Cours MA Private Equity

1
Mergers & Acquisitions, Private Equity
S9 GFC
ENCG Dakhla
2020-2021
Dr. Khalid EL BADRAOUI

Objectives
• Understand types of acquisitions.
• Explain why it may make sense for companies to merge.
• Estimate the gains and costs of mergers to the acquiring firm.
• Analyse the essential features of private equity and understand how

one can structure a private equity financing.
Road Book
• Background on M&As;
• Deal structuring;
• M&As valuation;
• Going private and Leveraged Buyouts (LBO)

transactions.
3
References
M&A:
• Bruner R. (2004) Applied Mergers and Acquisitions, Wiley.
• Gaughan, P. (2010) Mergers, acquisitions and corporate
restructurings, 5th edition, Hoboken, John Wiley & Sons.(*)
• Depamphilis, D. (2011) Mergers acquisitions and other
restructuring activities, 6th edition, Academic Press. (*)
• Sudarsanam S. (2010) Creating Value From Mergers And
Acquisitions, Prentice-Hall.
• Weston J.F. and Weaver S.C. (2001) Mergers and Acquisitions,
McGraw Hill.
Private Equity:
• Talmor, E. and Vasvari, F. (2011) International Private Equity,
John Wiley & Sons. (*)
* : eBook available
Background on M&As
Mergers and Acquisitions:
3 Types
A transaction where 2 firms agree to integrate their
Merger operations on a relatively co-equal basis;
A transaction where 1 firm buys another firm with

the intent of more effectively using a core
Acquisition competence by making the acquired firm a
subsidiary within its portfolio;
Takeover An acquisition where the target firm did not solicit

the bid of the bidder (acquiring firm).
•Mergers, acquisitions, takeovers are types of transactions that change the

ownership of firms.
•The words are often used interchangeably even though they mean
something very different.
•Merger sounds more amicable, less threatening.

Mergers Acquisitions & takeovers
• Parent stocks are usually • Can be a controlling share, a

retired and new stock issued. majority, or all of the target firm’s
stock.
• Name may be one of the
• Can be friendly or
parents’ or a combination.
hostile.
• One of the parents usually • Usually done through a tender
emerges as the dominant offer.
management.
•Friendly: The transaction takes place with the approval of each firm’s
management.
•Hostile: The transaction is not approved by the management of the target
firm.
•Tender offer: One firm offers to buy the outstanding stock of the other firm at
a specific price and communicates this offer to stockholders.
•Acquisition premium: Difference between the acquisition price and the
market price in friendly or hostile acquisitions.
Merger Classifications
• From an economic standpoint, mergers are often categorized as:
– Horizontal:
• Involve firms operating in similar businesses (competitors)
– i.e. Chevron and Texaco; Exxon and Mobil
– Vertical:
• Occur in different stages of production operations (buyer-seller
relationship)
– i.e. Time Warner and AOL
– Conglomerate:
• Firms are in unrelated business activities (not competitors and
no buyer-seller relationship)
– i.e. Philip Morris acquired (General Foods 1985, Kraft 1988
and Nabisco 2000).
Legal Forms of Acquisitions
• Merger  A Corp + B Corp = A Corp
– The complete absorption of one company by another, where the

acquiring firm retains its identity and the acquired firm ceases to
exist as a separate entity.
– In most cases, at least 50% of the shareholders of the target and
the bidding firm have to agree to the merger.
– (e.g. the acquisition of McDonnell Douglas by Boeing; Digital
Computers was absorbed by Compaq );
• Consolidation  A Corp + B Corp = New Co.
– A merger in which a new firm is created and both the acquired

and acquiring firms cease to exist. (e.g. Peco Energy and
Unicom merged to form the new utility firm Exelon in 2000);
Legal Forms of Acquisitions
(Cont.)
•Tender offer (Acquisition of Stock):
- The purchase of a firm’s voting stock in exchange for cash,

shares of stock, or other securities.
- Used to carry out hostile takeovers : it bypasses the
management and board of directors of the target firm.
- Most tender offers eventually become mergers, if the bidder
gains control of the target.
•Acquisition of Assets:
- A firm can effectively acquire another firm by buying most or all

of its assets and the target firm does not necessarily cease to
exist.
- Advantage: the bidder do not need the approval of its
shareholders. This is different from the position of the target:
shareholders may have to approve the sale.
Holding Companies
• Rather than a merger or an acquisition, the acquiring company may

choose to buy a portion of the target’s stock  Holding company.
• If an acquirer buys 100% of the target  Wholly owned subsidiary.
• It’s not necessary to own 100% to exert control over the target:
 > 50%  Exclusive control;

 = > 20%  Significant influence.
Holding Companies (Cont.)
• Advantages:
Advantages that may make HCs preferable to an outright acquisition:

– Lower cost
– No control premium
– Control with fractional ownership
– Approval not required
• Disadvantages:
HC form has also disadvantages:

– Multiple taxation
– Antitrust issues
– Lack of 100% ownership
Why Do It?
Theories and Reasons
There are several motives that firms might engage in M&As. The most
common reasons are:
•Increased Market Power

Acquisition intended to reduce the competitive balance of the industry.
i.e. British Petroleum’s acquisition of U.S. Amoco.
•Overcome Barriers to Entry

Acquisitions overcome costly barriers to entry which may make “start-
ups” economically unattractive.
i.e. Belgian-Dutch Fortis’ acquisition of American Bankers Insurance
Group.
•Lower Cost and Risk of New Product Development

Buying established businesses reduces risk of start-up ventures.
i.e. Watson Pharmaceuticals’ acquisition of TheraTech.
Why Do It?
Theories and Reasons (Cont.)
•Increased Speed to Market

Closely related to Barriers to Entry, allows market entry in a more
timely fashion.
Example: Kraft Food’s acquisition of Boca Burger.
•Diversification
Quick way to move into businesses when firm currently lacks
experience and depth in industry.
Example: CNET’s acquisition of mySimon.
•Reshaping Competitive Scope

Firms may use acquisitions to restrict its dependence on a single or
a few products or markets.
Example: General Electric’s acquisition of NBC.
Why Do It?
• Synergy (or efficiency):
–The positive incremental net gain associated with the
combination of two firms through a merger or an acquisition.
– Merger makes sense only if:
• VAB > VA + VB
– The incremental net gain from the merger is:

• V = VAB – (VA + VB)
• When V is positive, the merger is said to generate
synergy. If Firm A buys Firm B, it gets a company worth
VB plus the incremental gain V . Thus, the value of Firm
B to Firm A is: VB* = VAB – VA = VB + V
– How much should the bidder “A” pay for the target “B”?
At least VB. In this case the bidder shareholders keep
most benefits from merger.
At most VAB – VA. Here benefits accrue to target
shareholders.
Why Do It?
• There are 2 types of synergies: operating and financial.
– Operating synergies:
• Allow firms to increase their operating income and/or growth:
– Revenue enhancement: The combined firm may
generate greater revenues than two separate firms due
to:
• Marketing gains
• Strategic benefits (Talent, brands, business models,
relationships, reputation, ….)
• Market power
– Cost reductions: The combined firm may operate more

efficiently than two separate firms due to:
• Economies of scale (sharing of central facilities, such
as HQ)
• Economies of vertical integration (easier coordination
of activities)
• Complementary resources
– Operating synergies affect margins & growth affect value
of the firm.
Why Do It?
• Financial synergies refer to the impact of M&A on the cost of
capital and/or cash flows (CF) of the combined firms.
• Financial synergy  CF ↑ and cost of capital ↓
• Financial synergies can be due to:
– Risk decrease: The merger or acquisition lowers the volatility of
CF.
– Tax gains : The use of tax losses  a firm that loses money on
a pre-tax basis does not pay taxes, making it an attractive for a
partner with high tax liabilities.
– The use of unused debt capacity : when two firms combine
their earnings and cash flows they can borrow more than they
could have as individual entities, which generates tax shields
for the combined firm.
– The use of surplus funds: combination of a firm with excess
cash (and limited project opportunities) and a firm with high-
return projects (and limited cash)  higher value for the
17
combined firm.
Why Do It?
• Hubris hypothesis:
According to the hubris hypothesis (Roll, 1986), M&As occur
because of manager's overconfidence about expected
synergies from M&A which results in overpayment for the target
company.
Hubris hypothesis stipulates that managers seek to acquire the
target for their own personal motives and that the pure economic
gains to the bidder are not the sole motivation.
e.g: Vivendi and Messier’s hubris (see the case study).
• Executive compensation hypothesis:

Managers acquire other companies to increase their size  enjoy
higher compensations & profits. Managers motivations to build an
empire may lead to several acquisitions that end up destroy value
(e.g. WorldCom)
Why Do It?
• Undervaluation:
Firms that are undervalued by the market can be targeted for
acquisition. However, acquirer should take into account the
premium!
– Example: Assume that the estimated amount for a firm is $100

million and that the current market price is $75 million. In
acquiring this firm, the acquirer will have to pay a premium. If
that premium exceeds 33% of the market price, the price
exceeds the estimated value  the acquisition will not create
any value for the acquirer.
Why Do It?
• Earnings growth
Example -- Company A will acquire Company B with shares of

common stock.
Company A Company B
Present earnings $20,000,000 $5,000,000
Shares outstanding 5,000,000 2,000,000
Earnings per share $4.00 $2.50
Price per share $64.00 $30.00
Price / earnings ratio 16 12
Why Do It?
Example -- Company B has agreed on an offer of $35 in

common stock of Company A.
Surviving Company A
Total earnings $25,000,000

Shares outstanding* 6,093,750
Earnings per share $4.10
Exchange ratio = $35 / $64 = 0.546875
* New shares from exchange = 0.546875 x 2,000,000

= 1,093,750
Why Do It?
• The shareholders of Company A will experience an increase

in earnings per share because of the acquisition: $4.10 post-
merger EPS versus $4.00 pre-merger EPS.
• The shareholders of Company B will experience a decrease

in earnings per share because of the acquisition: 0.546875 x
$4.10 = $2.24 post-merger EPS versus $2.50 pre-merger
EPS.
• Surviving firm EPS will increase any time the P/E ratio “paid”
for a firm is less than the pre-merger P/E ratio of the firm
doing the acquiring. [Note: P/E ratio “paid” for Company B is
$35/$2.50 = 14 versus pre-merger P/E ratio of 16 for
Company A.]
Why Do It?
Example -- Company B has agreed on an offer of $45 in

common stock of Company A.
Surviving Company A
• Total earnings $25,000,000

• Shares outstanding* $6,406,250
• Earnings per share $3.90
Exchange ratio = $45 / $64 = 0.703125
* New shares from exchange = 0.703125 x 2,000,000

= 1,406,250
Why Do It?
• The shareholders of Company A will experience a decrease in

earnings per share because of the acquisition [$3.90 post-merger
EPS versus $4.00 pre-merger EPS].
• The shareholders of Company B will experience an increase in

earnings per share because of the acquisition [0.703125 x $3.90 =
$2.74 post-merger EPS versus $2.50 pre-merger EPS].
• Surviving firm EPS will decrease any time the P/E ratio “paid” for a
firm is greater than the pre-merger P/E ratio of the firm doing the
acquiring. [Note: P/E ratio “paid” for Company B is $45/$2.50 =
18 versus pre-merger P/E ratio of 16 for Company A.]
Why Do It?
• Question: What will new PER be?

