Analyst Training

T\TRAINING\TRAINING MAR2002\Pitches\ CF M&A Bootcamp Materials v3

1

Agenda

Introduction

Trading comparables

Transaction comparables

Discounted cash flow analysis

LBO analysis

Relative value analysis

Merger consequences– Accretion/(dilution) review– Pro forma balance sheet analysis review

Appendix


2

Objectives

Review the key valuation methodologies and techniques

Review merger consequences / pro-forma analysis including updates due to recent accounting changes

Communicate JPMorgan standards

Provide examples and “rules of thumb” to enhance valuation related intuition and highlight common mistakes


3

Why valuation is important?

Acquisitions

How much should we pay to buy the

company?

Divestitures

How much should we sell our

company/division for?

Fairness opinions

Is the price offered for our company/division fair (from a financial

point of view)?

Public equity offerings

For how much should we sell our

company/division in the public market?

Debt offerings

What is the underlying value of the business/assets

against which debt is being issued?

New business presentations

Various applications

Research

Should our clients buy, sell or hold

positions in a given security?

Hostile defense

Is our company undervalued/vulnerable

to a raider

Valuation


4

Valuation methodologies

Valuationmethodologies

Publicly tradedcomparable

companies analysis

Comparable transactions

analysis

Discountedcash flowanalysis

Leveragedbuyout/recap

analysisOther

• “Public Market Valuation”

• Value based on market trading multiples of comparable companies

• Applied using historical and prospective multiples

• Does not include a control premium

• “Private Market Valuation”

• Value based on multiples paid for comparable companies in sale transactions

• Includes control premium

• “Intrinsic” value of business

• Present value of projected free cash flows

• Incorporates both short-term and long-term expected performance

• Risk in cash flows and capital structure captured in discount rate

• Value to a financial/LBO buyer

• Value based on debt repayment and return on equity investment

• Liquidation analysis

• Break-up analysis• Historical trading

performance• Expected IPO

valuation• Discounted future

share price• EPS impact• Dividend discount

model


5

The valuation process

(3) Comparable Acquisition TransactionsUtilizes data from M&A transactions involving similar companies.

(1) DiscountedCash FlowAnalyzes the present value of a company's free cash flow.

(2) Publicly Traded Comparable Companies Utilizes market trading multiples from publicly traded companies to derive value.

(4) LeveragedBuy OutUsed to determine range of potential value for a company based on maximum leverage capacity.

Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies


6

$15.00

$9.75

$5.50

$26.75

$5.00

$4.00$5.00

$3.50

$4.94

$3.00

$4.00

$10.25

$6.00

$3.75

$0.00

$5.00

$10.00

$15.00

$20.00

Price per share

Implied offer = $8.46

Public trading comparablesTransaction comparables

DCF analysis

52-weekhigh/low

19.0x to 25.0x2001E cash

EPS of $0.16

15.0x to 19.0x2001E EBIT

of $20.6

2.5x to 4.0xLTM revenue

of $185.712% to 15%

Discount RateEBIT exit mult.

of 15.0x to 20.0x

15.0x to 20.0x2002E cash

EPS of $0.25

Mgmt. Case Street Case

12% to 15% Discount RateEBIT exit mult.

of 15.0x to 20.0x

The valuation summary is the most important slide in a valuation presentation

The science is performing each valuation method correctly, the art is using each method to develop a valuation recommendation


7

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


8

Trading comparables analysis as avaluation methodology



companies analysis


analysis



analysisOther















• Break-up analysis• Historical trading

performance• Expected IPO

valuation• Discounted future

share price• EPS impact• Dividend discount

model


9

ConsPros

Trading multiples analysis is a key technique – based on assumption that current market is right

Market values incorporate perception of all investors reflecting firm prospects, industry trends, business risk, market growth, etc.

Basic tool for estimating market value

Provides check for DCF

Values obtained are reliable indicator of the value of firm for minority investment

Difficult to identify 100% comparable companies

Must make the difficult decision whether the company being analyzed is valued higher, lower or the same as the average of the sample

May be short term divergences from fundamental value – Stock market may reflect "sentiment” and

not the "true picture”

Thinly traded, small capitalization and poorly followed stocks may not reflect fundamental value

Different accounting standards

Different level of information according to national stock market requirements

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


10

A primer: firm value vs. equity value

Firm value = Market value of all capital invested in a business(1)

(often referred to as “enterprise value” or “asset value”)

The value of the total enterprise: market value of equity + net debt

Equity value = Market value of the shareholders’ equity(often referred to as “offer value”)The market value of a company’s equity (shares outstanding x currentstock price)

Equity value = Firm value - net debt(2)

Liabilities and Shareholders’ EquityAssets

Enterprisevalue

Net debt

Equity value

EnterpriseValue

1 The value of debt should be a market value. It may be appropriate to assume book value of debt approximates the market value as long as the company’s credit profile has not changed significantly since the existing debt was issued.

2 Net debt equals total debt + minority interest + preferred equity + capitalized leases + short-term debt - cash and cash equivalents.

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


11

Firm value should take into consideration all relevant layers of capital

Item Comment

Equity value

Common stock Make sure to include multiple classes of stock

Do not include ADRs in the share calculation

Options Include incremental shares (treatment dependent on circumstances - treasurymethod for stand alone value)

Convertible preferred stock* Convert to common shares if in the money

Convertible debt* Convert to common shares if in the money

Debt

Preferred stock Market value, if available

Debt Market value, in theory

Capital leases

Convertible preferred stock* Include (market value, if available) if out of the money

Convertible debt* Include (market value, if available) if out of the money

Minority interest Generally include (market value, if available) in calculation of firm value

Cash

Cash

Marketable securities

Equity interests in affiliates Generally exclude from calculation of firm value

Overview

The right comps

The right multiple

Spreading the comp

Deriving value

Note: Asterisk (*) implies you need to decide on placement based on whether the security is in-the-money or not - do not put it both places!


12

Different multiples apply to equity value and firm value

The defining difference lies in the treatment of debt and its associated cost (interest expense)

A multiple that has debt in the numerator must have a statistic before interest expense in the denominator

Equity value Firm value

• Value for owners of business (after interest expense)

• Multiples of:– Net income– After tax cash flow– Book value

• Value available to all providers of capital (before interest expense)

• Multiples of:– Sales– EBITDA– EBIT

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


13

The key steps for trading comparables

Identify the right comparable companies

Choose the right multiples for comparison purposes

Spread the comp correctly

Apply the comparable data to derive a value

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


14

Key comparables must be in same business as target

Consider the perspective of equity investors (can use equity research as a proxy) – to what would they compare target?

You want to indentify companies that closely resemble the composition and function of the company you are evaluating

FinancialOperational

Overview

The right comps

The right multiple

Spreading the comp

Deriving value

• Industry

• Product

• Markets

• Distribution channels

• Customers

• Seasonality

• Cyclicality

• Growth prospects

• Size

• Margins

• Leverage

• Shareholder base (influence of a large shareholder)


15

Go even further, and identify a limited group as “closest comparables”

CountryBusiness/profit mix

Marketcap/sales

Financialmargins/growth

Comments/special issues

Company X

Company Y

Company Z

Company A

Company B

Company C

Example of criteria used

Veryrelevant

Others

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


16

Choosing the right multiples

Typical valuation measures include– Firm value multiples

• Firm value/sales• Firm value/EBITDA• Firm value/EBIT

– Equity value multiples• (Equity value/net income) or (price/EPS (P/E))• Equity value/after-tax cash flow• Equity value/book equity

Valuation multiple can be calculated on both a latest twelve months (“LTM”) and a forecasted basis

Companies trade most typically off expected future performance (analysts’ estimates)– EPS estimates are available from I/B/E/S on Bloomberg– Other income statement projections are found in equity research reports available

from Market Data Services, Multex and Investext

It is important to understand what metric the companies in a peer group trade off of (revenue, EBITDA, EPS, etc.)

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


17

The selection/presentation of appropriate multiples is as important as the calculation of the “comps”

Types of multiples used may differ significantly from industry to industry

Use analyst research for choosing comps and multiples

Seek guidance from more senior team members/industry group experts on which multiples to use

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


18

Determine multiples used by investors – there are three commonly used multiples . . .

Multiple Pros Cons

Price/earnings Widely used by investors, particularlyforward-year P/E estimates

Consensus prospective EPS figuresavailable

Distorted by different accountingpractices, particularly depreciation

Highly sensitive in cyclical companies

Can be distorted by leverage

Firm value/EBITDA Good ratio in cyclical industries

Good for cross-country comparisons

Independent of leverage

Distorted by differing tax rates incomps

P/E to growth Normalizes P/E ratios for growthprospects

Widely used in industrial, consumersectors

Distorted by different accountingpractices, particularly depreciation

Highly sensitive in cyclical companies


Price/cash flow Widely used by investors, particularlyin Europe

Corrects for different depreciationpolicies

Not always a consensus on whatshould be included in cash flow


Overview

The right comps

The right multiple

Spreading the comp

Deriving value


19

. . . supplemented by industry-specific ratios and other ratios

Multiple Pros Cons

Firm value/pop Telecom industry preferred ratio Critical for cellular/high growth situations

Dependent on number of competitors incountry and potential market share

Assumes same profitability for all compsFirm value/subscriber Important telecom ratio

Good for more mature situations Reflects current market share

Assumes same profitability for all comps Difficult to use in high growth situations

Firm value/ton Useful for cyclical stocks which exhibitsimilar profitability (i.e. metals & miningcompanies)

Fails to capture differences in product mixwhich impact overall profitability

Other ratios

Firm value/EBIT Independent of leverage Distorted by differentdepreciation/accounting polices

FV/EBITDA is better ratioFirm value/sales Most often used with high growth

companies that do not have earnings Benchmark for transactions in some

industries

Not used by investors Highly dependent on profitability

Price/book value Useful for capital intensive industries andfinancial institutions

Reflects long-term profitability outlook

Distorted by accounting differences Need profitability cross-check Not favored by investors

Relative price/earnings Can correct for accounting differencesbetween companies in different countries

Consensus prospective informationavailable

Distorted by cyclicality of country P/Es Assumes comps trade at similar relatives Some country P/Es influenced by

dominant companies/industries

Industry-specific examplesOverview

The right comps

The right multiple

Spreading the comp

Deriving value


20

Margins / profitability

Gross margin

EBITDA margin

EBIT margin

Net income margin

Operating margin

Return on total invested capital (industrial companies)

Return on equity (financial institutions companies)

Performance measures

Capitalization / credit

Leverage and liquidity ratios

Coverage ratios

Off-balance sheet debt/operating leases

Comparing various statistics and performance measures among the companies in your comparable universe can help shed light on why companies may trade the way they do

Growth rates

Sales

Operating income

Net income

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


21

Spreading the comps correctly - JPMorgan standards

Use diluted shares using the treasury method

Calendarize forward estimates so that all companies are being compared for the same twelve month time period

Pro forma companies’ financial results for announced transactions (acquisitions and divestitures)

Forward estimates for EPS should be based on IBES or First Call medians, but ensure you understand the components of these estimates– Some analysts included in those mean/median calculations may not have

updated their estimates even though there has been a significant change in the company’s prospects

Forward estimates for sales, EBITDA and EBIT based on analyst research

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


22

JPMorgan uses the treasury method to calculate fully diluted shares outstanding

Issues/pitfallsExample

The treasury method assumes all in-the-money options are exercised and the proceeds used to buy-back shares

ExampleCo Inc.

Total basic shares outstanding (latest 10K/10Q) 1,772,199,483.0

Current ExampleCo share price $40.0

OutstandingExerciseprice

In themoney?

Sharesissueduponexercise

Proceeds fromexercise

Treasurysharespurchasedwithproceeds

Tranche 1 2,975.0 $8.56 Yes 2,975.0 $25,466.0 636.7

Tranche 2 77,165.0 $24.99 Yes 77,165.0 $1,928,353.4 48,208.8

Tranche 3 96,782.0 $39.13 Yes 96,782.0 $3,787,079.7 94,677.0

Tranche 4 110,975.0 $57.00 No 0.0 $0.0 0.0

Total 287,897.0 176,922.0 5,740,899.0 143,522.5

Total shares issued upon exercise of options 176,922.0

Treasury shares purchased with proceeds (143,522.5)

Incremental shares outstanding 33,399.5

Fully diluted shares outstanding 1,772,232,882.5

Break out each tranche of outstanding options and warrants separately

Avoid double counting of options - do not include “Total” line in calculation!

Equity value should be calculated using all options and warrants outstanding (not just exercisable)

Stock splits

Pro forma adjustments

Note accounting convention for diluted EPS in financial statements uses average stock price over the prior year - not correct for calculating current shares outstanding

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


23

Calculating the LTM (latest twelve months)

Most RecentPeriod

Fiscal YearPeriod Endingone year priorto most recent

-+

ANNUAL

{ {QT-1 QT

Q1 Q2 Q3 Q4 Q1 Q2

Annual

TotalAnnual(12/00)

+ Six Months10Q (6/01)

- Six Months10Q (6/00)

= LTM(6/01)

Revenue $129,853 $62,470 $62,858 $129,465

Example: General Electric LTM = 6/30/01

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


24

Calendarizing financial data

When companies in the comparable universe have fiscal years ending at a date other than that of the client or focus company, it is common to employ the technique of calendarization

Calendarization adjusts the financial data of one company to reflect results representative of the period in time corresponding to the latest fiscal year of the client or focus company– This insures that the financial data of both companies is truly comparable by eliminating

seasonal or cyclical differences that may arise as a result of dissimilar fiscal year ends

Example: Client/Acquiror has fiscal year end (“FYE”) 12/31 while Target has FYE 10/31– Target FYE 2002E Net Income = $120, Target FYE 2003E Net Income = $150– Calendarize from 10/31/02 to 12/31/02:

Ideally could use quarterly estimates– However, availability and consistency are an issue Target CY2002E Net Income = $125$25$100

12

$150 2

12

$120 10

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


25

Two approaches are widely utilized for developing forward estimates

“Top-down” approach“Bottoms-up” approach

Use IBES median EPS estimate

Build-up from EPS to EBIT / EBITDA using analyst estimates for shares outstanding, tax rate, interest expense, depreciation & amortization

Advantages:– “Automatically” reflects changes in

earnings estimates as they are made by IBES

– Not tied to one specific equity analyst

Disadvantages:– Need to reality-check resulting EBIT

and EBITDA– Cannot foot directly to an analyst

report

Use IBES median EPS estimate

Use a specific analyst report (or the average of a group of reports) for EBIT / EBITDA estimates

Advantages:– Easy to check– Can cite specific source your

estimate came from

Disadvantages:– Does not “automatically” update– Will not necessarily reflect

consensus

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


26

Dealing with minority interest and equity in unconsolidated affiliates

Minority interest represents the portion of a consolidated subsidiary which you do not own

Need to make sure the numerator and denominator of a trading multiple are on an apples-to-apples basis– Numerator: Add the minority interest

(market value if available or book value) to firm value

– Denominator: Consolidated financial results

Consider the following example:– Market cap of $500MM – Debt of $500MM– Consolidated EBITDA of $100MM– Minority interest of $50MM

Firm Value = $1050, EBITDA = $100– FV / EBITDA = 10.5x

Equity interest in unconsolidated affiliates represents a minority stake you hold in another company

Need to make sure the numerator and denominator of a trading multiple are on an apples-to-apples basis– Numerator: Subtract the equity interest

(market value if available or book value) from firm value (i.e. treat as cash)

– Denominator: Consolidated financial results (do not include equity interest)

Consider the following example:– Market cap of $500MM – Debt of $500MM– Consolidated EBITDA of $100MM– Equity interest of $50MM

Firm Value = $950, EBITDA = $100– FV / EBITDA = 9.5x

Equity interestMinority interest

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


27

Other standards when spreading comps

Use income from continuing operations (i.e. income before discontinued operations, extraordinary charges/income and effect of change in accounting principles)

Eliminate non-recurring items– Restructuring charges– Gains/losses on sale of assets– One-time write-offs– Read all footnotes and Management Discussion and Analysis (“MD&A”) sections

Tax effect all adjustments, if they relate to an after-tax financial statistic and are tax-deductible– Check MD&A and footnotes for actual tax impact if available– Use marginal rate if tax impact not available

Double-check your calculations!!!– “Reality” check on multiples, margins, etc. (ruler check, brokerage report check)– Don’t assume model is always right!

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


28

Typical errors spreading comps

Stock splits, dividends & repurchases

Differences in fiscal year end (EPS estimate)

Cash (long term investments)

Recent acquisition and divestitures – pro forma #’s

Changes in earnings estimates

Non-recurring items

Recent debt or equity offerings

Take-over activity

Re-statements

Conversion of convertible securities since last reporting period

Differences in international accounting treatment

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


29

Using multiples to derive value

Generally a range of multiples are used to provide a valuation range for your target

Multiply the company’s sales, operating income, operating cash flow, net income, book value and other key operating statistics by the respective comparable company multiples

– Subtract net debt from firm values

Example: Target company has 98 million shares outstanding, 4 million options outstanding with an exercise price of $25, net debt of $200 million and the following statistics. What equity value per share does each multiple imply?

