VALUATION
 Analyzing Historical Performance
Return on Investment Capital = NOPLAT Invested Capital

Economic Profit

NOPLAT (Invested Capital x WACC)

FCF

Gross Cash Flow Gross Investments

STEPS IN VALUATION-2
 Forecast Performance
- Evaluate the companys strategic position, companys

competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC. - Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance. - Forecast income statement and balance sheet line items based on the scenarios. - Check the forecast for reasonableness.

STEPS IN VALUATION-3
 Estimating The Cost Of Capital

B P S WACC ! kb (1- Tc )  k p  ks V V V
where kb Tc B kp P ks S = the pretax market expected yield to maturity on non-callable, non convertible debt = the marginal taxe rate for the entity being valued = the market value of interest-bearing debt = the after-tax cost of capital for preferred stock = market value of the preferred stock = the market determined opportunity cost of equity capital = the market value of equity

Develop Target Market Value Weights Estimate The Cost of Non-equity Financing Estimate The Cost Of Equity Financing

STEPS IN VALUATION-4
 Estimating The Cost Of Equity Financing - CAPM

k s ! rf  E (rm )  r f F
where rf E(rm) E(rm)- rf = the risk-free rate of return = the expected rate of return on the overall market portfolio = market risk premium = the systematic risk of equity

. Determining the Risk-free Rate (10-year bond rate) . Determining The Market Risk premium 5 to 6 percent rate is used for the US companies . Estimating The Beta

STEPS IN VALUATION-5
 The Arbitrage Pricing Model (APM)
ks ! rf  E ( F1 )  rf F1  E ( F2 )  rf F 2  ....
where E(F k ) = the expected rate of return on a portfolio that mimics the kth factor and is independent of all others. Beta k = the sentivity of the stock return to the kth factor.

STEPS IN VALUATION-6
 Estimating The Continuing Value
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Selecting an Appropriate Technique . Long explicit forecast approach . Growing free cash flow perpetuity formula . Economic profit technique
CV = Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC  WACC ) + WACC WACC (WACC  g )

where Economic Profit T+1 = the normalized economic profit in the first year after the explicit forecast period. NOPLAT T+1 g ROIC WACC = the normalized NOPLAT in the first year after the explicit forecast period. = the expected growth rate of return in NOPLAT in perpetuity = the expected rate of return on net new investment. = weighted average cost of capital

STEPS IN VALUATION-7
 Calculating and Interpreting Results - Calculating And Testing The Results - Interpreting The Results Within The

Decision Context

HP-COMPAQ MERGER CASE

The HP/Compaq merger. By The Numbers: HIGH-END
High-end Unix Servers: Worldwide (2000) Factory Revenues ($m) Hewlett-Packard Compaq 512 134 Market Share 11.4% 3.0% Hewlett-Packard Compaq High-end Unix servers: US (2000) Factory Revenues ($m) 124 66 Market Share 6.1% 3.3% Closest Rival: Sun Microsystems with factory revenues of $2.1 billion and a 47.1% market share Closest Rival: Sun Microsystems with factory revenues of $1.2 billion and a 60.1% market share

MID-RANGE
Mid-range Unix servers: Worldwide (2000) Factory Revenues ($m) Hewlett-Packard Compaq 3,673 488 Market Share 30.3% 4.0% Hewlett-Packard Compaq Mid-range Unix servers: US (2000) Factory Revenues ($m) 1552 296 Market Share 28.2% 5.4%

Closest Rival: Sun Microsystems with $2.8 billion in factory revenue and a 23.5% market share

Market Leader: Sun Microsystems with revenues of $1.7 billion and a 30.5% market share)

PERSONAL COMPUTERS
PC Shipments: Worldwide (in thousands of units) HewlettPackard Units (q2/01) Share (q2/01) Units (q2/00) Share(q2/00) Growth 2,065 6.9% 2,260 7.4% -8.6% Compaq 3,590 12.1% 4.011 13.2% -10.5% Units (q2/01) Share (q2/01) Units (q2/00) Share(q2/00) Growth PC Shipments: US(in thousands of units) HewlettPackard 991 9.4% 1,221 10.7% -18.8% Compaq 1,332 12.7% 2,293 20.1% --21.3%