• What if bought for cash?
• EPS = 25,000,000 = 5.00

5,000,000
• But
– PER?
– Where did the cash come from?
– What will increased leverage do to required rate of return?
Why Do It?
• Merger decisions should not

be made without considering
the long-term consequences. With the
Expected EPS ($)

• The possibility of future merger
earnings growth may outweigh
the immediate dilution of
Equal
earnings.
Without the
merger
Time in the Future (years)
Initially, EPS is less with the merger.

Eventually, EPS is greater with the merger.
Problems with M&As
•Integration Difficulties
Differing financial and control systems can make integration of
firms difficult.
Example: Intel’s acquisition of DEC’s semiconductor division.
•Inadequate Evaluation of Target
“Winners Curse” bid causes acquirer to overpay for firm.
Example: Marks and Spencer’s acquisition of Brooks Brothers.
•Large or Extraordinary Debt
Costly debt can create onerous burden on cash outflows.
Example: AgriBioTech’s acquisition of dozens of small seed firms.
Problems with M&As (Cont.)
•Inability to Achieve Synergy

Justifying acquisitions can increase estimate of expected benefits.
Example: Quaker Oats and Snapple.
•Overly Diversified
Acquirer doesn’t have expertise required to manage unrelated
businesses.
Example: GE prior to selling businesses and refocusing.
•Managers Overly Focused on Acquisitions
Managers may fail to objectively assess the value of outcomes
achieved through the firm’s acquisition strategy.
Example: Ford and Jaguar.
•Too Large
Large bureaucracy reduces innovation and flexibility.
Reasons for Problems in
Acquisitions Achieving Success
Increased Integration
market power Difficulties/Cultures
Overcome Inadequate
entry barriers evaluation of target
Cost of new Large or

product development extraordinary debt
Increased speed Inability to

to market M&A achieve synergy
Lower risk Too much

compared to developing diversification
new products
Increased Managers overly

diversification focused on acquisitions
Avoid excessive
competition Too large
History of M&As (Cont.)
Mergers have typically occurred in cyclical patterns: periods of
intense merger activity have been followed by intervening periods of
fewer mergers.
Period Events coinciding with beginning of wave Events coinciding with
end of wave
1890’s- 1903 Economic expansion; industrialisation processes; Stock market crash;
Wave introduction of new state legislations on incorporations; economic stagnation;
1 development of trading on NYSE; radical changes in beginning of First World
technology War
Wave 1910’s – 1929 Economic recovery after the market crash and the First Stock market crash;
2 World War; strengthen enforcement of antimonopoly beginning of Great
law Depression
Wave 1950’s – 1973 Economic recovery after the Second World War; Stock market crash; oil
3 tightening of anti-trust regime in 1950 crisis; economic
slowdown
1981 – 1989 Economic recovery after recession; changes in anti- Stock market crash
Wave trust policy; deregulation of fin. services sector; new
4 financial instruments and markets (e.g. junk bonds);
technological progress in electronics
Wave 1993 – 2001 Economic and financial markets boom; globalization Stock market crash;
5 processes; technological innovation, deregulation and 9/11 terrorist attack
privatisation
Wave 2003 - 2007 Economic recovery after the downturn in 2000–2001 Subprime crisis
6
Worldwide M&A environment
Global Announced M&A Activity — 1/1/1985 – 9/5/2006
3 500 45 000
Deal value (in billion $) 40 000

3 000
Nbr of deals
35 000
2 500
30 000
Number of deals
Deal value
2 000 25 000
1 500 20 000
15 000
1 000
10 000
500
5 000
0 Source: Thomson Financial 0

85
87
89
91
93
95
97
99
01
03
05
19
19
19
19
19
19
19
19
20
20
20
Top M&A deals worldwide by value (in mil. USD)

Top 10 M&A deals worldwide by value (in mil. USD) from 1990 to 1999:
Transaction value
Rank Year Purchaser Purchased
(in mil. USD)
1 1999 Vodafone Airtouch PLC Mannesmann 183 000
2 1999 Pfizer Warner-Lambert 90 000
3 1998 Exxon Mobil 77 200
4 1998 Citicorp Travelers Group 73 000
5 1999 SBC Communications Ameritech Corporation 63 000
6 1999 Vodafone Group AirTouch Communications 60 000
7 1998 Bell Atlantic GTE 53 360
8 1998 BP Amoco 53 000
9 1999 Qwest Communications US WEST 48 000
10 1997 Worldcom MCI Communications 42 000
Top 10 M&A deals worldwide by value (in mil. USD) from 2000 to 2008:
1 2000 America Online Inc. (AOL) Time Warner 164 747
2 2000 Glaxo Wellcome Plc. SmithKline Beecham Plc. 75 961
3 2004 Royal Dutch Petroleum Co. Shell Transport & Trading Co 74 559
4 2006 AT&T Inc. BellSouth Corporation 72 671
5 2001 Comcast Corporation AT&T Broadband & Internet Svcs 72 041
6 2004 Sanofi-Synthelabo SA Aventis SA 60 243
7 2000 Spin-off: Nortel Networks Corporation 59 974
8 2002 Pfizer Inc. Pharmacia Corporation 59 515
9 2004 JP Morgan Chase & Co Bank One Corp 58 761
10 2008 Inbev Inc. Anheuser-Busch Companies, Inc 52 000
• Interestingly M&A seems to increase in years when stock market

does well  This phenomenon is counter to what we would expect if
the primary motive for acquisitions was “undervaluation”.
• Mergers also tend to be concentrated in a few sectors:
– In the early 1980s: oil companies;

– In the latter of 1980s: food and tobacco companies;
– In the early 1990s: financial firms;
– In the later of 1990s: TMT companies.
Measurement of M&As Profitability:
Empirical Evidence
• M&A success is measured by looking at the firm’s returns and
comparing with a benchmark.
• The benchmark for measuring M&A performance is investors’
required returns (E(Ri)), commonly defined as the return investors
could earned on other investment opportunities.
• Against the benchmark we can see 3 possible outcomes:
Ri < E(Ri) Ri = E(Ri) Ri > E(Ri)
Value is destroyed Value is conserved Value is created

Measurement of M&As Profitability:
Empirical Evidence (Cont.)
• The evidence suggests that bidders generally realize zero NPV

on their M&A transactions.
• In contrast, target shareholders appear to realize most (if not all)

of the benefits resulting from the M&A transaction.
Average acquisition premium and stock price reactions to M&A
Premium paid over Announcement price reaction

premerger price
Target Acquirer
38% 16% -1%
Source: Data based on 4256 deals from 1973 to 1998. Andrande, Mitchell and Stafford, “New Evidence and Perspectives on
Mergers”, Journal of Economic Perspectives 15(2) (2001): 103-120.
Measurement of M&As profitability:
Empirical evidence (Cont.)
• In efficient markets, the stock market reaction on the day of the
merger announcement represents the NPV of the transaction.
• Generally, bidder stock prices remain unchanged or even drop
when an acquisition is announced. Historically bidding firm
stock prices fall more often than increase.
• Target stock prices, however, increase by about 20% on the
announcement day.
Target
ABNORMAL RETURN (%)
CUMULATIVE AVERAGE
0 Bidder
- TIME AROUND ANNOUNCEMENT

(days)
Announcement
date
Measurement of M&As profitability:
Empirical evidence (Cont.)
•A good example is the market reaction to Exxon/Mobil merger.
Cumulative Abnomal Re turns around Merger

Announcement
20.00% Bidder
Target 15.00%
CAR (%)
10.00%
EXXON
MOBIL
5.00%
0.00%
-5 -4 -3 -2 -1 0 1 2 3 4 5
-5.00%
Day relative to announcement day
Where M&A Pays and When it Strays
Returns to buyers likely will be Returns to buyers likely will be

higher if lower if
1. Strategic motivation 1. Opportunistic motivation
2. Value acquiring 2. Momentum growth/ Glamour acquiring
3. Focused/related acquiring 3. Lack of focus/ Unrelated diversification
4. Credible synergies 4. Incredible synergies
5. To use excess cash profitability 5. Just to use excess cash
6.Negotiated purchase of private firms 6. Auctions of public firms
7. Cross borders for special advantage 7. Cross borders naively
8. Go hostile 8. Negotiate with resistant target
9. Buy during cold M&A markets 9. Buy during hot M&A markets
10. Pay with cash 10. Pay with stock
11. High tax benefits to buyer 11. Low tax benefits to buyer
12. Finance with debt judiciously 12. Over-lever
13. Stage the payments (Earnouts) 13. Pay fully up-front
14. Merger of equals 14. Not a merger of equals
15. Managers have significant stake 15. Managers have low or no stake
16. Active investors 16.Passive investors
Takeover Defenses
Takeover defenses are intended to either prevent the transaction from

taking place or to increase the offer.
– Pre-offer mechanisms are triggered by changes in control,

generally making the target less attractive.
– Post-offer mechanisms tend to address ownership of shares and

reduce the hostile acquirer’s power gained from its ownership
interest in the target.
Takeover Defenses (Cont.)
Pre-Offer Takeover Defense Mechanisms