$ millions,except pershare data

Targetstatistic

Relevant multiplefrom set of

comparables Calculate equity value

Impliedequityvalue

Impliedequity value

per share

EPS $2.50 20.0x $2.50 x 20.0 x 100 = $5,000 $50.00

Net income $250 20.0x $2.50 x 20.0 = $5,000 $50.00

EBIT $400 13.0x ($400 x 13.0) – 200 = $5,000 $50.00

EBITDA $500 10.0x ($500 x 10.0) – 200 = $4,800 $48.09

Sales $2,500 2.00x ($2,500 x 2.00) – 200 = $4,800 $48.09

Overview

The right comps

The right multiple

Spreading the comp

Deriving value

Note: different fully-diluted share count at

different prices


30

An example: Trading comparables

$ millions, except per share data

Firm value/ Price/

Company4/19/02

stock priceMarket

capFirm

valueLTM

EBITDA2002E

EBITDA 2003E

EBITDA2002E

EPS2003E

EPS LTG 2003 PEG

McDonald's $28.60 $37,450 $45,950 11.5x 10.2x 9.5x 19.5x 17.8x 10.0% 1.78x

YUM Brands 61.49 9,871 12,007 9.5 8.9 8.3 16.9 15.4 12.5% 1.23

Wendy’s 36.78 4,365 4,709 10.4 9.5 8.5 19.4 17.3 14.0% 1.23

Jack in the Box 31.40 1,285 1,548 7.0 6.5 5.9 13.7 12.3 15.5% 0.80

Sonic Corp 28.06 1,158 1,271 13.4 11.8 10.0 23.6 19.8 20.0% 0.99

AFC Enterprises 34.28 1,153 1,361 10.7 8.8 7.8 20.1 16.3 20.0% 0.82

Papa Johns 29.98 641 729 6.2 6.2 5.9 13.3 12.4 13.4% 0.93

Median 10.4x 8.9x 8.3x 19.4x 16.3x 14.0% 0.99x

Mean 9.8x 8.9x 8.0x 18.1x 15.9x 15.1% 1.11x

Note: Projections based on equity analyst research reports; all projections calendarized to 12/31 year-end

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


31

6.7x

7.3x7.6x

7.8x

6.8x

7.4x

8.6x 8.7x

5.7x

11.1x 11.1x10.8x

11.2x11.5x

11.4x

13.0x13.1x

16.1x

15.8x16.1x

16.3x

13.9x13.4x

14.0x

11.6x10.9x

11.6x

10.8x

11.7x

7.3x7.2x

8.2x

9.0x

7.9x

8.7x9.0x

8.0x7.9x

6.1x 6.1x

8.5x

9.5x

10.4x10.3x

8.7x8.6x

7.7x

8.0x

6.3x

5.7x5.3x5.6x5.6x

5.9x

10.2x10.4x

8.9x

7.4x7.9x

7.4x7.5x7.8x7.2x

7.9x7.5x

6.4x

5.9x

6.4x

5.9x

6.2x6.6x

6.0x

6.8x6.6x

8.6x

6.4x

7.1x6.6x

7.8x

8.2x

7.2x

8.5x

9.0x

8.1x

10.1x

9.6x9.5x

8.8x

8.1x8.1x8.3x

8.9x

9.8x9.5x

9.2x

8.5x7.4x

5.0x

6.0x

7.0x

8.0x

9.0x

10.0x

11.0x

12.0x

13.0x

14.0x

15.0x

16.0x

17.0x

1997

Q1

1997

Q2

1997

Q3

1997

Q4

1998

Q1

1998

Q2

1998

Q3

1998

Q4

1999

Q1

1999

Q2

1999

Q3

1999

Q4

2000

Q1

2000

Q2

2000

Q3

2000

Q4

2001

Q1

2001

Q2

2001

Q3

2001

Q4

Historical LTM EBITDA multiples

MCD

SONC

WEN

YUM

JBX

Firm value/LTM EBITDA5-yr avg.

MCD 12.8x

SONC 8.5x

WEN 8.1x

YUM 7.3x

JBX 7.0x

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


32

Champion vs. peers

Champion McDonald’s Wendy’s YUM Brands Jack in the Box Sonic

Growth (’00–’01)

Comp store sales growth (0.3%) (2.2%) 2.1% 1.0% 3.0% 1.8%

’02 Q1 comp store sales growth (2.5%) (0.8%) 5.6% 5.0% 0.1% 7.0%2

Systemwide sales growth (1.9%) 1.1% 7.7% 0.8% 10.4% 8.8%

Unit growth 1.9% 4.8% 5.6% 0.2% 7.9% 8.4%

Earnings growth (18.9%)1 (11.2%) 14.1% 10.3% 8.4% 19.0%

Positioning

Company-owned store % 9% 28% 16% 21% 81% 17%

International store % 27% 56% 34% 36% 0% 0%

Fair share % 81% 121% 89% 59% 94% 67%

Brand position Flame-broiledplatform is

differentiator;traditional

customer base:young males (18 –

29 yrs old)

Strong in families,children and pre-

teen market

Innovative menu withno discounting.

Appeals to an olderconsumer and

women

Leader in chicken,Mexican, and pizza

QSR

Broad menu incl.sandwiches and

tacos. Moreconcentrated in

18 to 34 year-oldsthan competitors

Unique drive-informat.

Regionalstrength in

South &Midwest

Franchisee financial condition Poor; estimated15% of system may

be in distress

Strong Strong Franchiseefinancial difficulties

in the Taco Bellsystem in ’00 & ‘01

Very smallfranchisee base

Strong

Commentary Strong brandrecognition but

has lost share overpast few years due

to lack of newproducts and poor

execution

Global brand withlargest store baseand highest AUV.Bellwether for the

sector hashistorically tradedat a premium to

other QSRs.Premium has

narrowed due tounderperformance

Impressiveturnaround in the last

decade. Stronggrowth from Tim

Horton’s andinnovative new

products at Wendy’shave helped increasevaluation. Believed tobe best-positioned toprofit from an aging

population

Success in turningaround KFC and

Pizza Hut brands.Multi-branded unitsexpected to drive

traffic.Experiencing

strong internationalgrowth. Recently

acquired A&W andLong John Silvers

Strong comp storesales growth and

innovativeadvertising.Currently

expanding fromtheir West Coast

base. Smallfranchise program

limits speed ofexpansion and

increases co. risk

Strong earningsgrowth andsame store

sales growthdriven by storeexpansion and

increasingroyalty rate

supportspremiumvaluation

1 Based on adjusted EBIT2 Blended growth rate based on Company and Franchised unit comp store sales growth

Overview

The right comps

The right multiple

Spreading the comp

Deriving value


33

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


34

Transaction comparables analysis as avaluation methodology



companies analysis


analysis



analysisOther















• Break-up analysis

• Historical trading performance

• Expected IPO valuation

• Discounted future share price

• EPS impact• Dividend

discount model


35

Comparable transaction analysis

Assists investment bankers, clients, lenders to understand the: – Valuation of a company – Structuring of a potential transaction – Current state of M&A in a specific industry (number and relative value)

Examines a group of transactions to identify a median/range/trend of:– The multiple (of cash flow, operating profit, earnings or other industry metrics)

paid for a target– The premium paid to gain control of a target (“control premium”)– Business fundamentals of a target (revenue/earnings growth, profitability)– Technical transaction elements (deal protection, conditions to closing)– Social issues (board seats, management)– Other value drivers (synergies, tax benefits)


36

Sources used to locate comparable transactions

Thompson Financial database (SDC)– Locates targets based on SIC code, business description, industry– Identifies transactions based on hostile vs. friendly, transaction size, announcement date, and several

other deal elements– The “Comprehensive Summary Report” is very helpful in hand-picking transactions since it includes a

synopsis of the deal in addition to general information regarding both parties and the transaction– Available on desktops and through the Business Research Center at (212) 622-4900

Senior bankers who work in the industry– Will be able to point you toward previously used presentations or valuations– Ensures you do not exclude any landmark deals or other deals they would specifically like to include

Merger proxies for similar transactions– Fairness opinions of financial advisors disclose the comparable transactions used in their valuation of

the target

Other sources include:– JPMorgan transaction comps databases– News runs– Equity research reports


37

Selecting comparable transactions

When valuing a company, key objective is to find the most comparable businesses– Similar industries with similar products or services– Size, margins, relative market position, major potential liabilities

When seeking guidance regarding structure, the situation surrounding the acquisition is crucial– Scenarios could include: LBO’s, bankruptcy-related acquisitions, hostile

transactions, reverse mergers, divestitures, asset vs. stock acquisitions, form of consideration, Morris Trust transactions, and many others

– If possible, try to locate transactions in a similar industry as well

Some types of transactions should, generally, not be considered as a comparable transaction– Acquisitions of a minority interest (not a change of control transaction)– Rumored or withdrawn transactions

Recent deals are typically a more accurate reflection of the values buyers are willing to pay

Remember that some transactions are more relevant than others when selecting a range of multiples for valuation


38

Comparable transaction multiples analysis document checklist

Item Source Comments

General transaction informationSDC "Comprehensive Summary Report" SDC Use to spot check your work; not extremely accurate but generally close;

helpful for business descriptions and summary of transaction

Bloomberg transaction description Bloomberg (TICKER <EQUITY> CACS) - click on deal Use to spot check your work; not extremely accurate but generally close; helpful for key transaction dates

Announcement press release Yahoo!, Dow Jones, target or acquirer websites Be sure it is the ORIGINAL announcement; excerpts are often reproduced throughout the day by other wire services; generally, the longest was issued first; INCLUDE ANNOUNCEMENT TIME as well

Closing press release Yahoo!, Dow Jones, target or acquirer websites Include only if transaction is closed

Target & Acquirer business descriptions Company websites Include only if necessary due to lack of detail in press release (target websitemay disappear)

A few equity research reports MorganWise, First Call, Multex Helps gauge the Street reaction to the announcement; analysts might publish historical or projected estimates for private companies; may give ball park estimates; provides explanations of complex transaction structures and general street perspective

Offer price*Merger agreement S4, Proxy, 8K, or potentially attached to other filings Check both acquirer and target SEC filings during the period; print out the

entire document

Acquirer historical prices Bloomberg (TICKER <EQUITY> HP) AND Include if acquirer is paying in stock; include several days prior and post Yahoo! unadjusted stock price listing announcement; Bloomberg prices are more reliable;However Yahoo! Prices are

unadjusted for stock splits, so print out BOTH

Acquirer Bloomberg "Corporate Action Calendar" Bloomberg (TICKER <EQUITY> CACS) Include if acquirer is paying in stock; check for stock splits or other relevant news

Historical exchange rates Bloomberg, Oanda (www.oanda.com/convert/fxhistory) Only for foreign acquirer; include several days prior and post announcement; be careful stock prices aren't already in US dollars

Target financial and business informationTarget Bloomberg historical prices Bloomberg (TICKER <EQUITY> HP) Use for premiums analysis; include LTM period to show 52 week high

Target Bloomberg "Corporate Action Calendar" Bloomberg (TICKER <EQUITY> CACS) Check for stock splits, substantial acquisitions, and other relevant news

Basic shares outstanding Merger agreement, latest 10Q or 10K, private company Use merger agreement if possible (latest share count available) ; otherwise 10Q financial disclosures* or 10K

Options, warrants, and convertible securities 10K and ALL following 10Q's, private company Print out all relevant sections including: cover page, management discussion, financial disclosures* financial statements and footnotes, exhibits index, and any other possibly

relevant sections or exhibits

Net debt Latest 10Q, 10K, quarterly financial press release, Print out all relevant sections including: cover page, management discussion, private company financial disclosures* financial statements and footnotes, exhibits index, and any other possibly


LTM operating statistics Latest 10K and 10Q quarterly financial press release, Print out all relevant sections including: cover page, management discussion, VentureSource, private company financial disclosures* financial statements and footnotes, exhibits index, and any other possibly


Historical exchange rates Bloomberg, Oanda (www.oanda.com/convert/fxhistory) Only for foreign target whose financials are in foreign currency; for operating statistics, use avg. over period; for balance sheet items, use spot rate as of that date

Projected financial performance MorganWise, First Call, Multex, VentureSource Include research reports on target if public; if private, check research reports on acquirer

* Financial information as well as consideration paid for private targets is often overlooked; They can be published in an ammended 8K, an S4, a 10Q, a 10K or as an exhibit to other acquirer filings;When necessary, search for target's name in any acquirer filings from announcement through a few months post closing (Use Control + F) to be certain no financial disclosures have been missed.


39

Calculating equity and firm value

Definitions of equity value and firm value similar to trading comparables:

Equity value Value received by the target / target shareholders (100%) + Net debt Debt assumed by acquiror minus cash received Firm value Total value of business acquired (100%)

BE CAREFUL: Transaction value for a change of control transaction will differ from equity and/or firm value when >50% but <100% is acquired

Equity value: – Cash consideration: (fully-diluted target shares @ offer price) x (cash consideration per share)– Stock consideration: (fully-diluted target shares @ offer price) x (exchange ratio) x (price per

acquiror share @ the closing price prior to announcement)– Cash and stock consideration: (fully-diluted target shares @ offer price) x (cash consideration per

share) plus (fully-diluted target shares @ offer price) x (exchange ratio) x (price per acquiror share @ the closing price prior announcement)

Firm value: – In all cases: Add the indebtedness and subtract the cash items that are to be transferred to the

acquirer through the transaction to the target equity value• Be careful not to add any convertible debt or preferred securities which were converted into

common shares (and already included in the fully-diluted share count) • May be appropriate to include certain other unfunded liabilities in the calculation of firm value

for a transaction


40

Other equity and firm value issues

Timing (announcement vs. closing)– Typically want to assess what buyer was willing to pay for business, so most interested in valuation based on stock prices

as of announcement date– Information regarding shares outstanding, options, debt, cash as of most recent publicly disclosed source as of

announcement date (i.e. 10-K, 10-Q, or Proxy, 8-K)– However, if terms of the transaction change (exchange ratio, amount of cash consideration), should look to valuation on

date of announcement of revised terms– Valuing a deal with stock consideration as of the closing date will give a sense for how market reacted to value of two

companies together

Transaction fees– Typically M&A fees/financing fees are not included in firm value of business acquired as they are not consideration received

by seller– However, in extreme cases (i.e., LBO/recap) it may be instructive to know amount of fees and indicate how they may have

impacted business valuation

Asset purchases– Note that debt can be transferred with businesses/assets being sold and must be added to the consideration paid by the

acquiror

Other liabilities– In some instances it may be appropriate to include the assumption of a non-debt other unfunded liability in firm value (such

as an existing restructuring reserve) but never NWI / working capital items

Earn-outs/purchase price adjustments


41

LTM financial information issues

Time horizon– LTM financial information should reflect what buyer bought the business “off-of” and is generally

backward-looking (typically last twelve months of financial information available prior the announcement date)

– In certain industry-specific circumstances (i.e. technology, biotech) it is more useful to look at projected financial information as well (typically IBES consensus estimates / median of several analyst reports)• However, the outlook of equity analysts may be quite different than the outlook of the buyer

at the time of acquisition

Adjustments– Exclude impact of extraordinary items on a tax-affected basis– Pro forma adjustments (i.e. acquisitions and divestitures) must be considered

Currencies – If target is foreign, most-commonly taught method is to apply average exchange rates over LTM

period because it is the accounting convention– Is this always appopriate for valuation purposes? Not necessarily– Need to consider carefully / discuss with team-members in extreme cases (i.e. when currency

has de-valued / re-valued substantially vs. US Dollar)


42

Other general considerations

Synergies– Synergies are not generally incorporated into the financial information but it may

be useful to consider their value when comparing transactions to each other– Sometimes will indicate announced synergies as a % of sales, SG&A, SG&A +

COGS, transaction value

Tax benefits– In certain cases (acquisition of assets, acquisition of stock with a 338(h)(10)

election) a buyer will receive substantial benefits from depreciating / amortizing a write-up and receiving incremental tax deductions

– An acquiror can often justify a higher purchase price and multiples may be higher in such circumstances

– Can attempt to estimate the value of tax benefits received by acquiror but depends on a lot of unknown variables (discount rate, amortization period, tax basis)

– However, should know which transactions are tax-advantaged and which aren’t


43

Most common errors

Unaffected stock prices (for premium analyses)

Stock splits

Proper interpretation of exchange ratio– Target share price / acquiror share price– Using the correct acquiror share price

Most recent common shares outstanding (use the merger agreement if available)

Use all outstanding, not exercisable, options and warrants and assume that all in-the-money securities are exercised in this analysis

Check for warrants

Repriced options

New issuances of debt or equity since most recent 10Q or 10K

Forgetting debt in an asset transaction

Acquisitions or divestitures completed by the target over LTM period

Exclude all extraordinary items - only tax affect those items that are tax deductible

Publicly-available information only, please!


44

General suggestions

Always check with JPMorgan databases and colleagues to see if work has already been done– Be sure you have carefully double-checked all work before showing to a client!!

