BA 7000-093
Chapter 11
Chapter 11 – Mergers and Acquisitions
Key Learning Outcomes

Understanding the potential items to value in M&A and to be able to assess
potential implications of acquirer’s method of payment
A. Basics
Valuation of merger target is from the perspective of acquiring
company´s shareholders
Net present value of acquisition is the “value of the target to
acquirer minus the effective cost“
B. Value of target to acquirer
 Value of the target to the acquirer is made up of:
1. Stand alone value of the target plus
- Value of improvements at target made by acquirer
management plus
- Value of pure synergies between target and acquirer
C. Valuations must make a capital structure assumption

The valuations (stand alone, improvements, and synergies) must make a
capital structure assumption
1. WACC model or APV model

Be careful!
2. The capital structure assumption should not be reflective of the
financing used to buy the target per se, but should reflect the
degree to which owning the target incrementally affects your debt
capacity
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For example, suppose you bought the target with debt
If you are using WACC to value target, the weights should
reflect the debt capacity of the target, not 100% debt
If you are using RE or AEG, the tax shields should only reflect
the contribution of the target firm towards affording those tax
shields
C. What is the effective cost?
1. Acquirer pays cash ($100M)
• Cash price is the effective cost of the acquisition
2. Acquirer must raise the cash ($100M)
- Assume Acquirer must borrow the money from government
with a subsidized rate
• Loan is $100M, but PV of loan payments is $95M
• Purchase price is $100M, but acquirer makes $5M NPV
on loan. Effective cost of acquisition is $95M
3. Assume Acquirer sells shares of combined firm ($100M)
- Purchase price is $100M, but suppose shares are actually
worth $60M. NPV on share sale is $40M. Effective cost of
acquisition is $60M.
D. Mergers and Acquisitions often involve share issues
• Residual earnings valuation cannot be done by forecasting pershare amounts if shares outstanding are likely to change
– Always carry out residual earnings valuations on a dollar
basis, then divide by current shares outstanding
• Abnormal Earnings Growth (AEG) valuation can be carried out by
forecasting per-share earnings and dividends
– However, must then work on a levered basis (requiring
changes in the cost of equity capital)
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Chapter 11
• Best to work with operations on a dollar basis
Valuation with an Anticipated Acquisition:
Dealing with Value Implicit in Exchange Ratio
Valuation of an Anticipated Acquisition: PPE Inc.
PPE Inc. is expected to acquire another firm at the end of Year 2 by issuing 50
million shares to that firms’ shareholders. The analyst follows the following
steps:
1. Forecast the value the new merged firm at the end of Year 2 from the
forecasted balance sheet of the new merged firm at that date and the
present value of subsequent residual earnings that the balance sheet is
anticipated to generate.
2. Calculate the anticipated value per share at the acquisition date (at the
end of Year 2) by dividing the merged firms’ value by the total shares
outstanding for the new firm.
3. Calculate the present value of this per-share value at Year 0.
4. Add the present value of expected dividends from the pre-merged firm
up to the merger date.
Suppose pro forma analysis calculates a value for the merged firm at the end of
Year 2 of $180 million. With 150 million shares outstanding (100 million held
by the original PPE shareholders and 50 million by the shareholders of the
acquired firm), the per-share value is $1.20. The value of one of PPE’s 100
million shares outstanding at Year 0 is calculated as follows:
Present value (at Year 0) of per-share Year 2 value:
1.20
1.1134 2
$0.97
Present value of Year 1 and Year 2 dividends per share
Assume DPS in Year 1 of $038 and in Year 2 of $0.041
0.038
0.041

