JP Morgan M&a DCF and Merger Analysis

D E C E M B E R 2 0 0 4

M & A : D C F A N D M E R G E R A N A L Y S I S

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M&A - DCF and M&A analysis

[For any pitchbook or presentation including advisory, equity or debt security or loan product or combinations thereof. NOT for use in fairness/valuation or Commercial Bank presentations.]

This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including such clients subsidiaries, the Company) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan.

The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. JPMorgans opinions and estimates constitute JPMorgans judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects.

Notwithstanding anything herein to the contrary, the Company and each of its employees, representatives or other agents may disclose to any and all persons, without limitation of any kind, the U.S. federal and state income tax treatment and the U.S. federal and state income tax structure of the transactions contemplated hereby and all materials of any kind (including opinions or other tax analyses) that are provided to the Company relating to such tax treatment and tax structure insofar as such treatment and/or structure relates to a U.S. federal or state income tax strategy provided to the Company by JPMorgan.

JPMorgans policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors.

JPMorgan is a marketing name for investment banking businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by a combination of J.P. Morgan Securities Inc., J.P. Morgan plc, J.P. Morgan Securities Ltd. and the appropriately licensed subsidiaries of JPMorgan Chase & Co. in Asia-Pacific, and lending, derivatives and other commercial banking activities are performed by JPMorgan Chase Bank, N.A. JPMorgan deal team members may be employees of any of the foregoing entities.

This presentation does not constitute a commitment by any JPMorgan entity to underwrite, subscribe for or place any securities or to extend or arrange credit or to provide any other services.

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Agenda

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Merger consequences

Relative value analysis

Discounted cash flow analysis

Introduction 1

1

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Valuation methodologies

Publicly tradedcomparablecompanies

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

Valuationmethodologies

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The valuation process

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

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

(2) Publicly Traded Comparable CompaniesUtilizes 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.

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

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$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 25.0x2005E cash

EPS of $0.16

15.0x to 19.0x2005E EBITof $20.6

2.5x to 4.0xLTM revenue

of $185.7 12% to 15% Discount RateEBIT exit mult.

of 15.0x to 20.0x

15.0x to 20.0x2006E 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

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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 firm value or asset value) The value of the total enterprise: market value of equity + (total debt + Capitalized Leases - Cash and Cash equivalents) + Minority Interest + Preferred Equity

Total debt includes all Long term debt, Current portion of Long term debt, short term debt and overdrafts

Equity value = Market value of the shareholders equity (often referred to as offer value) The market value of a companys equity (shares outstanding x current stock price)

Liabilities and Shareholders EquityAssets

Enterprisevalue

Net debt, etc.

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 companys credit profile has not changed significantly since the existing debt was issued.

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Agenda

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Merger consequences



Introduction 1

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Discounted cash flow analysis as a valuation methodology

Publicly tradedcomparablecompanies

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

Valuationmethodologies

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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

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Overview of DCF analysis

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

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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 520 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 companys 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

Overview

Free cash flow

Terminal value

WACC

Other topics

Projections/FCFProjections/FCF

Terminal valueTerminal value

Discount rateDiscount rate

Present valuePresent value

AdjustmentsAdjustments

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DCF theory and its application

Overview

Free cash flow

Terminal value

WACC

Other topics

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 assets value (including an estimated terminal value), discounted using an appropriate weighted-average cost of capital

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)

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The two basic DCF approaches must not be confused

Overview

Free cash flow

Terminal value

WACC

Other topics

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

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Other considerations

Overview

Free cash flow

Terminal value

WACC

Other topics

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 targets value. Generally, the best variables to sensitize are sales, EBITDA margin, WACC and exit multiples or perpetuity growth rate

Hence, always present a range for the valuation!

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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

Overview

Free cash flow

Terminal value

WACC

Other topics

Always double-check with a calculator!

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M&A - DCF and M&A analysisThe first step in DCF analysis is projection of unlevered free cash flows

Overview

Free cash flow

Terminal value

WACC

Other topics

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 companys management Acquiring companys management Research analysts Bankers

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Projecting financial statements

Overview

Free cash flow

Terminal value

WACC

Other topics

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

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M&A - DCF and M&A analysisFree cash flow is the cash that remains for creditors and owners after taxes and reinvestment

Overview

Free cash flow

Terminal value

WACC

Other topics

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 firms 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

Unlevered free cash flows can be forecast from a firms 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 amortizationLess: Taxes (at the marginal tax rate)

Equals: Tax-effected EBITAPlus: Deferred taxes1

Plus: Depreciation and any tax-deductible amortization

Less: Capital expendituresPlus/(less): Decrease/(increase) in net working investment