• Poison Pills
– A defense against a hostile takeover
• It is a rights offering that gives the target shareholders the
right to buy shares in either the target or an acquirer at a
deeply discounted price.
• Because target shareholders can purchase shares at less
than the market price, existing shareholders of the acquirer
effectively subsidize their purchases, making the takeover so
expensive for the acquiring shareholders that they choose to
pass on the deal.
• Goodbye Kiss / Greenmail / Bon Voyage Bonus:
– It’s the money paid by the target to the raider that has already
purchased a majority of the target shares. The target is forced to
repurchase these shares at a substantial premium to stop the
takeover bid.
• Golden Parachute
– An extremely lucrative severance package that is guaranteed to
a firm’s senior management in the event that the firm is taken
over and the managers are let go.
– If a golden parachute exists, management will be more
likely to be receptive to a takeover, lessening the likelihood of
managerial entrenchment.
• Restrict the voting rights of very large shareholders.
• Require a supermajority (sometimes as much as 80%) of votes

to approve a merger.
Post-Offer Takeover Defense Mechanisms
• White Knight
– A target company’s defense against a hostile takeover
attempt, in which it looks for another, friendlier company to
acquire it.
• White Squire
– A variant of the white knight defense, in which a large,
passive investor or firm agrees to purchase a substantial
block of shares in a target with special voting rights.
• “Pac-Man” Defense
– The target firm turns around and tries to acquire the other
company that has made the hostile takeover attempt.
• Leveraged Recapitalization
– With recapitalization, a company changes its capital structure
to make itself less attractive as a target.
– For example, companies might choose to issue debt and then
use the proceeds to pay a dividend or repurchase stock.
Deal Structuring
Deal Structuring
• Deal structuring involves:
– Methods of payment
– Exchange ratio
– Control premium
– Contingent Payout: Earnout
– Accounting methods
– Due diligence
M&A Financing
• M&A may be paid for in 3 ways: cash; stocks; hybrids
(combination of cash and stocks).
• Cash offering
– Cash offering may be cash from existing
acquirer balances or from a debt issue.
• Securities offering
– Target shareholders receive shares of
common stock, preferred stock, or debt of
the acquirer.
– The exchange ratio determines the
number of securities received in exchange
for a share of target stock.
• Factors influencing method of
payment:
– Sharing of risk among the acquirer and
target shareholders.
– Signaling by the acquiring firm. Based on data from Mergerstat Review, 2006.
– Capital structure of the acquiring firm. FactSet Mergerstat, LLC (www.mergerstat.com).
– Size of the transaction (The method of
payment in the largest transactions is
predominately stock for stock)
M&A Financing (Cont.)
Total value of M&A in US by Total value of M&A in EU by

payment method (1990-2007) payment method (1990-2007)
M&A Financing (Cont.)
The distinction between cash and stock financing in a merger is an

important one:
•If cash is used, the cost of an acquisition is not dependent on

the acquisition gains, and the selling firm’s shareholders do not
participate in the potential gains (or losses) of the merger.
•If common stock is used, then the selling firm’s shareholders

share in the potential gains (or losses) of the merger.
•Acquisition by cash usually results in a taxable transaction,

while acquisition by exchanging stock is generally tax free.
•Acquisition by cash does not affect the control of the acquiring

firm. Acquisition with voting shares does affect it.
Sale of Assets for Cash
Target Bidder
Shareholders Shareholders
Target Bidder
Target Assets Bidder Assets

and Liabilities and Liabilities
Sale of Assets for Cash (Cont.)
Target Bidder
Assets
Target Bidder
Cash +
Target Assets Assumption Bidder Assets
and Liabilities of Selected and Liabilities
Liabilities
Target Bidder
Target Bidder
Cash Bidder Assets

Remaining Liabilities and Liabilities
Target Assets
Selected Liabilities
Target Bidder
Cash
DISSOLUTION
Target Bidder
Cash Bidder Assets

Remaining Liabilities and Liabilities
Liabilities Target Assets
Paid Selected Liabilities
Target Bidder
Cash
Bidder
Bidder Assets
and Liabilities
Target Assets
Selected Liabilities
Stock-for-Stock Merger
Target Bidder
Target Bidder
Target Assets Merger Bidder Assets

and Liabilities and Liabilities
Stock-for-Stock Merger (Cont.)
Target Bidder
Shareholders Target shares Shareholders
become Bidder
shares
Target Assets and

Bidder
Liabilities
Target Assets (by operation Bidder Assets
and Liabilities of law) and Liabilities
Stock-for-Stock Merger (Cont.)
Old Target Bidder

Bidder
Bidder Assets
and Liabilities
Target Assets
and Liabilities
The Exchange Ratio in a Stock for Stock
Exchange
• Exchange Ratio: The number of shares the target shareholders
receive from the acquiring firm in exchange for their current
shares.
Exchange Ratio = Value per Share of Target Firm (with control premium)
Value per Share of Bidding Firm
• Example: SDC is buying GLM in a stock transaction. Terms of deal are

as follows:
– Bidder stock price:€125
– Target stock price: €90
– Control premium: 25%
• Calculate the exchange ratio?
• If SDC and GLM have respectively 120,000 and 100,000 shares
outstanding, how many new shares the acquirer should issue to
purchase the target?
Exchange (Cont.)
• Exchange ratio: [90 + 25% * 90]/125= 0.90 share.

• The terms of the deal gave 0.90 share of GLM for 1 share of SDC.
• SDC should increase its capital through issuing 0.90 * 100,000 =
90,000.
Ownership following the acquisition will be:
Shares Out Exchange Shares in

Ratio NewCo %
GLM 100,000 0.90 90,000 43%
SDC 120,000 1.000 120,000 57%

Exchange (Cont.)
• If the exchange ratio is set too high, there will be transfer of

wealth from the bidding firm’s stockholders to the target firm’s
stockholders.
• If the exchange ratio is set too low, there will be transfer of wealth
from the target firm to the bidding firm’s stockholders.
Control Premium
• Control premium is an amount that a buyer is usually willing to

pay over the current market price of a publicly traded company.
• This premium is justified by the expected synergies, such as the

expected increase in cash flow resulting from cost savings and
revenue enhancements achievable in the merger.
• Normally, the control premium is industry-specific and amounts to

20–30% of the MC of a company calculated based on a 20
trading days average of its stock price
Control Premium (Cont.)
Example
• Company XYZ has 1,000,000 shares outstanding. The 20 day

average price per share is $1. To buy control, an acquirer usually
needs to consolidate more than 50% of the shares. Say, the buyer
wants to acquire 60% of the stock.
• The market price will be 600,000 * $1.00 = $600,000. However, the

buyer estimates that he will be able to realize 25%-synergy, so the
maximum price he is willing to pay is:
$600,000 * (1 + 25%) = $750,000

• The formula of the control premium is:
SACQ x Exch. Ratio – STGT

STGT
Example:
In the case of the acquisition premium will be calculated as follows:
(125 x 0.90 – 90) / 90 = 25%

• Minimum Required Economic Gains : Total value of premium paid

to target shareholders. From the prior example:
(€125 x 0.90 – €90) x 100,000 shares = €2,250,000
• This is the minimum value that must be created in the deal to make
the acquirer’s shareholders as well off as they were before the deal.
Case Example:
Crédit Lyonnais- Crédit Agricole Merger (2002)

Contingent Payout: Earnout
• Earnout provides additional payments to acquired firms based

on their future performance.
• Earnout transactions account for about 2-3% of total deals.
• Most acquired companies in such transactions are small

privately held companies.
• Some empirical studies (e.g. Kohers and Ang, 2000) report that
the returns to buyers are higher when the payment is structured
to be contingent on meeting future performance benchmarks.
Volume of deals involving Earnouts by year, and in comparison to all deals
Earnout deals % Payment due
to Earnout
Year Total value ($ Mil) % all deals Number % all deals
1985 4,47$ 0.4% 8 1.3% 51%
1986 2,081$ 0.9% 15 1.2% 26%
1987 1,697$ 0.9% 15 1.1% 44%
1988 1,795$ 0.7% 26 1.5% 54%
1989 2,775$ 0.9% 52 2.4% 24%
1990 1,438$ 0.8% 53 2.6% 21%
1991 2,254$ 1.8% 55 2.8% 30%
1992 1,273$ 1.1% 61 2.7% 40%
1993 4,332$ 2.5% 89 3.4% 21%
1994 1,990$ 0.7% 92 2.7% 88%
1995 7,150$ 1.8% 86 2.3% 27%
1996 8,832$ 1.5% 85 2.0% 19%
1997 11,712$ 1.7% 144 3.1% 29%
1998 9,845$ 0.8% 167 3.5% 28%
1999 13,562$ 0.9% 163 1.7% 21%
2000 26,028$ 1.6% 174 1.9% 23%
2001 15,645$ 2.2% 151 2.4% 27%
2002 8,089$ 2.1% 150 2.6% 29%
Source: SDC, M&A database
Contingent Payout: Earnout (Cont.)
Examlpe 1:
• Say an entrepreneur selling a business is asking $2,000,000 based
on projected earnings, but the buyer is willing to pay only
$1,000,000 based on historical performance.
• An Earnout provision structures the deal so that the entrepreneur
receives more than the buyer's offer only if the business achieves a
certain level of earnings. The exact numbers would depend upon the
business, but in this example a simplified provision might set the
purchase price at $1,000,000 plus 5% of gross sales over the
next three years.
• The Earnout thereby helps eliminate uncertainty for the buyer.
Example 2:
Company X has posted an EBITDA of $4 million the last fiscal year.
The seller values the company at $20 million (a valuation multiple 5x
EBITDA). The M&A buyer believes the valuation is $18 million (a
valuation multiple of 4.5X EBITDA). The lower valuation is due to the
buyer’s concern that future EBITDA might be less than $4 million.
Therefore, the valuation gap between the seller and buyer is $2 million.
The earn-out might be structured so that the Seller receives an earn-

out payments of $1 million per year for two years if the EBITDA
exceeds $4 million for the year.
• Potential benefits of using Earnout:
– Bridging the valuation gap: The most common reason for using
an Earnout is to bridge the gap between the buyer’s and the
seller’s evaluation of the intrinsic value of the target.
– Retention of target managers: If a portion of the purchase price

is subject to performance goals after the closing, the target’s
managers (who are also shareholders) will have an incentive to
remain with the target in order to participate in the potential
future payment.
– Motivation of managers: Earnouts may be used to motivate the

target’s managers to continue the target’s aggressive growth
after closing the sale.
• Potential disadvantages of using Earnout:
– Complexity of definition: It’s difficult to create effective earnout

formulas. While the earnout concept may be simple, objective
numerical definitions can easily become complex.
– Managers don’t own a significant Earnout claim. Earnout may

not sufficiently motivate target management if they do not
receive a sizable earnout claim on future performance. (For
example management owns only 1 percent of the shares)
Accounting Aspects
Merger and acquisition accounting is done either by:
– The purchase method: requires that the actual transaction price

should be reflected in financial statement of the combined firm.
– or pooling of interests method: accounts are combined using
historical cost data.
Differences between these two accounting methods are discussed in

the following slides.
Accounting Aspects (Cont.)
• Pooling of interest approach:
– It can be used if payment is made in the form of acquirer’s stock.
– The balance sheet of the merged firm is nothing more than the
two separate balance sheets added together.
Example
Let’s illustrate this method by an actual case: Down Chemical / Union
Carbide merger (1999).
The following table presents the pro forma balance sheet taken from
the proxy to shareholders in the Down Chemical / Union Carbide
merger (figures are displayed in millions of $):
Dow Chemical Union Carbide Combined pro