Market leader: Dell Computer Corp. with a 24% market share and a 9.8% growth in the same period. LAPTOPS/NOTEBOOKS Worldwide shipments of portable computers (thousands of units) HewlettPackard Units(q4/00) Share(q4/00) Units(q4/99) 318 4.5% 139 Compaq 817 11.6% 739 Market Leader: Palm with a 52.9% market share and 3.53 million units. Hewlett-Packard Compaq SMART HANDHELDS Shipments (in 000s) 254 129 Share 2000 3.8% 1.9%

Rank 4 9

HP-COMPAQ MERGER CASE-2

 Arguments About The Merger - Supporters
. HP-COMPAQ will become the leader in most of the sub-sectors . Ability to offer better solutions to customers demands . New strategic position will make it possible to increase R&D efforts and customer research . Decrease in costs and increase in profitability . Financial strength to provide chances to invest in new profitable areas

HP-COMPAQ MERGER CASE-3

 Arguments About The Merger - Opponents

. Acquiring market share will not mean the leadership

. No new significant technology capabilities added to HP . Large stocks will increase the riskiness of the company (Credit rating of the HP is lowered after the merger announcement)

. Diminishing economies of scale sector which both

companies have already a great scale.

HP-COMPAQ MERGER CASE-4

 Valuation Process - Relative Historical Stock Price Performance
Historical Exchange Ratios Period ending August 31, 2001 August 31 2001 10-Day Average 20-Day Average 30 Day Average 3 Months Average 6 Months Average 9 Months Average 12 Months Average 0.532 0.544 0.568 0.573 0.557 0.584 0.591 0.596 18.9 16.3 11.3 10.3 13.7 8.2 7.1 6.1 Average Exchange Ratio Implied Premium (%)

HP-COMPAQ MERGER CASE-5

 Comparable Public Market Valuation Analysis
Firm Values As a Multiple of Revenue EBITDA and LTM EBIT Firm Values as a Multiple of Companies Compaq HP Selected Group LTM Revenue 0.5 X 1.0 X 0.2-2.1 X LTM EBITDA 5.7 X 12.4 X 5.3-18.2 X LTM EBIT 9.8 X 19.8 X 8.9-19.9 X

Closing Stock Prices As a Multiple of EPS Closing Stock Price as a Multiple of Companies Compaq HP Selected Group 2001 EPS 34.3 X 35.7 X 18.5-57.3 X 2002 EPS 18.4 X 19.2 X 10.7-27.1 X 2003 EPS 14.0 X 12.5 X 9.3-19.5 X

HP-COMPAQ MERGER CASE-6

 

Similar Transactions Premium Analysis Salomon Smith Barney's analysis resulted in a range of premiums of: - (8)% to 46% over exchange ratios implied by average prices for the 10 trading days prior to announcement, with a median premium of 23%. - (7)% to 58% over exchange ratios implied by average prices for the 20 trading days prior to announcement, with a median premium of 23%. - (12)% to (29) over exchange ratios implied by average prices for the 1 trading days prior to announcement with a median premium of 15%.

Based on its analysis, Salomon Smith Barney determined a range of implied exchange ratios of 0.585x to 0.680x by applying the range of premiums for other transactions to the closing prices of Compaq and HP on August 31, 2001 and the average historical exchange ratio for Compaq and HP for the 10-day period ending on August 31, 2001, as appropriate.

HP-COMPAQ MERGER CASE-7

 Contribution Analysis
Percentage Contribution Analysis Period Revenues LTM 2001 Estimated 2002 Estimated 2003 Estimated LTM 2001 Estimated 2002 Estimated 2003 Estimated 2001 Estimated Next Four Fiscal Q 2002 Estimated 2003 Estimated Equity Value Percentage Contribution Compaq HP 46.0 54.0 44.0 56.0 44.0 56.0 44.0 56.0 45.7 54.3 38.1 61.9 36.9 63.1 32.7 67.3 32.3 67.7 31.6 68.4 32.7 67.3 29.2 70.8 31.7 68.3

Net Income

At Market

HP-COMPAQ MERGER CASE-8

 Pro Forma Earnings Per Share Impact to Compaq
Accretion/Dilution Analysis EPS Accretion/Dilution Compaq stand-alone HP stand-alone Combined entity pro-forma, excluding proj. syne rgies Combined entity pro-forma, including proj. synergies Accre tion/(Dilution) to Compaq, excluding proj. synergies Accretion/(Dilution) to Compaq, including proj. synergie s 2002 0.67 1.21 0.74 1.05 11% 57% EPS 2003 0.88 1.86 1.09 1.51 24% 71%