VALUATION OF FIRMS IN
MERGERS AND ACQUISITIONS
OKAN BAYRAK
Definitions
 A merger is a combination of two or more
corporations in which only one corporation
survives and the merged corporations go out
of business.
 Statutory merger is a merger where the
acquiring company assumes the assets and
the liabilities of the merged companies
 A subsidiary merger is a merger of two
companies where the target company
becomes a subsidiary or part of a subsidiary
of the parent company
Types of Mergers
 Horizontal Mergers
- between competing companies
 Vertical Mergers
- Between buyer-seller relation-ship companies
 Conglomerate Mergers
- Neither competitors nor buyer-seller relationship
History of Mergers and
Acquisitions Activity in United
States
 The First Wave 1897-1904
-
After 1883 depression
Horizontal mergers
Create monopolies
 The Second Wave 1916-1929
-
Oligopolies
The Clayton Act of 1914
 The Third Wave 1965-1969
-
Conglomerate Mergers
Booming Economy
 The Fourth Wave 1981-1989
-
Hostile Takeovers
Mega-mergers
 Mergers of 1990’s
-
Strategic mega-mergers
Motives and Determinants of
Mergers

Synergy Effect
NAV= Vab –(Va+Vb) – P – E
Where Vab
= combined value of the 2 firms
Vb = market value of the shares of firm B.
Va = A’s measure of its own value
P
= premium paid for B
E
= expenses of the operation
-
Operating Synergy
Financial Synergy


Diversification
Economic Motives
-
Horizontal Integration
Vertical Integration
Tax Motives
-
FIRM VALUATION IN MERGERS
AND ACQUISITIONS
 Equity Valuation Models
-
Balance Sheet Valuation Models
•
Book Value: the net worth of a company as shown on the
balance sheet.
•
Liquidation Value: the value that would be derived if the firm’s
assets were liquidated.
•
Replacement Cost:
its liabilities.
the replacement cost of its assets less
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-2
 Dividend Discount Models
D3
D1
D2
V0 


.......
2
3
1k (1k) (1k)
Where
Vo = value of the firm
Di
= dividend in year I
k
= discount rate
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-3
 The Constant Growth DDM
D 0 (1  g ) D 0 (1  g ) 2
V0 

 ......
1 k
(1  k ) 2
And this equation can be simplified to:
V0 
D0 (1  g )
D1

kg
kg
where g = growth rate of dividends.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-4
 Price-Earnings Ratio
P0 1  PVGO 
 1
E1 k 
E / k 
where PVGO = Present Value of Growth Opportunity
P0
E1 (1  b )