Have all relevant documentation regarding the deal printed-out – Flag where you got your information from

Place all documents as well as a printout of the transaction comp model in a folder or binder

If possible, coordinate with M&A research to import your transaction data into our firm database

If a transaction is pending or is renegotiated, update the analysis to incorporate disclosures that were made subsequent to your analysis (e.g. S4, Proxy, research reports regarding transaction)

Be sure to update your list of transactions regularly on active projects to ensure that you do not exclude the most recent, and possibly most relevant, transactions


45

Output summary

Show any multiples or transactions that may be helpful for your analysis but don’t be afraid to base your conclusions off the multiples that are the most helpful

Spot check all outputs against your source documents for any obvious errors

Check for consistency regarding units - inputs are in thousands except per share values and outputs are in millions

Be careful of difference between not meaningful (NM) and information that is unavailable (NA)

Try to include any other relevant information


46

Transaction multiple analysis - example

Firm value/

Date Acquirer TargetFirm

valuePre-tax

synergiesTax

benefit Sales EBITDA EBIT

Apr-00 Unilever SlimFast $2,300 NA 3.8x 17.2x 18.4x

Aug-99 Procter & Gamble IAMS 2,300 $20 2.6 17.7 26.6

Oct-98 Newell Rubbermaid 6,383 325 2.5 17.0 25.4

Oct-98 Clorox First Brands 2,019 90 1.6 11.7 16.0

Apr-97 Procter & Gamble Tambrands 1,985 100 3.0 11.9 14.3

Sep-96 Gillette Duracell 7,801 120 3.3 14.1 17.1

Feb-96 Unilever Helene Curtis 906 NA 0.7 15.4 37.0

Jan-96 L'Oreal Maybelline 764 NA 2.1 14.8 19.2

Aug-95 Henkel Hans Schwarzkopf 888 NA 1.1 11.6 18.3

Jan-95 Colgate-Palmolive Kolynos (AHP) 1,040 NA 3.6 17.7 19.4

Aug-94 Johnson & Johnson Neutrogena 906 NA 3.1 19.3 22.3

Median overall 2.6x 15.4x 19.2x

Median tax benefit transaction 3.6x 17.7x 19.4x

Median non-tax benefit transaction 2.3x 14.4x 18.8x

$ millions

1 Estimated VFO multiples for SlimFast (based on the tax deductibility of the goodwill) were 2.9x sales, 13.0x EBITDA and 13.9x EBIT. Unilever presented post tax shield multiples in its public filings for the SlimFast acquisition.

2 Estimated VFO multiples for Kolynos were 3.0x sales, 14.8x EBITDA and 16.2x EBIT


47

Comparable asset transactions - example

Ann date Buyers Sellers

Totaltransactionvalue $MM

Reservevalue$MM Regions

Reserves(Bcfe)

Production(Bcfe) % gas R/P ratio

Impliedreserve value

$/Mcfe

2/20/01 AmeradaHess

LLOGExploration

$750 $750 Gulf Coast –offshore/onshore

360.0 72.0 70% 4.9 $2.08

1/31/01 PureResources

InternationalPaper

261 231 Gulf Coast –offshore/onshore

152.3 25.5 69 6.0 1.52

9/20/00 Evergreen KLT GasInc./KC P&L

176 176 Rocky Mountains 153.0 10.2 100 15.0 1.15

8/28/00 PanCanadian MontanaPowerCompany

468 351 Rocky Mountains 460.1 35.9 80 12.8 0.76

7/20/00 Apache Corp. OccidentalPetroleum

376 376 Gulf Coast – offshore 299.9 56.1 67 5.3 1.25

6/14/00 Apache Corp. Collins &Ware Inc.

330 292 Mid-Continent 501.9 23.4 67 21.5 0.58

5/2/00 AlbertaEnergy

McMurry Oil 627 548 Rocky Mountains 764.8 51.1 95 15.0 0.72

4/10/00 Westport EquitableResources


11/11/99 BP Amoco Repsol-YPFSA

500 430 Mid-Continent 526.0 62.1 48 8.5 0.82

4/29/99 Apache Corp. RoyalDutch/Shell


8/4/98 VastarResources

AtlanticRichfield


High $2.08

Median 1.15

Mean 1.14

Low 0.58

Source: John S. Herold, Inc.


48

Premiums paid analysis - example

Offer price premium (discount) % Exchange ratio premium (discount) %

Ann. Date Target Name Acquiror Name T-1 day T-1 week T-4 week T-90 days T-1 day T-1 week T-4 week T-90 days

1/12/00 Precision Response Corp USA Networks Inc 29.3% 31.5% 16.3% 44.1% 29.3% 28.9% 18.2% 29.7%

1/26/00 Interleaf Inc BroadVision Inc 40.0% 44.8% 52.3% 46.0% 40.0% 38.9% 46.1% 8.7%

2/3/00 Andover.net Inc VA Linux Systems Inc 61.6% 87.2% 73.4% 42.6% 61.6% 67.9% 82.2% na

2/22/00 IXnet Inc(IPC Information) Global Crossing Ltd 18.1% 19.9% 40.1% 84.0% 18.1% 29.5% 41.5% 78.0%

2/22/00 Medscape Inc MedicaLogic Inc/Medscape Inc 37.9% 47.8% 47.0% 48.3% 37.9% 38.6% 2.3% na

6/22/00 PSS World Medical Inc Fisher Scientific Intl Inc 20.1% 19.7% 28.5% 34.9% 20.1% 20.9% 19.1% 33.6%

7/3/00 Circle International Group Inc EGL Inc 22.4% 30.2% 57.0% 36.6% 22.4% 32.2% 49.8% 10.6%

7/26/00 Telxon Corp Symbol Technologies Inc 27.9% 35.4% 34.3% 53.7% 27.9% 32.1% 39.6% 53.2%

7/27/00 AXENT Technologies Inc Symantec Corp 67.0% 55.9% 38.6% 51.6% 67.0% 48.9% 16.0% 40.1%

9/8/00 Cyberonics Inc Medtronic Inc 57.0% 59.3% 75.7% 81.9% 57.0% 59.0% 76.6% 80.8%

10/3/00 Thermo Cardiosystems Inc Thoratec Laboratories Corp 96.2% 94.0% 83.0% 85.9% 96.2% 111.5% 86.3% 65.0%

10/16/00 Coulter Pharmaceuticals Inc Corixa Corp 43.3% 45.1% 40.5% 57.1% 43.3% 47.7% 51.8% 60.5%

10/24/00 Bluestone Software Inc Hewlett-Packard Co 9.0% 28.5% 42.3% 25.6% 9.0% 20.7% 34.2% 35.6%

10/27/00 About.com Inc PRIMEDIA Inc 46.3% 55.6% 56.3% 18.4% 46.3% 52.7% 51.3% 28.1%

11/13/00 Adaptive Broadband Corp Western Multiplex Corp 33.8% 22.4% 13.1% -17.8% 33.8% 34.6% 25.7% 1.0%

12/6/00 Accord Networks Ltd Polycom Inc 120.0% 141.3% 102.8% 78.1% 120.0% 100.1% 89.6% 110.4%

12/21/00 Great Plains Software Inc Microsoft Corp 29.3% 2.1% -7.9% 13.3% 29.3% 18.6% 25.9% 65.1%

3/22/01 Kent Electronics Corp Avnet Inc 28.9% 36.6% 24.8% 9.6% 28.9% 45.3% 37.5% 17.3%

4/30/01 Aurora Biosciences Corp Vertex Pharmaceuticals Inc 44.4% 51.5% 50.7% 34.6% 44.4% 49.8% 48.1% 48.7%

Median 37.9% 44.8% 42.3% 44.1% 37.9% 38.9% 41.5% 40.1%

Average 43.8% 47.8% 45.7% 43.6% 43.8% 46.2% 44.3% 45.1%


49

The JPMorgan M&A database can be used to locate precedent transactions

What information is available from the database?– Transaction descriptions including transaction structure information (i.e. termination fees,

collars, tax-elections, etc.) – Target and acquiror descriptions – Multiples (and underlying data used to calculate)

What transactions are contained in the database?– All U.S. deals > $1billion since 1998 (excluding FIG)– Smaller deals in certain industries:

• Telecom (RBOC, LEC, CLEC, wireless, LD-Tier 1, LD-Tier 2, SSIXC, internet & related)

• Healthcare (pharmaceuticals, devices and products)• Consumer (food, beverage and apparel)

How do I access the database?– On everyone’s desktop: Start Menu Main Menu Information MA Comps– If you are prompted to add a password, your initial password is comps– Refer to M&A webpage for detailed instructions on entering data

Project implemented by JPMorgan M&A Research Department and M&A Analysts


50

Transactions in the database may be referenced by several criteria

A

B

C

A

B

C

D

D

E

E

G

F

F

G

H I J K

.(A) Player Name: This field contains the legal name of the player. If the player is a division or subsidiary, only include the division name. (i.e. – Duncan Hines, not Bestfoods in this field).

(B) Player Description: This field contains the player description. It should be taken from a recent company release (10-K, 10-Q, 8-K, Annual Report).

(C) Player Industry: Select the most appropriate industry for the target and acquiror companies.

(D) Player Country: Select the home country of the target and acquiror companies from this list.

(E) Player Classification: Select whether the player is Public, Private, or a Division/Subsidiary of another company.

(F) Ultimate Parent: Select the ultimate parent of the player. If the player is the parent organization, then use the player as the ultimate parent. (i.e. – Bestfoods is the ultimate parent of Duncan Hines.)

(G) SIC Code Lookup: Either enter the appropriate SIC code into this box and hit enter, or click the SIC Code Lookup button to navigate the lists to choose the appropriate SIC Code.

(H) Announce Date: This field contains the official announcement date of the transaction

(I) Completion Date: This field contains the official completion of the transaction.

(J) Status: This field contains the status of the deal

(K) Presentation Method: This field indicates the date the deal was spread. It could be spread at Announcement, Completion, when the deal was Revised, or spread based on Private Basis.


51

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


52

Discounted cash flow analysis as avaluation methodology



companies analysis


analysis



analysisOther















• Break-up analysis

• Historical trading performance

• Expected IPO valuation

• Discounted future share price

• EPS impact• Dividend

discount model


53

Overview of DCF analysis

Discounted cash flow analysis is based upon the theory that the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate

DCF analysis is one of the most fundamental and commonly-used valuation techniques

– Widely accepted by bankers, corporations and academics

• Corporate clients often use DCF analysis internally

– One of several techniques used in M&A transactions; others include:

• Comparable companies analysis

• Comparable transaction analysis

• Leveraged buyout analysis

• Recapitalization analysis, liquidation analysis, etc.

– DCF analysis may be the only valuation method utilized, particularly if no comparable publicly-traded companies or precedent transactions are available

Overview

Free cash flow

Terminal value

WACC

Other topics


54

Overview of DCF analysis (cont’d)

DCF analysis is a forward-looking valuation approach, based on several key projections and assumptions

– Free cash flows

• What is the projected operating and financial performance of the business?

– Terminal value• What will be the value of the business at the end of the projection period?

– Discount rate• What is the cost of capital (equity and debt) for the business?

Depending on practical requirements and availability of data, DCF analysis can be simple or extremely elaborate

There is no single “correct” method of performing DCF analysis, but certain rules of thumb always apply– Do not simply plug numbers into equations– You must apply judgment in determining each assumption

Overview

Free cash flow

Terminal value

WACC

Other topics


55

The process of DCF analysis

Project the operating results and free cash flows of the business over the forecast period (typically 10 years, but can be 5–20 years depending on the profitability horizon)

Estimate the exit multiple and/or growth rate in perpetuity of the business at the end of the forecast period

Estimate the company’s weighted-average cost of capital to determine the appropriate discount rate range

Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present

Adjust the resulting valuation for all assets and liabilities not accounted for in cash flow projections

Projections/FCF

Terminal value

Discount rate

Present value

Adjustments

Overview

Free cash flow

Terminal value

WACC

Other topics


56

DCF theory: The value of a productive asset is equal to the present value of all expected future cash flows that can be removed without affecting the asset’s value (including an estimated terminal value), discounted using an appropriate weighted-average cost of capital

DCF theory and its application

The cash-flow streams that are discounted include:– Unlevered or levered free cash flows over the projection period– Terminal value at the end of the projection period

These future free cash flows are discounted to the present at a discount rate commensurate with their risk– If you are using unlevered free cash flows (our preferred approach), the

appropriate discount rate is the weighted-average cost of capital for debt and equity capital invested in the enterprise in optimal/targeted proportions

– If you are using levered free cash flows, the appropriate discount rate is simply the cost of equity capital (often referred to as flows to shareholders or dividend discount model)

Overview

Free cash flow

Terminal value

WACC

Other topics


57

DCF of unlevered cash flows (the focus of these materials)– Projected income and cash-flow streams are free of the effects of debt, net of

excess cash– Present value obtained is the value of assets, assuming no debt or excess

cash (“firm value” or “enterprise value”)– Debt associated with the business is subtracted (and excess cash balances

are added) to determine the present value of the equity (“equity value”)– Cash flows are discounted at the weighted-average cost of capital

DCF of levered cash flows (most common in valuation of financial institutions)– Projected income and cash-flow streams are after interest expense and net of

any interest income– Present value obtained is the value of equity– Cash flows are discounted at the cost of equity

The two basic DCF approaches must not be confused

Overview

Free cash flow

Terminal value

WACC

Other topics


58

Other considerations

Reliability of projections

DCF results are generally more sensitive to cash flows (and terminal value) than to small changes in the discount rate. Care should be taken that assumptions driving cash flows are reasonable. Generally, we try to use estimates provided by analysts from reputable Wall Street firms if the client has not provided projections

Sensitivity analysis

Remember that DCF valuations are based on assumptions and are therefore approximate. Use several scenarios to bound the target’s value. Generally, the best variables to sensitize are sales, EBITDA margin, WACC and exit multiples or perpetuity growth rate

Overview

Free cash flow

Terminal value

WACC

Other topics


59

Always remember . . .

Three key drivers:– Projections and incremental cash flows (unlevered free cash flow)– Residual value at end of the projection period (terminal value)– Weighted-average cost of capital (discount rate)

Avoid pitfalls:– Validate and test projection assumptions– Determine appropriate cash flow stream– Thoughtfully consider terminal value methodology– Use appropriate cost of capital approach– Carefully consider all variables in calculation of the discount rate– Sensitize appropriately (base projection variables, synergies, discount rates,

terminal values, etc.)– Footnote assumptions in detail– Think about other value enhancers and detractors

Always double-check with a calculator!

Overview

Free cash flow

Terminal value

WACC

Other topics


60

The first step in DCF analysis is projection of unlevered free cash flows

Calculation of unlevered free cash flow begins with financial projections– Comprehensive projections (i.e., fully-integrated income statement, balance

sheet and statement of cash flows) typically provide all the necessary elements

Quality of DCF analysis is a function of the quality of projections– Often required to “fill in the gaps”– Confirm and validate key assumptions underlying projections– Sensitize variables that drive projections

Sources of projections include:– Target company’s management– Acquiring company’s management– Research analysts– Bankers

Overview

Free cash flow

Terminal value

WACC

Other topics


61

Projecting financial statements

Ideally projections should go out as far into the future as can reasonably be estimated to reduce dependence on the terminal value

Most important assumptions:– Sales growth: Use divisional, product-line or location-by-location build-up or simple growth

assumptions– Operating margins: Evaluate improvement over time, competitive factors, SG&A costs– Synergies: Estimate dollars in Year 1 and evaluate margin impact over time– Depreciation: Should conform with historic and projected capex– Capital expenditures: Consider both maintenance and expansion capex– Changes in net working capital: Should correspond to historical patterns and grow as the business

grows

Should show historical financial performance and sanity check projections against past results. Be prepared to articulate why projections may or may not be similar to past results (e.g. reasons behind margin improvements, increased sales growth, etc.)

Analyze projections for consistency– Sales increases usually require working capital increases– Capex and depreciation should converge over time

Overview

Free cash flow

Terminal value

WACC

Other topics


62

Free cash flow is the cash that remains for creditors and owners after taxes and reinvestment

Unlevered free cash flows can be forecast from a firm’s financial projections, even if those projections include the effects of debt

To do this, simply start your calculation with EBIT (earnings before interest and taxes):

EBIT (from the income statement)

Plus: Non-tax-deductible goodwill amortization

Less: Taxes (at the marginal tax rate)

Equals: Tax-effected EBITA

Plus: Deferred taxes1

Plus: Depreciation and any tax-deductible amortization

Less: Capital expenditures

Plus/(less): Decrease/(increase) in net working investment

Equals: Unlevered free cash flow

1 Although beyond the scope of our current discussions, you should only include actual cash taxes paid in the DCF. Depending on the firm and industry, you may want to adjust for the non-cash (or deferred) portion of a firm’s tax provision. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue for your analysis

Overview

Free cash flow

Terminal value

WACC

Other topics


63

Fiscal year ending December 31,1998 1999 2000 2001P 2002P 2003P 2004P 2005P

Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5

EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9

Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4

EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5

Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0

Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5

Plus: Depreciation 16.0 17.6 19.3 21.3 23.4

Plus: Deferred taxes – – – – –

Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3

Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0

Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6

Adjustment for deal date (40.3) – – – –

Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6

Example: Calculating unlevered free cash flows

Stand-alone DCF analysis of Company X$ millions

Key assumptions:Deal/valuation date = 12/31/01Marginal tax rate = 40%

Overview

Free cash flow

Terminal value

WACC

Other topics


64

Valuing the incremental effects of changes in projected operating results

In performing DCF analysis, we often need to determine the incremental impact on value of certain events or adjustments to the projections, including:– Synergies achievable through the M&A transaction

• Revenue• Cost• Capital expenditures

– Expansion plans– Cost reductions– Change in sales growth– Margin improvements

These incremental effects can be valued by discounting them independently (net of taxes) or by adjusting the DCF model and simply measuring the incremental impact

Overview

Free cash flow

Terminal value

WACC

Other topics


65

The standard present value calculation takes into account the cost of capital by attributing greater value to cash flows generated earlier in the projection period than later cash flows

Since most businesses do not generate all of their free cash flows on the last day of the year, but rather more-or-less continuously during the year, DCF analyses often use the so-called “mid-year convention,” which takes into account the fact that free cash flows occur during the year

– This approach moves each cash flow from the end of the applicable period to the middle of the same period (i.e., cash flows are moved closer to the present)

FCF1 FCF2 FCF3 FCFnPresent value =

(1+r)1+

(1+r)2+

(1+r)3+

. . .+

(1+r)n

FCF1 FCF2 FCF3 FCFnPresent value =

(1+r)0.5+

(1+r)1.5+

(1+r)2.5+

. . .+

(1+r)n-0.5

Once unlevered free cash flows are calculated, they must be discounted to the present

JPMorgan standard

Overview

Free cash flow

Terminal value

WACC

Other topics


66

It is important to differentiate between the transaction date and the mid-year convention

Transaction date: 01/01

Year 0 1 2 30.5 1.5 2.5 3.5

First cash flow,mid-year 1

Second cash flow,mid-year 2

Third cash flow,mid-year 3

Discounting =CF1

(1+r)0.5

+CF2

(1+r)1.5

+CF3

(1+r)2.5

+ ….


