The greater danger for most of us is not that our aim is too high and we might miss it, but that it is too low and we reach it.
—Michelangelo

Course Layout: M&A & Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A
Process
Motivations for
M&A
Regulatory
Considerations
Takeover Tactics and Defenses
Business &
Acquisition
Plans
Search through
Closing
Activities
M&A Integration
Part III: M&A
Valuation &
Modeling
Public Company
Valuation
Private
Company
Valuation
Financial
Modeling
Techniques
Part IV: Deal
Structuring &
Financing
Payment &
Legal
Considerations
Accounting &
Tax
Considerations
Financing
Strategies
Part V:
Alternative
Strategies
Business
Alliances
Divestitures,
Spin-Offs &
Carve-Outs
Bankruptcy &
Liquidation
Cross-Border
Transactions

• Primary learning objectives: To provide students with an understanding of
– business valuation using discounted cash flow valuation techniques and
– the importance of understanding assumptions underlying business valuations
• Secondary learning objectives: To provide students with an understanding of
– discount rates and risk as applied to business valuation;
– how to analyze risk;
– alternative definitions of cash flow and how and when they are applied;
– the advantages and disadvantages of the most commonly used discounted cash flow methodologies;
– the sensitivity of terminal values to changes in assumptions; and
– Adjusting firm value for non-operating assets and liabilities.

Required Returns:
Cost of Equity (ke)
Capital Asset Pricing Model (3-factor model): ke = R f
+ ß(R m
– R f
) + FSP
Where R f
= risk free rate of return
ß = beta (systematic/non-diversifiable risk)
R m
R m
– R f
= expected rate of return on equities
= 5.5% (i.e., equity risk premium historical average since
1963)
FSP = firm size premium

Market Value (000,000)
>$18,600
$7,400 to $18,600
$2,700 to $7,400
$1,100 to $2,700.
$450 to $1,100
$200 to $450
$100 to $200
<$100 million
Percentage Points Added to
CAPM Estimate
0.0
.6
1.0
1.5
2.3
2.7
5.8
9.2
Source: Adapted from estimates provided by Ibbotson Associates.

Weighted Average Cost of Capital (WACC): 1,2
WACC = ke x E + i (1-t) x D + kpr x __PR__
(E+D+PR) (E+D+PR) (E+D+PR)
Where E = the market value of equity
D = the market value of debt
PR = the market value of preferred stock ke = cost of equity kpr= cost of preferred stock i = the interest rate on debt t = the firm’s marginal tax rate
1 To estimate WACC, use firm’s target debt-to-total capital ratio (TC).
2 (D/E)/(1+D/E) = [(D/E)/(E+D)/E] = [(D/E)(E/(E+D)] = D/(E+D) = D/TC; E/TC = 1 – D/TC.

• Risk consists of a non-systematic/diversifiable and systematic/nondiversifiable component
• Equity beta (ß) is a measure of non-diversifiable risk
• Equity beta quantifies a stock’s volatility relative to the overall market
• Equity beta is impacted by the following factors:
– Degree of industry cyclicality
– Operating leverage refers to the composition of a firm’s cost structure (fixed plus variable costs)
– Financial leverage refers to the composition of a firm’s capital structure (debt + equity)
• Firms with high ratios of fixed to total costs and debt to total capital tend to display high volatility and betas

How Operating Leverage Affects
Financial Returns?
1
Revenue
Fixed
Variable 2
Total Cost of Sales
Case 1
100
48
32
80
Case 2: Revenue
Increases by 25%
125
48
40
88
Case 3: Revenue
Decreases by 25%
75
48
24
72
Earnings Before Taxes
Tax Liability @ 40%
After-Tax Earnings
Firm Equity
20
8
12
100
37
14.8
22.2
100
3
1.2
1.8
100
Return on Equity (%) 12 22.2
1.8
1 All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but differ by revenue.
2 In Case 1, variable costs represent 32% of revenue. Assuming this relationship is maintained, variable costs in Cases
2 and 3 are estimated by multiplying total revenue by .32.
Key Point : High fixed to total cost ratios magnify fluctuations in financial returns.

1
Equity
Debt
Total Capital
Earnings before Interest and
Taxes
Case 1: No Debt
100
0
100
20
Case 2: 25% Debt to
Total Capital
Case 3: 50% Debt to
Total Capital
75
25
100
20
50
50
100
20
Interest @ 10%
Income before Taxes
Less income Taxes @ 40%
Net Income
0
20
8
12
2.5
17.5
7
10.5
5
15
6
9
After-Tax Return on Equity (%) 12 14 18
1 All figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases.
Key Point : High debt to total capital ratios magnify fluctuations in financial returns.

