Merger and Acquisition Valuation Author(s): Samuel C. Weaver, Robert S. Harris, Daniel W. Bielinski, Kenneth F.

MacKenzie Source: Financial Management, Vol. 20, No. 2 (Summer, 1991), pp. 85-96 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665732 . Accessed: 20/04/2011 14:01
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Panel

Discussion

Merger

and

Valuation Acquisition

DanielW.Bielinski, KennethF. MacKenzie and SamuelC. Weaver,RobertS. Harris,

Foods Corporation. SamuelC. Weaver, Moderator: Hershey Panelists: Robert Harris, S. University Virginia; of ArthurAndersen Company; & and Daniel W.Bielinski, Kenneth MacKenzie, Institute Business F. of Appraisers.

valuation animportant is and Merger acquisition topic in thatreceiveslimitedattention literature. purpose The of this session is to examineand discusscritical"real world" issues, such as screening targets, valuation models,discountrates,etc.
N

and Samuel C. Weaver:Thisis a merger acquisition valuation panel with four people of unique backwill grounds.The order of presentation be Robert S. DanielW. Bielinski, Arof Virginia; Harris,University thurAndersenand Company; thenI'll givemy presenInstituteof tation,followedby KennethF. MacKenzie, Bob Business Appraisers. willbringa generalacademics viewpointto the session. Dan, who has publisheda will numberof articles on mergersand acquisitions, bring a consultant's viewpointto the panel. I'll then industrial Followpresenta generalstandard viewpoint. who will bring some ing me will be Ken MacKenzie, and alternative models,backgrounds, uniqueviewson the valuation process.After that,we'll entertainquestionsand answers. Bob, I'llturnit overto you.
85

Robert S. Harris:Since Sam has let me go first,I wantto give an overview some key considerations of in a company.First, I'll examinethe process of valuing identifying, selectingand purchasing companies.This context is important to appreciate the full bigger benefits(and limitations) placinga valueon a comof I'lldiscussfourkeyissuesthataddlayers pany.Second, of complexity the use of standard to valuation modelsin a takeover lackthereof)of synersetting: (or uniqueness in meansof payment gies andcompetition bidding, (e.g., cashversusstock)usedin a transaction, wealthtransfers among different claimants (e.g., bondholders and shareholders), and treatmentof currencyissues in cross-bordertransactions.Finally, I'll discuss some to specificapproaches valuation. in Anyonewho has studiedor participated an acquisitionknows that the process is complicatedand involves numerous bankers to players(frominvestment laborunions).Fromthe buyer's the perspective, process interrelated mightinvolvethe following stages:strategy identification screening candidates, and of formulation,

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1991 FINANCIAL MANAGEMENT/SUMMER

valuationof targets, negotiation,purchase,and implementation. Manykeydecisionsaremadepriorto any formalvaluationof a target(e.g., selectionof general as in criteria potential for acquisitions) is typical a world An to look at of costly information. instructive way and is valuation in the contextof negotiation company A a disbid preparation. valuation framework provides ciplinedmeans for humans,who after all are the ulof timateactors,to bringtogethera widearray information and understand what price can be affordedby a buyer,whatprice is likelyto be acceptableto a seller, and importantly,what price may be affordable to the another bidder.Furthermore, valuation processis a the dynamicone that allowsunderstanding effects of in aboutfactorssuchasmarket changes keyassumptions In or growth cost structure. a negotiation processwhere new information becomes available, the valuation a framework critical providing timelyresponseand is to in limiting occasional of sesthe euphoria a negotiating into sion.Thevaluation insight the processalsoprovides aftertakeover. challenges management In this context,whatvaluesactually get paid for do Exhibit1 showspremiums companies? (percentmarket to offer)paidfor U.S. targetsas recorded by priceprior about40% W. T. Grimm. Whilethe premium averages variesover overthe 20-year clearly period,thepremium differamongsubsetsof firms time;moreover, premiums by etc.). The revelation (byindustry, meansof payment, is valuation avery of themarket showsthattakeover thus over current business.No simplemarkup complicated marketpriceworks.In fact, a marketprice is typically In recordedover2,000 not evenavailable. 1989,Grimm of U.S. firms, only 14% of which were acquisitions marketpriceas tradedfirms.Havinga current publicly a starting point is the exception, not the rule, in takeovers. Any valuationshould considernot only what the targetmaybe worthto the buyer,butwhatthe target's nextbestalternative likely be. Forinstance, is to suppose that when valued as a stand-alone,a target is worth the $10.00, whereas,due to substantial synergies, target firm.A keyelement as partof the buying is worth$15.00 for negotiationsis the value of the target to another in bidder.If allthe synergies $5.00increment value) (the are uniqueto one buyer,the buyermaywell be able to for purchase $10.01.On the otherhand,if the synergies to (e.g.,a taxbenefit)areequallyavailable manypotentialbidders,the buyerlikelymustraisethe bid close to As must to $15.00 buythetarget. a result,a fullvaluation take into accountthe uniquenessof synergiesand the