Year 0 1 2 30.75 1.5 2.5 3.5

First cash flow,mid-period 1

Second cash flow,mid-year 2

Third cash flow,mid-year 3

Discounting =CF1

(1+r)(0.75-0.5)

+ +CF3

(1+r)(2.5-0.5)

+ ….

0.5

Period 1 CF to buyer

CF2

(1+r)(1.5-0.5)


67

1st flow,mid-period 1

2nd cash flow,mid-year 2

3rd cash flow,mid-year 3

Discounting =CF1

(1+r)(0.875-0.75)

+ +CF3

(1+r)(2.5-0.75)

+ ….

Period 1 CF to buyer

CF2

(1+r)(1.5-0.75)

Practice exercise


Year 0 1 2 30.75 1.5 2.5 3.50.5


68

Example: Discounting free cash flows


Key assumptions:Deal/valuation date = 12/31/01Marginal tax rate = 40%Discount rate = 10%


Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4

EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0

Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5Plus: Depreciation 16.0 17.6 19.3 21.3 23.4Plus: Deferred taxes – – – – –Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0

Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6Adjustment for deal date (40.3) – – – –

Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6

Memo: Discounting factor 0.0 0.5 1.5 2.5 3.5

Discounted value of unlevered FCF $0.0 $44.6 $46.7 $48.4 $49.9Discounted value of FCF 2001P–2005P 189.6

Overview

Free cash flow

Terminal value

WACC

Other topics

$189.6 = $46.8

(1+.10)0.5

$53.8

(1+.10)1.5

$61.4

(1+.10)2.5

$69.6

(1+.10)3.5+ + +Formula


69

Terminal value can account for a significant portion of value in a DCF analysis

Terminal value represents the business’s value at the end of the projection period; i.e., the portion of the company’s total value attributable to cash flows expected after the projection period

Terminal value is typically based on some measure of the performance of the business in the terminal year of the projection (which should depict the business operating in a steady-state/normalized manner)

– Terminal (or “Exit”) multiple method• Assumes that the business is valued/sold at the end of the terminal year at a multiple of some

financial metric (typically EBITDA)

– Growth in perpetuity method• Assumes that the business is held in perpetuity and that free cash flows continue to grow at

an assumed rate– A terminal multiple will have an implied growth rate and vice versa. It is essential to review the

implied multiple/growth rate for sanity check purposes

Once calculated, the terminal value is discounted back to the appropriate date using the relevant rate

Attempt to reduce dependence on the terminal value– What is appropriate projection time frame?– What percentage of total value comes from the terminal value?

Overview

Free cash flow

Terminal value

WACC

Other topics


70

Terminal multiple method

This method assumes that the business will be valued at the end of the last year of the projected period

The terminal value is generally determined as a multiple of EBIT, EBITDA or EBITDAR; this value is then discounted to the present, as were the interim free cash flows– The terminal value should be an asset (firm) value; remember that not all

multiples produce an asset value– Note that in the exit multiple method terminal value is always assumed to be

calculated at the end of the final projected year, irrespective of whether you are using the mid-year convention

Should the terminal multiple be an LTM multiple or a forward multiple?– If the terminal value is based on the last year of your projection then the multiple

should be based on an LTM multiple (most common) – There are circumstances where you will project an additional year of EBITDA and

apply a forward multiple

Overview

Free cash flow

Terminal value

WACC

Other topics


71

Most common error: The final year is not normalized

Consider adding a year to the projections which represents a normalized year

A steady-state, long-term industry multiple should be used rather than a current multiple, which can be distorted by contemporaneous industry or economic factors

Treat the terminal value cash flow as a separate, critical forecast– Growth rate

• Consistent with long-term economic assumptions– Reinvestment rate

• Net working investment consistent with projected growth• Capital expenditures needed to fuel estimated growth• Depreciation consistent with capital expenditures

– Margins• Adjusted to reflect long-term estimated profitability

– Normalized tax rate

Overview

Free cash flow

Terminal value

WACC

Other topics


72

Example: Terminal multiple method


Key assumptions:Deal/valuation date = 12/31/01Marginal tax rate = 40%Discount rate = 10%Exit multiple of EBITDA = 7.0x


Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5Plus: Depreciation 16.0 17.6 19.3 21.3 23.4Plus: Deferred taxes – – – – –Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6Adjustment for deal date (40.3) – – – –Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6



EBITDA in 2005P $155.9Exit multiple 7.0xFirm value at exit 1,091.3Discounted terminal value 745.4Total present value to acquirer $934.9

Overview

Free cash flow

Terminal value

WACC

Other topics

$745.4 =($155.9 * 7.0x)

(1+.10)4

Formula


73

Example: Terminal multiple method (cont’d)

Stand-alone DCF analysis of Company X$ millions, except per share data

1 Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury methodNote: DCF value as of 12/31/01 based on mid-year convention

A + B = CDiscounted Discounted terminal value Firm value

FCF at 2005P EBITDA multiple of at 2005P EBITDA multiple ofDiscount rate 2001–2005 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x

8% $196.8 $687.5 $802.1 $916.7 $884.4 $999.0 $1,113.69% 193.1 662.6 773.1 883.5 855.8 966.2 1,076.7

10% 189.6 638.9 745.4 851.8 828.4 934.9 1,041.411% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.612% 182.7 594.5 693.5 792.6 777.2 876.3 975.3

- D = EEquity value Equity value per share1

Net debt at 2005P EBITDA multiple of at 2005P EBITDA multiple ofDiscount rate 12/31/01 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x

8% $100.0 $784.4 $899.0 $1,013.6 $19.17 $21.97 $24.779% 100.0 755.8 866.2 976.7 $18.47 $21.17 $23.87

10% 100.0 728.4 834.9 941.4 $17.80 $20.41 $23.0111% 100.0 702.3 804.9 907.6 $17.16 $19.67 $22.1812% 100.0 677.2 776.3 875.3 $16.55 $18.97 $21.39

Overview

Free cash flow

Terminal value

WACC

Other topics


74

This method assumes that the business will be owned in perpetuity and that the business will grow at approximately the long-term macroeconomic growth rate– Few businesses can be expected to have cash flows that truly grow forever; be

conservative when estimating growth rates in perpetuity

Take free cash flow in the last year of the projection period, n, and grow it one more year to n+1;1 this free cash flow is then capitalized at a rate equal to the discount rate minus the growth rate in perpetuity

To ensure that the terminal year is normalized, JPMorgan models are set up to project one year past the projection year and allow for normalizing adjustments; this FCFn+1 is then

discounted by the perpetuity formula

Growth in perpetuity method

1 This step is taken because the perpetuity growth formula is based on the principle that the terminal value of a business is the value of its

next cash flow, divided by the difference between the discount rate and a perpetual growth rate

Overview

Free cash flow

Terminal value

WACC

Other topics

Academic formula JPM recommended method


75

Note that when using the mid-year convention, terminal value is discounted as if cash flows occur in the middle of the final projection period– Here the growth-in-perpetuity method differs from the exit-multiple method

Typical adjustments to normalize free cash flow in Year n include revising the relationship between revenues, EBIT and capital spending, which in turn affects capex and depreciation– Working capital may also need to be adjusted– Often capex and depreciation are assumed to be equal

Growth in perpetuity method (cont’d)

Overview

Free cash flow

Terminal value

WACC

Other topics


76

Example: Growth in perpetuity method


Key assumptions:Deal/valuation date = 12/31/01Marginal tax rate = 40%Discount rate = 10%Perpetuity growth rate = 3%


Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5Plus: Depreciation 16.0 17.6 19.3 21.3 23.4Plus: Deferred taxes – – – – –Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6Adjustment for deal date (40.3) – – – –Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6



Value 2006P- 733.7Total present value to acquirer $923.3

Overview

Free cash flow

Terminal value

WACC

Other topics

$733.7 =$69.6 * (1 + .03)

(.10 - .03)*(1+.10)3.5

Formula


77

Example: Growth in perpetuity method (cont’d)

Stand-alone DCF analysis of Company X$ millions, except per share data

A + B = CDiscounted Discounted terminal value Firm value

FCF at perpetuity growth rate of at perpetuity growth rate of

Discount rate 2001–2005 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%8% $196.8 $991.0 $1,095.4 $1,223.0 $1,187.8 $1,292.2 $1,419.89% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0

10% 189.6 681.5 733.7 794.0 871.1 923.3 983.611% 186.1 582.6 622.0 666.7 768.7 808.1 852.812% 182.7 505.1 535.8 570.1 687.9 718.5 752.8

- D = EEquity value Equity value per share1

Net debt at perpetuity growth rate of at perpetuity growth rate of

Discount rate 12/31/01 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%8% $100.0 $1,087.8 $1,192.2 $1,319.8 $26.59 $29.14 $32.269% 100.0 905.0 977.0 1,062.0 $22.12 $23.88 $25.96

10% 100.0 771.1 823.3 883.6 $18.84 $20.12 $21.5911% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.4012% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95


Overview

Free cash flow

Terminal value

WACC

Other topics


78

Terminal multiples and perpetuity growth rates are often considered side-by-side

Assumptions regarding exit multiples are often checked for reasonableness by calculating the growth rates in perpetuity that they imply (and vice versa)

To go from the exit-multiple approach to an implied perpetuity growth rate:

g = [(WACC*terminal value) / (1+WACC)0.5 - FCFn] / [FCFn + (terminal value / (1 + WACC)0.5)]

To go from the growth-in-perpetuity approach to an implied exit multiple:

multiple = [FCFn * (1 + g)(1 + WACC)0.5] / [EBITDAn * (WACC - g)]

These formulas adjust for the different approaches to discounting terminal value when using the mid-year convention

Overview

Free cash flow

Terminal value

WACC

Other topics


79

Terminal multiple method and implied growth rates

Standalone Company X DCF analysis$ in millions


A + B = CDiscounted Discounted terminal value Firm value Terminal value as percent

FCF at 2005P EBITDA multiple of at 2005P EBITDA multiple of of total firm valueDiscountrate 2001–2005 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x

8% $196.8 $687.5 $802.1 $916.7 $884.4 $999.0 $1,113.6 78% 80% 82%9% 193.1 662.6 773.1 883.5 855.8 966.2 1,076.7 77% 80% 82%

10% 189.6 638.9 745.4 851.8 828.4 934.9 1,041.4 77% 80% 82%11% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.6 77% 79% 82%12% 182.7 594.5 693.5 792.6 777.2 876.3 975.3 76% 79% 81%

- D = EEquity value Equity value per share1 Implied perpetuity growth rate

Net debt at 2005P EBITDA multiple of at 2005P EBITDA multiple of at 2005P EBITDA multiple ofDiscountrate 12/31/01 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x

8% $100.0 $784.4 $899.0 $1,013.6 $19.17 $21.97 $24.77 0.2% 1.3% 2.1%9% 100.0 755.8 866.2 976.7 $18.47 $21.17 $23.87 1.1% 2.2% 3.0%

10% 100.0 728.4 834.9 941.4 $17.80 $20.41 $23.01 2.0% 3.1% 3.9%11% 100.0 702.3 804.9 907.6 $17.16 $19.67 $22.18 2.9% 4.0% 4.8%12% 100.0 677.2 776.3 875.3 $16.55 $18.97 $21.39 3.8% 4.9% 5.8%

Overview

Free cash flow

Terminal value

WACC

Other topics

At a 9% discount rate and an 8.0x exit multiple the price is $23.87 and the implied terminal growth rate is 3.0%


80

Perpetuity growth rate and implied terminal multiples

Standalone Company X DCF analysis$ in millions

A + B = C

Discounted Discounted terminal value Firm value Terminal value as percentFCF at perpetuity growth rate of at perpetuity growth rate of of total firm valueDiscount

rate 2001–2005 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%8% $196.8 $991.0 $1,095.4 $1,223.0 $1,187.8 $1,292.2 $1,419.8 83% 85% 86%9% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0 81% 82% 83%

10% 189.6 681.5 733.7 794.0 871.1 923.3 983.6 78% 79% 81%11% 186.1 582.6 622.0 666.7 768.7 808.1 852.8 76% 77% 78%12% 182.7 505.1 535.8 570.1 687.9 718.5 752.8 73% 75% 76%

- D = E

Equity value Equity value per share1 Implied EBITDA exit multipleNet debt at perpetuity growth rate of at perpetuity growth rate of at perpetuity growth rate ofDiscount

rate 12/31/01 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5%8% $100.0 $1,087.8 $1,192.2 $1,319.8 $26.59 $29.14 $32.26 8.6x 9.6x 10.7x9% 100.0 905.0 977.0 1,062.0 $22.12 $23.88 $25.96 7.4 8.0 8.8

10% 100.0 771.1 823.3 883.6 $18.84 $20.12 $21.59 6.4 6.9 7.511% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.40 5.7 6.1 6.512% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95 5.1 5.4 5.8


Overview

Free cash flow

Terminal value

WACC

Other topics

At a 9% discount rate and a terminal growth rate of 3.0%, the price is $23.88 and the implied exit multiple is 8.0x


81

Choosing the discount rate is a critical step in DCF analysis

The discount rate represents the required rate of return given the risks inherent in the business, its industry, and thus the uncertainty regarding its future cash flows, as well as its optimal capital structure

Typically the weighted average cost of capital (WACC) will be used as a foundation for setting the discount rate

The WACC is always forward-looking and is predicted based on the expectations of an investment's future performance; an investor contributes capital with the expectation that the riskiness of cash flows will be offset by an appropriate return

The WACC is typically estimated by studying capital costs for existing investment opportunities that are similar in nature and risk to the one being analyzed

The WACC is related to the risk of the investment, not the risk or creditworthiness of the investor¹

1 In valuing a company, always use the riskiness of its cash flows or comparable companies in estimating a weighted average cost of capital. Never use the acquirer’s cost capital unless, by some chance, it is engaged in an extremely similar line of business. However, if a business is small relative to an acquiror’s, sometimes ti may be appropriate to consider the use of the acquiror’s WACC in performing the valuation. The additional value created by using the acquiror’s WACC can be viewed as a synergy to the acquiror in the context of the transaction.