Leveraged versus Unleveraged Equity Betas
• In the absence of debt, the equity ß is called the unleveraged ß of the industry in which the firm competes u
, which is impacted by the firm’s operating leverage and the cyclicality
• In the presence of debt, the equity ß is called the leveraged ß l
• If a firm’s shareholders bear all the risk of operating and financial leverage and interest is tax deductible, leveraged and unleveraged betas can be calculated as follows:
ß l
= ß u
(1 + (1t) (D/E)) and ß u
= ß l
/ (1 + (1-t) (D/E)) where t, D, and E are the tax rate, debt and equity, respectively.
Implications:
-Increasing D/E raises firm’s breakeven and increases shareholder risk that firm will be unable to generate future cash flows sufficient to pay their minimum required returns.
--Tax deductibility of interest reduces shareholder risk by increasing after-tax cash available for shareholders.

• Regress percent change in firm’s share price plus dividends against percent change in a broadly defined stock index plus dividends for last 3-5 years.
– However, this assumes the historical relationship between risk and return will hold in the future
• Alternatively, use a sample of similar firms:
– Step 1: Select sample of firms with similar cyclicality and operating leverage (i.e., usually in the same industry)
– Step 2: Calculate average unlevered beta for firms in the sample to eliminate the effects of their current capital structures on their betas
– Step 3: Relever average unlevered beta using D/E ratio and marginal tax rate of firm whose beta you are trying to estimate (i.e., target firm)

Estimating Abbot Labs’ Equity Beta
Step 1 : Select sample of firms having similar cyclicality and operating leverage
Firm Levered
Equity
Beta 1
.2900
Debt /
Equity
.2662
.0762
.3204
1
Step 2 : Compute average of firms’ unlevered betas
Unlevered Equity
Beta 2
.2501
.5738
.5536
Step 3 : Relever average unlevered beta using target’s debt/equity ratio
Abbot Labs’
Relevered Equity
Beta 3
NA Abbot Labs
Johnson & Johnson
Merck
.6000
.6600
NA
NA
Pfizer .6800
.3044
.5750
NA
Average = .4881
.4209
1 Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firm’s share price and a broadly defined stock index.
2 ß u
= ß l
/ (1 + (1t) (D/E)), where ß u and ß l are unlevered and levered betas; marginal tax rate is .4.
Abbot Labs (ß u
) = .2900 / (1 + (1 - .4).2662)) = .2501
Johnson & Johnson (ß u
) = .6000 / (1 + (1 - .4).0762)) = ..5738
Merck (ß u
) = .6600 / (1 + (1 - .4).3204)) = .5536
Pfizer (ß u
3 ß l
= ß u
) = .6800 / (1 + (1 - .4).3044)) = .5750
(1 + (1t) (D/E)) using the target firm’s (Abbot Labs) debt/equity ratio and marginal tax rate.
Abbot Labs’ relevered beta = .4881 (1 + (1 - .4).2662)) = .4209

• Valuation cash flows represent actual cash flows available to reward both shareholders and lenders
• Cash flow statements include cash inflows and outflows from:
– operating,
– investing, and
– financing activities
• GAAP cash flows are adjusted for non-cash inflows and outflows to calculate valuation cash flow. Examples include the following:
– Adding depreciation back to net income
– Deducting gains from and adding losses to net income resulting from asset sales since such gains or losses are changes in book values only with the actual cash flows from the sale shown in the cash flow statement as cash from investing activities.
• Valuation cash flows include free cash flows to equity investors or equity cash flow and free cash flows to the firm or enterprise cash flow

Calculating Free Cash Flow to Equity Investors or Equity Cash Flow (FCFE)
FCFE (equity cash flow) 1 represents cash flow available for paying dividends or repurchasing common equity, after taxes, debt repayments, new issues, and all reinvestment requirements.
FCFE = (Net Income + Depreciation – Δ Net Working
Capital 2 ) 3 – Gross Capital Expenditures 4 + (New
Preferred Equity Issues – Preferred Dividends + New
Debt Issues – Principal Repayments) 5
1 PV of equity cash flows is the equity value of the firm.
2 Excludes cash in excess of normal operating requirements.
3 Cash from operating activities.
4 Cash from investing activities.
5 Cash from financing activities.