of characteristics other buyers, rather than be conductedsolelyon information aboutthe targetand bidder. In a worldwith taxesand information asymmetries, theformof payment justthenominal market value) (not can play a significant role. For instance, target shareholders mayprefershares(versuscash) to minimize personaltax liabilities since realization capital of can be deferredin equity offers. On the other gains if hand,a shareoffering mayitselfraiseproblems target of the buyer.Any ownershavedoubtsaboutthe future shouldconsider thesepossibleeffectsin looking analyst for a valuewhichcan be paidfor the target.Value can dependon the formof payment. Mostvaluation assumethatthe residual approaches benefitor lose fromchanges owners,the shareholders, in totalcorporate value.As a numberof highlylevered the transactions haveshown,however, linkbetweenthe of valueof the entirefirmandthe distribution thatvalue is morecomplex. Thiscomplexity wealthtransinvolves shouldassess,sincewealthtransfers,whichan analyst fers (as opposedto wealthcreation)canprovide importantincentives or againstan acquisition. for To illustrate, considera firmwhosevalue(VF)is the that the specific,assume priorto a takeover targetfirm's valueis as follows:
VF = VD + VE = $4.00 + $6.00 = $10.00.

sum of the values of debt (VD) and equity (VE). To be

substantial Nowsupposea buyer borrowing (an employs additional$5.00 of debt over and above the target's existingdebt) to buy the equityof the target.Assume that after the takeover,the value of the target firm remainsat $10.00 (no net value creation)but is distributed follows: as
VF = VD + VE = $8.00 + $2.00 = $10.00.

Notice thatI have assumedthatthe valueof debt goes from$4.00to $8.00,even thoughan additional $5.00is The borrowed. Howcan$4.00 + $5.00= $8.00? answer is thatexisting debtowners(withinadequate covenants) suffera valueloss as theirdebtbecomesmoreriskyand is downgraded. This wealth loss of $1.00 is a direct transfer the buyer.The buyerhas used $5.00of borto rowingplus $1.00 of his own capitalto purchasethe $6.00of equityin the target.At the end of the transaction, the buyerhas equityvalueof $2.00,havinghad to

VALUATION BIELINSKI MACKENZIE/M&A & HARRIS, WEAVER,

87

1970-1989 Exhibit1. U.S. Takeover Premium,

60

50

40

% over market
30

20

10

0
70

I
71 72

I
73

I
74

I
75

I
76

I
77

I
78

I
79

I
80

I
81

I
82

I
83

I
84

I
85

I
86

I
87

I
88

I
89

year

Source: W. T. Grimm

is investonly$1.00of hisownmoney.Thedifference the wealthtransfer fromexistingdebtowners. Wealthtransfers involvemanydifferenttypesof can claimants(debt owners,employees,etc.) and can be in the extremely important understanding effects of a on takeover value.The transfers raiseethicalconalso siderationssince wealth redistributions often involve contracts with important sets of breaking implicit stakeholders. important The is messageforvaluation to examine wealthtransfers. possible are takeovers cross-border transactions Increasingly, indifferent countries. thus involving operations Analysis involvesassessmentof differenteconomies and cultures.A specificchallenge valuation for is technique the choice of currencyin which to value the target firm. Shouldtheanalysis in thehomecurrency thetarget be of firmand be tied to financial marketconditionsin that Or country? shouldthefocusbe on thebuyer's currency andcountry? return thisissuebriefly discussing I'll to in models. specificvaluation The underlying philosophyof valuationmodels is Valuation models attempt to find straightforward. claimsthat are tradedin financialmarketswhich are reasonable substitutes the claimsofferedby a target for Marketpricingsubstitutes then be used can company.

to inform valuation the target.Valuation of approaches differlargely howsubstitutes defined(be it dollars in are of earnings, cash flowswith particular profiles,or risk or replacement valuesof specific physical accounting the assets). I'll discuss two basic approaches: use of anddiscounted cashflowmethods. multiples Whether based on publiclytraded companiesor the to recentlycompletedtakeovers, use of "multiples" valuecompanies common. is Valueis simply product the of a base numberand the appropriate multiple.The be based on earnings,book value, cash multiplemay flow or some other item.No matterhow multiplesare selected and applied,certaindifficulties crop up. It is often difficult findcomparable to Accountcompanies. can difficult ingcosmetics leadto notoriously problems. whenusingearnings cash-flow-based or mulEspecially to tiples, it maybe difficult,if not impossible, capture dimensions(of life cycle or recession)in a multiyear of one times simplecalculation multiplying multiplier one basenumber get a value.Inits worstapplication, to the use of multiplesfalls into the trapof beinga backexercise instead of the forward-looking ward-looking criticalto anyvaluation. a result,I focus on As analysis discounted cashflowanalysis (DCF).

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FINANCIAL 1991 MANAGEMENT/SUMMER

Exhibit 2. Two Discounted Cash Flow Models for Takeover Valuation "cost" capital I. Freecashflows,weighted average of FCF TVF
VF==

t=1 (1 + Kw)

N (1 + Kw)N

where FCF = Free cashflowpriorto debtservice cost of capital Kw= Weightedaverage TVF= Terminal valueof entirefirm N = Planning horizonin years VF= Valueof firm II. Equity residual flows, "cost" equity cash of