Overview

Free cash flow

Terminal value

WACC

Other topics


82

The cost of equity is the major component of the WACC

The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation)

JPMorgan estimates the cost of equity using the capital asset pricing model – Risk-free rate based on the 10 year bond yield– Incorporates the undiversifiable risk of an investment (beta)– Equity risk premium reflects expectations of today’s market

JPMorgan estimates the market cost of equity at approximately 10%

Cost of equity = Risk free rate + Beta x Equity risk premium

Long-term return onequity investment in

today’s market=

Long-term risk-freerate of return (beta=0)

+

Adjustment forcorrelation tostock market

returns

x

Appropriate “extra”return above risk free

rate

= 10-year bond yield(annual average)

+ Predicted betas x Estimated usingvarious techniques

For market average = 4.97% + 1.00 x 5.00%

= 9.97%

Overview

Free cash flow

Terminal value

WACC

Other topics


83

JPMorgan estimates the equity risk premium at 5.0%

Equity returns less 10-year bond yieldArithmetic average

Equity risk premiums is estimated based on expected returns and recent historical returns

2%

4%

6%

8%

10%

12%

14%

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Year

Pe

rce

nt

Rolling 40 years

Rolling 50 years

Equity premiumsRolling average over 10-year bond

Rolling 30 years

30 years endingEquity risk

premium (%)

1994 2.7

1995 3.4

1996 4.4

1997 4.7

1998 5.2

1999 6.2

2000 5.8

2001 5.0

Overview

Free cash flow

Terminal value

WACC

Other topics


84

Predicted betas are constructed to adjust for many risk factors, incorporating firms’ earnings volatility, size, industry exposure, and leverage– Predicted betas are more consistent and less volatile than historical betas

Historical betas only measure the past relationship between a firm’s return and market returns and are often distorted

JPMorgan uses predicted betas to calculate the cost of equity

0

200

400

600

800

(0.5) 0.2 1.0 1.9 2.60

200

400

600

800

(1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

# of companies # of companies

Distribution of predicted and historical betas for 5,600 publicly-traded companies

Predicted betas

Historical betas

Predicted betas

Supermarkets0.78

Utilities0.43

Food0.52

Internet2.09

Cellular1.62

Beta Beta

Overview

Free cash flow

Terminal value

WACC

Other topics


85

JPMorgan uses the long-term cost of debt in estimating WACC

The long-term cost of debt is used because the cost of capital is normally applied to long-term cash flows

Using the long-term cost of debt removes any refinancing costs/risks from the valuation analysis– To the extent a company can fund its investments at a lower cost of

debt (with the same risk), this value should be attributed to the finance staff

JPMorgan uses the company’s normalized cash tax rate

Overview

Free cash flow

Terminal value

WACC

Other topics


86

Cost of equity Cost of debt

Cost of capital10-year T-bond (Avg) 4.97%

Market risk premium 5.00%(x) Beta (current predicted) 0.62Adjusted market premium 3.10%

Cost of equity = 8.07%

Cost of debt 6.25%

(-) Tax shield1 2.19%

After-tax cost of debt 4.06%

The target capital structure reflects the company’s rating objective– Firms generally try to minimize the cost of capital through the appropriate use of leverage

The percentage weighting of debt and equity is usually based on the market value of a firm’s equity and debt position– Most firms are at their target capital structure– Adjustments should be made for seasonal or cyclical swings, as well as for firms moving toward a target

Using a weighted average cost of capital assumes that all investments are funded with the same mix of equity and debt as the target capital structure

The cost of equity and debt are blended together based on a target capital structure

Target capital structure(Assumes current = optimal)

Debt/total capital2 = 6.1%

Nominal WACC = 7. 82%1 Assumes 35% marginal tax rate2 Total capital = debt + market value of equity

Illustrative SYSCO Weighted Average Cost of Capital calculation

WACC formula

Overview

Free cash flow

Terminal value

WACC

Other topics


87

The cost of a firm’s equity should be adjusted for size

Investors typically expect higher returns when investing in smaller companies– Increased risk– Lower liquidity

Betas vary very little by size

Historical equity returns suggest higher return required by investors in smaller companies

P/E growth ratios (PEG) tend to decline with size

Empirical data combined with judgement should be applied when estimating the cost of equity for smaller firms

2.2%

1.6%

1.1%0.8%

0.0%

$100–500 $500–1,000 $1,000–2,500 $2,500–5,000 $5,000+

5.2%

3.1%2.5%

1.9% 1.7% 1.4% 1.1% 0.8%0.0%

Size premium by market capBased on PE/growth (PEG)

Size premium by market capBased on historical returns analysis

Market cap ($MM)

Market cap ($MM)

$0–100 $100–250 $250–500 $500–700 $700–1,000

$1,000–1,500

$1,500–2,500

$2,500–5,000

$5,000+

Overview

Free cash flow

Terminal value

WACC

Other topics


88

Predicted betas declined substantially in several industries, although food distribution has been increasing over the last few years

Predicted betas are declining in industries whose fundamentals do not appear to have changed

JPMorgan believes that current predicted betas do not fully represent the equity risk of investments in these sectors

Using a predicted beta adjusted to reflect historical levels over a longer time frame (up to 5–10 years) is appropriate

1 Typically between three and five large-cap companies were used to develop these “industry” predicted betas Source: Barra

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

Jan-95 Oct-96 Jul-98 Apr-00 Jan-02

Pharma

Food retail

Packaged food

Food dist.

Predicted betas for various industries1

Overview

Free cash flow

Terminal value

WACC

Other topics


89

$ millions

Note: Share prices as of July 3, 2002Source: Barra as of May 30, 2002

Historical analysis suggests current predicted betas may understate cost of equity in food distribution

Predicted beta (levered) Predicted beta (unlevered) Current

CompanyMarket

capDebt/equity Current

5 yravg.

10 yr.avg.

1992–1997 Current

5 yravg.

10 yr.avg.

1992–1997

hist.beta

SYSCO $17,358 6.7% 0.62 0.67 0.79 0.91 0.59 0.64 0.76 0.87 0.55

Ahold 14,903 96.8% 0.64 0.66 0.82 0.97 0.40 0.41 0.50 0.60 0.76

Other food distributors

Performance Food Group $1,482 18.4% 0.68 0.61 0.70 0.82 0.61 0.54 0.62 0.73 0.47

International Multifoods 5102 107.4% 0.39 0.46 0.60 0.73 0.23 0.27 0.35 0.43 0.66

United Natural Foods 352 31.1% 0.57 0.63 0.63 0.64 0.47 0.52 0.53 0.54 1.46

Fleming Companies 825 298.9% 1.02 0.69 0.78 0.87 0.35 0.23 0.26 0.30 0.19

Nash Finch 391 97.8% 0.24 0.31 0.43 0.54 0.15 0.19 0.26 0.33 (0.09)

SuperValu 3,276 69.0% 0.56 0.66 0.75 0.84 0.39 0.46 0.52 0.58 0.30

Median $696 78.9% 0.56 0.62 0.66 0.77 0.37 0.36 0.43 0.48 0.39

Overview

Free cash flow

Terminal value

WACC

Other topics


90

The appropriate cost of capital will depend on the entity which is being valued

CompanyRisk

premiumUnlevered

betaOptimal

debt/equityRe-levered

betaCost ofequity

Cost offinancing WACC

SYSCO 5.0% 0.70 20% 0.80 9.0% 6.25% 8.2%

$1BN target 5.0%-6.5% 0.70 20% 0.80 9.0%-10.3% 6.25% - 7.50% 8.3%-9.3%

$500MM target 5.0%-7.0% 0.70 20% 0.80 9.0%-10.6% 6.25% - 8.00% 8.4%-9.7%

$200MM target 5.0%-7.5% 0.70 20% 0.80 9.0%-11.0% 6.25% - 8.50% 8.4%-10.1%

For illustrative purposes

SYSCO WACC sensitivity $1BN target WACC sensitivity1 $200MM target WACC sensitivity2

Note: Assumes 35% marginal tax rate1 Assuming an equity risk premium of 6.5%2 Assuming an equity risk premium of 7.5%

Debt/equity10% 20% 30% 40%

0.65 7.8% 7.5% 7.3% 7.0%

0.70 8.1% 7.7% 7.5% 7.2%

0.75 8.3% 7.9% 7.7% 7.4%

0.80 8.5% 8.2% 7.8% 7.6%

Lev

ered

bet

a

0.85 8.8% 8.4% 8.0% 7.8%

Debt/equity10% 20% 30% 40%

0.70 9.1% 8.7% 8.4% 8.2%

0.75 9.4% 9.0% 8.7% 8.4%

0.80 9.7% 9.3% 8.9% 8.7%

0.85 10.0% 9.6% 9.2% 8.9%

Lev

ered

bet

a

0.90 10.3% 9.8% 9.4% 9.1%

Debt/equity10% 20% 30% 40%

0.70 9.8% 9.4% 9.1% 8.9%

0.75 10.1% 9.8% 9.4% 9.1%

0.80 10.5% 10.1% 9.7% 9.4%

0.85 10.8% 10.4% 10.0% 9.7%

Lev

ered

bet

a

0.90 11.2% 10.7% 10.3% 10.0%

Overview

Free cash flow

Terminal value

WACC

Other topics


91

Most common errors in calculating WACC

• Equity risk premium based on very long time frame (post 1926: Ibbotson data)

• Substitute hurdle rate (goal) for cost of capital

• Use of historical (or predicted) betas that are clearly wrong

• Investment specific risk not fully incorporated (e.g., country risk premiums)

• Incorrect releveraging of the cost of equity

• Cost of equity based on book returns, not market expectations

• The actual, not target, capital structure is used

• WACC calculated based on book weights

Cost of equity

Target capital structure

Overview

Free cash flow

Terminal value

WACC

Other topics


92

Valuing synergies

When two businesses are combined, the term “synergies” refers to the changes in their aggregate operating and/or financial results attributable to their being operated as a combined enterprise. Synergies can take many forms:– Revenue enhancements– Raw material discounts/purchasing power– Sales and marketing overlap– Corporate overhead reductions– Distribution cost reductions– Facilities consolidation– Tax savings

The value of achievable synergies is often a key element in whether to proceed with a proposed transaction– Calculate synergies for both the acquiring company and the target– Remember incremental cash flow

Synergies are generally valued by toggling pre-tax changes to various financial statement line items into a DCF model of the combined enterprise and simply measuring the incremental impact

Overview

Free cash flow

Terminal value

WACC

Other topics


93

Sensitivity analysis is vital when presenting the results of DCF analysis

Recall that DCF valuation is highly sensitive to projections and assumptions

So-called “sensitivity tables” chart the output based on ranges of input variables– It is common to use a 3x3 table (i.e., showing three different values for each of

two input variables) to enable the reader to “triangulate” to the appropriate inferences

Since DCF results are by their nature approximate, depicting sensitivity tables enables users of DCF output to assess the degree of “fuzziness” in the results

As shown in our previous examples, DCF analyses using exit multiples and perpetuity growth rates generally show sensitivities for the method used to calculate terminal value and a range of discount rates– Sensitivities can be shown for any variable in the model (including financial

projections)– Judge which sensitivities would be useful to decision makers

Overview

Free cash flow

Terminal value

WACC

Other topics


94

Companies with multiple businesses are often valued on a sum-of-the-parts basis

This approach is sometimes referred-to as a “break-up” valuation– Particularly common when the company is believed to be undervalued by the

public– Better accounts for discrepancies in market conditions facing the businesses

The methodology requires estimating financial results for each business (EBIT, EBITDA and/or net income), which can then be used with appropriate multiples or growth rates in order to arrive at a firm value for each part before the results are summed

Completing a sum-of-the-parts valuation can be more challenging than a straightforward (single-business/consolidated) DCF analysis– Typically less detailed financial data is publicly-available for segments– Often assumptions must be made about how to allocate expenses, especially

those that are clearly shared across businesses (like corporate-level SG&A)– Need to consider different characteristics of each business segment (discount

rate, terminal value assumptions, etc.)

Overview

Free cash flow

Terminal value

WACC

Other topics


95

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


96

LBO analysis provides another perspective on M&A transactions

A leveraged buyout is an acquisition transaction in which much of the purchase price is funded with debt

This type of capital structure enables financial sponsors to “leverage” returns on their relatively small equity investment, as cash flows generated during the investment period are used to pay down debt

Financial sponsors profit by exiting three to five years after the transaction– Sell the target to another buyer– Take the target public– Recapitalize the target

Assumptions regarding the investment transaction, the exit and the period between the acquisition and the exit are critical to determining an appropriate capital structure and potential returns to equity

Overview

Example


97

LBO analysis can play an important role in many M&A engagements

M&A clients include both financial sponsors and strategic players– Financial sponsors typically pursue M&A transactions with different

perspectives and objectives (e.g., a shorter investment horizon)– Strategic buyers sometimes behave like financial investors (i.e., acquiring with

the expectation of selling in several years)

Financial sponsors generally analyze a transaction using LBO methodologies in the first instance (and DCF, comparable companies/transactions analyses thereafter)

LBO analysis provides another data point for strategic players that may chiefly rely on DCF analysis

LBO valuation may be useful from a competitive point of view, as strategic players vie with financial sponsors for the same assets

Overview

Example


98

The process of LBO analysis

Develop an integrated model of the business that projects EBITDA and cash available for debt repayment over the investment horizon (typically 3–5 years)

Estimate the multiple at which the sponsor can be expected to exit the investment at the end of the investment period

Determine a transaction structure and a pro forma capital structure that result in realistic financial coverage

Calculate returns (IRR) to the equity sponsor

Projections

Terminal value

Pro formacapitalization

IRR

AdjustmentsTweak the transaction/capital structure as needed to achieve harmony (if possible) between IRR, leverage and valuation

Overview

Example


99

The initial steps in an LBO analysis are identical to those in a DCF analysis

The same financial projections developed for a DCF analysis can be used to build a basic LBO model

Free cash flows are expected to be used to service debt, with positive flows to equity typically coming at exit– Amount and predictability of free cash flows dictate whether a company is an

attractive or viable LBO target

Cash flows are not discounted

Terminal value drives valuation, and is calculated on the basis of multiples– Multiple of exit-year EBITDA is generally used to bound the valuation of the

enterprise in any possible exit scenario

Overview

Example


100

Pro forma capitalization and transaction structure are set forth in “sources and uses”

Sources should show the entire pro forma capitalization of the company, including:– New debt– New equity– Rolled-over debt and equity

Uses of funds should address all parts of the target’s existing capital structure, as well as transaction-related leakage:– Refinancing existing debt– Transaction expenses– Equity purchase price– Debt and equity to be rolled-over

Sources must equal uses– Any debt or equity that is rolled-over shows up under both sources and uses– Always depict every part of the capitalization, whether it changes pro forma or not

Overview

Example


101

LBO models are driven by the characteristics of the sources of capital for the transaction

Typically supplied by an investment or commercial bank Usually secured / most restrictive covenants Amortizing 5- to 8-year tenor First in line at liquidation Lowest coupon

Typically supplied by an investment or commercial bank or a mezzanine fund

Riskier debt / typically unsecured Primarily bullet structures Typical tenor is 10-year High coupon

Typically supplied by an investment or commercial bank or a mezzanine fund (often sponsor-affiliated)

Multiple forms: Convertible debt, exchangeable debt, convertible preferred stock, PIK securities and warrants

Expected IRR in the 15%– 20% range

Typically supplied by a financial sponsor Highest risk / cost of capital Sometimes “stapled” to high-yield paper to attract broader investor

group Minimum annual returns >20%

Mezzanine securities

Subordinated debt

Common equity

Senior debt

Components of capital

Revolving Term

30%–50% of total capital

LIBOR + 200-400 5–8 years

Senior/sub notes Discount notes


T + 350–650 7–10 years

Sub. debt (conv.) Preferred stock PIK Warrants

0%–35% total capital High teens/low 20s 7–10+ years


20%-30% IRR 5–7 year horizon

Sample inputs

Sample inputs

Sample inputs

Sample inputs

Overview

Example


102

Internal rate of return (IRR) is the key return benchmark utilized by financial investors

IRR represents the implied discount rate at which the net present value of cash flows equals zero– The math underlying IRR is highly complex– Excel and financial calculators effectively back into IRR by narrowing a series of

guesses at the appropriate rate– When calculating IRR, cash outflows (e.g., initial investment) are always negative,

and cash inflows (e.g., exit proceeds) are always positive

Keep in mind that there may be cash flows to the sponsor prior to exit– These flows must be factored into the calculation of IRR in the period in which

they are received

Remember that equity sits at the bottom of the capital structure– Debt must be paid-off or refinanced for holders of equity to receive any return on

their investment

IRR is also driven by the investor’s pro forma equity ownership percentage

Overview

Example


103

Together, IRR and credit ratios serve as gauges of the transaction structure’s viability

Key credit ratios include:– Total debt to EBITDA– Senior debt to EBITDA– EBITDA to total interest– EBITDA less capital expenditures to total interest

Both providers of debt and equity have minimum requirements for participating in a transaction– Debt covenants typically require periodic certification of financial ratios– Equity sponsors generally will not invest without comfort as to likely returns

Overview

Example


104

Structural benchmarks vary across industries and reflect current market conditions

M&A professionals require input from colleagues actively involved in debt capital markets in order to develop reasonable assumptions regarding capital structures in LBO analyses

Guidance received from debt-market participants could include, for example:– EBITDA coverage (EBITDA/total interest expense) of not less than 2.0x– EBITDA – capital expenditures coverage [(EBITDA ‑ CAPEX)/interest

expense] of not less than 1.2x– Total debt/EBITDA of not more than 4.5–5.5x– Senior debt/EBITDA of not more than 3.0–4.0x– Senior bank term loan completely repaid in 5–7 years– Bank debt not to exceed 60% of the initial capitalization– Pure equity of not less than 25%– Ability to convey “growth” prospects to banks and high-yield investors

Always remember that markets are dynamic

Overview

Example


105

IRR drivers

Atpurchase

No operatingimprovement/

No arbitrage

Operatingimprovement/

No arbitrage

Operatingimprovementand arbitrage

EBITDA Purchase multiple 7.0x

EBITDA on Purchase date $100

Firm value at Purchase date $700

Debt at purchase (5x EBITDA) 500

Equity value invested 200

EBITDA Exit multiple 7.0x 7.0x 8.0x

EBITDA at Exit $100 $128 $128

Firm value at Exit 700 896 1,024

Debt (after paydown of $75 peryr)

125 125 125

Equity value at exit 575 771 899

IRR (5-Year exit) 23.5% 31.0% 35.1%

Three important factors drive IRRs: 1) De-levering 2) Operating improvement and 3) Multiple expansion (arbitrage)

Overview

Example


106

Sample LBO valuation analysis

$ millions

1 Assumes management promote of 5%

2 Valuation as at 12/31/013 Leverage based on bank/bond case

Overview

Example


107

Stand-alone LBO analysis of Company X

$ millions

Uses of fundsAmount % of total

Minimum cash balance 5.0$ 0.7%Refinance existing senior debt 200.0 27.7%Roll-over senior debt - 0.0%Refinance existing sub. debt 60.0 8.3%Roll-over sub. debt 30.0 4.2%Refinance existing mezz. debt - 0.0%Roll-over mezz. debt - 0.0%Equity purchase price 400.0 55.3%Transaction fees 7.8 1.1%Roll-over equity 20.0 2.8%

