Part III Merger and Acquisition Valuation and Modeling

Chapter 7: A Primer on Merger and Acquisition Cash Flow Valuation

Chapter Summary and Learning !"ecti#es
$he purpose o% this chapter is to pro#ide an o#er#iew o% the !asics o% #aluing mergers and acquisitions using discounted cash %low methods& $he chapter pro#ides an o#er#iew o% elementary %inance concepts including measuring ris' and return( the capital asset pricing model( the e%%ects o% le#erage on ris' and return( and calculating present and %uture #alues o% cash %low& Cash %low de%ined !y generally accepted accounting principles is re)de%ined !y ad"usting %or certain non)cash considerations to create cash %low de%initions suita!le %or #aluation& $he chapter concludes with a discussion o% the #aluation o% non)operating assets such as e*cess cash and mar'eta!le securities( in#estments in other %irms( unutili+ed and pension %und assets( and intangi!le assets& Chapter 7 Learning Objectives: Providing students with an understanding of ,& /& 0& 1& 3& -ow to analy+e ris' and return. -ow to de%ine #aluation cash %lows consistent with the cost o% equity and weighted a#erage cost o% capital and when they are applied. Alternati#e discounted cash %low methods and under what conditions they are applied. 2etermining growth rates and the sensiti#ity o% terminal #alues to changes in assumptions. Valuation o% non)operating assets and lia!ilities and ad"ustment o% %irm #alue&

Learning Objective 1: How to analyze ris and return! Cost o% equity 4'e5: Minimum return required to induce in#estors to in#est in equities o% compara!le ris'& Capital asset pricing model: 'e 6 7% 8 47m 9 7%5 8 FSP where 7% 6 ris' %ree rate o% return 6 !eta 7m 6 the e*pected rate o% return on equities 7m 9 7% 6 3&3: 4i&e&( its historical a#erage since ,;<05

FSP 6 %irm si+e ad"ustment Cost o% pre%erred stoc' 4'pr5: Pre%erred di#idend di#ided !y mar'et #alue o% pre%erred stoc'& =eighted A#erage Cost o% capital 4=ACC5: Minimum return required !y in#estors to purchase common and pre%erred equity and !onds o% %irms o% compara!le ris'& =ACC 6 'e >> ?> 8 i 4, 9 t5 >>2 8 'pr * PF 428?8PF5 428?8PF5 428?8PF5 47)15

where ? 6 the mar'et #alue o% common equity 2 6 the mar'et #alue o% de!t PF 6 the mar'et #alue o% pre%erred stoc' t 6 the %irm@s marginal ta* rate& i 6 nominal interest rate 7is' consists o% a di#ersi%ia!le component 4e&g&( stri'es( de%ault( lawsuits( etc&5 and a non) di#ersi%ia!le component 4e&g&( %actors a%%ecting all %irms such as in%lation( war( etc&5& Aeta Coe%%icient 45 is a measure o% non)di#ersi%ia!le ris' 4i&e&( the e*tent to which a %irm@s 4or asset@s5 return changes due to a change in the mar'et@s return5& ?%%ects o% Le#erage on Aeta: l 6 u 4, 8 4, 9 t5 2B?5 and u 6 l B 4, 8 4,)t5 2B?5 where l and u are le#eraged and un)le#eraged !etas( respecti#ely& Learning Objective ": How to define valuation cash flows consistent with the cost of e#uity and weighted average cost of capital and when they are applied CAAP cash %lows must !e rede%ined to include cash %low a#aila!le %or common equity in#estors and %or !oth equity in#estors and lenders& $o retain or attract equity in#estors( the amount o% cash %low a#aila!le %or in#estors must !e su%%icient to allow equity in#estors to earn at least their cost o% equity& $o retain !oth or attract !oth equity in#estors and lenders( the amount o% cash %low a#aila!le %or !oth constituent groups must !e su%%icient to ena!le the %irm to earn its weighted a#erage cost o% capital& Free cash %low to equity in#estors 4FCF?5 or equity cash %low is cash %low remaining %or paying di#idends to common equity in#estors a%ter the %irm satis%ies all o!ligations including de!t payments( capital e*penditures( changes in net wor'ing capital( and pre%erred di#idend payments&