Equals: Unlevered free cash flow

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AdministratorThe tax shield effect of debt is not reflected in this formula, by which I mean I*(1-t)


Fiscal year ending December 31,

2001 2002 2003 2004P 2005P 2006P 2007P 2008P

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

Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%

Example: Calculating unlevered free cash flows

Overview

Free cash flow

Terminal value

WACC

Other topics

Stand-alone DCF analysis of Company X$ millions


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M&A - DCF and M&A analysisValuing 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

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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 FCFn Present value =

(1+r)1 +

(1+r)2 +

(1+r)3 +

. . . +

(1+r)n

FCF1 FCF2 FCF3 FCFn Present 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

Overview

Free cash flow

Terminal value

WACC

Other topics

JPMorgan standard

JPMorgan standard

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M&A - DCF and M&A analysisIt is important to differentiate between the transaction date and the mid-year convention

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)

Transaction date: 01/01Transaction date: 01/01


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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


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Example: Discounting free cash flows

Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%

$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

Overview

Free cash flow

Terminal value

WACC

Other topics


2001 2002 2003 2004P 2005P 2006P 2007P 2008P

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


EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5










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 $49.9

Discounted value of FCF 2005P2008P 189.6

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M&A - DCF and M&A analysisTerminal value can account for a significant portion of value in a DCF analysis

Terminal value represents the businesss value at the end of the projection period; i.e., the portion of the companys 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

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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

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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

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Example: Terminal multiple method

Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%Exit multiple of EBITDA = 7.0x

$745.4 =($155.9 * 7.0x)

(1+.10)4Formula

Overview

Free cash flow

Terminal value

WACC

Other topics


2001 2001 2003 2004P 2005P 2006P 2007P 2008P 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

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 $49.9 Discounted value of FCF 2005P2008P 189.6 EBITDA in 2008P $155.9 Exit multiple 7.0x Firm value at exit 1,091.3 Discounted terminal value 745.4 Total present value to acquirer $934.9



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Example: Terminal multiple method (contd)

A + B = C

Discounted Discounted terminal value Firm value

FCF at 2008P EBITDA multiple of at 2008P EBITDA multiple of

Discount rate 20052008 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 9% 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 1,041.4 11% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.6 12% 182.7 594.5 693.5 792.6 777.2 876.3 975.3

D = E

Equity value Equity value per share1

Net debt at 2008P EBITDA multiple of at 2008P EBITDA multiple of

Discount rate 12/31/04 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 9% 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 $23.01 11% 100.0 702.3 804.9 907.6 $17.16 $19.67 $22.18 12% 100.0 677.2 776.3 875.3 $16.55 $18.97 $21.39

Overview

Free cash flow

Terminal value

WACC

Other topics

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


Note: DCF value as of 12/31/01 based on mid-year convention1 Based on 40.91 million diluted shares outstanding

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Growth in perpetuity method

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 thediscount 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

Overview

Free cash flow

Terminal value

WACC

Other topics

JPM recommended methodJPM recommended methodAcademic formulaAcademic formula

Terminal value = (FCFn * (1 + g))/(WACC g)

where FCFn = FCF in final projected period g = growth rate in perpetuityWACC = weighted-avg. cost of capital

PV of terminal value = terminal value/(1+WACC)n-0.5

Terminal value = (FCFn+1)/(WACC g)

where FCFn+1 = FCF in year after projections g = growth rate in perpetuityWACC = weighted-avg. cost of capital

PV of terminal value = terminal value/(1+WACC)n-0.5

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

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Growth in perpetuity method (contd)

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

Overview

Free cash flow

Terminal value

WACC

Other topics

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Example: Growth in perpetuity method

Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%Perpetuity growth rate = 3%


2001 2002 2003 2004P 2005P 2006P 2007P 2008P

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


EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5










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 $49.9

Discounted value of FCF 2005P2008P 189.6

PV of Terminal Value 733.7

Total present value to acquirer $923.3

$733.6 =$69.6 * (1 + .03)

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

Overview

Free cash flow

Terminal value

WACC

Other topics



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Example: Growth in perpetuity method (contd)

A + B = C

Discounted Discounted terminal value Firm value

FCF at perpetuity growth rate of at perpetuity growth rate of

Discount rate 20052008 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 9% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0

10% 189.6 681.5 733.7 794.0 871.1 923.3 983.6 11% 186.1 582.6 622.0 666.7 768.7 808.1 852.8 12% 182.7 505.1 535.8 570.1 687.9 718.5 752.8

D = E

Equity value Equity value per share1

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

Discount rate 12/31/04 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 9% 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 $21.59 11% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.40 12% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95