VEZ=
where

TVE + N+ t=1 (1 +Ke) (1 + e)N

ECF

ECF = Equitycashflow,afterdebt service TVE= Terminal valueof equity Ke = Costof equitycapital VE= Valueof equity= VF- VD

formsof DCF analysisapThe two most prevalent to company valuation shownin Exhibit2. In are plied both cases, a finite horizonis chosen with a terminal value estimate proxyingfor value at the end of the A horizon. greatdealhasbeenwritten both on planning I offeronlya fewcomments. free The Here, approaches. cashflowapproach focuseson incremental (operating) cashflowspriorto debtserviceandestimatesthevalue As of theentirefirmVF. a result, valueof equity(VE) the is determined subtracting valueof debt(VD)from the by
total firm value: VE = VF - VD. The appropriate dis-

countrateis a weighted of capital(Kw) cost appropriate for the businessriskandfinancial structure the cash of flowsofferedby the target.The target'scost of capital a (not the buyer's)is typically usefulstarting pointfor estimating but the analystfaces challengesin that Kw, the prospective cash flows mayincorporate operating in risk different prospective thanthe synergies (perhaps target'sexistingoperations).Furthermore, proposed

can changesin capitalstructure affectKw.The logic of is the freecashflowapproach to handlefinancing issues in the discount rateandfocuson the valueof the entire firm.Givenpossible wealthtransfers, one however, must be specially carefulinvaluing debtbeingsubtracted the fromVFif a reasonable estimateof equityvalueis to be A market obtained. valueof debtmustbe subtracted. A second DCF approachfocuses directlyon the residualcashflowsto equity.Suchan approach therefore looksat equitycashflowsafterdebt serviceandis where capitalstrucsuitableto situations particularly ture is intimately linked to the proposed transaction (such as an LBO). Discountingthese equity residual cashflowsby a cost of equityappropriate the busifor risk flowsgivesa direct nessandfinancial of theresidual A estimate thevalueof equity. particularly of nettlesome the challengeis appropriately adjusting cost of equity for riskas moredebtis used. and Under ideal conditions consistentassumptions, will the free cash flow and equityresidualapproaches both the samevalueof equity,butin practice, yield they and different pose substantial slightly challenges. of Keyissuesforbothare:(i) the estimation terminal flows, (iii) the values, (ii) the natureof incremental of valuation futureoptions,and (iv) the choice of curto be used. rency (i) Terminalvalues play a key role in the overall valuation, especially in highly levered transactions wherecashflows(to equity)maybe lowin initial years. An analyst shouldbe careful use a variety estimates to of an andchecktheseestimates viewof the against overall if the terminal businessand industry. value is of Also, risk termcash different thanintermediate substantially it maybe discounted a different at rate. flows, modelscallfor lookingat incremental (ii) Valuation derived from the takeoverdecision. The cash flows analystmust be carefulnot to attributeto the target valuethatcanbe derived thebuyerpursuing novo de by The acquisitionis not the only course of investment. mustbe especially actionpossible.As well, the analyst aboutfuturesynergies. careful curboptimism to Getting people involvedwho actuallymust implementthese or synergies(e.g., people frommarketing production) check. mayprovidea reasonable with (iii) A difficulty usingDCFmethodsis valuation Often to of management's ability makefuturedecisions. is to a strategic acquisition positioned givethebuyerthe is optionto makea futuredecision.Suchflexibility not easily incorporatedin DCF models. Option pricing models have the potential for valuing such oppor-

BIELINSKI MACKENZIE/M&A & VALUATION WEAVER, HARRIS,

89

to is tunities,thoughapplication real investments difficult. context,one can state cash (iv) In a cross-border flowsin a foreigncurrency discountsuchflowsat a and cost of capitalbased on foreigncapitalmarketconditions.The resultant valuecanthenbe translated backto a buyer's home currency spot exchangerates.Alterat cashflowscan be converted homecurrency to natively, at projected futureexchange ratesandevaluated witha home currency discountrate.Withstrongassumptions aboutcapitalandexchange market the equilibrium, two yieldthe sameresult.In practice,however, procedures results fromthe twoapproaches differ.Administracan tively,a firm may choose one or the other approach, thoughuse of both providesthe most completeinsight intovaluecreation. Whatever methodis used,the buyer mustbe especially careful to confuseestimated not value creationbased on a guess about exchangerates with valuederived fromsuccessin realinvestment decisions. Cross-border are costlywaysto speculate acquisitions in exchange markets. to as Returning the viewof valuation partof a larger takeover selectionandnegotiation process,a keyuse of valuation modelsis inorganizing, and developing testing the effects of changes in key assumptions. effect, In valuationmodels discipline managersto confront a wholeset of issuesaboutthefuture a company. use of By of sensitivity the modelscan showhow imporanalysis, tantvariations assumptions be. Themagnitude in can of the value changeprovidesinsightinto what additional information shouldbe gatheredand analyzed. Perhaps the keyfor a particular valueis cost control.If target's the so, the buyerwoulddo well to understand natureof costs and thinkthrough post-takeover the steps necesto effect such control.In sum,the learningin the sary can asset processof doinga valuation be an important in both buying and managing a company. The framework affordedby financemodelsallowsintegration of the whole arrayof relevantinformation. the In end, however,the qualityof judgmentsused in those modelsis the key to successful valuations acquisiand tions.I'llnowturnthe paneloverto Dan. DanielW. Bielinski:In recentyears,Arthur Andersen has evolvedinto a worldwidebusinessconsulting We've investedsignificantresourcesto organization. identifyclient needs and to hire specialistswith the expertiseto meet those needs. For example,Arthur has Andersen hireda number personssuchas myself, of with a background finance and investments in rather