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FCF? 6 Det Income ) 4Cross Capital ?*penditures 9 2epreciation5, ) Det =or'ing Capital 8 Dew 2e!t Issues 9 Principal 7epayments 9 Pre%erred 2i#idends

Free cash %low to the %irm 4FCFF5 or enterprise cash %low is the cash %low a#aila!le %or equity in#estors and lenders. it can !e calculated in two ways: a& Ay adding up cash %lows to all o% a %irm@s claim holders FCFF 6 FCF? 8 Interest ?*pense 4, 9 $a* 7ate5 8 Principal 7epayments 9 Dew 2e!t Issues 8 Pre%erred 2i#idends or 6 Det Income9 4Cross Capital ?*penditures 9 2epreciation5 ) Det =or'ing Capital 8 Interest ?*pense 4, 9 $a* 7ate5 2i#idends 4Dote: $he inclusion o% the components o% FCF? in this equation result in the cancellation o% Dew 2e!t Issues( Principal 7epayments( and Pre%erred 2i#idends&5 !& Ay ad"usting earnings %rom operating earnings !e%ore interest and ta*es 4?AI$5/(0 FCFF 6 ?AI$ 4, 9 $a* 7ate51 ) 4Cross Capital ?*penditures 9 2epreciation5 ) Det =or'ing Capital

4Cross Capital ?*penditures 9 2epreciation5 represents that portion o% capital spending that cannot !e %inanced out o% internal cash %low 4i&e&( net income plus non)cash e*penses such as depreciation5& ther non)cash e*penses not directly related to capital e*penditures that need to !e added !ac' to net income include things such as goodwill e*pense& / Aoth /a and /! pro#ide the same estimates o% cash %low& 0 2i%%erences !etween FCF? and FCFF are due to de!t)related cash %low plus non)equity claims& 1 4,)t5 * i represents the portion o% interest paid to !ondholders that is not reco#era!le !y shareholders as a result o% the ta* deducti!ility o% interest& $he e%%ects o% this ta* sa#ing are already included in Det Income& Alternati#ely( ?AI$4,)t5 can !e e*pressed as DI 8 i 4,)t5( since DI 6 ?AI$ 9 i 9 4?AI$)i5 * t 6 ?AI$ 9 i 9?AI$ * t 9 i * t 6 ?AI$4,)t5 9i 4,)t5 and ?AI$4,)t5 6 DI 8 i 4,)t5& Learning Objective $: %lternative discounted cash flow &ethods and under what conditions they are applied Eero Crowth Model: Free cash %low is constant in perpetuity& $he #alue o% the %irm is the Fcapitali+edG #alue o% its annual cash %low& a& !& PH 6 FCFFH B =ACC( where FCFFH is %ree cash %low to the %irm and =ACC is the weighted a#erage cost o% capital& PH 6 FCF?H B 'e( where FCF?H is %ree cash %low to equity in#estors and 'e is the cost o% equity&

?*ample: Calculate the cost o% capital and #alue o% a %irm whose capital structure consists only o% common equity o% I1H million and de!t o% I<H million& Aoth equity and de!t are e*pressed in terms o% their mar'et #alues& $he %irm@s marginal ta* rate is &1 and !eta is ,&/& $he corporate !ond rate is <:( the $reasury !ond rate is 1:( and the e*pected annual return on stoc's is ;&3:& Annual FCFF is e*pected to remain at I7 million inde%initely& 'e 6 &H1 8 ,&/ 4&H;3 ) &H15 6 &,H< * ,HH 6 ,H&<: =ACC 6 &,H< * 41HB,HH5 8 &H< * 4,)&15 * 4<HB,HH5 6 &H1/ 8 &H// 6 &H<1 * ,HH 6 <&1: PH 6 I7 B &H<1 6 I,H;&1 million

Constant Crowth Model: Cash %low ne*t year 4i&e&( the %irst year o% the %orecast period5 is e*pected to grow at a constant amount( i&e&( FCFF, 6 FCFFH 4, 8 g5& a& !& PH 6 FCFF, B 4=ACC 9 g5( where g is the e*pected rate o% growth o% FCFF,& PH 6 FCF?, B 4'e 9 g5( note: FCF?, 6 FCF?H 4, 8 g5

