Chapter 9: Applying Financial Modeling Techniques

To Value, Structure, and Negotiate Mergers and Acquisitions

Answers to End of Chapter Discussion Questions

9-1. Why are financial modeling techniques used in analyzing M&As?

Answer: The primary objective in applying financial modeling techniques is to create a computer-based
model, which facilitates the acquirer’s understanding of the impact of changes in certain operating variables
on the firm’s overall performance and valuation. The models can be used to answer several different sets
of questions. The first set pertains to valuation. How much is the target company worth without the effects
of synergy? What is the value of expected synergy? What is the maximum price that the acquiring
company should pay for the target? The second set of questions pertains to financing. Can the maximum
price be financed? What combination of potential sources of funds, both internally generated and external
sources, provides the lowest cost of funds for the acquirer, subject to known constraints? The final set of
questions pertains to deal structuring. What is the impact on the acquirer’s financial performance if the deal
is structured as a taxable rather than a nontaxable transaction? What is the impact on financial performance
and valuation if the acquirer is willing to assume certain target company liabilities?

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9-2. Give examples of the limitations of financial data used in the valuation process.

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Answer: There are several major sources of error in any valuation methodology. These include the

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conceptual limitations of the valuation methodology, the difficulty in predicting either the magnitude and
the timing of projected earnings or cash flows, and the inaccuracies inherent in the published data used to

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apply the various valuation tools. Data limitations can result in severe distortions in any of the valuation
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techniques employed. Without credible data, the range of potential error in efforts to value target
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companies expands considerably. Hence, the analyst should never become so preoccupied with the choice
and application of the valuation methodology that he or she overlooks the need to understand the
limitations of the data. The most widespread abuse of GAAP occurs when the decision is made to count a
sale to a customer as revenue. Studies show that improper revenue recognition was found to be the most
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common form of financial reporting fraud, with about 50% resulting from revenue having been stated
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incorrectly. Other examples include establishing reserves to artificially “smooth” earnings and the write-off
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of in-process R&D to inflate future earnings.

9-3. Why is it important to analyze historical data on the target company as part of the valuation process?

Answer: The accuracy of any valuation is heavily dependent on understanding the historical competitive
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dynamics of the industry, the historical performance of the company within the industry, and the reliability
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of the data used in the valuation. A careful examination of historical information can provide insights into
key relationships among various operating variables and represents the first step in the process for
modeling both the acquirer and the target companies. Examples of relevant historical relationships include
seasonal or cyclical movements in the data, the relationship between fixed and variable expenses, and the
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impact on revenue of changes in product prices and unit sales. If these relationships can reasonably be
expected to continue through the forecast period, they can be used to project the earnings and cash flows
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that will be used in the valuation process.

9-4. Explain the process of normalizing historical data and why it should be done before undertaking the
valuation process.
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Answer: To ensure that these historical relationships can be accurately defined, it is necessary to cleanse
the data of anomalies, nonrecurring changes, and questionable accounting practices. For example, cash
flow may be adjusted by adding back unusually large increases in reserves or by deducting large decreases
in reserves from free cash flow to the firm. Similar adjustments can be made for significant nonrecurring
gains or losses on the sale of assets or for nonrecurring expenses such as those associated with the
settlement of a lawsuit or warranty claim. Monthly revenue may be aggregated into quarterly or even

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 annual data to minimize period-to-period distortions in earnings or cash flow due to inappropriate
accounting practices. Ideally, at least 3–5 years of historical data should be normalized.

9-5. What are common-size financial statements and how might they be used to analyze a target firm?

Answer: Common-size financial statements are among the most frequently used tools to uncover data
irregularities. These statements may be constructed by calculating the percentage each line item of the
income statement, balance sheet, and cash flow statement is of annual sales for each quarter or year for
which historical data are available. Common-size financial statements are useful for comparing businesses
of different sizes in the same industry at a specific moment in time. Such analyses are called cross-sectional
comparisons. By expressing the target’s line-item data as a percent of sales, it is possible to compare the
target company with other companies’ line item data expressed in terms of sales to highlight significant
differences.

9-6. Why should a target company be valued as a standalone business? Give examples of the types of
adjustments that might have to be made if the target company is part of a larger company?

Answer: The valuation of the target firm on a standalone basis provides an estimate of the minimum price
that might have to be paid to acquire the firm. If the acquirer or target is part of a larger firm, the projected

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cash flows must be adjusted to reflect all costs and revenue associated with the acquirer’s or target’s
operation. The failure to make the proper adjustments can result in an over-or-understatement of value.