Total uses 722.8$ 100.0%

Sources of fundsFunded Committed EBITDA Term Interest Warrants Cash fee

Amount % of total Amount % of total coverage (years) rate (% dil shs) (points)Existing cash balance 6.0$ 0.8% 6.0$ 0.8%Revolver - 0.0% 75.0 9.4% 0.70x 7.0 9.00%Senior term loans 271.1 37.5% 271.1 34.0% 2.55x 7.0 9.00% 2.00%New sub. debt 53.2 7.4% 53.2 6.7% 0.50x 9.0 12.00% 2.50%Roll-over sub. debt 30.0 4.2% 30.0 3.8% 0.28x 8.0 12.00%New mezz. debt 49.9 6.9% 49.9 6.3% 0.47x 9.0 16.00% 1.25% 0.00%New equity 292.6 40.5% 292.6 36.7%Roll-over equity 20.0 2.8% 20.0 2.5%

Total sources 722.8$ 100.0% 797.8$ 100.0%

Overview

Example


108

Stand-alone LBO analysis of Company X (cont’d)

$ millions

5-year levered returns to equity at various prices

Exit multiple of EBITDA25.78% 6.0x 6.5x 7.0x 7.5x 8.0x350.0$ 25.5% 27.9% 30.2% 32.4% 34.4%

Equity 375.0 23.2% 25.6% 27.9% 30.0% 32.0%purchase 400.0 21.2% 23.6% 25.8% 27.9% 29.8%price 425.0 19.3% 21.7% 23.9% 25.9% 27.8%

450.0 17.6% 19.9% 22.1% 24.1% 26.0%

New equity required under various structures

Total initial leverage$292.59 4.00x 4.25x 4.50x 4.75x 5.00x

350.0$ 295.8$ 269.2$ 242.6$ 216.0$ 189.4$ Equity 375.0 320.8 294.2 267.6 241.0 214.4 purchase 400.0 345.8 319.2 292.6 266.0 239.4 price 425.0 370.8 344.2 317.6 291.0 264.4

450.0 395.8 369.2 342.6 316.0 289.4

Overview

Example


109


$ millions

Equity ownership summary% basic % dilutedshares shares

Acquirer/new equity investors 93.6% 92.4%New mezz. lenders 0.0% 1.3%Roll-over equity holders 6.4% 6.3%

100.0% 100.0%

Other assumptionsTax rate 40.0%LTM (2001) EBITDA 106.5$ Non-financing trans. exp. 1.0$ Maximum senior leverage 3.25xMaximum total leverage 4.50xEBITDA exit multiple 7.0xInterest on cash balances 5.0%

Terminal equity value2002P 2003P 2004P 2005P 2006P

EBITDA 117.1$ 128.8$ 141.7$ 155.9$ 170.0$ Exit multiple of EBITDA 7.0x 7.0x 7.0x 7.0x 7.0xFirm value 819.9$ 901.9$ 992.1$ 1,091.3$ 1,190.0$ Less: Debt 382.0 351.4 311.4 260.6 198.5Plus: Cash 5.0 5.0 5.0 5.0 5.0 Less: Refinancing fees - - - - - Plus: Dividends - - - - - Equity value 442.9$ 555.5$ 685.7$ 835.7$ 996.5$

Overview

Example


110


$ millions

Returns to new equity2001P 2002P 2003P 2004P 2005P 2006P IRR

Exit at 12/31/04 (292.6)$ - - 633.8$ 29.4%Exit at 12/31/05 (292.6) - - - 772.4$ 27.5%Exit at 12/31/06 (292.6) - - - - 921.1$ 25.8%

Returns to mezzanine lenders2001P 2002P 2003P 2004P 2005P 2006P IRR

Exit at 12/31/04 (49.9)$ 8.0$ 8.0$ 66.4$ 20.7%Exit at 12/31/05 (49.9) 8.0 8.0 8.0 68.3$ 19.9%Exit at 12/31/06 (49.9) 8.0 8.0 8.0 8.0 70.3$ 19.4%

Credit statisticsAt closing 2002P 2003P 2004P 2005P 2006P

Senior debt / EBITDA 2.55x 2.13x 1.69x 1.26x 0.82x 0.38xTotal debt / EBITDA 3.80x 3.26x 2.73x 2.20x 1.67x 1.17xEBITDA / total interest NA 2.83x 3.30x 3.96x 4.91x 6.38x(EBITDA - capex) / total interest NA 2.30x 2.68x 3.21x 3.99x 5.25x

Overview

Example


111


$ millionsSummary financing schedule

2002P 2003P 2004P 2005P 2006PEBITDA 117.1$ 128.8$ 141.7$ 155.9$ 170.0$ Depreciation & amortization 17.6 19.3 21.3 23.4 25.0 Normalized EBIT 99.6 109.5 120.5 132.5 145.0Interest expense 41.4 39.0 35.8 31.7 26.6 Interest income 0.3 0.3 0.3 0.3 0.3 Taxable income 58.4 70.8 84.9 101.0 118.6Less: Income taxes 23.4 28.3 34.0 40.4 47.4Income after taxes 35.1 42.5 50.9 60.6 71.2Plus: Depreciation 17.6 19.3 21.3 23.4 25.0 Plus: PIK non-cash interest - - - - - Less: Capital expenditures 22.0 24.2 26.6 29.3 30.0Less: Incr./(decr.) in working capital 8.5 7.0 5.5 4.0 4.0Cash available for debt service 22.1$ 30.6$ 40.1$ 50.7$ 62.2$

Memo: Period 1 2 3 4 5

RevolverBalance at beginning of period -$ 16.6$ 24.7$ 23.4$ 11.4$ Plus: Borrowings (repayments) 16.6 8.1 (1.4) (12.0) (11.4) Balance at end of period 16.6$ 24.7$ 23.4$ 11.4$ -$ Interest 0.7$ 1.9$ 2.2$ 1.6$ 0.5$

Senior term loansBalance at beginning of period 271.1$ 232.3$ 193.6$ 154.9$ 116.2$ Plus: Borrowings - - - - - Less: Mandatory payments 38.7 38.7 38.7 38.7 38.7 Less: Optional payments - - - - 12.1 Balance at end of period 232.3$ 193.6$ 154.9$ 116.2$ 65.4$ Interest 22.7$ 19.2$ 15.7$ 12.2$ 8.2$

Maximum senior leverage 380.7$ 418.7$ 460.6$ 506.7$ 552.5$ Revolver + senior debt balance at end of pd. 248.9 218.3 178.3 127.5 65.4Difference 131.7$ 200.4$ 282.4$ 379.1$ 487.1$ Recap year? (1=yes, 0=no) 0 0 0 0 0

Overview

Example


112


$ millions2002P 2003P 2004P 2005P 2006P

New sub. debtBalance at beginning of period 53.2$ 53.2$ 53.2$ 53.2$ 53.2$ Plus: Borrowings - - - - - Less: Mandatory payments - - - - - Less: Optional payments - - - - - Balance at end of period 53.2$ 53.2$ 53.2$ 53.2$ 53.2$ Interest 6.4$ 6.4$ 6.4$ 6.4$ 6.4$

Roll-over sub. debtBalance at beginning of period 30.0$ 30.0$ 30.0$ 30.0$ 30.0$ Plus: Borrowings - - - - - Less: Mandatory payments - - - - - Less: Optional payments - - - - - Balance at end of period 30.0$ 30.0$ 30.0$ 30.0$ 30.0$ Interest 3.6$ 3.6$ 3.6$ 3.6$ 3.6$

New mezz. debtBalance at beginning of period 49.9$ 49.9$ 49.9$ 49.9$ 49.9$ Plus: Borrowings - - - - - Less: Mandatory payments - - - - - Less: Optional payments - - - - - Balance at end of period 49.9$ 49.9$ 49.9$ 49.9$ 49.9$ Interest 8.0$ 8.0$ 8.0$ 8.0$ 8.0$

CashBalance at beginning of period 5.0$ 5.0$ 5.0$ 5.0$ 5.0$ Plus: Free cash flow 22.1 30.6 40.1 50.7 62.2 Less: Minimum cash balance 5.0 5.0 5.0 5.0 5.0 Less: Mandatory debt repayments 38.7 38.7 38.7 38.7 38.7 Cash available (need to finance) (16.6)$ (8.1)$ 1.4$ 12.0$ 23.4$ Net change in cash - - - - - Cash at end of period 5.0$ 5.0$ 5.0$ 5.0$ 5.0$ Interest income on avg. cash 0.3$ 0.3$ 0.3$ 0.3$ 0.3$

SummaryBeginning Debt Balance 404.2$ 382.0$ 351.4$ 311.4$ 260.6$ Ending Debt Balance 382.0 351.4 311.4 260.6 198.5

Overview

Example


113

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


114

Introduction to relative valuation

Relative valuation is utilized to illustrate how the value of one company compares to another company

Typically, relative valuation analysis is utilized in the context of stock-for-stock exchanges to determine the appropriate exchange ratio offered to shareholders in a transaction

The exchange ratio reflects the number of acquiror shares offered for each target share– So if you are a target shareholder and you are offered an exchange ratio of 0.500x,

you are being offer 1/2 of an acquiror share for each share of the target you own

Several relative valuation approaches exist– Historical trading and exchange ratio analysis– Contribution analysis – Relative multiple and discounted cash flow analysis– Valuation of synergies


115

Historical trading and exchange ratio analysis

Historical exchange ratio analysis Illustrates the relative movement in stock prices (and implied exchange ratios, aka “natural exchange ratios”) looking back over a certain timeframe

Calculated simply as the target share price on a given date divided by the acquiror share price on the same date– Does not include any premium to the target

Provides a historical benchmark to justify the contemplated exchange ratio

Issues to consider when analyzing data include– Liquidity of shares / trading volume (small vs. large cap)– Relative market attention / analyst coverage– Multiple expansion of one of the company’s peer group versus the other over

the selected time horizon


116

Illustrative historical trading and exchange ratio analysis

Current = 0.194x

1 Represents average exchange ratio over the trailing period ended June 27, 20022 Closing prices as of June 27, 20023 Assumes Acquiror’s current price of $34.60 per share

Current stock price2 Current market capitalization2

Acquiror Target Acquiror Target$34.60 $6.70 $274.8 $89.7

At $12 per share = 0.347x

Historical exchange ratio

More favorableto Target

Less favorableto Target

# of acquiror shares per target share


117

Contribution analysis

Compares the relative equity valuation of two parties to their respective “contribution” to a combined company’s financial performance

Typical firm value metrics would include– Revenues– EBITDA– EBIT– Unlevered free cash flow measures– Industry-specific (i.e. customers, reserves, etc.)

Typical equity value metrics would include– Net income– Levered free cash flow measures

Cautionary note: contribution analysis does not measure the growth and risk profile of the two companies’ financial performance and differing multiples may be justifiablie when assessing relative value


118

Relative contribution analysis

$ millions

Implied equity value ImpliedACQUIROR TARGET Total ACQUIROR TARGET exchange ratio

Market value $18,150 $7,653 $25,803 $18,150 $7,653 0.4340x

% contribution 70.3% 29.7% 70.3% 29.7%

Firm value1 $38,450 $19,592 $58,042 $18,150 $7,653 0.4340x

% contribution 66.2% 33.8% 70.3% 29.7%

EBITDA

2001E $5,275 $3,528 $8,803 $14,482 $11,322 0.8046x

% contribution 59.9% 40.1% 56.1% 43.9%

2002E $5,320 $3,253 $8,573 $15,716 $10,087 0.6606x

% contribution 62.1% 37.9% 60.9% 39.1%

Net income

2002E $1,790 $1,210 $3,000 $15,397 $10,406 0.6956x

% contribution 59.7% 40.3% 59.7% 40.3%

2003E $2,018 $1,380 $3,398 $15,326 $10,477 0.7036x

% contribution 59.4% 40.6% 59.4% 40.6%

1 As of 2/6/02; net debt for ACQUIROR as of 12/31/01 (per press release) and for TARGET as of 9/30/01 (per 10-Q); pro forma for acquisitions2 2001A for ACQUIROR; based on company press release; other estimates based on JPMorgan Equity Research3 Based on I/B/E/S consensus estimates; ACQUIROR 2002E EPS based on company guidance; TARGET EPS estimates based on I/B/E/S consensus estimates post 1/29/02


119

Sample contribution analysis

29.7% 29.7%39.1% 40.3% 40.6%

70.3% 70.3%

56.1% 60.9% 59.7% 59.4%

$58,042 $3,000 $3,398

43.9%

$8,803 $8,573$25,308

Market value Firm value 2002E EBITDA 2003E EBITDA 2002E Net Income 2003E Net Income

Target Acquiror

Offer = 35.0%

Relative ownership

Exchange ratio 0.5385xTarget 35.0%

Acquiror 65.0%

ImpliedER

.4340x .4340x .8046x .6606x .6956x .7036x


120

Implied exchange ratio (equity value metrics)

Company statistics

Calculating the implied exchange ratio

Acquiror

Current share price $34.22

Fully-diluted share count 531

Fully-diluted market cap 18,150

Net debt 20,300

EBITDA 5,320

Net income 1,790

Target




Net debt 11,939

EBITDA 3,253

Net income 1,210

% of net income contributed by acquiror 59.7%

Fully-diluted acquiror shares 530

Pro forma shares outstanding to yield

59.7% ownership

888

Implied shares issued to target 358

Current target shares outstanding 515

Implied exchange ratio based on net

income (358 / 515)

0.6956x

Natural exchange ratio based on current

share prices ($14.85 / $34.22)

0.4340x


121

Implied exchange ratio (firm value metrics)

Calculating the implied exchange ratio (cont’d)

Combined firm value 58,042

Combined equity value 25,803

% EBITDA contributed by acquiror 62.1%

Firm value based on EBITDA

contribution

36,044

Implied equity value 15,744

As a % of total equity value 61.0%

Fully-diluted acquiror share count 531

Pro forma shares outstanding to yield

61.0% acquiror ownership

869

Implied shares issued to target 338

Fully-diluted target share count 515

Implied exchange ratio based on

EBITDA (338 / 515)

0.6606x

Natural exchange ratio based on current

share prices ($14.85 / $34.22)

0.4340x

Company statistics

Acquiror




Net debt 20,300

EBITDA 5,320

Net income 1,790

Target




Net debt 11,939

EBITDA 3,253

Net income 1,210


122

Relative multiple and discounted cash flow valuation

Compares the ranges suggested by stand-alone valuations of two companies on a multiples or discounted cash flow basis– Step 1: Valuation the acquiror and the target separately– Step 2: create a relative value summary

Need to consider which ends of the range it is appropriate to compare when determing an appropriate exchange ratio / ownership percentage– High/Low and Low/High– High/High and Low/Low


123

$15.00

$9.75

$5.50

$26.75

$5.00

$4.00$5.00

$3.50

$4.94

$3.00

$4.00

$10.25

$6.00

$3.75

$0.00

$5.00

$10.00

$15.00

$20.00

Sample relative value football field: Target valuation

Price per share

Implied offer1 = $8.46

1 Based on the offer exchange ratio of 0.311x and Pedro’s closing price $27.19 as of 7/12/012 Certain of the multiples implied by precedent transactions have been adjusted by indexing them to the movement in an index of stock prices of companies comparable to Pablo. (see p. 22 for additional detail)3 Based on IBES EPS growth estimate and average margin estimates of brokerage reports

Public trading comparablesTransaction comparables2

DCF analysis

52-weekhigh/low

19.0x to 25.0x2001E cash

EPS of $0.16

15.0x to 19.0x2001E EBIT

of $20.6

2.5x to 4.0xLTM revenue

of $185.712% to 15%

Discount RateEBIT exit mult.

of 15.0x to 20.0x

15.0x to 20.0x2002E cash

EPS of $0.25

Mgmt. Case Street Case3

12% to 15% Discount RateEBIT exit mult.

of 15.0x to 20.0x

Lowest public comp price

Highest public comp price

Street case DCF


124

$43.25

$29.50$29.25$28.00

$33.00

$60.60

$22.50$20.50

$30.75

$26.50

$21.00$21.28

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

Sample relative value football field: Acquiror valuation

Price per share

Current = $27.19

52-weekhigh/low

DCF analysis2

Discount rate 9% to 13%EBITDA with exit multiple

of 11.0x to 13.0x

Public company analysis

Sum-of-the-parts12.0x to 15.0x2001E EBIT

of $239

10.0x to 12.0x2001E EBITDA

of $346

19.0x to 25.0x2001E EPS

of $1.18

Comparable diversified company analysis

1 Comparable diversified company analysis and public company analysis are based on brokerage report estimates2 Based on management projections

Lowest public comp price

Highest public comp price

DCF


125

0.488x0.441x

0.311x

0.217x

0.476x

0.179x

0.313x

0.244x

0.162x

0.074x

0.182x

0.091x

0.219x0.237x

0.073x0.081x0.000x

0.250x

0.500x

0.750x

1.000x

Natural exchange

ratio

Public

comparables to

Public

comparables

(Sum of Parts &

Diversified)

Transaction

comparables to

Public

comparables

(Sum of Parts &

Diversified)

Street

case/Mgmt. case

Street

case/Mgmt. case

with $40 mm of

synergies

Mgmt.

case/Mgmt. case

Mgmt.

case/Mgmt. case

with $40 mm of

synergies

Contribution

analysis

Relative valuation summary

Offer: 0.311x

Exchange ratio1

1 Exchange ratio ranges computed by taking the high/low equity value per share of Target using various valuation methodologies over the low/high valuation of the acquiror using various valuation methodologies