+ = forma
(Acquirer) (Acquired)
Total assets 23,105 7,465 30,570
Total liabilities 15,411 5,024 20,435
Net stockholders’ equity 7,694 2,441 10,135
Total liabilities & equity 23,105 7,465 30,570
Balance sheet of the combined company is generated by adding

up items.
• Pooling of interests is therefore quiet simple

• It’s also attractive : No GW is created that will be tested for
impairment (↓ charges  ↑ Net income)
• But … pooling of interests method is prohibited by IFRS and in many

countries.
• …. Why?
The mean reason  This method simply added historical numbers

without reflecting the current realities that had been revealed by the
transaction.
• Purchase accounting method:
– Historically, under the purchase of assets method, the acquiring

firm buys the target firm using cash.
– FASB announced on 12/15/01 that all business combinations

must use the purchase method for financial reporting purposes.
– If the acquiring firm pays a premium over the target firm’s book
value (e.g. for intangible assets, such as a promising new
technology developed by the target), the difference is booked
against goodwill.
– Goodwill has to be tested for impairment => Eventual impairment

losses reduce reported income, which most firms do not like and
that is why the pooling of interests method is typically preferred.
• Requirements:
– Record target firm’s tangible and intangible assets and

assumed liabilities at fair market value on acquiring firm’s
balance sheet.
– Record the excess of the price paid (PP) over the target’s net
asset value (i.e., FMVTA - FMVTL) as goodwill (GW) on the
acquirer’s balance sheet, where FMVTA and FMVTL are the
fair market value of total acquired assets and liabilities.
• These relationships can be summarized as follows:
– Purchase price distribution: PP = FMVTA– FMVTL+ FMVGW

– Goodwill estimation: FMVGW = PP – FMVTA + FMVTL
= PP - (FMVTA - FMVTL)
Purchase Method of Accounting
Example1
The Acquirer purchases the Target firm for $1,250 in cash on June 30,
2006.
Target Firm
Acquirer Pre- Target Firm (Fair Market
Merger (Book Value) Value)
Current assets 10 000 1 200 1 300
Long-term assets 6 000 800 900
Goodwill
Total Assets 16 000 2 000 2 200
Current liabilities 8 000 800 800

Long-term debt 2 000 200 250
Common stock 2 000 400 1 250
Retained earnings 4 000 600
Total Claims 16 000 2 000 2 300
Example 1 (Cont.)
Goodwill = Acquirer
Price paid – MV
Value preofmerger
Target+firm Equity
Target Firm (FMV) = Acquirer Post Merger
= $1,250 – (MV of target assets – MV of target Liabilities)

= $1,250 – ($2,200 - $1,050) Target Firm
Acquirer Pre- Target Firm (Fair Market Acquirer Post
= $100
Merger (Book Value) Value) Merger
Current assets 10 000
Book 1 200 1 300 11 300
Long-term assets 6 000 Values800 900 6 900
Goodwill are not 100
Total Assets 16 000 relevant.
2 000 2 200 18 300
Current liabilities 8 000 800 800 8 800

Long-term debt 2 000 200 250 2 250
Common stock 2 000 400 1 250 3 250
Retained earnings 4 000 600 4 000
Total Claims 16 000 2 000 2 300 18 300
Accounting aspects (Cont.)
• Goodwill is subject to an impairment test each year.
• This will require FMV estimating using discounted cash flow

approaches annually following the acquisition and capitalization of
Goodwill on the balance sheet.
• Goodwill is changed only if it is ‘impaired’ in subsequent years

resulting in a write down and a charge against earnings.
Example 2
Assume Acquiring Company pays $26 million for all of the
outstanding stock in Target Company.
The FMV of the Target Company’s tangible assets is $9.00 million
and intangible assets is $5 million. The FMV of assumed liabilities is
$1 million.
Estimate the value of goodwill that must be shown on the balance
sheet of the combined companies.
Purchase Price $26.00

- FMV of tangible assets $9.00
- FMV of intangible assets $5.00
+ FMV of assumed liabilities $1.00

= FMV of Goodwill $13.00
Example 3
B/S Example:
Prior to Merger Adjust B to B as Purchase Price Combined
A B Fair Value Adjusted Allocation A and B
Assets
Current assets $ 200 $ 100 10a $ 110 (100)g $ 210
b
Net plant and equipment 200 100 50 150 - 350
c
Goodwill 100 50 (50) - 130h 230
Total assets $ 500 $ 250 $ 260 $ 790
Liabilities and Shareholders' Equity
Current Liabilities $ 50 $ 30 - $ 30 - $ 80
d
Long-term debt 100 100 (5) 95 100g 295
Deferred taxes 100 40 25e 65 - 165
Total liabilities $ 250 $ 170 $ 190 $ 540
Common equity 250 80 (10)f 70 (70) 250
Total liabilities and shareholders' equity $ 500 $ 250 $ 260 $ 790
Transaction Assumptions
A acquires B
Each share of B is exchanged for $24 cash
Total transaction size is $200, which A raises by issuance of $100 in long-term debt and $100 in excess cash
Example 3 cont’d
• Purchase Method of Accounting. B/S Example:
Notes on B/S:
- a Since B is on LIFO, B’s B/S understates the value of B’s inventory
by $10
- b B’s fixed assets are worth 50% more as a result of long-term
inflation effects
- c Goodwill incurred by B in its own past acquisitions has no
identifiable value and therefore is eliminated
- d B’s outstanding fixed-rate debt is worth less today because of
general interest rate rises. It therefore must be revalued at a
discount
- e B’s deferred tax liabilities are increased by the tax effect on
timing differences arising from valuation adjustments, which creates
an additional deferred tax provision of $25 (at a 38% tax rate)
Notes on B/S: (cont.)
- f This is a balancing adjustment reflecting the net effect on the fair
value of B’s common equity
- g Transaction price of $200 is financed by $100 in excess cash and

$100 in new long-term debt
- h Goodwill incurred is aggregate price paid ($200) less fair value of

net assets acquired ($70)
• Purchase Method of Accounting. Income Stat. Example:
Projected Income
Statements in
Absence of Mergers Purchase Accounting Combined
A B Adjustments A+B
Sales $ 300 $ 120 (10)a $ 410,0

Cost of Sales (100) (50) 8.4b (158,4)
Selling General and admin. Expenses (100) (40) (140,0)
Interest Expense (20) (14) 11.0c (45,0)
Income before taxes $ 80 $ 16 $ 66,6
Income taxes (32) (6) (11.8)d (26,2)
Net Income $ 48 $ 10 $ 40,4
EPS $ 1,20 $ 1,20 1,01
Dividends per share $ 0,50 $ 0,30 0,5
Number of shares outstanding 40 8,3 40,0
Market Assumptions
Stock price per share $ 12 $ 24 $ 12,0
P/E Ratio 10 20 11,9
Total Market Value $ 480 $ 200 $ 480,0
Dividend Yield 4,20 1,30 4,2
Credit Statistics
Long-term debt capitalization (see B/S) 29% 56% 54%
Interest Coverage 5,0 2,1 2,4
Transaction Assumptions
A acquires B
Each share of B is exchanged for $24 cash
Total transaction size is $200, which A raises by issuance of $100 in long-term debt and $100 in excess cash
Notes on Income Statement:
- a Interest Income forgone on $100 of excess cash (at 10%)
- b Increased depreciation on B’s fixed assets’ $50 increase,
amortized over remaining life of six years
- c Increased expense: $100 new debt, financed at 10%. In addition,

amortization of debt discount will generate another $1 of interest
expense
- d Income tax effect of all purchase accounting adjustments other

than goodwill at 40%
Due Diligence
• Process of investigating the details of a potential target and

the industry within which it operates.
• Once the acquirer has a target company in its sights, there is

a thrill in the chase.
• However this should not blind the acquirer
– to the importance of achieving a clear appreciation of the

target company
– and the environment in which it is located.
• Due diligence allows the buyer to be better prepared for the

negotiations and assess risks effectively .
Due Diligence (Cont.)
Due diligence can be divided into 2 types:
External due diligence Internal due diligence

(Conducted before the deal) (Conducted through the deal)
•Operational (business description,

•Economic analysis
marketing, customers, suppliers, sales,
•Industry analysis and …)
trends: historical and
•Financial: profitability, cash-flows,
forecasted growth,
capitalization, financial statements, tax,
competition, innovation,
…
regulation, …
•Accounts and accounting policies
•Technology
•Products
•Legal issues
•Human resources
Merger & Acquisition Process in a Public Offering
 Seller Announces Public Offering of Target &

Pre-Due Diligence
Marketplace considers its interest in Target.

Activities
 Prospective Buyers contact Seller for more data in

order to perform Valuation of Target.
 Buyers make Conditional Bids for Target.

Due
Diligence  Qualified Buyers perform Due Diligence.
Post-Due  Remaining Buyers make Binding Offers.

Diligence
Pre-Due Diligence Activities
 Market Considers Target: Using public information and general

knowledge of Target, Buyer considers if Target might represent a
good fit. Factors include (among others):
• Size / Lines of Business / Geographic Mix.