than accounting,to counsel clients on the value of thatthese clientsare lookingto buy privatecompanies or sell. WhatI wantto do todayis talkabouttwo aspectsof our servicesin this area.Firstof all, I'd like to discuss the roleof the merger acquisition and valuation consultfor ant, whetherworking ArthurAndersenor another firm.Second,I wantto talkaboutthe discountedcash flowanalysis Bob touchedon briefly. that DCF analysis is, by far,our mostwidelyused tool for valuing private companies. Theroleof theM&Avaluation consultant outlined is in Exhibit Clientswho use a valuation 3. consultant can be corporations, investorgroups,or individual investors. They can be lookingto buy or sell a division,a or firm. subsidiary, a stand-alone As a valuationconsultant, serve three functions: I with deal structuring negotiationsupport,interfacing andfinancing, negotiation and leverage. In offeringnegotiation support,it's myjob to make sure my client understands value of the subject the beforesittingdownat the negotiating privatecompany table. I look at value from the perspectiveof both a generalbuyerand the specificbuyeror seller that my clientis goingto be sittingacrossthe tablefrom.I will look at synergies how they mightbe split between and and seller.If I'mcounseling someoneon the buy buyer sometimes askedto come up withwhatmight I'm side, be calleddefensivepricing.Thatis, the buyerwantsto risk on paya pricethatminimizes - buying histermsor not at all.Onthe otherhand,if I'mcounseling someone on thesellside,the sellermight wantto knowthehighest possible selling price that can be justified,based on economics- knownas "pricing the bubble". on Letme giveanexample whatcanhappenif a client of doesn'treceivethisnegotiation We support. hada client did who, unfortunately, not come to us aheadof time. Ourclientwas a manufacturer hadjust purchased who a distributor at the timeof acquisition, buying was that, severalproductlines froma competingmanufacturer. Ourclientreasoned,correctly, afterthe acquisition that theseproductlineswouldbe purchased fromourclient our bythe distributor, increasing client'smanufacturing what volume,profits,andso on. Unfortunately, theydid was take all the incremental manufacturing profitand includeit in theirdiscounted cashflowwhenformulating their initialbid. So, all of a sudden,a $30 million distributor you mighthavepaid $34 to $35 million that for becauseof synergies, purchased an initialbid was at of $40 million.I mightadd that this is not an unusual

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FINANCIAL 1991 MANAGEMENT/SUMMER

Exhibit3. The Role of the M&AValuation Consultant

Clients * Corporations * InvestorGroups * Individual Investors

Valuation Consultant I. Negotiation Support II. Interfacewith Deal " Structuring/Financing Ill. NegotiationLeverage
* * *

PurchaselSale of: Divisions Subsidiaries Private Firms

event. By the way, I am changingthe numberson all but for theseexamples confidentiality reasons, the point for is valid. It's extremelyimportant people that are these lookingto buy or sell a businessto understand issuesaheadof time. is consultant interThe seconddutyof the valuation and side.This withthe deal structuring financing facing than is less of an issuein a straight corporate purchase is a big partof an acquisistructure whenthe financing On tion.Here,youoftenrunintotwoproblems. the one hand,you have those people that try to combinethe decisionwiththe valuation. Theyeithertake financing all the financingcash flows and include them in the discounted cashflowor theyattemptto builda moving into the discountrate. Mixinginvestcapitalstructure decisions resultin a goodfinanccan mentandfinancing businesslookgood, an making overpriced ingpackage, wantto separatethesetwo You generally or vice-versa. decisions.On the otherhand,othersattemptto look at in and thevaluation question avacuum ignorethebigger contextwithinwhicha deal is takingplace.It is incumwith to bentuponthevaluation specialist interface those or who are doingthe deal structuring financing people to makesurethatthe client'sbest interestsare served. For example,what we often do at ArthurAndersen, after comingup with a range of values for a private is company, sit downwiththe peoplewho do the strucand and financing help themmatchup the cash turing flows, see if the timingof the cash flows matchesthe financing packagethat'sbeing put together,see if the amount time,and of debtcanbe paidoff in a reasonable

etc. lookat the taxconsequences, In the lastyear,we've had two deals that looked good from a valuation perspective,until our tax people analyzedthem and foundoutthatif the dealsweredone,withinthefirsttwo minimum years,therewouldbe a verylargealternative taxproblemin each case. It was a big enoughproblem to thatit killedeach deal.The pointI'mtrying makeis that in bringingto the table the knowledgeof how to the value a company, valuation specialistmustalso be of the biggerpictureand serve the client's cognizant interest. is consultant negotiaThe thirdrole of the valuation with anotherexample. this tion leverage.I'll illustrate I This summer, had a clientcome to me whowantedto I of to sell a subsidiary the management thatsubsidiary. valuedit andgavethema rangeof $4.5to $5.5million. When the client met with management, management for Our offeredthem$4million thecompany. clientsaid, ArthurAndersensaid "What you mean,$4 million? do The I shouldn't for less than$5 million." subsidiary sell The soldfor$4.9million. clientcamebackto us andsaid they felt ArthurAndersenwas an integralpartof this negotiation process,and helpedthemget moremoney wouldhave.The pointhere is, they thantheyotherwise were able to both use us for leverageand to makean decisionaboutan acceptable informed sellingprice. Thatis whatwe do;the nextquestionis "how?" available use by for of Therearea variety techniques cash One thevaluation consultant. of theseis discounted In flow analysis. valuingprivatefirms,it is, by far, our used tool. There is a thoughtprocess most frequently

BIELINSKI MACKENZIE/M&A & VALUATION WEAVER, HARRIS,

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Exhibit4. DCF BusinessValuation Step One -

Exhibit5. DCF BusinessValuation- StepTwo

ValuationModel

ValuationModel
ResidualValue (Rangeof

Projection (Range of Assumptions)Multiples)

ValuationCrosschecks

Implied Going-in Multiples

DiscountRate (Range)

Indicated Value

Implied

Going-In

Payback

Periods .Going-Out

1 ,

Vs.

