Chapter 10

Increasing the Value

of the Organization
 Valuation and Merger Analysis
 Valuation approaches and tests
• Comparable companies or transactions
• Spreadsheet and formula approaches
• Test whether transaction makes sense
• Test whether premium paid is justified by
potential synergies
 Additional analysis
• Nature of industry
• Value drivers (historical and projected)
• Competitive and antitrust effects of merger
• Issues related to implementing the merger
Chapter 10-2
Merger Analysis:
 Oil industry experienced a merger wave in the
late 1990s
 Characteristics of the oil industry
• Oil is a global market
• Strategically important for industrial, political,
and military reasons
• OPEC has historically played a large role
• Large costs for environmental protection
• High degree of price instability – mergers can
be seen as a response to lower breakeven levels

Chapter 10-3
Merger Analysis:
 Reasons for the merger
• Stronger presence in promising oil regions
• Better position to invest in costly programs
with high risks and returns
• Complementary operations in South America,
Russia, Canada, Asia, Africa
• Synergies: predicted $2.8B, analysts estimated
to be $7B by 2002 (actual)
 Deal terms
• Mkt. value before: XON $175B, MOB $59B
• XON offer: 1.32 XON shares x $72 share price
x 780 outstanding MOB shares = $74B (26%
premium over premerger mkt. cap.)
Chapter 10-4
Merger Analysis:
 Impact of the deal
• Premerger, Exxon shares represented
75% of combined market value
• Postmerger, Exxon shares represented
70% of combined market value
 Event analysis
• (-10,0): +14.8% Mobil, -0.5% Exxon
• (-10,+10): +20.6% Mobil, +3.1% Exxon
• Positive returns reflect market view that
the merger made economic sense
Chapter 10-5
Cost of Capital:
 Cost of equity: ke = rf + ERP(beta)
• rf = risk free rate (10 yr. treasuries) = 5.6%
• ERP = equity risk premium (historical market
return patterns) = 7%
• Beta = firm’s systematic risk = 0.85 (Exxon),
0.75 (Mobil)
• Exxon ke = 5.6 + 7(0.85) = 11.55%
• Mobil ke = 5.6 + 7(0.75) = 10.85%
 Cost of debt (before-tax)
• Exxon: AAA (160bp over treasuries) = 7.2%
• Mobil: AA (190bp over treasuries) = 7.5%
Chapter 10-6
 Cost of Capital:
 Capital structure
• Oil companies have usually had debt-to-total capital
ratios between 20 and 40%
• During acquisitions, ratios at upper end
• Plausible target ratio would be 30% (B/V)
 Weighted average cost of capital
• WACC = (S/V) ke + (B/V) kb (1–T)
• Cash tax rates estimated: 35% Exxon, 40% Mobil
• Exxon=(70%)(11.55%)+(30%)(7.2%)(1–35%)= 9.49%
• Mobil=(70%)(10.85%)+(30%)(7.5%)(1–40%)= 8.95%
• Combined firm should have a lower beta due to
reduced business risk – cost of equity = 11.2%
• WACC=(70%)(11.2%)+(30%)(7.2%)(1–38%)= 9.18%
Chapter 10-7
Valuation:
 Valuation considerations
• Historical patterns are only the foundation for
projections
• Projections are modified by business-economic
analysis of future prospects for the industry
• Revenue growth reflects the economics of the
industry
• Net operating margins depend on realization of
synergies and oil prices
• Individual value drivers may need adjustment