• Distribution Channel(s).
• Historic Profitability, including Cost Structure.
• Market Perception / Target’s Reputation & Brand.
• Technology / Competitive Advantages.
 Valuation: Interested Buyers approach Seller for non-public

information about Target. In addition to Target’s intrinsic value,
Buyers look for potential enhancements, synergies, +/or
diversification to existing operations to estimate value added
upon acquiring Target.
• Product
• Distribution
• Production
• Service
 Conditional Bid: Buyer offers Seller a price based upon its

own Valuation of Target.
– Having estimated its own economic “Value in Use” of the

Target, Buyer submits to Seller a conditional offer to
purchase, pending a Due Diligence audit to validate the
assumptions underlying its Valuation.
So, what is left for Due Diligence?
 Due Diligence: A process of examination by the prospective

buyers to validate the assumptions underlying their conditional
bids.
• Business strategies and operating models

• Historic results
• Perceived competitive advantages
• Cash Flow Projections
• Look for overstatements and sugar coatings
Post-Due Diligence Process
 Final Bids: Buyer refines conditional bid with information

gathered in Due Diligence.
– Final Bid reflects changes to assumptions underlying Future

Cash Flow estimates.
– Bid may still include conditions that must be agreed to and
met by Seller.
– Seller selects winning bid and begins negotiations with Buyer
to finalize deal.
Valuation in M&A
Valuation in M&A
• Valuation is a critical part of the merger process.

• Its purpose is to provide a disciplined procedure for arriving at a
price:
– If the buyer offers too little, the target may resist and seek to
interest other bidders.
– If the price is too high, the premium may never be recovered
from post merger synergies
Valuation in M&A
The acquiring firm shareholders want

to minimize the amount paid to target
shareholders, not paying more than
the pre-merger value of the target plus
the value of the synergies.
The target shareholders want to

maximize the gain, accepting nothing
below the pre-merger market value.
Analysis
Remember: M&A increase value only when :
VB
Combined entity:
VBT > +
VT
More formally: NVI = VBT – (VB+VT)
Where: NVI  Net value increase

VB value of bidder alone
VT  value of target alone
VBT  value of firms combined
Let’s Illustrate Through a Simple Example
• Company B (the bidder) has a current MV of €40 million

• Company T (the target) has current MV of €40 million
• The sum of the values as independent firms is €80 million
• Assume that as combined company synergies will increase the
value to €100 million
• The amount of value created is: €20 million. How will this value be
divided?
– If the bidder pays a premium < €20 million => It will share in the
value ↑.
– If the bidder pays a premium > €20 million => The value of the
bidder will ↓.
The Use of Stocks in M&A
• High % of M&A transactions beginning in 1992 has been stock
for stock transactions.
• Some hold the view that this does not represent real money. But
this is not valid!!!!
Example:
• Scenario 1: B exchanges 1 of its shares for 1 share of T.
• Since the combined firm is valued €100, T will receive 0.5 x €100
= €50
Ownership
Pre-merger Post-merger
B =50% T=50% B =50% T=50%

The Use of Stocks in M&A (Cont.)
• Scenario 2:
– If B exchanges 1.5 of its own shares per share of T.

– This is equivalent to paying €60 million to the target.
– Target shareholders will own 60% of the combined company.
– The bidder will receive 0 synergy gains.
Ownership
B =50% T=50% B =40% T=60%

The Use of Stocks in M&A (Cont.)
• Scenario 3:
– The bidder pays more than €60 for the target.

– Assume B pays €70 for the target  1.75 to 1 shares
– Since the value of the combined firm is €100, the value
of the bidder shares must decline from €40 to €36.36
Ownership
B =50% T=50% B =36.36% T=63.64%
Valuation Methods
• 4 major valuation methods
– Comparable firms approach (or Multiples approach).

– Comparable transactions approach
– Discounted Cash Flows (DCF).
– The sum of the parts.
Comparable Firms (or Multiples) Approach
• Comparable firms approach  Similar companies should sell for

similar prices.
• The value of the company is derived by applying a certain multiplier to
the company’s profitability parameters.
• Multiples depend on expected growth, risk and interest rates.
• Higher expected growth, low risk in the company’s sector and low
interest rates will all push multiples higher
• The approach is comparative. Multiples can derive from a sample of

comparable companies.
• To test for comparability, we consider (among other variables): size,
similarity of products, age of company, growth rates, recent trends.
• This method is widely used by investment bankers
Multiples Approach (Cont.)
Select Comparable Companies

• Publicly traded companies that are similar to the subject company
• Same or similar industry
Calculate Relative Value Measures

• Enterprise value multiples
• Price multiples
Apply Metrics to Target

• Judgment needed to select appropriate metric
Estimate the Offer Price

• Control premium added
• These multiples result from comparing a market value with

accounting figures, the two must be consistent.
• The enterprise value must be compared with an operating data,

such as turnover or EBIT.
• The value of equity capital must be compared with a figure after

interest expense, such as net profit or cash flow.
• For market multiples, a peer group comparison consists in setting

up a sample of comparable, listed companies that have similar
sector characteristics, but also similar operating characteristics,
such as ROCE and expected growth rates
Enterprise value
multiples (the value of
capital employed)
Indirect approach
=> EBITDA multiple;
Revenue multiple, FCF
multiple, …
There are two
major groups of
multiples
Direct approach Value of equity

capital multiples
=> P/E ratio; Price to
Book ratio; Price to
Cash Flow ratio, …
Multiples, Indirect Approach (Cont.)
EBITDA multiples (indirect approach)
• EBITDA it enables us to compare the genuine profit-generating

capacity of the various companies
• A company’s genuine profit-generating capacity is the normalised

operating profitability it can generate year after year, excluding
exceptional gains and losses and other non-recurring items
EV
EBITDA MULTIPLE 
EBITDA
• The value of the firm is calculated as the product of its

EBITDA and the EBITDA multiple of (a) similar
company(ies).
EV  EBITDA MULTIPLE Similar companies  EBITDA
• The value of the equity is the difference between the values

of the firm and net debt:
Vequity  EV  Net debt

Other multiples
• Operating multiples can also be calculated on the basis of

other measures, such as turnover, FCF or EBIT.
• Some industries have specific multiples, such as multiples of
the number of subscribers, number of visitors or page views
for Internet companies, tonnes of cement, etc
• These multiples are particularly interesting when the return
on capital employed of the companies in the sample is
standard.
• Are generally used to value companies that are not yet
profitable (used during the Internet bubble)
• They tend to ascribe far too much value to the company to
be valued.
Multiples, Direct Approach
Equity value multiples
• These multiples include
• P/E ratio
• Price to Book ratio
• Price to Cash Flow ratio
• These multiples use market capitalization at the valuation

date (or price paid for the equity for transaction multiples)
as their numerator.
110
Multiples, Direct Approach (Cont.)
Equity value multiples
• The denominators are net profit, book equity or cash flow.
• The net profit used by analysts is the company’s bottom

line restated to exclude exceptional items and the
amortization of goodwill.
• These multiples indirectly value the company’s financial

structure, thus creating distortions depending on whether
the companies in the sample are indebted or not.
111
• Ratios:
Market Capitalisation  Market Price per share 

P/BV =  = 
Equity Book value  Equity Book value per share 
Market Capitalisation  Market Price per share 

P/E =  
Earnings  Earnings per share 
Market Capitalisation
P/CF =
Cash flow
112
• The value of the firm is then computed as follows
Vequity =P/BVsimilar company Book Value
Vequity =P/Esimilar company Earnings
Vequity =P/CFsimilar company CF

EV/EBIT, EV/EBITDA, P/E, … for some European countries
Source: MSCI, Worldscope, IBES, Morgan Stanely

114
Example 1:
We are seeking to place a value on company W and we find
three companies that are comparable: A, B and C.
Ratio Company A Company B Company C Average

EV/Revenues 1.4 1.2 1.0 1.2
EV/EBITDA 15.0 14.0 22.0 17.0
EV/FCF 25.0 20.0 27.0 24.0
Application of valuation ratios to company W
Data for company W (in millions) Average ratio EV

Revenue €100 1.2 €120
EBITDA €7 17 €119
FCF €5 24 €120
Average €120
Example 2: Suppose an analyst has gathered the following information on the

target company, the XYZ Company:
XYZ Company Average of Comparables

Earnings $10 million P/E of comparables 30 times
Cash flow $12 million P/CF of comparables 25 times
Book value of equity $50 million P/BV of comparables 2 times
Sales $100 million P/S of comparables 2.5 times
If the typical takeover premium is 20%, what is the XYZ Company’s

value in a merger using the comparable company approach?
Example: Comparable Company Analysis
Assuming that the average of the values from the different multiples is
most appropriate:
Comparables’ Estimated
Multiples Stock Value
Earnings $10 million × 30 $300 million
Cash flow $12 million × 25 $300 million
Book value of equity $50 million × 2 $100 million
Sales $100 million × 2.5 $250 million
Average = $237.5 million
Estimated takeover price of the XYZ Company

= $237.5 million × 1.2 = $285 million
Advantages
Multiples approach is widely used in practice because:

– It can be used to value non-quoted companies => To predict what
the publicly traded price is likely to be.
– It can be used by both the buyer and the seller in M&A to confirm
that the price is fair compared to the values of other companies.
Disadvantages
– Sensitive to market mispricing
– Sensitive to estimate of the control premium, and historical
premiums may not be accurate to apply to subsequent mergers
– Does not consider specific changes that may be made in the target
post-merger
Comparable Transactions Approach
Collect
information on Calculate Estimate the
recent multiples for target Value
transactions of comparable based on
comparable companies multiples
companies
Comparable Transactions Approach (Cont.)
Example:
Suppose an analyst has gathered the following information on the
target company, the MNO Company:
Average of Multiples of
MNO Company Comparable Transactions
Earnings $10 million P/E of comparables 15 times
Cash flow $12 million P/CF of comparables 20 times
Book value of equity $50 million P/BV of comparables 5 times
Sales $100 million P/S of comparables 3 times
Estimate the value of the MNO Company using the comparable

transaction analysis, giving the cash flow multiple 70% and the other
methods 10% each.
Comparables’
Transaction Estimated
Multiples Stock Value
Earnings $10 million × 15 $150 million
Cash flow $12 million × 20 $240 million
Book value of equity $50 million × 5 $250 million
Sales $100 million × 3 $300 million
• Advantages
– Does not require specific estimation of a takeover premium
– Based on recent market transactions, so information is current
and observed
– Reduces litigation risk
• Disadvantages
– Depends on takeover transactions being correct valuations
– There may not be sufficient transactions to observe the valuations
– Does not include value of changes to be made in target
122
Discounted Cash Flows Approach
• This method requires projections of the future FCF of a project or

firm which are discounted back to the present by an applicable cost
of capital.
• The discounted cash flow (DCF) method consists in applying the
techniques of the investment decision to the calculation of the value
of the firm.
• This is the fundamental valuation method. Its aim is to value the

company as a whole.
• The cash flows to be valued are the after-tax amounts produced by

the firm. They should be discounted out to infinity at the company’s
cost of capital (Kc).
 FCFt
In theory… EV   t
t 1(1  K c)
123
An Illustration of Discounted Cash Flow