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Such costs include all administrative expenses such as legal, tax, audit, benefits, and treasury functions that

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may be heavily subsidized by the parent. Moreover, intercompany revenues must be restated to reflect
what they would have been if they had been valued at current market prices.

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9-7.
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Define the minimum and maximum purchase price range for a target company.
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Answer: The maximum purchase price for a target firm is its minimum price plus 100% of anticipated net
synergy. Net synergy is the present value of the difference between sources and destroyers of value. The
minimum price is the target’s current share price if it is a publicly traded firm or its standalone value.
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9-8. What are the differences between the final negotiated price, total consideration, total purchase, and net
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purchase price?

Answer: The offer or purchase price was defined in a different context as total consideration, total purchase
price or enterprise value, and net purchase price. Total consideration refers to what is actually paid to the
target’s shareholders and may consist of cash, stock, debt, or some combination of all three. The total
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purchase price or enterprise value refers to the total consideration plus assumed debt. The final negotiated
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price reflects the enterprise value plus any other assumed liabilities whether on or off the balance sheet.
The net purchase price includes the final negotiated price less the proceeds from the sale of any non-
strategic target assets.
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9-9. Can the initial offer price ever exceed the maximum purchase price? If yes, why? If no, why not?
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Answer: Yes. Hubris on the part of acquiring company’s management may result in an offer price that
exceeds what is economically justifiable assuming the acquiring firm has accurately identified all sources
and destroyers of value.
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9-10. Why is it important to clearly state assumptions underlying a valuation?

Answer: The credibility of any valuation ultimately depends on the validity of its underlying assumptions.
Valuation-related assumptions tend to fall into five major categories: (1) market, (2) income statement, (3)
balance sheet, (4) synergy, and (5) valuation. Note that implicit assumptions about cash flow are already
included in assumptions made about the income statement and changes in the balance sheet, which together
drive changes in cash flow. Market assumptions are generally those that relate to the growth rate of unit
volume and product price per unit. Income statement assumptions include the projected growth in revenue,

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 the implied market share, and the growth in the major components of cost in relation to sales. Balance sheet
assumptions may include the growth in the primary components of working capital and fixed assets in
relation to the projected growth in sales. Synergy assumptions relate to the amount and timing associated
with each type of anticipated synergy, including cost savings from workforce reductions, productivity
improvements due to the introduction of new technologies or processes, and revenue growth because of
increased market penetration. Finally, examples of important valuation assumptions include the acquiring
firm’s target debt to equity ratio used in calculating the cost of capital, the discount rates used during the
forecast and stable growth periods, and the growth assumptions used in determining the terminal value.

9-11. Assume two firms have little geographic overlap in terms of sales and facilities. If they were to merge, how
might this affect the potential for synergy?

Answer: The potential for selling each firm’s products to the other firm’s customers (i.e., cross-selling) in
the absence of overlap could increase the combined firms’ aggregate revenue. However, the absence of
contiguous facilities could limit the opportunity for cost savings by sharing underutilized operations (e.g.,
closing one firm’s operations and moving its output to another nearby facility producing below its
capacity.).

9-12. Dow Chemical, a leading manufacturer of chemicals, announced in 2008 that they had an agreement to

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acquire competitor Rhom and Haas Company. Dow expects to broaden its current product offering by
offering the higher margin Rohm and Haas products. What would you identify as possible synergies

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between these two businesses? In what ways could the combination of these two firms erode combined

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cash flows?

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Answer: As competitors, the two firms should be able to generate sizeable cost savings by combining
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certain overhead functions such as sales, marketing, human resources, finance, engineering, R&D, etc. In
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addition, since they produce similar products, one could anticipate better utilization of existing facilities in
that products produced in underutilized facilities could be moved to other facilities to achieve better
economies of scale. Economies of scope realized by sharing common resources such as IT and R& D
centers also could provide significant efficiencies. Furthermore, cross-selling opportunities could exist for
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each firm to sell its products to the other’s customers. Some loss of cash flow could be experienced as a
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result of normal customer attrition during the integration period as product quality and delivery times
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suffer. Moreover, customers may choose to diversify their sources of supply by shifting a portion of what
they formerly purchased from these businesses to other suppliers. Finally, key employees will inevitably be
lost as competitors exploit the uncertainty experienced by the employees of these two companies.

9-13. Dow Chemical’s acquisition of Rhom and Haas included a 74 percent premium over the firm’s pre-
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announcement share price. What is the probable process Dow employed in determining the stunning
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magnitude of this premium?