E1 k  ROExb
Implying P/E ratio
P0
1 b

E1 k  ROExb
where ROE = Return On Equity
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-5
 Cash Flow Valuation Models
-
The Entity DCF Model : The entity DCF model values the value of a company as
the value of a company’s operations less the value of debt and other investor claims,
such as preferred stock, that are superior to common equity
.
Value of Operations: The value of operations equals the discounted value of expected
future free cash flow.
Continuing Value =
. Value of Debt
. Value of Equity
Net Operating Profit - Adjusted Taxes
WACC
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-6
 What Drives Cash Flow and Value?
- Fundamentally to increase its value a company must
do one or more of the following:
. Increase the level of profits it earns on its existing
capital in place (earn a higher return on invested
capital).
. Increase the return on new capital investment.
. Increase its growth rate but only as long as the return
on new capital exceeds WACC.
. Reduce its cost of capital.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-7
 The Economic Profit Model: The value of a
company equals the amount of capital invested plus a
premium equal to the present value of the value created each
year going forward.
Economic Profit  Invested Capital x (ROIC WACC)
where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital
Economic Pr ofit  NOPLAT  ( Invested Capital x WACC )
where NOPLAT = Net Operating Profit Less Adjusted Taxes
Value=Invested Capital+Present Value of Projected Economic Profit
STEPS IN VALUATION
 Analyzing Historical Performance
Return on Investment Capital =
Economic Profit
FCF
=
=
NOPLAT
Invested Capital
NOPLAT – (Invested Capital x WACC)
Gross Cash Flow – Gross Investments
STEPS IN VALUATION-2
 Forecast Performance
- Evaluate the company’s strategic position, company’s
competitive advantages and disadvantages in the
industry. This will help to understand the growth
potential and ability to earn returns over WACC.
- Develop performance scenarios for the company and
the industry and critical events that are likely to
impact the performance.
- Forecast income statement and balance sheet line
items based on the scenarios.
- Check the forecast for reasonableness.
STEPS IN VALUATION-3
 Estimating The Cost Of Capital
B
P
S
WACC  kb(1-Tc )  kp  ks
V
V
V
where
-
kb
= the pretax market expected yield to maturity on non-callable, non convertible debt
Tc
= the marginal taxe rate for the entity being valued
B
= the market value of interest-bearing debt
kp
= the after-tax cost of capital for preferred stock
P
= market value of the preferred stock
ks
= the market determined opportunity cost of equity capital
S
= the market value of equity
Develop Target Market Value Weights
Estimate The Cost of Non-equity Financing
Estimate The Cost Of Equity Financing
STEPS IN VALUATION-4
 Estimating The Cost Of Equity Financing
- CAPM
ks  rf  E(rm)  rf  
where rf
= the risk-free rate of return
E(rm)
= the expected rate of return on the overall market portfolio
E(rm)- rf
= market risk premium
В
= the systematic risk of equity
. Determining the Risk-free Rate (10-year bond rate)
. Determining The Market Risk premium 5 to 6 percent rate is used for the US
companies
. Estimating The Beta
STEPS IN VALUATION-5
 The Arbitrage Pricing Model (APM)
ks  rf  E(F1) rf  1  E(F2) rf  2 ....
where E(Fk) = the expected rate of return on a portfolio that mimics the kth factor and is
independent of all others.
Beta k = the sentivity of the stock return to the kth factor.
STEPS IN VALUATION-6
 Estimating The Continuing Value
Selecting an Appropriate Technique
. Long explicit forecast approach
. Growing free cash flow perpetuity formula
. Economic profit technique
-
CV =
Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC  WACC )
+
WACC
WACC (WACC  g )
where
Economic Profit T+1
= the normalized economic profit in the first year after the explicit
forecast period.
NOPLAT T+1
= the normalized NOPLAT in the first year after the explicit forecast period.
g
= the expected growth rate of return in NOPLAT in perpetuity
ROIC
= the expected rate of return on net new investment.
WACC
= weighted average cost of capital
STEPS IN VALUATION-7
 Calculating and Interpreting Results
- Calculating And Testing The Results
- Interpreting The Results Within The
Decision Context
HP-COMPAQ MERGER CASE
The HP/Compaq merger. By The Numbers:
HIGH-END
High-end Unix Servers: Worldwide (2000)
High-end Unix servers: US (2000)
Factory
Revenues ($m)
Market Share
Hewlett-Packard
512
11.4%
Compaq
134
3.0%
Factory
Revenues ($m)
Market Share
124
6.1%
66
3.3%
Hewlett-Packard
Compaq
Closest Rival: Sun Microsystems with factory revenues of Closest Rival: Sun Microsystems with factory
revenues of $1.2 billion and a 60.1% market share
$2.1 billion and a 47.1% market share
MID-RANGE
Mid-range Unix servers: Worldwide (2000)
Mid-range Unix servers: US (2000)
Factory
Revenues ($m)
Market Share
3,673
30.3%
488
4.0%
Hewlett-Packard
Compaq
Closest Rival: Sun Microsystems with $2.8 billion in
factory revenue and a 23.5% market share
Factory
Revenues ($m)
Market Share
1552
28.2%
296
5.4%
Hewlett-Packard
Compaq
Market Leader: Sun Microsystems with revenues of $1.7
billion and a 30.5% market share)
PERSONAL COMPUTERS
PC Shipments: Worldwide (in thousands of units)
PC Shipments: US(in thousands of units)
HewlettPackard
Compaq
HewlettPackard
Units (q2/01)
2,065
3,590
Units (q2/01)
991
1,332
Share (q2/01)
6.9%
12.1%
Share (q2/01)
9.4%
12.7%
Units (q2/00)
2,260
4.011
Units (q2/00)
1,221
2,293
Share(q2/00)
7.4%
13.2%
Share(q2/00)
10.7%
20.1%
Growth
-8.6%
-10.5%
Growth
-18.8%
--21.3%
Compaq
Market leader: Dell Computer Corp. with a 24% market
share and a 9.8% growth in the same period.
LAPTOPS/NOTEBOOKS
SMART HANDHELDS
Worldwide shipments of portable computers
(thousands of units)
HewlettPackard
Compaq
Units(q4/00)
318
817
Share(q4/00)
4.5%
11.6%
Units(q4/99)
139
739
Shipments
(in 000s)
Share
2000
Rank
Hewlett-Packard
254
3.8%
4
Compaq
129
1.9%
9
Market Leader: Palm with a 52.9% market share and
3.53 million units.
HP-COMPAQ MERGER CASE-2
 Arguments About The Merger
- Supporters
. HP-COMPAQ will become the leader in most of the
sub-sectors
. Ability to offer better solutions to customer’s demands
. New strategic position will make it possible to increase
R&D efforts and customer research
. Decrease in costs and increase in profitability
. Financial strength to provide chances to invest in new
profitable areas
HP-COMPAQ MERGER CASE-3
 Arguments About The Merger
- Opponents
. Acquiring market share will not mean the leadership
. No new significant technology capabilities added to HP
. Large stocks will increase the riskiness of the
company (Credit rating of the HP is lowered after the
merger announcement)
. Diminishing economies of scale sector which both
companies have already a great scale.
HP-COMPAQ MERGER CASE-4
 Valuation Process
- Relative Historical Stock Price Performance
Historical Exchange Ratios
Period ending August 31,
Average Exchange Ratio
Implied Premium (%)
2001
August 31 2001
0.532
18.9
10-Day Average
0.544
16.3
20-Day Average
0.568
11.3
30 Day Average
0.573
10.3
3 Months Average
0.557
13.7
6 Months Average
0.584
8.2
9 Months Average
0.591
7.1
12 Months Average
0.596
6.1
HP-COMPAQ MERGER CASE-5
 Comparable Public Market Valuation Analysis
Firm Values As a Multiple of Revenue EBITDA and LTM EBIT
Firm Values as a Multiple of
Companies
LTM Revenue
LTM EBITDA
LTM EBIT
Compaq
0.5 X
5.7 X
9.8 X
HP
1.0 X
12.4 X
19.8 X
0.2-2.1 X
5.3-18.2 X
8.9-19.9 X
Selected Group
Closing Stock Prices As a Multiple of EPS
Closing Stock Price as a Multiple of
Companies
2001 EPS
2002 EPS
Compaq
34.3 X
18.4 X
14.0 X
HP
35.7 X
19.2 X
12.5 X
18.5-57.3 X
10.7-27.1 X
9.3-19.5 X
Selected Group
2003 EPS
HP-COMPAQ MERGER CASE-6