PMultiples

ValuationCrosschecks

the valuationanalystgoes throughin utilizinga discountedcashflowmodelto determine rangeof value. a This thoughtprocess could be viewed as havingtwo in stepsthatare iterative nature. The first step can be seen in Exhibit4. This is a schematic of model,witha projecdrawing a valuation tion based on a range of assumptionsfor margins, rate etc.; growth, capitalexpenditures, a discount range derivedfromanynumber techniques; a residual of and valuebasedon a rangeof going-out The multiples. lines indicate that each of the variables,while developed is through independent analysis, alsorelatedto theother variables. threevariables combined awaythat The are in is consistentwith both the independentanalysesand theirinterrelationships, in resulting an initialvalue indication. 5, Steptwo,shownin Exhibit teststhereasonableness of this value indication.Three valuationcross-checks are utilized: implied going-in multiples, implied betweengoing-in payback periods,andthe relationship andgoing-out A going-in multiples. multiplerelatesthe valueindicatedby the discounted cashflowmodelto a currentearningsstream.Impliedpaybackperiodsare one of the most pervasive guidelinesused today;most investors wanta five-to seven-year on generally payback theirmoney. Thisis a guideline, anabsolute not but rule,

investorsare at risk and want their money out in a will reasonable periodof time.Of course,thisguideline withthenature the subject of A vary company. going-out is residual multiple the multiple impliedbythe assumed value.Whatto watchoutforhereis pricing company the a that by assuming going-out multiple is higherthanthe for going-inmultiple; example,"Ican pay 15xearnings todaybecauseI can sell in fiveyearsfor 20xearnings." This will generallyresult in overpricing. The lines on Exhibit5 indicatethat the three cross-checksare related. For example,if I have a decent payback,I can affordto pay a highermultiple. whathappenswhenyou look at the output Typically of yourvaluation modelthefirsttimethrough thatone is or moreof these cross-checks don'tmakesense.Thisis the point at which the process becomes iterative,as shownin Exhibit6. One mustvarythe threevaluation modelvariables withintheirranges, perhapsreevaluate the derivationof these ranges,and often rethinkasreasonable valuesfor each crosssumptions regarding check variable.This process continuesuntil all of the "sixboxes"(see Exhibit6), each of the relationships within the valuationmodel and the valuationcrossbetweenthe modelandthe checks,andthe connection cross-checks makesenseat the sametime.Whenyou all get to this point, you do some additionalsensitivity

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FINANCIAL 1991 MANAGEMENT/SUMMER

Exhibit6. DCF BusinessValuation- An Iterative Process

ValuationModel
Projection
Residual
Value

(Rangeof(Rangeof Assumptions)Gon-u

DiscountRate

(Range) Indicated Value

ValuationCrosschecks

Implied Going-In Multiples

Implied
Payback
-.4

Going-in
Vs.

Payback

Going-Out Multiples

analysisto come up with what a reasonablerangeof value mightbe. That is the discountedcash flow approachviewedas an iterative process.Thankyou. Sam Weaver:I thinkwhatBob andDan had to say were perfectsetupsfor the specificcommentsthat I'd like to make. I'm going to talk about a very generic valuationmodel, and why companiesdo acquisitions. Last year's annualreport talked about some of the that acquisitions Hershey'sdone since 1986,and gives some of the best reasonsI knowof why companiesdo is Hershey goingto stayfocusedinthefood acquisitions. in processing business, particularly confections and has made three major confectionery pasta. Hershey the confecPeterPaul/Cadbury, Canadian acquisitions: and snack nut businessesof Nabisco Brands tionery Ltd.,andLuden's. When we acquiredLuden's,we decided to concentrateon four mainbrands: Avenuecandybars, 5th Luden'sthroatdrops,Mello Mintpeppermint patties, andQueeneAnne chocolatecoveredcherries. Luden's

used to have about 750 different products,and we streamlinedto these four productlines. The driving factor in this decisionwas our perceivedabilityto exof panddistribution thesefourbrands. was Oursecondmajoracquisition the Canadian acThe problems Bob mentioned involving quisition. foreign acquisitionswere encountered by Hershey. When a companyconsidersa foreignacquisition, the There are manydifgrows geometrically. complexity ferent issues that must be addressed.We acquired NabiscoBrandsconfectionery businessin Canadabecause of two factors. One was our need to achieve sufficient size in the market to have a meaningful of presence.The otherfactorwas the underutilization in Canada. decided We chocolateproduction capacity we couldcombineplantsandbe muchmoreefficient. We purchased Peter Paul/Cadburybecause we believed we could improve its operatingmarginby reducing manufacturing, selling, marketing,and administrativeexpenses. We are better positioned to achievethe desiredmargins.