?*ample: Constant growth model: ?stimate the #alue o% a %irm 4PH5( whose cost o% equity is ,/: and whose cash %low in the preceding year o% I1 million is pro"ected to grow ,H: in the current year and then at a constant 3: annual rate therea%ter& PH 6 41&H * ,&,54,&H35 B 4&,/ ) &H35 6 I<< million Varia!le Crowth Model: Cash %low e*hi!its !oth a high and a sta!le or terminal growth period& $he growth rate and discount rates during the high growth period e*ceed the rates during the terminal growth period&

?*ample: Varia!le growth model: ?stimate the #alue o% a %irm@s equity 4PH5 whose cash %low is pro"ected to grow at a compound annual a#erage growth rate o% ,3: %or the ne*t %i#e years& $he current year@s cash %low is I0&HH million& $he %irm@s cost o% capital during the high growth period is ,/:& $he sustaina!le growth rate and cost o% capital during the terminal period are 3: and J:( respecti#ely& $he mar'et #alue o% the %irm@s current outstanding de!t is I< million& PH 6 0&HH * ,&,3 8 0&HH * ,&,3/ 8 0&HH * ,&,30 8 4,&,/5 4,&,/5/ 4,&,/50 0&HH * ,&,31 8 0&HH * ,&,33 8 440&HH * 4,&,353 * ,&H355 B 4&HJ ) &H35 4,&,/51 4,&,/53 4,&,/53 6 0&13 B ,&,/ 8 0&;7 B ,&,// 8 1&3< B ,&,/0 8 3&/3 B,&,/1 8 <&H0 B,&,/3 8 /,,&/B ,&,/3 6 0&HJ 8 0&,< 8 0&/3 8 0&01 8 0&1/ 8 ,,;&J1 6 I,0<&H;

PV o% equity 6 I,0<&H; 9 I< 6 I,0H&H; Learning Objective ': (eter&ining growth rates and the sensitivity of ter&inal values to changes in assu&ptions Key Premise: $he #alue o% the %irm can !e represented !y the sum o% the high growth period4s5 plus a sta!le growth period e*tending inde%initely into the %uture& Key 7is': Sensiti#ity o% annual cash %lows and terminal #alues to choice o% assumptions a!out the sta!le growth rate and the discount rate associated with each period& Sta!le Crowth 7ate: $he %irm@s growth rate that is e*pected to last %ore#er is generally equal to or less than the industry or o#erall economy@s growth rate& For multinational %irms( the growth rate is that o% the world economy& Length o% the -igh Crowth Period: $he greater the current growth rate o% a %irm@s cash %low relati#e to the sta!le growth rate( the longer the high growth period& Ad"usting the 2iscount 7ate: Since ris' and return are positi#ely correlated( the discount rate %or the sta!le growth period should !e reduced&