Approach
124

(Cont.)
• In practice, we project specific cash flows over a certain

number of years. This period is called the explicit forecast
period.
• For the years beyond the explicit forecast period, we

establish a terminal value.
• The value of the firm is the sum of the present value of after-
tax cash flows over the explicit forecast period and the
terminal value at the end of the explicit forecast period.
PV of
n FCFt  FCFt terminal
EV   t
  t
period
t 1(1  Kc) t n1(1  Kc)
Sum of initial
PV
125

(Cont.)
Free cash flows are calculated as follows:
Operating income (EBIT)

EBITDA
+Depreciation and amortisation
– Normalised tax on operating income
– Capital expenditure
– Change in working capital
= Free cash flow after-tax

126

(Cont.)
• It is very difficult to estimate a terminal value, because it

represents the value at the date when existing business
development projections will no longer have any meaning.
• Often analysts assume that the company enters a phase of

maturity after the end of the explicit forecast period.
• In this case, the terminal value is usually based on the

free cash flow in the last year of the explicit forecast
period: it consists of a normalised cash flow, or annuity, that
grows at a rate (g) out to infinity (Gordon-Shapiro formula).
Value of the company at the end of the explicit forecast period =

Impossible d’afficher l’image.
127
Where the Discount Rate Comes From?
• The discount rate should reflect the investors’ opportunity cost,

the rate of return required on assets of comparable risk.
• For free cash flows (that’s flows to all providers of capital), the
appropriate rate will be a blend of the required rates of return
on debt and equity, weighted by the proportion of those
sources of capital in the firm’s market value capital structure.
• The result is the Weighted Average Cost of Capital, or

WACC.
128
Cost of Capital
• The general expression for calculating the weighted average

cost of capital WACC is :
E D
WACC  ke  k d (1 T)
ED E D
E : Market value of firm’s equity

D : Market value of firm’s debt
Ke : Cost of firm’s equity
Kd : Cost of firm’s debt
T : Marginal corporate tax rate of the firm
129
Cost of Capital (Cont.)
• Key principle: Use a discount rate consistent with the risk of

cash flow being valued.
• Remember that one can value the enterprise or equity:
– Cash flows to all providers of capital (FCF) are discounted

using WACC  This approach value the enterprise;
– Cash flows to equity (Residual cash flows) are discounted
using the cost of equity  This approach value the firm
equity;
• So be careful about how you define “cash flow” and “cost of

capital”!
130
Properly match discount rates and cash flows
Value of: Cash Flow Discount Rate
Firm or assets FCF (Before servicing debt, WACC

preferred, or common equity)
FCF = EBITx(1-T) +
Depreciation - Capex - WC
Equity Dividends or residual CF (after Cost of equity
servicing debt)
Debt Interest, fees, principal Cost of debt
To calculate the cost of capital of a firm, we first calculate

the costs of its major individual components of financing:
1. Equity
2. Debt
132
Cost of Equity Approaches
• Dividend Discount Model

• Capital-Asset Pricing Model
• Before-Tax Cost of Debt plus Risk Premium
Dividend Discount Model
The cost of equity capital, ke, is the discount rate that equates the
present value of all expected future dividends with the current
market price of the stock.
D1 D2 D
P0 = + +...+
(1+ke) (1+ke)
1 2 (1+ke)
Constant Growth Model
• The constant dividend growth assumption reduces the model to:
Ke = ( D1 / P0 ) + g
Where: D1/P0 = Current dividend yield.

g = Constant expected growth rate of dividends to
infinity.
•This method:
Assumes that dividends will grow at the constant rate “g” forever.
This method is best used in estimating equity costs for firms in stable
industries, such as public utilities.
Determination of the Cost of Equity
Capital
Assume that Basket Wonders Ltd. (BW) has common stock

outstanding with a current market value of $64.80 per share, current
dividend of $3 per share, and a dividend growth rate of 8% forever.
Ke = ( D1 / P0 ) + g
Ke = ($3(1.08) / $64.80) + 8%
Ke = 5% + 8% = 13%
Growth Phases Model
The growth phases assumption leads to the following formula

(assume 3 growth phases):
a D0(1+g1)t b Da(1+g2)t-a  Db(1+g3)t-b

P0 = S + S + S
t = b+1 (1+ke)t
t =1 (1+ke)t t =a+1 (1+ke)t
Capital Asset Pricing Model (CAPM)
The cost of equity capital, Ke, is equated to the required rate of

return in market equilibrium. The risk-return relationship is
described by the Security Market Line (SML):
Ke = E(Rj) = Rf + (E(Rm) - Rf)ßj
Where:
–Rf = The expected return on risk-free securities over a time horizon

consistent with the investment in the target. Generally we use LT
government bond rates.
– (E(Rm) - Rf) = The risk premium of common stocks.
– ß = Measure of systematic risk of the firm’s common stock.
Determination of the Cost of Equity
(CAPM)
Assume that Basket Wonders Ltd. (BW) has an equity beta of

1.25. If the risk-free rate is 4% and the expected return on the
market is 11.2%.
Ke = Rf + (Rm - Rf)ßj
= 4% + (11.2% - 4%)1.25
Ke = 4% + 9% = 13%
Before-Tax Cost of Debt Plus Risk
Premium
The cost of equity capital, ke, is the sum of the before-tax cost of debt
and a risk premium in expected return for common stock over debt.
Ke = Kd + Risk Premium*
* Risk premium is not the same as CAPM risk premium

Determination of the
Cost of Equity (Kd + R.P.)
•Assume that Basket Wonders Ltd. (BW) typically adds a 3% premium

to the before-tax cost of debt.
ke = Kd + Risk Premium
= 10% + 3%
ke = 13%
Comparison of the
Cost of Equity Methods
•Constant Growth Model 13%

•Capital Asset Pricing Model 13%
•Cost of Debt + Risk Premium 13%
Generally, the three methods will not agree.

Cost of Debt
•Cost of Debt is the required rate of return on investment of the

lenders of a company.
•The cost of debt should be on an after tax basis (interest
payments are tax-deductible).
•The cost of debt is calculated as follows:
– Ki = Kd ( 1 - T )
n
P0 = S
j =1
Ij + Pj
(1 + Kd)j
Where: I = Interest; P = Principal; Kd: Pre-tax cost of debt.

Determination of the Cost of Debt
Assume that Basket Wonders Ltd. (BW) has $1,000 par value zero-
coupon bonds outstanding. BW bonds are currently trading at
$385.54 with 10 years to maturity. BW tax bracket is 40%.
$0 + $1,000
$385.54 =
(1 + kd)10
Determination of the Cost of Debt
(Cont.)
• (1 + Kd)10 = $1,000 / $385.54 = 2.5938
• (1 + Kd) = (2.5938)(1/10) = 1.1
• Kd = 10%
• Ki = 10% ( 1 - 0.40 )
Ki = 6%
Weighted Average Cost of Capital (WACC)
•To calculate the marginal weighted cost of capital we first need to
compute financing proportions at market values for Basket
Wonders Ltd.
•Let’s suppose that BW has currently 100,000 common shares
and 10,000 straight bonds outstanding.
– MV of common stocks: 100,000 x $64.80
– MV of debt: 10,000 x $385.54
Financing proportions at MVs

Shareholders’ 100,000 x $64.8= = 63%
Equity $6,480,000
Debt 10,000 x $385.54 = = 37%
$3,855,400
Total $10,335,400 = 100%
– WACC = 63% x (13%) + 37% x (6%)

= 10.4%
Case Example:
Merger of Digital & Compaq (1997)

Discounted Cash Flows Approach:
Advantages & Limitations
• Advantages of using the DCF method:

– The model allows for changes in cash flows in the future.
– The cash flows and estimated value are based on forecasted
fundamentals.
– The model can be adapted for different situations.
• Disadvantages of using the DCF method:

– Estimating future cash flows is difficult because of the uncertainty.
– Estimating discount rates is difficult, and these rates may change
over time.
– The terminal value estimate is sensitive to the assumptions and
model used.
The Sum of the Parts Approach
• The “sum of the parts” method belongs rather to the

category of indirect methods, but does not rely on
projections of future cash flows.
• The sum-of-the-parts method consists in valuing the

company’s different assets and liabilities separately
and then adding them together.
• It consists in systematically studying the value of each

asset and each liability on the company’s balance sheet.
The Sum of the Parts Approach (Cont.)
Reappraised Balance Sheet :
Equity
Assets - Debt =
• There are two basis types of value used in the sum-of-the-

parts method.
– Market value. This is the value we could obtain by

selling the asset.
– Value in use. This is the value of an asset that is used
in the company’s operations.
• The sum-of-the-parts method is the easiest to use and the

values it generates are the least questionable when the
assets have a value on a market that is independent of
the company’s operations.
• Tangible assets
– Production assets can be evaluated on the basis of
• Book value
• Replacement value
• Liquidation value
• Going-concern value
• Other values
• Inventories
– For industrial companies, valuing inventories usually does
not pose a major problem, unless they contain products that
are obsolete or in poor condition.
• Intangible assets
– The value of a company is partly determined by the very
real value of its intangible assets (brands, patents,
softwares, copyrights, …).
• The sum-of-the-parts method is useful for valuing small

companies with no particular strategic value.
• The sum-of-the-parts method is particularly applicable for

companies, such as airlines, whose assets can be sold
readily on a secondary market.
Example: Liquidation Value of the Target Firm
• The table bellow gives an example in which an analysts assumes

that the liquidation value of ABC corp. would result in realization of
all its cash, 80% of its receivables, 60% of its inventories, and 40%
of its plants and equipment.
Book Assumed % of BV Liquidation

value collected in liquidation value
Cash $10 100% $10
Receivables $30 80% $24
Inventory $25 60% $15
Plant & equipment $35 40% $14
Total $100 $63
Equity $50 $13