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In eachof thesecases,Hershey lookingatprivate was dealswheretheycouldadd something. Before discussinga specific acquisitionmodel, I wouldliketo discusshowourrecentacquisition activity Manyof our acquisitionreviewsare contranspired. ductedvia the sealed bid process in whicha firmlike Dan'smightbe representing company we would a that like to acquire.Dan wouldgive our corporatedirector of acquisitions callsayingthe company goingto sell. a is If we wereinterested, couldbe one of manycorporawe tionssubmitting preliminary a of indication nonbinding value.We would then begin the preliminary valuation valueup process.You haveto give a good preliminary front,or youget cutoff fromgoingto the secondround. to (Youhaveto be one of the top threebidders, usually, into the second round and have access to more get information refinethe valuation.) to The valuation focusthatwe use is a discounted cash flow approach. also do the benchmarking Dan We that mentioned.When you'relookingat acquiringa company,you'revery honest rightup front.As Bob menon tioned,in manycasesyouputyourgeneralsynergies the tableandpaythe company you'reacquiring that for those synergiesthat any buyermay bringto the table (special synergiesthat are uniqueto Hersheyprovide discussion So, interesting material). it makessense that the value of the acquiring firm shouldgo up, whereas our valueacquiring themreallydoesn'tchangeall that much.We payfor thosegeneralsynergies. When calculatingthe value of an acquisitioncancashflowmodel.We focus didate,we use a discounted on forecastedoperating cash flows.Whatyou'rereally dealingwith is a verylarge capitalbudgetingproblem withsome otherancillary aspectsto it. In our business, sales growthand operatingmarginsare the two key valuedrivers. The acquisitionprice is calculatedas the present value of forecastedoperatingcash flows.The acquisitionpriceis driven salesgrowth rate,operating by: profit incometaxrate,fixedcapitalinvestment, workmargin, hurdlerate,andresidual value. ing capitalinvestment, To find out what we can do with the prospective we divisions Hershey in and company, talkto thevarious ask themwhattheycoulddo withthese businesses. We our own experienceto projectoperatingperforgo by mance.It may not be sophisticated, it's not a bad but numbers. thevarious All factors placeto startprojecting combineto providea cash flow,whichwe forecastfor 15years.

We look at all the variousaspects,performa lot of and what's sensitivity analyses, thenwe tryto highlight to In reallyimportant seniormanagement. our presentationto management, presentallof thisinformation we as simplyas possible.We tryto help themfocus on the strategic rationaleand financialvaluation.The sensalesgrowth, operating and are sitivity analysis, margins thekeyitems.Shareholder valueis createdbybuying the at a valuation discountand by betteringour actarget is quisition planas the company assimilated. Whenwe beginnegotiations, coursewe startat a of belowwhatwe arewillingto pay.Withthat,I'dlike price to turnit overto Ken. Kenneth F. MacKenzie:Thank you.I foundthe use of a coupleof termsnot to makeanysenseto me. Inone timewe talkvaluation. Price word,we talkprice,another is whatyoupayandvalueis whatyouhopeto get.We've got all kindsof people payingprices.If you look at all the LBO world,I'd say a lot of people aren'tgetting value. Whatare someof thevaluation issues?The environmentis one of ourbiggesttimebombsrightnow.Many businessesrightnow are of uncertain value. They acthat time quirecompanies are sittingon environmental bombs,wherethe cost to curewill exceed the valueof the company.So, banks today won't give them any moneyuntilan impactstudyis done. The banksdon't even forecloseso theywon'thaveto takeownership. to Manypeopleattempt valuecloselyheldcompanies fromthe conceptof the publicworld,but most of the timeyou can'tfindcomparable publiccompanies. I defyyouto findfivecloselyheldbusinessesthatare that profitable, let theworldknowthattheywereup for sale.A profitable doesn'twantto let theworld company knowthey'refor sale.Theydon'twanttheiremployees to know.They don't want their banksto know, their vendorsto know,the competition know.Whoarethe to ones you findfor sale?The ones thathaveto get out of thosethatcan'tsurvive. theprinciple fair of business, So, marketvaluefor closelyheld companiescan'texistbecausethe knowledge isn'tthere. We havean interesting world.Selectingcomparable companiesdoesn'tmean in the same line of business alone. What'sthe asset base? What'stheir location? What'stheir technology? There'sabout 25 items that couldmakethe basisfor comparison. In businessappraisal, havethe dilemma trying of you to be independent objective, and whichis whatvaluation is reallyabout and being an advocateof your client's