Discounted Cash Flow Analysis

Less favorable

to

Acquiror

More favorable

to

Acquiror

$3.00/$33.00$5.00/$20.50High/Low Low/High

$3.50/$43.25$5.50/$30.75High/Low Low/High


126

MoE transactions - example

Acquiror Acquiror/Ann. Transaction NewCo pro forma target Accountingdate Target Acquiror value Premium1 Chairman CEO ownership Board Split regime

3/19/01 Billiton PLC BHP Ltd $11,511 20.9% Acquiror Acquiror 58.0% 9/9 United Kingdom

6/20/00 Seagram Vivendi 40,428 22.8% Acquiror Acquiror 59.0% 14/6 France

5/17/00 Compass Group PLC Granada group PLC 8,089 3.4% Acquiror Joint 66.3% 8/8 United Kingdom

5/16/00 Lycos Inc. Terra Networks (Telefonica SA) 6,188 58.3% Acquiror Target 63.0% 11/3 Spain

2/21/00 Norwich Union PLC CGU PLC 11,858 (12.2%) Acquiror Target 58.5% 9/8 United Kingdom

1/17/00 SmithKline Beecham Glaxo Wellcome 75,961 (2.3%) Acquiror Target 58.8% 8/8 United Kingdom

12/21/99 Pharmacia & Upjohn Monsanto 26,486 (7.1%) Acquiror Target 51.0% 9/9 United States

9/27/99 VIAG AG VEBA AG 13,153 6.8% Acquiror Joint 67.0% 7/3 United States

6/30/99 Banca Commerciale Italiana SpA Banca Intesa Spa 15,940 8.5% Acquiror Joint 57.0% NA Italy

5/17/99 Hoechst Rhone Poulenc 21,918 (9.9%) Target Target 47.0% 5/5 France

1/5/99 AirTouch Communications Vodafone group PLC 60,287 40.6% Target Acquiror 50.0% 7/7 United Kingdom

1/15/99 Banco Central Hispanoamericano Banco de Santander SA 11,320 (3.6%) Joint Target 63.8% 13/12/2 Spain

12/9/98 Astra AB Zeneca Group plc 32,199 9.8% Target Acquiror 53.5% 7/7 United Kingdom

12/2/98 Synthelabo SA Sanofi SA 11,234 5.7% Acquiror Joint 64.1% 4/3/5 France

8/11/98 Amoco British Petroleum 55,040 22.7% Joint Acquiror 60.0% 13/9 United Kingdom

5/7/98 Chrysler Corp Daimler-Benz AG 40,467 38.0% Joint Joint 58.0% 6/6 United States

2/25/98 General Accident Commercial Union 11,152 (4.2%) Acquiror Target 53.6% 7/7 United Kingdom

12/8/97 Swiss Bank Union Bank of Switzerland 22,765 0.3% Acquiror Target 60.0% 4/4/1 IAS

5/12/97 Guinness PLC Grand Metropolitan 15,970 1.3% Joint Acquiror 52.8% 5/5 United Kingdom

3/7/96 Ciba-Geigy AG Sandoz AG 29,000 9.5% Target Acquiror 55.0% 8/8 IAS

Source: Press releases, SEC filings, SDC1 Premium to target share price one day prior to announcement

$ in millions


127

Agenda

Introduction

Trading comparables



LBO analysis


Merger consequences

– Accretion/(dilution) review– Pro forma balance sheet analysis review

Appendix


128

Introduction

Pro forma analysis provides both acquirers and targets insight into the income statement and balance sheet impact of a transaction– Revenue, EBITDA or earnings impact– Capitalization, leverage and credit capacity impact

Valuable tool for both acquirer and target– Indicates buyer’s ability to pay– Suggests most appropriate form of consideration to offer– Allows buyer to predict or manage market reaction to announcement– Demonstrates landscape of competing buyers

Balance sheet and income statement impact go hand-in-hand– Both driven by form and amount of consideration


129

Agenda

Introduction

Trading comparables



LBO analysis


Merger consequences


Appendix


130

Overview of accretion/(dilution) analysis

Accretion/(dilution) primarily measures the impact of a merger or acquisition on the income statement of a potential buyer

Accretion/(dilution) analysis can be based on revenue, EBITDA, earnings, after-tax cash flow, and dividends per share – EPS is most commonly used form of accretion/(dilution) analysis– Industry will typically dictate which are the most relevant metrics (for example, Radio may

focus on ATCF while wireless telecom companies may prefer to show EBITDA)

Two methods exist for calculating accretion/(dilution)– “Top down”: integrated merger model– “Bottom up”: transaction-adjusted, estimate-based model

Key measures for accretion/(dilution)– Dollar and percent change of acquirer earnings per share– Pre-tax synergies required for break-even impact to EPS– Pro forma ownership when stock is used as an acquisition currency– Pro forma leverage/capitalization¹

1 Note that capitalization will change when stock is used and net debt leverage levels will change when cash is used


131

Purpose of accretion/(dilution) analysis

Accretion/(dilution) analysis can be used to determine– The capacity of the acquirer (or potential acquirers) to pay a premium for a

target– Optimal form of consideration (cash, stock, other securities, combination)

Used by both buyers and sellers– Buyers identify highest price they can afford to pay and what currency to offer– Buyers evaluate how much competing bidders can afford to pay – Sellers evaluate what price potential buyers can afford to pay and in what

currency– In the context of a divestiture, sellers also evaluate their break-even sale price

and required currency

Typically, JPMorgan performs sensitivity analyses to find break-even points where the offer price for a target results in no incremental earnings or losses to acquirer’s earnings per share


132

Two primary methods exist to compute accretion/(dilution)

Top down Bottom up

Integrated merger model with projectedbalance sheet and cash flow statementfor target, acquirer and the combinedcompany

EPS estimate-based analysis thatcombines acquirer and targetprojections, adjusting for impact ofincremental transaction-relatedexpenses and income

Provides most accurate picture ofcombined companies

Reflects impact of debt pay-down andother cash flow implications to netinterest expense and net income

Clearly and accurately shows balancesheet impact in pro forma statistics

Quick and intuitive demonstration ofaccretive or dilutive impact

Flexible analysis that canincorporate multiple buyers ortargets

Difficult to efficiently incorporatemultiple acquirers and targets forcompetitive analysis

Relies on estimates which, althoughmore robust, are also subject touncertainty or questionableassumptions

Risks over-simplifying pro formaanalysis and over- or under-statingimpact to acquirer

May be inappropriate for a dealwhere the acquirer’s credit rating isimpacted by the transaction

Must be customized for asset deals,joint ventures and other transactions

Description

Benefits

Considerations


133

Current share price $12.25Shares outstanding 41.500

Market capitalization $508.4

Net debt (6/30/02) 500.0Firm value $1,008.4Earnings per share:

2002E $1.202003E 0.952004E 1.45

Dividend per share (annual): $0.48Implied gross dividends paid (annual, $MM): $19.2

Sample transaction assumptions

Acquirer buying target with the following transaction assumptions:– Transaction closes 12/31/02– Advisory fees of 0.25% of transaction value– Financing fees of 1.0% on debt issued (amortized as deferred

financing fees over 7 years)– Interest rates assumptions

• Tranche I ($300MM maximum senior debt): 7.0%• Tranche II (subordinated debt): 12.5%

Transaction description

Target Acquirer

– Interest rate earned on existing cash: 3.0%– Tax rate on incremental earnings and expenses

(including net interest expense): 35%– Dividend policy of acquirer remains unchanged– 50% of excess purchase price allocated to goodwill

(approximately $70 million)• Remaining 50% of excess purchase price allocated

to asset write-up and depreciated over 20 years– Target's existing debt not refinanced

Current share price $20.03Shares outstanding 58.669

Market capitalization $1,175.1

Net debt (6/30/02) 750.0

Firm value $1,925.1Earnings per share:

2002E $1.562003E 1.682004E 1.80

Dividend per share (annual): $0.85Implied gross dividends paid (annual, $MM): $44.6


134

Key adjustments to pro forma income statement

The applicability of most income statement adjustments depends on the consideration issued to the seller and the way the acquiror funds an acquisition

Consideration

Adjustment Stock Cash Mix

After-tax financing fee amortization X X

Non-deductible advisory fee amortization

After-tax incremental DD&A from asset write-up X X X

After-tax interest on transaction debt X X

After-tax interest deduction from cash used X X X

After-tax interest (loss) gain on dividend shortfall X X X

After-tax synergies X X X

Transaction goodwill impairment X X X

Change in pro-forma fully diluted shares X X


135

What is in a “consensus” estimate?

First Call and I/B/E/S consensus estimates are based on an aggregation of research analysts’ estimates, with little discretion applied to mean and median calculations

– Quality of estimates and analysts varies dramatically across consensus samples

– Modeling conventions are often not explained or apparent

– Analysts may be assuming different projected share counts, rather than net income

Some estimates included in consensus numbers are out-dated

– May not reflect updated company guidance or recent financial results

– May not reflect abrupt changes to underlying industry economics

– May not reflect recent M&A transactions or securities offerings

Items embedded in consensus estimates are not always clearly explained or uniform across samples

– Fully diluted share assumptions and treatment of options and convertibles may vary

– Interest expense

– Tax rates

– Accounting policies

– Stock-based compensation and amortization of intangibles other than goodwill

While First Call or I/B/E/S estimates may provide a perceived “Street” consensus, they introduce some degree of uncertainty


136

Transaction assumptions are the foundation of all sound analysis

Choose an appropriate closing date reflecting available information and transaction structure– Timing of process requirements for closing (share registration, shareholder votes, etc.)– Timing of regulatory requirements for closing (HSR review, etc.)– Seasonality of industry economics and impact on estimates or calendarization

Capital structures should best reflect current circumstances– Equity currency should be reviewed in context of recent share price and larger equity market

performance– Cash deals should reflect reasonable interest rates and lending market capacity– Pro forma leverage and interest coverage levels should be consistent with acquirer’s desired credit

rating

Both advisory and financing fees have a meaningful impact on pro forma financials– Although equity analysts tend to “look through” some extraordinary charges, advisory and other one-time

fees will impact the cash balance used in the transaction and subsequent annual interest expense– Amortization of financing fees will impact EPS over the immediate future of the combined entity

Tax rate on incremental earnings and expenses should reflect acquiror’s and target’s combined tax efficiencies and adjustments should be made to post-transaction tax expenses for potential NOLs assumed by an acquirer

ALWAYS CLEARLY DESCRIBE TRANSACTION ASSUMPTIONS


137

Sample transaction – 100% stock consideration

Earnings impact

Earnings impactAssumptions

Acquirer share price: $20.03

2003 P/E 12.0x

2004 P/E 11.1

Acquirer shares outstanding 58.669

Target share price: $12.25

2003 P/E 12.9x

2004 P/E 8.4

Transaction assuming 25% premium

Offer price (assuming 25% premium) $15.31

Shares acquired¹ 42.468

Implied exchange ratio (T/A) 0.764x

Shares issued 32.466

Tax rate on incremental expenses: 35.0%

Figures in millions, except per share data 2003 2004

Acquirer EPS $1.68 $1.80Acquirer net income 98.3 105.7

Target EPS $0.95 $1.45Target net income 39.4 60.2

Adjustments

After-tax financing fee amortization ($0.0) ($0.0)Non-deductible advisory fee amortization 0.0 0.0After-tax DD&A from asset write-up (2.3) (2.3)After-tax interest on transaction debt (0.0) (0.0)After-tax interest deduction from cash used² (0.1) (0.1)After-tax interest (loss) gain on dividend shortfall (0.2) (0.3)After-tax synergies 0.0 0.0Transaction goodwill amortization (or impairment) 0.0 0.0Other reductions 0.0 0.0

Total adjustments to net income (2.5) (2.7)

Pro forma net income $135.2 $163.2Pro forma shares outstanding 91.135 91.135

Pro forma EPS $1.48 $1.79Accretion/(dilution) ($) ($0.19) ($0.01)Accretion/(dilution) (%) (11.5%) (0.6%)

Pre-tax synergies to break-even $26.9 $1.5

1 Should be calculated using the offer price not current target price² Used to fund transaction expenses and advisory fees of $2.9 million


138

Considerations for a stock transaction

P/Es and relative valuations play a meaningful role in accretion/(dilution) analysis– High P/E of an acquirer may imply stock may be “cheap” acquisition currency, relative to lower

P/E stock or the “implied debt P/E”

A number of issues will play an important role in the optics, attitudes and receptivity of principals and investors in a transaction– Exchange ratios should not be grossly inconsistent with historical relative trading performance of

acquirer and target– Purchase price and pro forma ownership should take into account contribution analysis

Flow back and sell-off of acquirer stock could meaningfully affect acquirer’s share prices on announcement/closing – Cross-shareholder analysis– Whether acquirer and target are included in the same indexes, if any– Fund limitations on owning international stocks and/or stocks not listed on local exchanges– Dividend policy implications of receiving acquirer stock


139

Sample transaction – 100% cash consideration

Earnings impact

Earnings impactAssumptions

Target share price: $12.25Offer price (assuming 25% premium) 15.31

Shares acquired¹ 42.468

Debt issued to fund acquisition:Equity purchased with cash $650.3Transaction fees 2.9Financing fees 6.6Cash balance used in transaction (0.0)

Total debt raised $659.8

Debt allocation:Tranche I $300.0Tranche II 359.8

Interest Rates:Tranche I 7.0%Tranche II 12.5%

Interest rate on foregone cash balance 3.0%

Tax rate on incremental earnings 35.0%




AdjustmentsAfter-tax financing fee amortization ($0.6) ($0.6)Non-deductible advisory fee amortization 0.0 0.0After-tax DD&A from asset write-up (2.3) (2.3)After-tax interest on transaction debt (42.9) (44.8)After-tax interest deduction from cash used 0.0 0.0After-tax interest (loss) gain on dividend shortfall 0.4 0.8After-tax synergies 0.0 0.0Transaction goodwill amortization (or impairment) 0.0 0.0Other reductions 0.0 0.0



Pro forma EPS $1.57 $2.03Accretion/(dilution) ($) ($0.10) $0.23Accretion/(dilution) (%) (6.1%) 12.5%

Pre-tax synergies to break-even $9.1 NM

1 Should be calculated using the offer price not current target price


140

Considerations for a cash transaction

Use multiple tranches of debt where appropriate– Reflects capital structure and market capacity limitations for larger deals– Varying interest rate on debt tranches will impact interest expense on offer price increases or decreases– Note that depending on debt mix, stock may be more or less appropriate as an acquisition currency

Financing assumptions should reflect both acquirer’s stand-alone and combined debt capacity and ratings circumstances– Debt coverage and capitalization statistics should be included to highlight potential ratings issues and

support interest rate assumptions– Current and recent ratings history of acquirer should be reviewed to confirm ability to issue debt securities– Covenants of existing acquirer debt should be considered– Review transaction and pro forma financials with ratings advisory and DCM teams to determine

appropriate rates

Use existing acquirer cash sparingly, if at all – Existing cash is likely used to meet working capital funding requirements– Minimum cash balance may be required for debt covenants– Opportunity cost of using cash on hand should always be contemplated and reflected in interest expense– Restricted cash considerations


141

Sample transaction – 50% cash / 50% stock consideration

Earnings impact

Earnings impactMixed consideration assumptions

Target share price: $12.25Offer price (assuming 25% premium) 15.31

Shares acquired 42.468

Shares issued 16.233

Debt issued to fund acquisition:Equity purchased with cash $325.1Transaction fees 2.9Financing fees 3.3Cash balance used in transaction (0.0)

Total debt raised $331.3

Debt allocation:Tranche I $300.0Tranche II 31.3

Interest Rates:Tranche I 7.0%Tranche II 12.5%

Interest rate foregone on cash balance 3.0%

Tax rate on incremental earnings 35.0%




AdjustmentsAfter-tax financing fee amortization ($0.3) ($0.3)Non-deductible advisory/ other fee 0.0 0.0After-tax DD&A from asset write-up (2.3) (2.3)After-tax interest on transaction debt (16.2) (16.9)After-tax interest deduction from cash used 0.0 0.0After-tax interest (loss) gain on dividend shortfall 0.1 0.2After-tax synergies 0.0 0.0Transaction goodwill amortization (or impairment) 0.0 0.0Other reductions 0.0 0.0



Pro forma EPS $1.59 $1.96Accretion/(dilution) ($) ($0.09) $0.16Accretion/(dilution) (%) (5.1%) 8.6%

Pre-tax synergies to break-even $9.9 NM


142

The role of P/E valuations in accretion/(dilution)

For stock-for-stock deals, accretion or dilution potential will usually be evident by simply comparing the P/E multiples of the acquirer and the target– If the acquirer has a higher P/E than the target, the deal will be accretive because the

acquirer is buying more EPS than the target shareholders are accepting as consideration– If the acquirer has a lower P/E than the target, the deal will be dilutive because the

acquirer is buying less EPS than the target shareholders are accepting as consideration– Remember to take the premium into account when calculating the target’s P/E– Utility of comparison will also depend on transaction assumptions regarding goodwill

impairment or other asset amortization

For 100% cash transactions, the cost of debt (interest payments) and cost of acquiring the target’s earnings will determine the accretive or dilutive impact of a transaction– Where the inverse cost of debt (1/(after-tax cost of debt)) is greater than the P/E of the

target, the deal will be accretive– Where the inverse cost of debt is lower than the P/E of the target, the deal will be dilutive