FCFF (enterprise cash flow) 1 is cash flow available to repay lenders and/or pay common and preferred dividends and repurchase equity, after taxes and reinvestment requirements but before debt repayments.
FCFF = (Earnings before interest & taxes (1-tax rate) +
Depreciation – Δ Net Working Capital 2 ) 3 – Gross Capital
Expenditures 4
1 PV of enterprise cash flows is the enterprise value of the firm
2 Excludes cash in excess of normal operating requirements.
3 Cash from operating activities.
4 Cash from investing activities.

Cash from Operating
Activities
Cash from Investing
Activities
Cash from Financing
Activities
Total Cash Flow
Free Cash Flow to the Firm
40
Free Cash Flow to Equity
40
(22)
18
(22)
(10)
8

1. How does the size of the firm affect its perceived risk? Be specific?
2. How would you estimate the beta for a publicly traded firm? For a private firm?
3. Explain the difference between equity and enterprise cash flow?
4, What is the appropriate discount rate to use with equity cash flow? Why? With enterprise cash flow? Why?

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model

• Free cash flow is constant in perpetuity.
P
0
= FCFF
0
/ WACC, where FCFF
0 is free cash flow to the firm and WACC is the weighted average the cost of capital
P
0
= FCFE
0
/ ke where FCFE
0 is free cash flow to equity investors and ke is the cost of equity

• What is the value of a firm, whose annual
FCFF
0 of $1 million is expected to remain constant in perpetuity and whose weighted average cost of capital is 12%.
P
0
= $1 / .12 = $8.3 million

• Cash flow next year (i.e., FCFF
1
, the first year of the forecast period) is expected to grow at a constant rate.
FCFF
1
=FCFF
0
(1+g)
P
0
= FCFF1 / (WACC-g), where g is the expected rate of growth of FCFF
1
.
P
0
= FCFE
1
/ (ke –g), where g is the expected rate of growth of FCFE
1
.

• Estimate the value of a firm (P
0
) whose cost of equity is 15% and whose cash flow in the prior year is projected to grow 20% in the current year and then at a constant 10% annual rate thereafter. Cash flow in the prior year is $2 million.
P
0
= ($2 x 1.2)(1.1) / (.15 - .10) = $52.8 million

• Cash flow exhibits both a high and a stable growth period.
• High growth period: The firm’s growth rate exceeds a rate that can be sustained long-term.
• Stable growth period: The firm is expected to grow at a rate that can be sustained indefinitely (e.g., industry average growth rate).
• Discount rates: Reflecting the slower growth rate during the stable growth period, the discount rate during the stable period should be lower than doing the high growth period (e.g., industry average discount rate).

P
0,FCFF n
= Σ FCFF
0 x (1+g t=1 (1+ WACC) t t
) t + P n
(1+WACC) n
Where
P n
= FCFF n x (1 + g m
)
(WACC m
– g m
)
FCFF
0
= free cash flow to the firm in year 0
WACC = weighted average cost of capital through year n
WACC m
= Weighted average cost of capital beyond year n
(Note: WACC > WACC m
)
P n g t
= value of the firm at the end of year n (terminal value)
= growth rate through year n g m
= stabilized or long-term industry average growth rate beyond year n
(Note: g t
> g m
)

• Estimate the value of a firm (P
0
) whose cash flow is projected to grow at a compound annual average rate of 35% for the next five years and then assume a more normal 5% annual growth rate. The current year’s cash flow is $4 million. The firm’s weighted average cost of capital during the high growth period is 18% and then drops to the industry average rate of
12% beyond the fifth year.

PV
1-5
= $4 x 1.35 + $4 x (1.35) 2
(1.18) (1.18) 2
+ $4 x (1.35) 3
(1.18) 3
+
$4 x (1.35) 4
(1.18) 4
+ $4 x (1.35) 5
(1.18) 5
= $30.5
PV
5
= (($4 x (1.35) 5 x 1.05)) / (.12 - .05) = $117.65
(1.18) 5
P
0
= PV
1-5
+ PV
5
= $30.5 + $117.65 = $148.15

Solving Variable Growth Model Example
Using A Growing Annuity
P
0,FCFF
= High Growth Period + Terminal Period
(Growth Annuity) (Constant Growth Model)
P
0,FCFF
= FCFF0(1 + g) x {1 – [(1 + g)/(1 + WACC)] n } + FCFF n x (1 + g)/(WACC - g)
(WACC – g) (1 + WACC) n
= $4.00 (1.35) x {1 – [(1.35/1.18)] 5 } + [($4.00 x 1.35
5 x 1.05]/(.12 - .05)
(.18 - .35) 1.18
5
= -.91.8 x -.96 + $117.65
= $30.50 + $117.65
= $148.15