Chapter 10-8
Valuation:
 Uses for valuation
• Key component of a continuing process of
reassessing economic and competitive impacts
related to the firm’s operating performance and
adjustments
• Planning benchmarks to be monitored by firm
• Basis for setting performance targets and
performance-based compensation systems
• Important role in value based management —
planning relationships between value drivers,
performance results, and the resulting projected
intrinsic value levels of the firm
Chapter 10-9
 DCF Spreadsheet:
 Advantages of spreadsheet valuation
• Provides great flexibility in projections
• Growth rate for each item in spreadsheet can be
unique from year to year
 Forecast of projected ratios
• Example: Table 10.5’s first 3 projection years
2000 2001E 2002E 2003E
NOI 12.2% 12.0% 15.0% 16.0%
NOPAT 7.3% 7.4% 9.3% 9.9%
Depreciation 3.9% 4.0% 4.0% 4.0%
Change in working capital 2.7% 1.5% 1.5% 1.5%
Capital expenditures 4.1% 4.5% 4.0% 4.0%
Change in other assets net 0.3% -1.25% -1.25% -1.25%
Free cash flow 4.3% 6.7% 9.1% 9.7%
Chapter 10-10
 DCF Spreadsheet:
 Conversion of ratios to numerical projections
2000 2001E 2002E 2003E
1. Net revenues* $206,083 $185,475 $191,039 $198,680
2. Revenue growth rate 28.1% -10.0% 3.0% 4.0%
3. NOI $ 25,179 $ 22,257 $ 28,656 $ 31,789
4. Cash tax rate 39.9% 38.0% 38.0% 38.0%
5. Income taxes 10,056 8,458 10,889 12,080
6. NOPAT $ 15,123 $ 13,799 $ 17,767 $ 19,709
7. + Depreciation 8,130 7,419 7,642 7,947
8. – Change in working capital 5,463 2,782 2,866 2,980
9. – Capital expenditures 8,446 8,346 7,642 7,947
10. – Change in other assets net 583 (2,318) (2,388) (2,484)
11. Free cash flows $ 8,761 $ 12,408 $ 17,289 $ 19,212
12. WACC 9.18% 9.18% 9.18% 9.18%
13. Discount factor 0.91592 0.83891 0.76837 0.70376
14. Present values $ 8,025 $ 10,409 $ 13,284 $ 13,521
Chapter 10-11
 DCF Spreadsheet:
 Calculation of terminal value
FCFn+1 $27,892
Terminal Value n = = = $451,327 million
WACC − g 0.0918 − 0.03
• Equation discounts the free cash flows in year
n+1 (in this case year 11) by the cost of capital
minus the projected terminal growth rate
• $451 billion is the value of ExxonMobil in year
10 – it must be discounted to the present
$451,327
11
= $451,327 × 0.38056 = $171,757 million
(1.0918)

Chapter 10-12
 DCF Spreadsheet:
 Total firm value
PV – projected cash flows (2000-10) $130,331
Add: PV of terminal value (2010+) $171,757
Add: Marketable securities 73
Total value of the firm $302,161
 Intrinsic share price
• Deduct total interest-bearing debt ($18,972) from
firm value to find intrinsic market value of equity
($283,189)
• Divide equity value by outstanding shares (3,477
million) to find implied share price $81.45 (prior
to a 2-for-1 split in 7/01)
 Caveat: analysis may differ due to changes in
business economic environment Chapter 10-13
 DCF Formula:
 Advantages of formula valuation
• Compact mathematical summary of DCF
• Isolates value drivers, which can be tied
to performance results and the intrinsic
value of the firm
 Formula
n
(1 + g s )t
V0 = R0 [ms (1 − Ts ) + d s − I ws − I fs − I os ] ∑
t =1 (1 + k s ) t

R0 (1 + g s ) n (1 + g c )[mc (1 − Tc ) + d c − I wc − I fc − I oc ]
+
(kc − g c )(1 + k s ) n
Chapter 10-14
DCF Formula:
 Value driver estimates
Initial Terminal
Value Driver Value Value
m NOI margin 16.5% 15.5%
T Cash tax rate 38.0% 38.0%
g Growth rate 5.1% 3.0%
d Depreciation 4.0% 4.0%
Iw Working capital req. 1.5% 1.5%
If Capital expenditures 4.5% 2.5%
Io Change in other assets -1.25% 0.1%
k Cost of capital 9.18% 9.18%
R Initial revenues $160,883
n Number growth years 11 Chapter 10-15
DCF Formula:
 Intrinsic share price
• After deduction of debt, intrinsic market value
of equity is $283,292
• Share price = $81.48 (compared to $81.45 with
spreadsheet method)
• Demonstrates the equivalence between DCF
methods
 Sensitivity analysis
• Varying key value drivers adds insight to
valuation results
• Enables decision makers to identify most
important value drivers
Chapter 10-16
DCF Formula:
 Sensitivity analysis
Equity Value ($ billions)
Net Operating Income Margin, ms
10.5% 12.5% 16.5% 18.5% 20.5%
7.50% $269.3 $288.5 $326.9 $346.1 $365.3
8.00% $257.0 $275.7 $313.1 $331.8 $350.6
Discount Rate, k s