143

Presenting accretion/(dilution) with sensitivities

Sensitivities provide the total picture of a transaction’s potential impact; relevant sensitivities to demonstrate may include– Premium (discount)– Consideration offered (% of stock/% of cash)

Acquirer’s stock price Earnings per share Synergies

– Interest rate(s) on debt issued

Sensitivities should reflect consideration specifics– Purchase price and ownership (stock)

2003 accretion / (dilution) – (% per share) 2003 synergies to break-even – ($MM)

Stock consideration

50.0% 62.5% 75.0% 87.5% 100.0%

10.0% 1.0% (1.1%) (3.0%) (4.8%) (6.4%)

20.0% (3.0%) (4.6%) (6.5%) (8.3%) (9.8%)

30.0% (7.7%) (8.4%) (10.2%) (11.9%) (13.4%)

40.0% (14.1%) (13.5%) (15.2%) (16.8%) (18.1%)

50.0% (20.2%) (19.0%) (19.9%) (21.3%) (22.5%)

Pre

miu

m

Stock consideration

50.0% 62.5% 75.0% 87.5% 100.0%

10.0% NM $2.2 $6.3 $10.4 $14.4

20.0% 5.8 9.3 13.8 18.3 22.8

30.0% 15.0 17.3 22.3 27.2 32.1

40.0% 28.2 28.8 34.3 39.9 45.3

50.0% 41.7 41.9 46.6 52.8 58.9

Pre

miu

m


144

Relevant sample transaction sensitivities

2003 accretion / (dilution) – (% per share) 2003 accretion / (dilution) – (% per share)

2003 accretion / (dilution) – (% per share) 2003 accretion / (dilution) – (% per share)

Stock deals

Cash deals

Acquirer stock price

$19.00 $20.03 $21.00 $22.00 $23.00

10.0% (8.1%) (6.4%) (5.0%) (3.5%) (2.2%)

20.0% (11.6%) (9.8%) (8.3%) (6.8%) (5.5%)

30.0% (15.2%) (13.4%) (11.8%) (10.3%) (8.9%)

40.0% (20.0%) (18.1%) (16.5%) (15.0%) (13.5%)

50.0% (24.4%) (22.5%) (20.9%) (19.3%) (17.8%)

Pre

miu

m

Pre-tax synergies realized 2003

$5.0 $10.0 $15.0 $20.0 $25.0

10.0% (4.2%) (2.0%) 0.2% 2.5% 4.7%

20.0% (7.7%) (5.5%) (3.3%) (1.2%) 1.0%

30.0% (11.3%) (9.2%) (7.1%) (5.0%) (2.9%)

40.0% (16.1%) (14.1%) (12.1%) (10.1%) (8.1%)

50.0% (20.6%) (18.7%) (16.8%) (14.9%) (13.0%)

Pre

miu

m

Interest rate on senior debt (Tranche I)

6.5% 7.0% 7.5% 8.0% 8.5%

10.0% 3.1% 2.1% 1.1% 0.1% (0.9%)

20.0% (2.4%) (3.4%) (4.3%) (5.3%) (6.3%)

30.0% (8.4%) (9.4%) (10.4%) (11.4%) (12.4%)

40.0% (17.1%) (18.1%) (19.1%) (20.1%) (21.1%)

50.0% (25.9%) (26.9%) (27.9%) (28.9%) (29.9%)

Pre

miu

m

Blended interest rate (%)

11.0% 10.5% 10.0% 9.5% 9.0%

10.0% (2.3%) (0.1%) 2.1% 4.2% 6.4%

20.0% (7.7%) (5.5%) (3.4%) (1.2%) 1.0%

30.0% (13.8%) (11.6%) (9.4%) (7.2%) (5.1%)

40.0% (22.5%) (20.3%) (18.1%) (15.9%) (13.7%)

50.0% (31.3%) (29.1%) (26.9%) (24.7%) (22.6%)

Pre

miu

m


145

Synergies and transaction related costs

Synergies– For top-down modeling simplicity, assume synergies come from cost-savings unless told

otherwise– Revenue synergies

• Incremental revenues may have costs associated with them that need to be reflected in any synergy calculations (e.g variable margins on incremental revenues)

• Equity markets heavily discount or, in many cases, disregard revenue synergies, as they are typically difficult to quantify and accurately project

– Synergies are typically realized gradually over time and should be phased in accordingly– It may be prudent to “risk-adjust” any expected synergies to account for ability to realize them

and/or for negative synergies (i.e., integration costs)– Consider the cash flow impact of synergies

One-time charges and expenses– Acquiring companies will incur one-time merger-related costs due to reorganization, severance

packages• One-time charges are disclosed in SEC filings• From a valuation perspective, the Street “looks through” one-time charges • Include the net interest impact of cash changes


146

Additional items to consider

Tax benefits– In assuming additional options are exercised under premium scenarios a tax shield will be generated

based on the implied deductible compensation expense generated from the vesting / exercise of options at a discount to the acquisition price

– Asset write-ups have tax implications1

Acquirers may be forced to pay “interest on interest”– In using cash and thereby raising debt, an acquirer will incur future interest and amortization payments

that may require additional borrowing– AccretionOne calculation method

Asset write-ups and additional depreciation expenses– While asset write-ups will reduce goodwill generated in a transaction, they will increase annual

depreciation expenses based on the incremental increase in depreciable assets– Limiting asset write-ups will reduce negative impact of increased depreciation expenses– In some cases, asset write-downs may impact EPS accretion / dilution

Impact of dividends paid by acquirer – Additional cash will be necessary to fund new dividends paid and should be reflected in incremental

expenses– Dividend accretion/(dilution) analysis may be relevant to determine appropriate premium

1 Write-ups create a deferred tax liability (equal to the write-up multiplied by the tax rate)


147

Summary considerations for EPS accretion/(dilution) analysis

EPS-based accretion/(dilution) is only a back-of-the-envelope exercise and is not a substitute for an integrated merger model– Does not necessarily reflect cash flow implications and debt pay-down capabilities of

combined company

EPS estimates should be used with caution– First Call and I/B/E/S estimates are consensus numbers that do not always reflect consistent underlying

assumptions– Small differences in EPS figures can have dramatic impact on net income ($0.05 per share on 200

million shares reflects a $10 million variance in net income)

Share count of target must be a dynamic number– Share count should increase (decrease) with offer price to reflect additional (reduced) shares underlying

in-the-money options

Negative net income targets CANNOT create meaningful accretion

Accretion/(dilution) should always be sanity-checked– Relative P/Es– Acquirer’s cost of debt vs. cost of target’s earnings

Accretion/(dilution) should always be checked with your calculator


148

Agenda

Introduction

Trading comparables



LBO analysis


Merger consequences


Appendix


149

Overview of pro forma balance sheet analysis

Pro forma balance sheet analysis provides a means of assessing the impact of a potential transaction on an acquirer’s cost of borrowing, market access, and financial flexibility

Two methods exist for demonstrating balance sheet impact:– “Top down”: integrated merger model with income statement, balance sheet and cash

flow statement (preferred)– “Bottom up”: transaction-adjusted, LTM-based model

Pro forma balance sheet analysis relies primarily upon a comparison of an acquirer’s pre- and post-acquisition credit metrics

Key credit metrics include:– Pretax Interest Coverage– EBITDA Interest Coverage– Funds from Operations to Interest– Funds from Operations to Debt– Debt to EBITDA– Debt to Book Capitalization


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Significance of pro forma balance sheet analysis

Pro forma balance sheet analysis is critical in determining

– The debt-financed acquisition capacity of an acquirer (or competing bidders)

– Required equity component of an offer to ensure a particular rating outcome

– Financing implications of a particular transaction structure (cost of capital and market access)

– In a divestiture, the pro forma credit rating of the seller and the minimum level of cash consideration needed

Used by both buyers and sellers– Buyers identify highest price they can afford to pay and how much cash can be

offered– Buyers evaluate how much other competitive bidders can afford to pay – Sellers evaluate how much potential buyers can afford to pay and how much

cash to demand

Typically, JPMorgan performs sensitivity analyses to address relevant inflection points where the offer price for a target results in meaningful changes to a combined capital structure


151

Credit ratings as a key financing decision driver

A company’s corporate credit rating determines its

– Cost of borrowing

– Breadth and depth of access to the capital markets

– Financial flexibility (liquidity/covenant constraints)

Pro forma balance sheet analysis allows potential acquirers to assess leverage breakpoints and their associated ratings outcomes in order to develop a comprehensive financing plan

Significant debt-financed transactions can erode credit profile and can lead to a ratings downgrade

The determination of potential financing structures is often bound by the trade-offs between maximizing EPS subject to limiting ratings pressure


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Sample transaction – 100% cash consideration

Acquirer Target Adjustments Pro forma

Balance sheet:Total debt $800.0 $575.0 $659.8 $2,034.8

Shareholders’ equity value 950.0 525.0 (525.0) 950.0

Minority interest 0.0 0.0 0.0 0.0

Income statement:LTM EBITDA $226.0 $119.0 $345.0

LTM EBIT 176.0 94.0 270.0

LTM interest expense 55.0 40.0 42.6 137.6

Capitalization:

Debt/equity 84.2% 109.5% 214.2%

Debt/total capitalization1 45.7% 52.3% 68.2%

Coverage ratios:Debt/LTM EBITDA 3.5x 4.8x 5.9x

Debt/LTM EBIT 4.5 6.1 7.5

LTM EBITDA/interest 4.1 3.0 2.5

LTM EBIT/interest 3.2 2.4 2.0

Note: excludes lease-related leverage and hybrid securities1 Includes minority interest


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Sample transaction – 100% stock consideration

Acquirer Target Adjustments Pro forma

Balance sheet:Total debt $800.0 $575.0 $0.0 $1,375.0

Shareholders’ equity value 950.0 525.0 125.3 1,600.3

Minority interest 0.0 0.0 0.0 0.0

Income statement:LTM EBITDA $226.0 $119.0 $345.0

LTM EBIT 176.0 94.0 270.0

LTM interest expense 55.0 40.0 0.0 95.0

Capitalization:

Debt/equity 84.2% 109.5% 85.9%

Debt/total capitalization1 45.7% 52.3% 46.2%

Coverage ratios:Debt/LTM EBITDA 3.5x 4.8x 4.0x

Debt/LTM EBIT 4.5 6.1 5.1

LTM EBITDA/interest 4.1 3.0 3.6

LTM EBIT/interest 3.2 2.4 2.8

Note: excludes lease-related leverage and hybrid securities1 Includes minority interest


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Debt / EBITDA EBITDA / interest

Debt / total capitalization

Pro forma balance sheet sensitivities

Similar to EPS analysis, sensitivities provide the “whole picture”

Sensitivities should demonstrate the impact of changes to relevant metrics

– Consideration (stock vs. cash)

– Estimates (EBITDA)

– Assumptions (premium, interest rates, etc.)

Stock consideration

0.0% 25.0% 50.0% 75.0% 100.0%

10.0% 67.3% 62.4% 57.4% 52.5% 47.5%

20.0% 67.9% 62.6% 57.3% 52.0% 46.6%

30.0% 68.5% 62.8% 57.2% 51.5% 45.7%

40.0% 69.4% 63.2% 57.0% 50.7% 44.4%

50.0% 70.3% 63.5% 56.8% 50.0% 43.2%

Pre

miu

m

Stock consideration

0.0% 25.0% 50.0% 75.0% 100.0%

10.0% 2.63x 2.89x 3.19x 3.39x 3.63x

20.0% 2.54 2.81 3.13 3.37 3.63

30.0% 2.45 2.73 3.06 3.35 3.63

40.0% 2.34 2.62 2.97 3.32 3.63

50.0% 2.23 2.51 2.88 3.29 3.63

Pre

miu

m

Stock consideration

0.0% 25.0% 50.0% 75.0% 100.0%

10.0% 5.66x 5.24x 4.83x 4.41x 3.99x

20.0% 5.82 5.36 4.91 4.45 3.99

30.0% 6.00 5.49 4.99 4.49 3.99

40.0% 6.25 5.68 5.12 4.56 3.99

50.0% 6.50 5.88 5.25 4.62 3.99

Pre

miu

m


155

Agenda

Introduction

Trading comparables



LBO analysis



Appendix


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JPMorgan estimates the cost of equity using the capital asset pricing model

The Capital Asset Pricing Model (CAPM) classifies risk as systematic and unsystematic. Systematic risk is unavoidable. Unsystematic risk is that portion of risk that can be diversified away, and thus will not be paid for by investors

The CAPM concludes that the assumption of systematic risk is rewarded with a risk premium, which is an expected return above and beyond the risk-free rate. The size of the risk premium is linearly proportional to the amount of risk taken. Therefore, the CAPM defines the cost of equity as equaling the risk-free rate plus the amount of systematic risk an investor assumes

The CAPM formula follows:

Cost of equity = Risk-free rate + (beta * market risk premium)re = rf + ß * (rm - rf)

– There is also an error term in the CAPM formula, but this is usually omitted

Where

re = the required market return on the equity of the company

rf = the risk-free rate

rm = the return on the market

ß = the company’s projected (leveraged) beta


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Beta

Beta provides a method to estimate an asset's systematic (non-diversifiable) risk

Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market

A company whose equity has a beta of 1.0 is “as risky” as the overall stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the stock market; a company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop twice as fast as the overall market

Returning to our CAPM formula, the beta determines how much of the market risk premium will be added to or subtracted from the risk-free rate

Since the cost of capital is an expected value, the beta value should be an expected value as well

Although the CAPM analysis, including the use of beta, is the overwhelming favorite for DCF analysis, other capital asset pricing models exist, such as multi-factor models like the Arbitrage Pricing Theory


158

The yield-to-maturity on the 10-year U.S. Treasury note is generally used to approximate the risk-free rate

– Long-term cost of debt is used, because the cost of capital is normally applied to long-term cash flows

– Obtain from Bloomberg or a similar source

Projected betas can be obtained from Barra or an online database (e.g., IDD)– Barra predicted betas can be found through the Investment Bank Home Web page1

– Note that Bloomberg betas are based on historic prices and are therefore not forward-looking– Impute unlevered beta for private company from public comparables

The market risk premium (rm - rf; i.e., the spread of market return over the risk-free rate) is

periodically estimated by M&A research based on analysis of historical data– The current MRP assumption is 4.0%

Using the capital asset pricing model

1 In the “Investment Banking” menu, select “more”, then “Financial Database Services”, then “Barra Betas”


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Recalling our previous discussion regarding the difference between asset values and equity values, a similar argument exists for betas. The predicted equity beta, i.e., the observed beta, includes the effects of leverage. In the course of performing a variance analysis, which looks at different target capitalizations, the equity beta must be delevered to get an asset, or unlevered, beta. This asset beta is then used in the CAPM formula to determine the appropriate cost of capital for various debt levels

The formula follows:

Delevering and relevering beta

To relever the beta at a target capital structure:


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Delevering and relevering beta (cont’d)

Note that JPMorgan M&A sometimes uses a factor, tau, in place of the marginal tax rate, T– Tau, currently equal to 0.26, represents the average blended benefit a

shareholder gets from a company borrowing (reflects many factors)– The value of tau is derived by researchers using complicated statistical

analyses

Although the delevering/relevering methodology is standard for WACC analyses, the formula does not produce a highly accurate result

Remember the fundamentals: the market charges more for equity of companies that are financially risky


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Example:Calculating WACC based on comparable companies

Target WACC analysis as of 1/1/01

Macroeconomic assumptions

Risk-free rate15.40% Projected Target marginal tax rate 40.0%

Estimated market equity risk premium24.0%

Industry beta analysis

Projected Net debt/ Total debt/ Unlevered Cost of Cost of

Comparable company levered beta3 mkt. cap. mkt. equity Tax rate beta4 levered equity unlevered equity

Company A 1.06 17.2% 22.5% 0.40 0.93 9.6% 9.1%

Company B 0.90 18.0% 22.2% 0.40 0.79 9.0% 8.6%

Company C 0.90 40.3% 78.4% 0.40 0.61 9.0% 7.8%

Company D 0.89 8.6% 10.1% 0.40 0.84 9.0% 8.8%

Average 0.94 21.0% 33.3% 0.40 0.79 9.1% 8.6%

Target WACC calculation

Optimal Optimal Pre-tax Levered beta assuming

debt/market debt/ Spread to 10-yr Country long term unlevered beta of Cost of Target

capitalization equity Treasuries (bp) risk premium cost of debt 0.79 levered equity nominal WACC

30.0% 42.9% 175.0 0.00% 7.1% 1.00 9.4% 7.9%

40.0% 66.7% 200.0 0.00% 7.4% 1.11 9.8% 7.7%

50.0% 100.0% 300.0 0.00% 8.4% 1.27 10.5% 7.8%

60.0% 150.0% 400.0 0.00% 9.4% 1.51 11.4% 8.0%

70.0% 233.3% 500.0 0.00% 10.4% 1.91 13.0% 8.3%

Notes:1 Risk-free rate = yield-to-maturity of 10-year U.S. Treasury bond as of 1/1/01 (Source: Bloomberg)2 Source: JPMorgan M&A research3 Source: Barra predicted betas4 Unlevered beta = Levered beta / (1 + (total debt / market value of equity) * (1 - tax rate)). Assumes beta of debt equals zero.

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August 2002

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