Overview

Free cash flow

Terminal value

WACC

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Note: DCF value as of 12/31/04 based on mid-year convention

1 Based on 40.91 million diluted shares outstanding



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M&A - DCF and M&A analysisTerminal 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

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Free cash flow

Terminal value

WACC

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Terminal multiple method and implied growth rates

A + B = C

Discounted Discounted terminal value Firm value Terminal value as percent Discount FCF at 2008P EBITDA multiple of at 2008P EBITDA multiple of of total firm value

rate 20052008 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 = E

Equity value Equity value per share1 Implied perpetuity growth rate Discount Net debt at 2008P EBITDA multiple of at 2008P EBITDA multiple of at 2008P EBITDA multiple of

rate 12/31/04 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

Standalone Company X DCF analysis$ millions


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%

Note: DCF value as of 12/31/04 based on mid-year convention

1 Based on 40.91 million diluted shares outstanding

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Perpetuity growth rate and implied terminal multiples

Overview

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A + B = C

Discounted Discounted terminal value Firm value Terminal value as percent Discount FCF at perpetuity growth rate of at perpetuity growth rate of of total firm value

rate 20052008 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 multiple Discount Net debt at perpetuity growth rate of at perpetuity growth rate of at perpetuity growth rate of

rate 12/31/04 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 10.7x 9% 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 7.5 11% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.40 5.7 6.1 6.5 12% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95 5.1 5.4 5.8



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

Note: DCF value as of 12/31/04 based on mid-year convention 1 Based on 40.91 million diluted shares outstanding

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M&A - DCF and M&A analysisChoosing 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 investor

Overview

Free cash flow

Terminal value

WACC

Other topics

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 acquirers 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 acquirors, sometimes ti may be appropriate to consider the use of the acquirors WACC in performing the valuation. The additional value created by using the acquirors WACC can be viewed as a synergy to the acquiror in the context of the transaction.

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M&A - DCF and M&A analysisJPMorgan 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 + * (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 = the companys projected (leveraged) beta

Overview

Free cash flow

Terminal value

WACC

Other topics

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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)

Risk-free rate based on the 10 year bond yield

Incorporates the undiversifiable risk of an investment (beta)

Equity risk premium reflects expectations of todays market

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

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

Long-term return on equity investment in

todays market

=

Long-term risk-free rate of return

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Adjustment for correlation to stock market

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x

Appropriate extra return above risk free

rate

= 10-year bond yield (annual average)

+ Predicted betas x Estimated using various techniques

For market average = 4.97% + 1.00 x 5.00%

= 9.97%

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Free cash flow

Terminal value

WACC

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JPMorgan estimates the equity risk premium at 5.0%

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

Overview

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WACC

Other topics

Equity premiumsRolling average over 10-year bond

Equity premiumsRolling average over 10-year bond

Equity returns less 10-year bond yieldArithmetic average

Equity returns less 10-year bond yieldArithmetic average

2%

4%

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1955 1959 1963 1968 1972 1976 1980 1984 1988 1993 1997 2001

Rolling 30 years Rolling 40 years Rolling 50 years

30 years ending Equity 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

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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

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Free cash flow

Terminal value

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JPMorgan uses predicted betas to calculate the cost of equity

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(0.5) 0.2 1.0 1.9 2.6Beta

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Predicted betasSupermarkets0.78

Utilities0.43

Food0.52

Internet2.09

Cellular1.62

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

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 firms return and market returns and are often distorted

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

Overview

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Terminal value

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Delevering and relevering beta

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, included 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:

U= L/[1 = ((1 T) * (Debt/Equity))]Where:

U = unlevered (asset) betaBL = leveraged beta

T = marginal tax rate

To relever the beta at a target capital structure:

L= U*[1 + ((1 T) * (Debt/Equity))]

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Delevering and relevering beta (contd)

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

Exercise 1. Levered Beta = 1.25, T = 40%, D/E= 0.75; What is the Beta Unlevered? 2. Find the levered Beta at a D/E = 1.0

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The cost of a firms 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 judgementshould be applied when estimating the cost of equity for smaller firms

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

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

Size premium by market capBased on historical returns analysis

Size premium by market capBased on historical returns analysis

5.2%

3.1%2.5%

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

2.2%

1.6%

1.1%0.8%

0.0%

$100500 $5001,000 $1,0002,500 $2,5005,000 $5,000+

Market cap ($mm)

$0100

$100250

$250500

$500700

$700-1,000

$1,0001,500

$1,5002,500

$2,5005,000 $5,000+

Market cap ($mm)