1.1134 1.1134 2
Per-share value of PPE Inc.
0.07
$1.04
As PPE was valued at $0.96 before the anticipated acquisition, this
calculation indicates that the acquisition adds value to the current shareholders.
Assume a cost of equity of 11.34% before the acquisition.
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Chapter 11
Question 1.
During the early 1990s there was a noticeable increase in mergers and acquisitions
between firms in different countries (termed cross-border acquisitions). What factors
could explain this increase? What special issues can arise in executing a crossborder acquisition and in ultimately meeting your objectives for a successful
combination?
Several factors could help explain the increase in merger and acquisition activity between firms in
different countries. These factors may include:
Relaxation of foreign ownership laws. As countries have allowed greater foreign
ownership of companies in certain industries (e.g., broadcasting, telephone, steel, automobile), foreign
companies have undertaken mergers that were previously prevented due to governmental restrictions.
Expansion of regional free trade areas. Once a regional trading block is implemented, it can
become more difficult for foreign firms to export its products to countries within the block. As a
result, a foreign firm may purchase a company within the block to guarantee access to the block. For
example, many American firms rushed to purchase European firms before January 1, 1996 to assure
continued access to markets of European Union members as integration of the EU markets entered its
next phase. Similarly, increased free trade can create new opportunities for firms within the block to
expand their markets. Acquisitions can provide a way of taking advantage of these opportunities. For
example, the integration of markets in Europe may provide opportunities for, say, German and U.K.
banks to use cross-border acquisitions to develop into a European bank.
Globalization of certain industries. Once a company has reached the maximum production in
its home market, it may seek greater economies of scale and scope by purchasing competitors in
foreign markets. By expanding its production to the greatest extent possible, the firm hopes to achieve
the most efficient cost structure. This globalization forces the remaining companies to consolidate to
achieve the same level of scale and scope economies.
Search for new markets. Once domestic markets for a specific product have matured, a
domestic firm will often try to continue its expansion in foreign markets. Often, the easiest way to
enter a foreign market is to purchase a company already operating in that market. It guarantees
immediate market share and instant name recognition with local consumers.
International mergers will create special issues that will ultimately affect the success of the merger.
These special issues may include valuing a foreign company that operates and prepares its financial
reports under different accounting rules. Differences in accounting rules may include:







Treatment of intangibles, such as R&D expenses, brand names, goodwill, patents, etc.
Treatment of inflation.; Foreign exchange exposure.; Hedging acquisition price.
Hedging future cash flows from the foreign firm.; Regulatory considerations.
Foreign government investment approvals.; Foreign government antitrust approvals.
Ability to expatriate earnings from the foreign country.
Differences in laws, regulations, and rules governing personnel and human resources areas.
Differences in the operations of foreign markets and companies, including differences in
management practices, worker norms and expectations, roles of government in the economy, and
corruption in the business and political environments of the economy.
 Management and coordination of domestic and foreign operations.
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BA 7000-093
Question 5.
Chapter 11
You have been hired by GS Investment Bank to work in the merger department. The
analysis required for all potential acquisitions includes an examination of the target
for any off-balance-sheet assets or liabilities that have to be factored into the
valuation. Prepare a checklist for your examination.
Off-Balance Sheet Liabilities


Executory contracts; Contingent obligations; Operating leases;
Liabilities under environmental regulations
Off-Balance Sheet Assets—Depending on the specific circumstance, these assets may already be
included on the balance sheet. These assets are either valued (e.g., intangible assets) or revalued (e.g.,
land held for sale) once they have been purchased by another company.