Similar Transactions Premium Analysis
Salomon Smith Barney's analysis resulted in a range of premiums of:
- (8)% to 46% over exchange ratios implied by average prices for the 10
trading days prior to announcement, with a median premium of 23%.
- (7)% to 58% over exchange ratios implied by average prices for the 20
trading days prior to announcement, with a median premium of 23%.
- (12)% to (29) over exchange ratios implied by average prices for the 1
trading days prior to announcement with a median premium of 15%.
Based on its analysis, Salomon Smith Barney determined a range of
implied exchange ratios of 0.585x to 0.680x by applying the range of
premiums for other transactions to the closing prices of Compaq and HP
on August 31, 2001 and the average historical exchange ratio for Compaq
and HP for the 10-day period ending on August 31, 2001, as appropriate.
HP-COMPAQ MERGER CASE-7
 Contribution Analysis
Percentage Contribution Analysis
Period
Revenues
Net Income
At Market
LTM
2001 Estimated
2002 Estimated
2003 Estimated
LTM
2001 Estimated
2002 Estimated
2003 Estimated
2001 Estimated
Next Four Fiscal Q
2002 Estimated
2003 Estimated
Equity Value
Percentage
Contribution
Compaq
HP
46.0
54.0
44.0
56.0
44.0
56.0
44.0
56.0
45.7
54.3
38.1
61.9
36.9
63.1
32.7
67.3
32.3
67.7
31.6
68.4
32.7
67.3
29.2
70.8
31.7
68.3
HP-COMPAQ MERGER CASE-8
 Pro Forma Earnings Per Share Impact to Compaq
Accretion/Dilution Analysis
EPS
EPS
Accretion/Dilution
2002
2003
Compaq stand-alone
0.67
0.88
HP stand-alone
1.21
1.86
Combined entity pro-forma, excluding proj. synergies
0.74
1.09
Combined entity pro-forma, including proj. synergies
1.05
1.51
Accretion/(Dilution) to Compaq, excluding proj. synergies
11%
24%
Accretion/(Dilution) to Compaq, including proj. synergies
57%
71%