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interests.Furthermore, sellingprice is affectedby the versusthe seller.Thejob bargaining powerof the buyer of business valuationis interesting,but never easy. Thank you. do Question: Whatmethodology you employwhen an international performing acquisition analysis? Sam: Ourcurrent recommendation thatyouwould is valuethe company local currency, in it discounting at a local cost of capitalfor thatkindof firm.We bringthat valuebackto a present valuetodayin localcurrency and then convert at today's spot rate to determine the in equivalent U.S. dollars. Bob: Therearesometrade-offs here.Thealternative to Sam's viewis thatyou haveto projectexchange rates in the futureso thatyou can then convertcash flow in the localcurrency backto U.S. dollars thenuseU.S. and I capitalmarkets. thinkSam'sapproachis ideal,espethat ciallyincountries havefairly well-developed capital whereit is possibleto get a reasonable estimate markets, of whatcapitalmarkets intheforeigncountry. are Sam's avoidsconfounding bet on exchange the rates approach withwhetherthe acquisition a smartbusinessmove. is Sometimes can makea deal look good becauseof you the exchangerate that forced the cash, not because it was good businessin that country.The difficultyis a countrywhere the capital marketsare such that it's almostimpossible comeupwitha localcostof capital. to The otherproblemis the portfolios It problem. maybe a little harderto communicate that in the corporate world.I sort of like Sam'sapproachfor the reasonsI mentioned. Sam: I would say my commentswere specifically relatedto valuation.If we were lookingat something as sizable,lets sayin Europe,we woulddo thevaluation I justoutlinedforyou.Then,forthingslikeearnings per shareimpact, aninternal and on measure called"return to net assets," wouldlook at impacts we translated U.S. dollars. wouldbe cleanlikeIjust the However, valuation suggested. Dan: Like Sam, I also value foreignfirmsutilizing local currency cashflowsand a discountratebasedon local capitalmarkets. that Someadvocatean approach convertscash flows back to dollarsand increasesthe rate for rate discount to account exchange riskandother But riskspecificto a foreigninvestor. as longasyouhave a marketfor the subjectcompanyin the host country, you would have potentialinvestorsnot subjectto the investor" risks,so a foreignbuyerwill not be "foreign

these risks.Hence, the use of local paid for assuming and currency projections foreigncapital-market-based discountrates.Myexperience been thatanalysts in has countriestend to build their discountrate European froma government due to the lackof a corporate rate bond marketcomparable that in the U.S. Further, to becausetheydon'thavethe extensive market corporate and researchthatwe have,Europeananalysts analysis tend to set risk premiums based on researchdone on U.S. riskpremiums. we Question: In thepublicmarkets, oftenfind what we call "the winner's curse" where realized the returns I seem to be less thanprobably in the analysis. required wonder see thesameevidence private in transactions ifyou or is this some kind of anomalywe only see in public transactions? Dan:It dependson the situation. Whatwe'veseen is that the humanfactor plays a big part. If you have a who wantsto buy a companyand they're corporation on goingto do somefairly good analyses it andevaluate it objectively, chancesare,they're well goingto do fairly in their pricing and achieve their returnobjectives. When you look at a privatefirmlike Ken was talking about,you'reneverquitesurewhat'sburiedthere.You can tryto cleanup the financials well as possible,but as there'salwaysa questionandthatmakesbuyersa little morecarefulabouthowmuchthey're willingto bid. On the other hand, you sometimesfind investorgroups anxious do a deal.Theywantto buya company. to You have to reallytry to workwith them so they don'tget carried You haveto be careful, I wouldsayit's but away. at than less prevalent, least in my experience, probably wouldfindin the publicmarket. you Sam: I'd like to respondto that.Again,Dan has a much broadersamplesize than I do. But, out of the alludedto in our annual sampleof three acquisitions two of them are clearlywinnerswherewe far report, exceeded the assumptions that went into a valuation effort. The third one, however,had the same strong modelunderlying The modelworkedwell. it. analytical Whatdidn'tmaterialize well were some of the astoo sumptions. For instance, the Canadianacquisition, wherewe weregoingto consolidate twelveplantsdown to three or four. After workingwith it, we found we and couldn't pickup ourequipment moveit rightin and Frommy levelsof efficiency resumeprevious overnight. that than perspective, maynot havebeen anydifferent

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if itwasa publiccompany opposedto a private. as Again, that'sa sampleof onlythreecompanies.

Question: Whendevelopinga residual value, do you calculate it on an "after-tax sales proceeds" basis?

Sam: I'll give a verymechanical reaction.If you're valuein my model in thatfifteenth lookingat terminal valueis basedon the capitalization of year,the residual after-tax cashflows.
Question: So whatyou're saying is thatHershey'stax rate and position are included in the residual value as opposed to a potential buyer's?

Sam: Good point.I wouldcome backandofferyou the that, again,the premiseunderlying residualvalue underliesthe dividend growthmodel,so eitherthat'sa terminal value indicating whatwe would sell the business for or that's a terminalvalue representingthe presentvalue of the futurecash flows in yearssixteen through infinity.
Question: So you view it as representing future cash to Hershey,ratherthan an actualplanned sale? flows

Sam: True.Ourviewstend to be more of "thiswill continueto be a company the Hersheyfold, so what in is it worthon thatbasis," it is at a pointwhenwe go but backand look at the residual valueof those occasions. We havedifferent on whatwouldbe done. opinions Dan: We also basicallydo what Sam was talking about.It's not a case of saying,"Well,I'mgoingto sell thiscompany whatare myafter-tax and We proceeds." takethe viewpoint, Samexplained, this number as that the represents presentvalueof all the futurecashflows to that point and we bringthat numberback to its up presentvalue.
Question: I get the impression that, in the typical acquisition analysis, the acquiringfirm will frequently visualize a repairjob of some kind to be done on what they'rebuying,or will visualizeeconomies of scale, or will visualizesynergies,and the historyseems to say that these estimatesarefrequentlyrose-colored,shall we say. Dan, I guess my questionis primarilyto you and it's an extension of whatyou all have been talkingabout. Couldyou comment on recurring sources of overoptimismby acquiring do firms in your experience?Where these thingsusuallygo wrong?