Research and development expenditures
Patents, trademarks, and other intellectual property
Brand names; Goodwill; Land held for sale
Question 8.
A leading oil exploration company decides to acquire an Internet company at a 50
percent premium. The acquirer argues that this move creates value for its own
stockholders because it can use its excess cash flows from the oil business to help
finance growth in the new Internet segment. Evaluate the economic merits of this
claim.
The oil company is arguing that a merger could create value by providing low-cost financing to a
financially-constrained electronics firm. This argument is based on the idea that capital market
imperfections have prevented the electronics company from investing in all of its growth
opportunities. These imperfections may have developed as a result of information asymmetries
between management and outside investors. If the electronics firm has to rely on outside investors to
finance its growth, capital market constraints could prevent it from undertaking worthwhile projects
because public capital markets would probably be a costly source of funds for the firm. However, by
purchasing the electronics company, the oil company can help it overcome the capital market
imperfections and enable the electronics firm to invest in all of its growth opportunities.
The merits of the oil company’s argument for buying the electronics company depend on two
conditions. First, financial constraints must be preventing the electronics firm from undertaking some
profitable projects. If the electronics firm is not financially-constrained or does not have a set of
unfunded but profitable projects, then having access to the additional capital of the oil company will
not create value. The only projects the firm would have left would be unprofitable ones. Second, the
financial constraints must be due to capital market imperfections. It is plausible that the electronics
firm could face capital market imperfections due to information asymmetries. Information problems
are likely to be severe for newly-formed, high-growth companies, a description typical of many
electronics firms. If information problems make it difficult for outside investors to value the
electronics firm because of its short track record or because its financial statements provide little
insight about the value of its growth opportunities, then outside investors could be an expensive
source of funds.
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BA 7000-093
Chapter 11
Digital Equipment Company Valuations:
Stand Alone Valuation: Digital - Status Quo
Digital had earning before interest and taxes of $391.38 million in
1997, which translated into a
• A pre-tax operating margin of 3% on its revenues of $13,046 million
• An after-tax return on capital of 8.51%
Based upon its beta of 1.15, an after-tax cost of borrowing of 5% and
a debt ratio of approximately 10%, the cost of capital for Digital in
1997 was
• Cost of Equity = 6% + 1.15 (5.5%) = 12.33%
• Cost of Capital = 12.33% (.9) + 5% (.1) = 11.59%
Digital had capital expenditures of $475 million, depreciation of $ 461
million and working capital was 15% of revenues.
Operating income, net cap ex and revenues are expected to grow 6%
a year for the next 5 years, and 5% thereafter.
Year
FCFF
1
$133.26
2
$141.25
3
$149.73
4
$158.71
5
$168.24
Terminal Year $156.25
Firm Value = $2,110.41
Terminal Value
$2,717.35
PV
$119.42
$113.43
$107.75
$102.35
$1,667.47
 The capital expenditures are assumed to be 110% of revenues
in stable growth; working capital remains 15%;
 Debt ratio remains at 10%, but after-tax cost of debt drops to
4%. Beta declines to 1.
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BA 7000-093
Chapter 11
Digital: Change in Control
Digital will raise its debt ratio to 20%. The beta will increase, but the
cost of capital will decrease.
•
•
•
•
New
Cost
New
Cost
Beta = 1.25 (Unlevered Beta = 1.07; Debt/Equity Ratio = 25%)
of Equity = 6% + 1.25 (5.5%) = 12.88%
After-tax Cost of Debt = 5.25%
of Capital = 12.88% (0.8) + 5.25% (0.2) = 11.35%
Digital will raise its return on capital to 11.35%, which is its cost of
capital. (Pre-tax Operating margin will go up to 4%)
The reinvestment rate remains unchanged, but the increase in the
return on capital will increase the expected growth rate in the next 5
years to 10%.