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Terminal value

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M&A - DCF and M&A analysisJPMorgan 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 companys normalized cash tax rate

Overview

Free cash flow

Terminal value

WACC

Other topics

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Cost of equity Cost of capital 10-year T-bond (Avg) 4.97% Market risk premium 5.00% (x) Beta (current predicted) 0.62 Adjusted market premium 3.10% Cost of equity = 8.07%

Cost of debt Cost of debt 6.25% (-) Tax shield1 2.19% After-tax cost of debt 4.06%

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

The target capital structure reflects the companys 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 firms 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

Target capital structure(Assumes current = optimal)Debt/total capital2 = 6.1%

Nominal WACC = 7. 82%

WACC = rd * [D *(1-T)] + re * E D+E D+E

Where: E = Market value of equity D = Market value of debt

T = Marginal tax rate re = Return on equity rd = Return on debt

Overview

Free cash flow

Terminal value

WACC

Other topics

Illustrative SYSCO weighted average cost of capital calculationIllustrative SYSCO weighted average cost of capital calculation

WACC formulaWACC formula

1 Assumes 35% marginal tax rate2 Total capital = debt + market value of equity

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M&A - DCF and M&A analysisExample: Calculating WACC based on comparable companies

Risk free rate1 5.40% Projected Target marginal tax rate 40.0%

Estimated market equity risk premium 4.0%

Target WACC analysis as of 1/1/01Target WACC analysis as of 1/1/01

Macroeconomic assumptionsMacroeconomic assumptions

Comparable company

Projected levered beta3

Net debt/mkt.

cap

Total debt/mkt.

equity Tax rate Unlevered

beta4

Cost of levered equity

Cost of 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%

Industry beta analysisIndustry beta analysis

Optimal debt/market capitalization Optimal debt/equity

Spread to 10-yr

treasuries (bp)

Country risk premium

Pre-tax long term cost of

debt

Levered beta assuming

unlevered beta of 0.79

Cost of levered equity

Target 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

Target WACC calculationTarget WACC calculation

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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M&A - DCF and M&A analysisThe appropriate cost of capital will depend on the entity which is being valued

Company Risk

premium Unlevered

beta Optimal

debt/equity Re-levered

beta Cost of equity

Cost of financing 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 purposesFor illustrative purposes

Debt/equity

10% 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%

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0.85 8.8% 8.4% 8.0% 7.8%

SYSCO WACC sensitivitySYSCO WACC sensitivity $1bn target WACC sensitivity$1bn target WACC sensitivity $200mm target WACC sensitivity$200mm target WACC sensitivity

Debt/equity

10% 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%

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0.90 10.3% 9.8% 9.4% 9.1%

Debt/equity

10% 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%

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0.90 11.2% 10.7% 10.3% 10.0%

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

Overview

Free cash flow

Terminal value

WACC

Other topics

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DCF in-class exercise

The Forecasted EBITDA and FCF for the next three years (2005, 2006, 2007) are EBITDA (US $mm): 450, 500, 550 FCF (US $mm): 250, 261, 277

Other assumptions: Perpetuity growth rate of 3.0% Terminal exit multiple of 7.5x Unlevered beta of 0.80 Risk free rate= 4.6% Market risk premium= 6% Cost of debt: 6.2% Marginal tax rate: 35% Market value of equity=US $4,541mm Net debt= US $2,524mm

Overview

Free cash flow

Terminal value

WACC

Other topics

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DCF in-class exercise (contd)

Calculate The cost of equity WACC PV of FCF NPV of company Perpetual growth method PV of Exit multiple method What if we use end period discounting in:

Perpetual growth method Exit multiple method

What is the valuation if we need to value the company as on March 31, 2005? Use Exit/Perpetual growth methods using mid year conventions Use Exit/Perpetual growth methods using end year conventions

Overview

Free cash flow

Terminal value

WACC

Other topics

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Most common errors in calculating WACC

Cost of equity

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

Target capital structure

The actual, not target, capital structure is used

WACC calculated based on book weights

Overview

Free cash flow

Terminal value

WACC

Other topics

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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 Cost savings

Raw material discounts/purchasing power Sales and marketing overlap, Corporate overhead reductions Distribution cost reductions, Facilities consolidation Tax savings

Merger related expenses (restructuring, additional CAPEX, integration expenses)

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

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Valuing synergies

Sources of synergy projections Management Research Estimates from comparable transaction (% of sales, increase in EBITDA

margin etc.)