Dan: Buyerstend to underestimate future capital and the workingcapital investmentreexpenditures quired in order to achieve their projectedsales and margins. Theyfind it difficultto carveas muchout of operating expensesastheythought could,andoften they underestimate transition the timeand costsrequired to implementoperatingchanges.Risk is often not adefor own by quately captured, example, usingthe buyer's discountrateratherthanthatof the target.Thosetypes of things. WhenI valuea company thiscontext, tend in I to two-step it. First, I will value the companyon a stand-alonebasis, and then make a conservative estimate of synergies.This is particularly true from a I buy-sideperspective. alsolookat whatotherpotential buyersthere are and how muchof those synergies my buyerwouldneed to payfor - whatkindof splitthere wouldbe of thosesynergies betweenbuyerandseller. Sam: If I couldrespondto maybean ancillary question associated withthat,in thatofferingdocument that in the sealedbid process,thereare two you alwaysget things that are generallyincluded.One, if the seller realizeshe is going to sell his businesswell enoughin advance,it's funnyhow thatfinalyearof actualperformancehas been adjusted to cosmetically reflecta good withinthatfinalyear.My secondpointis performance thatwe typically look at thatfinalyearof actualperformancealongwiththefiveto tenyearsof projections that are providedfor information perspectiveonly.We or and base rarelylook at their final year performance on that.We'llgo backa fewyears,andbringin anything our ownpeopleto betterassessthe situation. Question: Howdo you determine optimum the debt
capacityand the cost of equity?

Sam: Hersheyis grosslyunderleveraged. we alSo, debtforthesizeof acquisiwaysonlythinkaboutissuing tions that we look at. We don't even considerissuing equity.Ourcost of capitalthatwe woulduse wouldbe our current cost of capital, corporate weightedaverage say 12%. Question: Howdoyou estimate yourcostof capital?
Sam: We do have some debt. About 16% of our capital structureis debt on book basis. Our after-taxcost of debt is 5.5%. Our cost of equity using CAPM is about 14.5 - 15%and we just do the mechanics to come up with 12%.

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Dan: In selectingan "optimal" I'll capitalstructure, take a look at whatthe companyhas done historically. Each company is individual,and if the companyis and levelof debt, profitable seemsto havea reasonable that (it's typically acknowledged it's good to havesome debt on the books),thisbecomesone important factor. I'll also look at industry normsto get a feel for what a reasonable wouldbe. Intermsof equity capitalstructure rates, I look at the marketfirst and alwaysbring my

answerbackto the marketto be sureit makessense.In developinga cost of equity,I may look at CAPM but typicallyuse a built-up approach.I'll begin with the company'smarginalcost of debt, add an equity risk basedon certaininvestment banker's studies, premium look at a smallfirmpremiumand then startevaluating specificriskareasfor the subjectcompany. Sam: I see we're out of time.Thankyou verymuch for coming.

OF AND MANAGEMENT ANALYSIS JOURNAL FINANCIAL

INTERNATIONAL REVIEW FINANCE OF
Vol. 3 No. 2 Contents July-December 1990 Page Nos. i - iii Foreword on JFMA as Judicious Financial Adviser iv World Organizations Rely v - xi of Financial Management and Analysis Acquires Global Recognition Journal xii - xxii Financial Management Indicators to Aid Decision Making (Statistics) 1-8 Miller, E.M Arbitrage Pricing Theory: A Counter-Example Barua. S.K. & Srinivasan, G 9- 13 Application of Markov Chain Evaluation andMonitoring of Lease A Financial Analysis of Model Housing Scheme for Low Income 14-28 Swamy, M.R.K Earners in Developing Countries: A Case Study An Appraisal of Infrastructure Development Financing in the 29-35 Dadibhavi, R. V Indian Economy: A Methodological Approach to Analyze Imbalances Regional A Financial Management Appraisal of Rural Underdevelopment Nwosu, A. C 36 -40 in the Imo State of Nigeria An Examination of Rural Credit Delivery System vis-a-vis G.N. & 41 - 44 Nagaraja, Venkataram. J. V Cropping Pattern by Peasant Farmers in India -- A Case Study: Application of Linear Programming Technique Functional Relationship between Macroeconomic Data 45-50 Ngiam. Kee-Jin Announcements and Canada-U.S.A. Exchange Rate Fluctuations: Application of Efficient Markets Hypothesis 51 - 61 Pandey. I.M. & Bhat, R Significance of Financial Goals Pursued by Companies in India: Survey Findings An Appraisal of Federal Government Expenditure Pattern in Taiwo. I. 0 62- 67 Nigeria (1960-1986) Employing Chi-square (C2) Test Om Sai Ram Centre for Financial Management Research and Training The Anatomy ofJohnson Matthey Bank (JMB) Collapse: Need for Strengthening Accounting Information Financial Management Digest Guidelines for Bankers (A) Are Balance Sheets Meaningful and Trustworthy? (B) Need for Broadbased Environment Accounting Standards (C) Notes on Joint Account (D) On Forged Cheques 'Profession' News & Announcements: currencies ANNUAL SUBSCRIPTION: $65orin equivalent U.S. convertibleforeign & ARTICLES SUBSCRIPTION maybe sentto: ManagingEditor and Jounmalof Financial Management Analysis OmSaiRamCentrelefor and Financial Research Traniing Management 15 Prakash Cooperative HousingSociety ReliefRoad,Juhu,Santacruz(West) BOMBAY-400 054,INDIA

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