After year 5, the beta will drop to 1, and the after-tax cost of debt will
decline to 4%.
Digital Valuation: Change in Control
Year
FCFF
Terminal Value
1
$156.29
2
$171.91
3
$189.11
4
$208.02
5
$228.82
$6,584.62
Terminal Year $329.23
PV
$140.36
$138.65
$136.97
$135.31
$3,980.29
Value of the Firm: with Control Change = $ 4,531 million
Value of the Firm: Status Quo
= $ 2,110 million
Value of Control
= $2,421 million
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Chapter 11
Synergy Effects in Valuation Inputs
If synergy is
Valuation Inputs that will be affected are
Economies of Scale
Operating Margin of combined firm will be greater
Growth Synergy
More projects:Higher Reinvestment Rate (Retention)
than the revenue-weighted operating margin of
individual firms.
Better projects: Higher Return on Capital (ROE)
Longer Growth Period
Again, these inputs will be estimated for the
combined firm.
Valuing Synergy: Compaq and Digital
In 1997, Compaq acquired Digital for $ 30 per share + 0.945 Compaq
shares for every Digital share. ($ 53-60 per share) The acquisition
was motivated by the belief that the combined firm would be able to
find investment opportunities and compete better than the firms
individually could.
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Chapter 11
Background Data ($ in Millions)
Current EBIT
Current Revenues
Capital Expenditures - Depreciation
Expected growth rate -next 5 years
Expected growth rate after year 5
Debt /(Debt + Equity)
After-tax cost of debt
Beta for equity - next 5 years
Beta for equity - after year 5
Working Capital/Revenues
Tax rate is 36% for both companies
Compaq
$ 2,987
$25,484
$ 184
10%
5%
10%
5%
1.25
1.00
15%
Digital: Opt Mgd
$ 522
$13,046
$ 14 (offset)
10%
5%
20%
5.25%
1.25
1.0
15%
Valuing Compaq
Year
1
2
3
4
5
Terminal Year
FCFF
$1,518.19
$1,670.01
$1,837.01
$2,020.71
$2,222.78
$2,832.74
Terminal Value
$56,654.81
PV
$1,354.47
$1,329.24
$1,304.49
$1,280.19
$33,278.53
$38,546.91
Value of Compaq = $ 38,547 million
After year 5, capital expenditures will be 110% of depreciation.
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Chapter 11
Combined Firm Valuation
1. The Combined firm will have some economies of scale, allowing it
to increase its current after-tax operating margin slightly. The
dollar savings will be approximately $ 100 million.
• Current Operating Margin = (2987+522)/(25484+13046) = 9.11%
• New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%
2. The combined firm will also have a slightly higher growth rate of
10.50% over the next 5 years, because of operating synergies.
3. The beta of the combined firm is computed in two steps:
• Digital’s Unlevered Beta = 1.07; Compaq’s Unlevered Beta=1.17
• Digital’s Firm Value = 4.5; Compaq’s Firm Value = 38.6
• Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16
• Combined Firm’s Debt/Equity Ratio = 13.64%
• New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26
• Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98%
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BA 7000-093
Chapter 11
Combined Firm Valuation
Year
1
2
3
4
5
Terminal Year
FCFF
$1,726.65
$1,907.95
$2,108.28
$2,329.65
$2,574.26
$3,345.38
Terminal Value
$66,907.52
PV
$1,541.95
$1,521.59
$1,501.50
$1,481.68
$39,463.87
Value of Combined Firm = $ 45,511
The Value of Synergy
Value of Combined Firm with Synergy
= $45,511 million
Value of Compaq + Value of Digital
= 38,547 + 4532
= $ 44,079 million
Total Value of Synergy
= $ 1,432 million
Digital: Valuation Blocks
Value of Firm - Status Quo
+ Value of Control
Value of Firm - Change of Control
+ Value of Synergy
Total Value of Digital with Synergy
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= $ 2,110 million
= $ 2,521 million
= $ 4,531 million
= $ 1,432 million
= $ 5,963 million
BA 7000-093
Chapter 11
Evaluating Compaq’s Offer
Value of Digital with Synergy
= $5,963 mil
- Value of Cash paid in deal = $ 30 * 146.789 mil shares
= $4,403 mil
- Digital’s Outstanding Debt (assumed by Compaq)
$1,006 mil
Remaining Value
$ 554 mil
/ number of Shares outstanding
/ 146.789
= Remaining Value per Share
$ 3.77
Compaq’s price per share at time of Exchange Offer
$ 27
Appropriate Exchange Ratio = 3.77/27 = 0.14 Compaq shares/Digital share
Actual Exchange Ratio = 0.945 Compaq shares/Digital Share
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