8.50% $245.4 $263.6 $300.1 $318.3 $336.5

9.00% $234.4 $252.1 $287.6 $305.4 $323.1
9.18% $230.5 $248.1 $283.3 $300.9 $318.5
9.50% $223.9 $241.2 $275.8 $293.1 $310.4
10.00% $213.9 $230.8 $264.5 $281.4 $298.3
10.50% $204.5 $220.9 $253.8 $270.3 $286.7
11.00% $195.5 $211.5 $243.6 $259.7 $275.7
Chapter 10-17
 Tests of Merger Performance
 Gain from merger
Value of combined company $283.3B
Less: Amount paid to Mobil $74.2B
Remainder $209.1B
Less: Premerger Exxon value $175.0B
Gain from merger $ 34.1B
 Allocation of gain
• Exxon owns 70% of combined company:
70%($34.1B) = $23.9B for XON shareholders
• Gain to Mobil = 30% × $34.1 = $ 10.2B
Plus: Premium to Mobil $ 15.5B
Mobil Total Gain $ 25.7B
 Positive event returns in almost all major oil
mergers – reflects good economic rationale
Chapter 10-18
 Tests of Merger Theory
 Possible ExxonMobil merger motivations
• Synergy: far exceeded initial $2.8B estimate
• Hubris: no, large gains for bidder and target
• Agency: no, large combined gains
• Tax savings: not a major factor
• Monopoly: no antitrust actions upstream, but
forced to divest some downstream activities
• Redistribution: no redistribution from
bondholders, but possibly some from labor
(employment reductions)
 Theory suggests ExxonMobil merger success
may have been aided by favorable economic
environment of 1990s Chapter 10-19
 Tests of Merger Theory
 Role of industry shocks
• Price uncertainty in oil industry creates strong
incentive for increased efficiency
• Oil industry is sensitive to overall economic
conditions
 Increased competitive pressures
• Government connected national oil companies
becoming major players
• Technological developments had potential to
alter industry
• BP Amoco combination spurred firms to
consider competitive responses
Chapter 10-20
 Multiple Stage Valuation
 Previous examples used only two distinct
growth stages (forecast and terminal
periods)
 To reflect stages in the product life cycle,
a practitioner may want to add
additional periods
 Demonstrates that a main limitation of
valuations is the ability of a practitioner
to accurately forecast value drivers
Chapter 10-21
 Multiple Stage Valuation
 Formula expression of 4-Stage Valuation
n
[ ]
1

1 ∑ 1
t
Stage 1: V0
1
= R0 ⋅ m1 (1 − T1 ) − I ⋅ h = (1,490)
t =1
n2
V02 = R0 ⋅ h ⋅ [ m2 (1 − T2 ) − I 2 ] ⋅ ∑ h2
n1 t
Stage 2: 1 = 19,788
t =1
n3
V03 = R0 ⋅ h ⋅ h2 ⋅ [ m3 (1 − T3 ) − I 3 ] ⋅ ∑ h3
n1 n2 t
Stage 3: 1 = 2,235
t =1

(1 + g 4 )
⋅ [ m4 (1 − T4 ) − I 4 ] ⋅
n1 n2 n3
Stage 4: V = R0 ⋅ h ⋅ h2 ⋅ h3
0
4
1 = 4,229
(k4 − g 4 )

Total PV = $ 24,762

Chapter 10-22
 Calculating Growth Rates
 Discrete compound annual growth rate (d)
• Geometric average based on the end points of the
time series
• Found by dividing the final year number (Xn) by
the initial year figure (X1), then taking the n-th root
(for n number of years between initial and final
number) 1/ n
 Xn 
d =   − 1
 X1 

• May be seriously flawed if end values are not

representative of fluctuations in the time series of
the variable Chapter 10-23
 Calculating Growth Rates
 Continuously compounded growth rate (c)
• Estimated from regression
ln(Xt) = a + bt where
ln(Xt) = natural log of variable X
t = time in annual periods
• Continuous compounded growth rate, c, for
variable X
c = b' = estimated slope coefficient of regression
• Regression method considers fluctuations; takes
into account all data points

Chapter 10-24
 Calculating Growth Rates
 Relation between discrete and continuously
compounded rate
d = ec - 1 where e = the base of the natural
system of logarithms
= 2.71828

c = ln(1+d)

Chapter 10-25