Debt $50 100% $50
Comparison of Methods
• If markets are efficient, all of the valuation methods should
lead to the same valuation…
• In reality, however, there are often differences among the sum-

of-the-parts value, the DCF-based value and the peer-
comparison value
• If the sum-of-the-parts value is higher than DCF value or the

value derived from a comparison of multiples, then the company
is being valued more for its past, its revalued equity capital, than
for its outlook for future profitability
• If the sum-of-the-parts value is lower than the DCF value or the

value derived from multiples, which is the usual case in an
economy where companies have a lot of intangibles, then the
company is very profitable and invests in projects with expected
profitability greater than their cost of capital
Comparison of Methods (Cont.)
• If the value obtained via peer comparison is greater than

the DCF-based value then the company’s managers
should be thinking about floating the company on the
stock exchange.
• If the value obtained by comparison is lower than the DCF

value and if the business plan is reliable, it would be wiser
to wait until more of the long-term growth potential in the
company’s business plan feeds through to its financial
statements before launching an IPO.
Conclusion
• The value of a company’s equity capital is the difference

between the enterprise value and the value of its net debt
• DCF is based on the notion that the value of the company

is equal to the amount of free, after-tax cash flows
generated by the company and discounted at a rate
commensurate with its risk profile. The discount rate
applied is the weighted average cost of capital (WACC)
• The peer-group or multiples method is a comparative

approach that sets the company to be valued off against
other companies in the same sector. In this approach, the
enterprise value of the company is estimated via a multiple
of its profit-generating capacity before interest expense
Conclusion (Cont.)
• The sum-of-the-parts method of valuation consists in

valuing each of the company’s assets and commitments
separately, then subtracting the latter from the former
• A company valuation should be completed with an

analysis of the reasons behind differences in the results
obtained by the various valuation methods. These
differences give rise to decisions of financial engineering
and evolve throughout the life of the company
Valuation Case:
Merger of Chrysler & Daimler-Benz (1998)

Valuing Synergies
• Synergy assessment should be the centerpiece of M&A analysis for

3 reasons:
– Value creation: Deal having no foreseeable synergies will

destroy value in the long run.
– Investors reaction to the announcement of M&As depends on
synergies expected.
Buyer’s share price If this equation is satisfied

will:
Rise Price < VTarget + V Synergies
Not change Price = VTarget + V Synergies
Fall Price > VTarget + V Synergies
– Valuing synergies can help the analyst develop a strategy for
disclosing those synergies to the investors.
A Framework for Synergy Analysis
• Two components of valuation:
– Assets in place
– Growth options or real options

Synergies from Activities or Assets that are
in Place
• Discounted CF valuation is the best approach applied for
valuing these synergies:
n FCFt
VSynergies in place   t
t 0(1 WACC)
•Synergies in place can arise from improvements in any of the

FCF components or in WACC. These improvements include:
•Revenue enhancement synergies
•Cost reduction synergies
•Asset reduction synergies
•Tax reduction synergies
•Financial synergies:
•Reducing WACC by optimizing the use of debt tax shields
•Coinsurance effects
Real Option Synergies
• Depend on some triggering event to produce a payoff:
– Growth option synergies: Would arise from the combination of

resources in a transaction that allows the combined entity to
grow more rapidly.
– Options to defer: A combination of 2 firms could grant the
flexibility to wait on developing a new technology, entering a
new market, …
– Options to switch: These may include the ability to change the
mix of inputs or outputs of the firm.
Case Study:
Valuing Synergies in the Merger of Compaq & Digital

Going Private
Transactions and
Leveraged Buyouts
(LBO)
What is Private Equity?
• Any type of equity investment (i.e., stock of a company) in which the
stock is not freely tradable on a public stock market.
• Institutional investors (e.g., pension funds, university endowments)
may invest in private equity funds, which are in turn used by private
equity firms for investment in target companies.
• Categories of private equity investment include:
• Leveraged buyouts
• Venture capital
• Growth capital
• Angel investing
• Mezzanine capital
• Private equity funds typically control management of the companies in
which they invest, and often bring in new management teams that
focus on making the company more valuable.
• Private equity investments are typically sold through an initial public
offering (IPO), sale to strategic buyer, or a sale to another private
equity firm.
Private Equity: Financing Types
Variable Venture Capital Leveraged Buyout (LBO)
Expected returns: 40%+ 25-40%

Leverage: Has little or no debt Relies heavily on debt to acquire
companies
Target preference: Focus on startup and early stage companies, Focus on companies that are
must build business from scratch undervalued with predictable cash
flow and operating inefficiencies
Value creation: Create shareholder value by providing high Create shareholder value by
returns to equity investors paying off lenders and servicing
debt
Exits: IPO or sale of company IPO, sale of company,
recapitalization
Investment horizon: Generally longer relative to LBOs 4-6 years
Fund examples: Kleiner Perkins (Amazon, Google), Draper KKR (Toys R Us, Dollar General),
Fisher (Skype, Hotmail) Blackstone (Orangina, Sirius)
Private Equity: Geographical Distribution
Leading Private Equity Firms by Funds Raised
Firm 5-year Fundraising Total

($m)
TPG 52,352
Goldman Sachs Principal 48,993
investment Area
The Carlyle Group 47,732
Kohlberg Kravis Roberts 40,460
Appolo Capital 35,183
Management
Bain Capital 34,949
CVC Capital Partners 33,726
The Blackstone Group 30,800
Warburg Pincus 23,000
Apax Partners 21,336
Source: Private Equity International’s 2009 PEI 300.
What is a Leveraged Buyout (LBO)?
• LBO is a general form of corporate restructuring. It entails the

purchase of a company by a by a small group of investors (“financial
buyers”), usually including members of existing management.
• LBO is financed largely by debt.
• The debt is secured by the assets of the enterprise involved. Thus,

this method is generally used with capital-intensive businesses.
• Financial buyers:
– Focus on ROE rather than ROA.
– Succeed through improved operational performance.
– Focus on targets having stable cash flow to meet debt service
requirements: Typical targets are in mature industries (e.g.,
retailing, textiles, food processing, apparel, and soft drinks)
• The buying group may be associated with buyout specialists,

investment bankers, or commercial bankers.
Impact of Leverage on
Financial Returns
Impact of Leverage on Return to Shareholders
All-Cash 50% Cash/50% 20% Cash/80%
Purchase Debt Debt
($Millions) ($Millions) ($Millions)
Purchase Price $100 $100 $100
Equity (Cash Investment by Financial $100 $50 $20
Sponsor)
Borrowings 0 $50 $80
Earnings Before Interest and Taxes $20 $20 $20

(EBIT)
Interest @ 10%1 0 $5 $8
Income Before Taxes $20 $15 $12

Less Income Taxes @ 40% $8 $6 $4.8
Net Income $12 $9 $7.2
After-Tax Return on Equity (ROE)2 12% 18% 36%

LBOs Create Value by Reducing Debt and Increasing Margins
Thereby Increasing Potential Exit Multiples
Firm
Value
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Debt Reduction & Reinvestment Increases Free Cash Flow and in turn Builds Firm
Value
Debt Debt Reduction Reinvest in Firm Reinvestment

Reduction Adds to Free
Adds to Free Cash Flow by
Cash Flow by Improving
Reducing Operating
Interest & Free Cash Flow Margins
Principal
Repayments
Tax Shield Adds to Free Cash Flow
Tax
Shield
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

LBO Value is Maximized by Reducing Debt, Improving
Margins, and Properly Timing Exit
Case 1: Case 2: Case 3:
Debt Reduction Debt Reduction + Margin Debt Reduction + Margin
Improvement Improvement + Properly
Timing Exit
LBO Formation Year:
Total Debt $400,000,000 $400,000,000 $400,000,000
Equity 100,000,000 100,000,000 100,000,000
Transaction Value $500,000,000 $500,000,000 $500,000,000
Exit Year (Year 7) Assumptions:

Cumulative Cash Available for
Debt Repayment1 $150,000,000 $185,000,000 $185,000,000
Net Debt2 $250,000,000 $215,000,000 $215,000,000
EBITDA $100,000,000 $130,000,00 $130,000,000
EBITDA Multiple 7.0 x 7.0 x 8.0 x
Transaction Value3 $700,000,000 $910,000,000 $1,040,000,000
Equity Value4 $450,000,000 $695,000,000 $825,000,000
Internal Rate of Return 24% 31.2% 35.2%

Cash on Cash Return5 4.5 x 6.95 x 8.25 x
1Cumulative cash available for debt repayment increases between Case 1 and Case 2 due to improving margins and lower interest and
principal repayments reflecting the reduction in net debt.
2Net Debt = Total Debt – Cumulative Cash Available for Debt Repayment = $400 million - $185 million = $215 million
3Transaction Value = EBITDA in 7th Year x EBITDA Multiple in 7th Year
4Equity Value = Transaction Value in 7th Year – Net Debt
5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
accounts for the time value of money.

LBO: Advantages & Disadvantages
• Advantages include the following:

– Management incentives,
– Tax savings from interest expense and depreciation from asset
write-up,
– More efficient decision processes under private ownership,
– A potential improvement in operating performance, and
– Serving as a takeover defense by eliminating public investors
• Disadvantages include the following:

– High fixed costs of debt,
– Vulnerability to business cycle fluctuations and competitor
actions,
– Not appropriate for firms with high growth prospects or high
business risk, and
– Potential difficulties in raising capital.
Stages of a Typical LBO Operation
(1). Raise the cash required for the buyout and design a new
management incentive system.
(2). The organizing sponsor group buys all the outstanding

shares of the company and takes it private.
To reduce the debt by paying off a part of the bank loan, the new
owners sell off some parts of the acquiring firm.
(3). The management strives to increase profits and cash flows

by cutting operating costs and changing marketing strategies.
Stages of a Typical LBO Operation (cont’d)
(4). It will consolidate or reorganize production facilities, improve

inventory control and accounts receivables management, improve
product quality and customer service, try to extract better terms from
suppliers, and any other ways to increase firm value and most
importantly, meet payments on the swollen debt.
(5). The investor group may take the company public again if the
company emerges stronger and the goals of the group are achieved
 Reverse LBOs
Requirements for Successful LBO
•Improvement in operations, reducing cost and increasing CF.