Answer: To gain a controlling interest in the target, Dow had to determine the range of value for Rhom and
Haas between the firm’s current market value and the market value plus 100 percent of the net synergy
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resulting from combining the two firms. Dow could then determine how much of the difference in this
range it would have to share with Rohm and Haas’ shareholders in order to complete the transaction. This
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determination could be made by identifying what portion of the net synergy would be contributed by the
target and the multiples paid on recent comparable transactions.

9-14. For most transactions, the full impact of net synergy will not be realized for many months. Why? What
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factors could account for the delay?

Answer: The full effects of synergy are not realized immediately because of facility leases that must expire
or be bought out, severance expenses that offset savings that result from layoffs, management inertia,
employee resistance, morale concerns, the time required to sell redundant assets, and the tendency to
underestimate the time that is needed to implement savings programs. In addition, savings programs often
require retraining and relocating workers, which also offset some portion of the savings in the early years.

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 9-15. How does the presence of management options and convertible securities affect the calculation of the offer
price for the target firm?

Answer: While so-called “in the money” options (those whose exercise price is below the firm’s current
share price) and convertible securities (including preferred and debt) are likely to be converted to common
shares, “out of the money” options usually are convertible to common stock whenever a firm faces a
change in control. Assuming the buyer wishes to buy all outstanding target shares, the increase in the
number of shares outstanding will add to the dollar value of the purchase price. In an all-cash purchase, the
acquirer’s cash outlay to buy 100 percent of outstanding shares will increase; in an all-stock purchase, the
increase in the number of new acquirer shares issued will dilute the acquirer’s current shareholders’
ownership share of the combined businesses.

Practice Problems

9-16. Acquiring Company is considering the acquisition of Target Company in a stock for stock transaction in
which Target Company would receive $50.00 for each share of its common stock. The Acquiring
Company does not expect any change in its price/earnings multiple after the merger.

Acquiring Co. Target Co.

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Earnings available for $150,000 $30,000
common stock

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Number of shares of 60,000 20,000

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common stock outstanding

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Market price per share $60.00 $40.00

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Using the information provided above on these two firms and showing your work, calculate the following:
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a. Purchase price premium = Offer price for target company stock / Target Company market price per
share
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= $50.00 / $40.00
= 1.25 or 25% (i.e., 1.25 – 1.00)
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b. Exchange ratio = Price per share offered for Target Company / Market price per share for Acquiring
Company
= $50.00 / $60.00 = .8333 (i.e., Acquiring Company issues .8333 shares of stock
for each share of Target Company’s stock)
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c. New shares issued by Acquiring Company = 20,000 (shares of Target Company) x .8333 (Exchange
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ratio) = 16,666

d. Total shares outstanding of the combined companies = 60,000 + 16,666 = 76,666

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e. Post-merger EPS of the combined companies = ($150,000 + $30,000)/ 76,666 = $2.35

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f. Pre-merger EPS of Acquiring Company = $150,000 / 60,000 = $2.50

g. Post-merger share price = $2.35 x 24 (pre-merger P/E = $60.00/$2.50) = $56.40 (as compared to
$60.00 pre-merger)
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9-17. Acquiring Company is considering buying Target Company. Target Company is a small biotechnology
firm, which develops products that are licensed to the major pharmaceutical firms? Development costs are
expected to generate negative cash flows during the first two years of the forecast period of $(10) and $(5)
million, respectively. Licensing fees are expected to generate positive cash flows during years three
through five of the forecast period of $5, $10, and $15 million, respectively. Due to the emergence of
competitive products, cash flow is expected to grow at a modest 5 percent annually after the fifth year. The
discount rate for the first five years is estimated to be 20 percent and then to drop to 10 percent beyond the

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 fifth year. In addition, the present value of the estimated synergy by combining Acquiring and Target
companies is $30 million. Calculate the minimum and maximum purchase prices for Target Company.
Show your work.

Year Cash Flow Discount Rate Present Value

1 (10) 1.2 (8.33)
2 (5) 1.202 = 1.4400 (3.47)
3 5 1.203 = 1.7280 2.89
4 10 1.204 = 2.0736 4.82
5 15 1.205 = 2.4883 6.03
Present value = 1.94

Terminal Value = (15 x 1.05)/(.10-.05) = 15.75/.05 = 315 = 126.59

2.4883 2.4883 2.4883

Minimum Price = 126.59 + 1.94 = $128.5

Maximum Price = $128.5 + $30 = $158.5

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