Learning Objective ): *aluation of non+operating assets and liabilities and adjusting fir& value Don)operating assets include the %ollowing: ))Cash and mar'eta!le securities in e*cess o% normal operating requirements& ))In#estments in other %irms ))Lnutili+ed or underutili+ed assets such as patents( trademar's( or o#er)%unded pension plans& Don)operating lia!ilities include the %ollowing: ))=arranty claims ))Legal "udgments ))?n#ironmental lia!ilities Ad"ust the #alue o% the %irm@s equity %or the present #alue o% non)operating assets and lia!ilities !y adding their PV to the PV o% the %irm@s equity& Chapter 7 ,tudy -est $rueBFalse Muestions: ,& $he capital asset pricing model relates the return required !y shareholders to the ris' %ree rate o% return( the ris' premium on stoc's( and to the %irm@s di#ersi%ia!le ris'& $rue or
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False /& 0 1& 3& $he weights associated with the cost o% equity and de!t in calculating the %irm@s weighted a#erage cost o% capital re%lect the %irm@s target capital structure& $rue or False A !eta re%lecting the e%%ects o% !oth the increased #olatility o% earnings and the ta*)shelter e%%ects o% le#erage is called an unle#ered !eta& $rue or False ?nterprise cash %low is the cash %low a#aila!le %or common and pre%erred stoc'holders( as well as lenders& $rue or False ?quity cash %low is the cash %low remaining %or paying di#idends to common equity in#estors( !uying !ac' stoc'( or rein#esting in the %irm a%ter satis%ying all o% the %irm@s o!ligations& $rue or False In applying discounted cash %low methods( enterprise cash %low is discounted !y the %irm@s cost o% equity& $rue or False An important ad#antage o% discounted cash %low methods is that they are relati#ely insensiti#e to changes in estimates o% the sustaina!le growth rate and discount rate& $rue or False $he +ero growth model is a special case o% the constant growth #aluation model& $rue or False $he #aria!le growth model consists o% a high growth and a no growth period& $rue or False It is possi!le %or the sustaina!le growth rate %or a %irm@s cash %low to e*ceed the o#erall mar'et growth rate inde%initely& $rue or False $he mar'et #alue o% a %irm@s equity can !e estimated !y su!tracting the !oo' #alue o% the %irm@s current de!t %rom the present #alue o% the %irm@s enterprise cash %low& $rue or False Cash in e*cess o% the %irm@s operating requirements should !e added to the #alue o% the %irm@s equity in calculating the total #alue o% the %irm& $rue or False I% the terminal #alue accounts %or a large percentage 473: or more5 o% the total PV( the con#entional 3)year pro"ection o% %uture cash %lows should !e e*tended to at least ,H years& $rue or False In calculating the present #alue o% a %irm@s equity cash %lows( the cash %lows are discounted !y the %irm@s cost o% equity& $rue or False

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In calculating the #alue o% a %irm( it is unnecessary to consider the #alue o% a %irm@s non) operating assets and lia!ilities& $rue or False

Multiple Choice Muestions: ,<& All o% the %ollowing are used in the calculation o% the weighted a#erage cost o% capital e*cept %or a& !& c& d& ,7& Cost o% equity A%ter)ta* cost o% interest Aoo' #alue o% de!t Mar'et #alue o% equity

?nterprise cash %low re%lects all o% the %ollowing e*cept %or a& !& c& d& Cash %rom operating acti#ities Cash %rom %inancing acti#ities Cash %rom in#esting acti#ities A%ter ta* operating income

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=hich o% the %ollowing should !e added to the present #alue o% a %irm@s equity in determining the total equity #alue o% the %irmN a& !& c& d& Cash !alances in e*cess o% normal operating requirements Surplus land PV o% unused patents All o% the a!o#e

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=hich o% the %ollowing are not e*amples o% non)operating assetsN a& !& c& d& Cash in e*cess o% normal operating requirements Finished goods in#entories Vacant land shown on the %irm@s !alance sheet Lnused patents

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=hich o% the %ollowing is not included in calculating a %irm@s cost o% equity using the Capital Asset Pricing ModelN a& !& c& d& 7is' %ree rate o% return $he %irm@s !eta 7eturn on all stoc's Aoo' #alue o% assets

Practice Pro!lems: /,& $he C? o% Au%%alo Ao!@s Chic'en =ings is considering selling his %irm& She estimates