DCF with synergies Valued separately from standalone DCF Run sensitivity on synergy valuations

Other considerations Timeline for achieving synergies Run as sensitivity various cases of realization e.g., 25%, 50%, 75%, 100% realization Tax impact Costs incurred to achieve synergies

Overview

Free cash flow

Terminal value

WACC

Other topics

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M&A - DCF and M&A analysisSensitivity 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

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M&A - DCF and M&A analysisCompanies 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

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Agenda

Page


Merger consequences



Introduction 1

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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

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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 acquirorshare 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 companys peer group versus the other over the

selected time horizon

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Ratio at $12.00 Current1

Last month1

Last 3 months1

Last 6 months1

Last 12 months1

Acquiror shares per Target share 0.347x 0.194x 0.184x 0.203x 0.236x 0.270x

Implied Target share price3 $12.00 $6.70 $6.38 $7.02 $8.15 $9.33

$12.00 ratio as a premium 0% 79.1% 88.2% 71.0% 47.3% 28.7%

Implied Target pro forma ownership 38.7% 24.6% 23.6% 25.6% 28.9% 32.2%

Source:

Illustrative historical trading and exchange ratio analysis

0.00x

0.05x

0.10x

0.15x

0.20x

0.25x

0.30x

0.35x

0.40x

0.45x

Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02

Historical exchange ratioHistorical exchange ratio

At $12 per share = 0.347x

Current = 0.194x

More favorableto Target

Less favorableto Target

Current stock price2 Current market capitalization2

Acquiror Target Acquiror Target

$34.60 $6.70 $274.8 $89.7

# of acquiror shares per target share

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

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Contribution analysis

Compares the relative equity valuation of two parties to their respective contribution to a combined companys 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

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Relative contribution analysis

Implied equity value Implied

Acquiror 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 value $38,450 $19,592 $58,042 $18,150 $7,653 0.4340x

% contribution 66.2% 33.8% 70.3% 29.7%

EBITDA

2004E $5,275 $3,528 $8,803 $14,482 $11,322 0.8046x

% contribution 59.9% 40.1% 56.1% 43.9%

2005E $5,320 $3,253 $8,573 $15,716 $10,087 0.6606x

% contribution 62.1% 37.9% 60.9% 39.1%

Net income

2004E $1,790 $1,210 $3,000 $15,397 $10,406 0.6956x

% contribution 59.7% 40.3% 59.7% 40.3%

2005E $2,018 $1,380 $3,398 $15,326 $10,477 0.7036x

% contribution 59.4% 40.6% 59.4% 40.6%

$ millions$ millions

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

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29.7% 29.7%

43.9% 39.1% 40.3% 40.6%

70.3% 70.3%

56.1% 60.9% 59.7% 59.4%

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

Target Acquiror

Sample contribution analysis

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

$25,308 $58,042 $8,803 $8,573 $3,000 $3,398

Relative ownership

Exchange ratio 0.5385x

Target 35.0%

Acquiror 65.0%

Offer =35.0%

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Calculating the implied exchange ratio

Implied exchange ratio (equity value metrics)Implied exchange ratio (equity value metrics)Company statisticsCompany statistics

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

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Calculating the implied exchange ratio (contd)

Company statisticsCompany 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

Implied exchange ratio (firm value metrics)Implied exchange ratio (firm value metrics)

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 60.9%

Fully-diluted acquiror share count 531

Pro forma shares outstanding to yield 61.0% acquiror ownership

871

Implied shares issued to target 340

Fully-diluted target share count 515

Implied exchange ratio based on EBITDA (338 / 515) 0.66x

Natural exchange ratio based on current share prices ($14.85 / $34.22)

0.43x

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Class exercise

Company statisticsCompany statistics

Acquiror


Fully-diluted share count (mm) 110.3

Net debt 450

EBITDA 172

Net income 65

Target


Fully-diluted share count 30.4

Net debt 295

EBITDA 81

Net income 25

Calculate the % contribution based on the EBITDA and the Net income

What is the implied exchange ratio?

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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 determining an appropriate exchange ratio / ownership percentage

High/Low and Low/High High/High and Low/Low

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Sample relative value football field: Target valuation

$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

Implied offer1 = $8.46

1 Based on the offer exchange ratio of 0.311x and Pedros 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

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 EBITof $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

Price per sharePrice per share

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Sample relative value football field: Acquiror valuation

$43.25

$29.50$29.25$28.00

$33.00

$22.50$20.50

$30.75

$26.50

$21.00$21.28

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

Current = $27.19

52-weekhigh/low

Discount rate 9% to 13%EBITDA with exit multiple

of 11.0x to 13.0x

DCF analysis2Public 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 EPSof $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

Price per sharePrice per share

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Documents

subject company

tax analyses

state income tax structure

state income tax treatment

d e c e

state income tax strategy

jpmorgan client

e r g e r