• Key premise: A firm’s value can be approximated by the sum of the high growth plus a stable growth period.
• Key risks: Sensitivity of terminal values to choice of assumptions about stable growth rate and discount rates used in both the terminal and annual cash flow periods.
• Stable growth rate: The firm’s growth rate that is expected to last forever. Generally equal to or less than the industry or overall economy’s growth rate. For multinational firms, the growth rate is the world economy’s rate of growth.
• Length of the high growth period: The greater the current growth rate of a firm’s cash flow relative to the stable growth rate, the longer the high growth period.

Choosing the Correct Tax Rate
(Marginal or Effective)
• Effective rates are those a firm is actually paying after allowable deductions (e.g., investment tax credits) and deferrals (e.g., accelerated depreciation)
• Marginal tax rates are those paid on the last dollar of income earned
• Zero and Constant Growth Models: In calculating valuation cash flows, use marginal tax rates 1
• Variable Growth Model: In calculating valuation cash flows,
– Use effective rates to calculate annual cash flows when effective rates are less than marginal rates and
– Use marginal rates in calculating terminal period cash flows.
1
1 The use of effective tax rates during the terminal or an indefinite growth period implies the firm will defer the payment of taxes indefinitely.

Free cash flow to equity last year was $4 million. It is expected to grow by 20% in the current year, at a 15% rate annually for the next five years, and then assume a more normal 4% growth rate thereafter. The firm’s cost of equity is 10% and weighted average cost of capital is 8% during the high growth period and then drop to 8% and
6%, respectively, during the normal growth period. What is the present value of the firm to equity investors (equity value)? If the market value of the firm’s debt is $10 million, what is the present value of the firm (enterprise value)?

PV
1-5
= $4 x 1.2 x 1.15 + $4 x 1.2 x (1.15) 2
(1.10) (1.10) 2
+ $4 x 1.2 x (1.15) 3
(1.10) 3
+
$4 x 1.2 x (1.15) 4
(1.10) 4
+ $4 x 1.2 x (1.15) 5
(1.10) 5
= $27.47
PV
5
P
0
= (($4 x 1.2 x (1.15) 5 x 1.04)) / (.08 - .04) = $155.86
(1.10) 5
= PV
1-5
+ PV
5
= $27.47 + $155.86 = $183.33 (equity value)
P
0
= $183.33 + $10 = $193.33 (enterprise value) 1
1 Recall that the enterprise value of a firm is equal to the sum of the value of its equity and debt.

Adjusting Firm Value
• Generally, the value of the firm’s equity is the sum of the present value of the firm’s operating assets and liabilities plus terminal value
(i.e., enterprise value) less market value of firm’s long-term debt.
• However, value may be under or overstated if not adjusted for present value of non-operating assets and liabilities assumed by the acquirer.
PV
FCFE
= PV
FCFF
(incl. terminal value) – PV
D
+ PV
NOA
– PV
NOL where PV
FCFE
PV
FCFF
= PV of free cash flow to equity investors
= PV of free cash flow to the firm (i.e., enterprise value)
PV
D
PV
NOA
PV
NOL
= PV of debt
= PV of non-operating assets
= PV of non-operating liabilities

• A target firm has the following characteristics:
– An estimated enterprise value of $104 million
– Long-term debt whose market value is $15 million
– $3 million in excess cash balances
– Estimated PV of currently unused licenses of $4 million
– Estimated PV of future litigation costs of $2.5 million
– 2 million common shares outstanding
What is the value of the target firm per common share?

$104 Enterprise Value
Plus: Non-Operating Assets
Excess Cash Balances
PV of Licenses
Less: Non-Operating Liabilities
PV of Potential Litigation
Less: Long-Term Debt
Equals: Equity Value
Equity Value Per Share
$3
$4
$2.5
$15
$93.5
$46.75

Things to Remember…
• Zero growth model: Cash flow is expected to remain constant in perpetuity.
• Constant growth model: Cash flow is expected to grow at a constant rate.
• Variable growth model: Cash flow exhibits both a high and a stable growth period.
– Total present value represents the sum of the discounted value of the cash flows over both periods.
– The terminal value frequently accounts for most of the total present value calculation and is highly sensitive to the choice of growth and discount rates.