that the %irm@s current year equity cash %low is I1 million& She as's her CF to create se#eral estimates o% the %irm@s #alue& Scenario , is to !e !ased on a 1: annual growth rate. the second scenario is to re%lect a <: annual growth rate %or the ne*t %i#e years and 0: therea%ter& $he %irm@s cost o% equity %or !oth scenarios is estimated to !e ,H:& =hat is the #alue o% the %irm under scenario , and scenario /N //& $he current di#idend yield o% the Standard O Poor 3HH Inde* is ,&/:& $he a#erage earnings o% %irms in the inde* are e*pected to grow at 3: annually into the %oreseea!le %uture& =hat is the equity #alue o% a %irm whose equity cash %low was I0 million last year and whose cash %low is e*pected to grow !y 7: this year and 0: therea%ter& Sematech has achie#ed a dominant mar'et position in its targeted mar'et& Its huge mar'et share ma'es it unli'ely that the %irm can grow %aster than the growth rate o% the o#erall mar'et( which is e*pected to !e J: annually through the %oreseea!le %uture& Its net income in /HH/ was I,3 million& 2epreciation e*pense and capital e*penditures were I3 million and I,H million( respecti#ely& $he annual change in wor'ing capital was minimal& $he ,H)year $reasury !ond rate was 3: and the %irm@s !eta was estimated to !e ,&0& $he historical ris' premium on stoc's o#er the ris' %ree rate o% return is 3&3:& a& Calculate Sematech@s discount rate& !& Calculate the %irm@s %ree cash %low in /HH/& c& ?stimate the #alue o% Sematech at the end o% /HH/& /1& $he present #alue o% a %irm@s operating cash %lows is estimated to !e I/7 million& Cash in e*cess o% the %irm@s normal operating requirements is I/ million& $he present #alue o% %uture warranty claims is e*pected to !e I0 million& =hat is the #alue o% the %irmN A %irm@s cost o% equity and pre%erred stoc' are estimated to !e ;&3: and <&3:( respecti#ely& $he %irm@s cost o% de!t and marginal ta* rate are <: and 1H:( respecti#ely& $he mar'et #alues o% the %irm@s common and pre%erred equity are IJ7H million and I,/H million( respecti#ely& $he mar'et #alue o% the %irm@s de!t is I/3H million& =hat is the %irm@s weighted a#erage cost o% capitalN Free cash %low to equity last year was I1 million& It is e*pected to grow !y /H: in the current year( at a ,3: rate annually %or the ne*t %i#e years( and then assume a more normal 1: growth rate therea%ter& $he %irm@s cost o% equity is ,H: during the high growth period and then drops to J: during the normal growth period& =hat is the present #alue o% the %irmN Answers to $est Muestions $rueBFalse ,& False /& $rue 0& False 1& $rue 3& $rue
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Multiple Choice

<& False 7& False J& $rue ;& False ,H& False ,,& False ,/& $rue ,0& $rue ,1& $rue ,3& False ,<& C ,7& A ,J& 2 ,;& A /H& 2

Answers to Practice Pro!lems /,& PV 4scenario ,5 6 41 * ,&H15 B 4&,H)&H15 6 <;&00 PV 4scenario /5 6 1*,&H< 8 1*,&H</ 8 1*,&H<0 8 1*,&H<1 8 1*,&H<3 8 ,&,H ,&,H/ ,&,H0 ,&,H1 ,&,H3 41*,&H<3*,&H0B4&,H)&H05 ,&,H3 60&J3 8 0&7, 8 0&3J 8 0&13 8 0&0/ 8 1J&;, 6<<&J/ //& 'e 6 d,BPH 8 g 6 &H,/ 8 &H3 6 &H</ PV 6 40 * ,&H7 * ,&H05B4&H</ ) &H05 6 I,H0&0/ million /0& a& a& !& C ? 6 &H3 8 ,&04&H335 6 ,/&,3 FCF? 6 ,3 8 3 9,H 6 ,H PV 6 ,H * ,&HJB4&,/,3 )&HJ5 6 I/<H&/1

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I/7 8 I/ )I0 6 I/< million &H;3*4J7HBJ7H8,/H8/3H5 8 &H<3 * 4,/HBJ7H8,/H8/3H5 8 &H<*4,)&15*4/3HBJ7H8,/H8/3H5 6 &H<<7 8 &HH<0 8 &HH70 6 &HJH0 * ,HH 6 J&H0:

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PV,)3 6 I1 * ,&/ * ,&,3 8 I1 * ,&/ * 4,&,35/ 8 I1 * ,&/ * 4,&,350 8 4,&,H5 4,&,H5/ 4,&,H50
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I1 * ,&/ * 4,&,351 8 I1 * ,&/ * 4,&,353 4,&,H51 4,&,H53 6 I3&H/ 8 I3(/3 8 I3&1J 8 I3&70 8 I3&;; 6 I/7&17 PV3 6 44I1 * ,&/ *4,&,353 * ,&H155 B 4&HJ ) &H15 6 I,33&J< 4,&,H53 PH 6 PV,)3 8 PV3 6 I/7&17 8 I,33&J< 6 I,J0&00

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