•The % of equity ownership by management strengthens
management incentives.
•Valuations in LBO transaction must be 5 to 7 times of EBITDA
•Higher % of equity in financial structures provides greater
flexibility in making the additional investment that may be
required.
•Financial buyers assistance in formulating strategies and
providing managerial expertise.
Buyout Premium
• Premium paid to target firm shareholders consistently exceeds

40%.
• This premium reflects the following (in descending order of

importance):
– Anticipated improvement in efficiency and tax benefits

– Wealth transfer effects
– Superior Knowledge
– More efficient decision-making
Deal Size and Premium in LBOs & MBOs
• Relative Size of LBOs (in $MM)

– Weston, Chung, & Siu, 1998
LBOs Mean LBOs Median
Period
Price Price
1986-1990 329.2 75.5
1991-1992 77.3 27.1
1993-1995 111.4 33.7
• Relative Premiums Offered
All Acquisitions LBOs

Period Mean (%) Median (%) Mean (%) Median (%)
1986-1990 40.3 30.5 34.0 27.5
1991-1992 38.1 32.1 24.3 14.1
1993-1995 41.8 32.4 35.5 24.7
Buyouts: Fundraising
US Market
US LEVERAGED BUYOUT FUNDRAISING VOLUME
$ in billions
$350
$300
$302
$250
$255
$200
$173
$150 $160
$100 $105 $106

$95 $94
$50 $68
$55 $50
$32 $33
$7 $20
$0 $14
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: The Private Equity Analyst
Leveraged Buyout fundraising reached an all-time high in 2007

Buyouts: Fundraising
European Market
(€ billions)
140 300
120 250
100
200
80
150
60
100
40
20 50
0 0
1999 2000 2001 2002 2003 2004 2005 2006
Total LBO loan volume (left-hand scale)
Number of transactions (right-hand scale)
Source: Standard & Poor's LCD

Buyouts: Returns
OUTPERFORMANCE BY FUND TYPE

As of December 31, 2006
Fund Type 1 Year 3 Years 5 Years 10 Years 20 Years
Small Buyouts 8.6% 8.7% 5.9% 5.6% 22.4%
Medium Buyouts 33.8% 13.3% 7.4% 10.5% 13.8%
Large Buyouts 27.3% 14.2% 9.2% 7.2% 12.2%
Mega Buyouts 23.8% 15.2% 11.5% 8.8% 11.8%
All Buyouts 24.5% 14.6% 10.4% 8.5% 12.9%
NASDAQ 4.8% 6.3% 4.3% 6.4% 10.1%
S&P 500 10.8% 8.2% 4.3% 6.7% 9.2%
Source: Thomson Venture Economics/National Venture Capital Association
Buyouts have outperformed the S&P 500 over the past 20 years
181
Valuing LBOs
• A LBO can be evaluated from the perspective of common equity

investors or of all investors and lenders.
• LBOs make sense from viewpoint of investors and lenders if present

value of free cash flows to the firm is greater than or equal to the
total investment consisting of debt and common and preferred
equity.
• However, an LBO can make sense to common equity investors but

not to other investors and lenders. The market value of debt and
preferred stock held before the transaction may decline due to a
perceived reduction in the firm’s ability to:
– Repay such debt as the firm assumes substantial amounts of

new debt.
– Pay interest and dividends on a timely basis.
Valuing LBOs
Target Holding
100% Equity (H)
Equity Shares
Value of value of the target
Assets of the Financial Debt (H)
target leverage
Debt
• LOB valuation  It is the maximum price that can be paid :
– Debt financing, ie long term loan granted by banks
+
– Equity financing, ie capitalisation by private equity funds
Valuing LBOs: Adjusted Present Value
Method (APV)
• Separates value of the firm into:
• (a) its value as if it were debt free and

• (b) the value of tax savings due to interest expense.
– Step 1: Project annual free cash flows to equity investors and

interest tax savings.
– Step 2: Value target without the effects of debt financing and
discount projected free cash flows at the firm’s estimated
unlevered cost of equity.
– Step 3: Estimate the present value of the firm’s tax savings
discounted at the firm’s estimated unlevered cost of equity.
– Step 4: Add the present value of the firm without debt and the
present value of tax savings to calculate the present value of
the firm including tax benefits.
– Step 5: Determine if the deal makes sense.
APV Method: Step 1
• Project annual free cash flows to equity investors and interest tax
savings for the period during which the firm’s capital structure is
changing.
– Interest tax savings = INT x T, where INT and T are the firm’s
annual interest expense on new debt and the marginal tax rate,
respectively.
– During the terminal period, the cash flows are expected to grow
at a constant rate and the capital structure is expected to remain
unchanged.
APV Method: Step 2
• Value target without the effects of debt financing and discount

projected cash flows at the firm’s unlevered cost of equity.
– Apply the unlevered cost of equity for the period during which the
capital structure is changing.
– Apply the WACC for the terminal period using the proportions of
debt and equity that make up the firm’s capital structure in the
final year of the period during which the structure is changing.
APV Method: Step 3
• Estimate the present value of the firm’s annual interest tax savings.
– Discount the tax savings at the firm’s unlevered cost of equity.
– Calculate PV for annual forecast period only, excluding a

terminal value, since the firm is sold and any subsequent tax
savings accrue to the new owners.
APV Method: Step 4
• Calculate the present value of the firm including tax benefits:
– Add the present value of the firm without debt and the PV of tax
savings.
APV Method: Step 5
• Determine if deal makes sense:
– Does the PV of free cash flows to equity investors plus tax

benefits equal or exceed the initial equity investment including
transaction-related fees?
Valuing LBOs: Cost of Capital Method1
Adjusts for the varying level of risk as the firm’s total

debt is repaid.
• Step 1: Project annual cash flows until
target D/E achieved
• Step 2: Project debt-to-equity ratios
• Step 3: Calculate terminal value
• Step 4: Adjust discount rate to reflect
changing risk
• Step 5: Determine if deal makes sense
1Also known as the variable risk method.
Cost of Capital Method: Step 1
• Project annual cash flows until target D/E ratio

achieved
• Target D/E is the level of debt relative to equity
at which
– The firm will have to resume payment of taxes and
– The amount of leverage is likely to be acceptable to IPO
investors or strategic buyers (often the prevailing industry
average)
• Project annual debt-to-equity ratios

• The decline in D/E reflects:
– The known debt repayment schedule and
– The projected growth in the market value of the
shareholders’ equity (assumed to grow at the same
rate as net income)
• Calculate terminal value of projected cash flow to equity

investors (TVE) at time t, (i.e., the year in which the initial
investors choose to exit the business).
• TVE represents PV of the dollar proceeds available to

the firm through an IPO or sale to a strategic buyer at
time t.
• Adjust the discount rate to reflect changing risk.
• The firm’s cost of equity will decline over time as debt is repaid and
equity grows, thereby reducing the leveraged ß. Estimate the firm’s
ß as follows:
ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))
where ßFL1 = Firm’s levered beta in period 1

ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1 = Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI = Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF = Firm’s marginal tax rate in period 1
• Recalculate each successive period’s ß with the D/E ratio for that
period, and using that period’s ß, recalculate the firm’s cost of equity
for that period.
• Determine if deal makes sense
– Does the PV of free cash flows to equity investors (including the

terminal value) equal or exceed the equity investment including
transaction-related fees?
Evaluating the Cost of Capital Method
• Advantages:
– Adjusts the discount rate to reflect diminishing risk as the debt-
to-total capital ratio declines
– Takes into account that the deal may make sense for common
equity investors but not for lenders or preferred shareholders
• Disadvantage: Calculations more burdensome than
Adjusted Present Value Method
Things to Remember…
• LBOs make the most sense for firms having stable cash flows, significant
amounts of tangible assets, and strong management teams.
• Successful LBOs rely heavily on management incentives to improve

operating performance.
• Tax savings from interest expense and depreciation enable LBO investors
to offer targets substantial premiums over current market value.
• Excessive leverage and the resultant higher level of fixed expenses makes
LBOs vulnerable to business cycle fluctuations.
• For an LBO to make sense, the PV of cash flows to equity holders must
equal or exceed the value of the initial equity investment in the transaction.
Case Study:
The valuation of RJR Nabisco Buyout

Cours MA Private Equity

Uploaded by

Copyright:

Available Formats

You might also like

Cours MA Private Equity

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cours MA Private Equity

Uploaded by

Copyright:

Available Formats

1

Mergers & Acquisitions, Private Equity

Dr. Khalid EL BADRAOUI

• Understand types of acquisitions.

• Explain why it may make sense for companies to merge.

• Estimate the gains and costs of mergers to the acquiring firm.

• Analyse the essential features of private equity and understand how

• Going private and Leveraged Buyouts (LBO)

A transaction where 1 firm buys another firm with

Takeover An acquisition where the target firm did not solicit

•Mergers, acquisitions, takeovers are types of transactions that change the

•Merger sounds more amicable, less threatening.

• Parent stocks are usually • Can be a controlling share, a

• From an economic standpoint, mergers are often categorized as:

• Merger  A Corp + B Corp = A Corp

– The complete absorption of one company by another, where the

• Consolidation  A Corp + B Corp = New Co.

– A merger in which a new firm is created and both the acquired

- The purchase of a firm’s voting stock in exchange for cash,

- A firm can effectively acquire another firm by buying most or all

• Rather than a merger or an acquisition, the acquiring company may

• If an acquirer buys 100% of the target  Wholly owned subsidiary.

 > 50%  Exclusive control;

Advantages that may make HCs preferable to an outright acquisition:

HC form has also disadvantages:

•Increased Market Power

•Overcome Barriers to Entry

•Lower Cost and Risk of New Product Development

•Increased Speed to Market

•Reshaping Competitive Scope

– The incremental net gain from the merger is:

– Cost reductions: The combined firm may operate more

• Executive compensation hypothesis:

– Example: Assume that the estimated amount for a firm is $100

Example -- Company A will acquire Company B with shares of

Example -- Company B has agreed on an offer of $35 in

Total earnings $25,000,000

Exchange ratio = $35 / $64 = 0.546875

* New shares from exchange = 0.546875 x 2,000,000

• The shareholders of Company A will experience an increase

• The shareholders of Company B will experience a decrease

Example -- Company B has agreed on an offer of $45 in

• Total earnings $25,000,000

Exchange ratio = $45 / $64 = 0.703125

* New shares from exchange = 0.703125 x 2,000,000

• The shareholders of Company A will experience a decrease in

• The shareholders of Company B will experience an increase in

• Question: What will new PER be?

• EPS = 25,000,000 = 5.00

• Merger decisions should not

Expected EPS ($)

Initially, EPS is less with the merger.

•Inability to Achieve Synergy

Cost of new Large or

Increased speed Inability to

Lower risk Too much

Increased Managers overly

Deal value (in billion $) 40 000

0 Source: Thomson Financial 0