J.V. Rizzi August, 2007. Strategic Issues Do I make the acquisition? Valuation How much do I pay? Financing How do I pay? Integration Implementation of.

J.V. RizziAugust, 2007

Strategic Issues • Do I make the acquisition?

Valuation • How much do I pay?

Financing • How do I pay?

Integration • Implementation of acquisition

Tactics • How do I make the offer?

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Market • What is the price?

Market Conditions • Product availability

• Conversion• Accrual to Cash• Cost to Market

• Starting Point• Private Firm: Asset Valuation (LHS)• Public Firm: Liabilities (RHS)• Note: Private/Public Market arbitrage

• Value Gaps• Expectation• Strategic

• Price ≠ Value• Note: Both price and value are dynamic concepts

• Firms Compete in Two Markets• Product Markets: For Customers• Financial Markets: For Capital

• Passive Trading Price• Control Price

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• Other• Distress• Employees• Other (community, retirees, etc.)

• Ordinarily, value is independent of claims issued• Claims can impact value through their incentive on management behavior

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Assets (LHS)

Assets in Place

Growth

Opportunities

Claims (RHS)

Other

DebtEquity

Taxes (Govt)

=

• A bird in the hand is worth ….two in the bush

◦ How certain are you that there are birds in the bush?◦ When will they emerge and how many will there be?◦ What is the risk-free interest rate (i.e. the yield on long

term sovereign bonds)?

Answer these three questions and …you will know the maximum value of the

bush!

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• When new businesses and rapidly changing industries are under examination, no one can anticipate the number of birds about to emerge.

◦ In these cases, any investment would be considered speculative

◦ - Speculation - the focus is not on what the asset will produce, but rather on what the next fellow will pay for it…

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Valuation Overview

V = MAX (liquidation, Going Concern, Third Party Sale)

method used depends on point of life cycle and market conditions – value of asset with no cash flow is only what someone will pay you for it (Sardine theorem)

TPS – Startup GC – Mature Liq - Decline

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Market Size

Emerging High Growth Mature Market Stage

Independent Value

BuyerDrivenValue

Timing

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Enterprise (or controlling interest value)

Premium for Control

Marketable minority-interest value(Wall Street Journal Listed Price)

Non-marketable minority-interest value

Controlling shareholders (those who own more than 50% in most cases) have the powerto declare dividends, sell assets, Change corporate bylaws , and more

• Free Cash Flow (WACC) – Focus of our discussion• Best known method• Best used for stable capital structure

• Adjust to fit rapidly changing capital structure by using an assumed target capital structure (BBB+/A-)

• Capital Cash Flow (APV)• Less well known• Best for rapidly changing capital structures

• Equity Cash Flows• Best used with complex equity flows• Used by financial sponsors

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Plus DepreciationLess Capital Expenditures

Less Working Capital Increases

Equity Cash Flow

Subtract Actual TaxesTax Rate + (EBIT – Interest)

Operating Cash Flow

Discount at Expected Asset Return

Capital Cash Flow

Subtract Actual TaxesTax Rate + (EBIT – Interest)

Free Cash Flow

Earning Before Interest and TaxesEBIT

Discount at Expected Equity Return

Less InterestLess Debt PaymentsPlus Debt Issuance

Subtract Hypothetical TaxesStatutory Tax Rate x EBIT

Discount at WACC

• A Discounted Cash Flow method that applies a discount rate to the projected free cash flows generated by the firm. There are three primary inputs in the DCF analysis:

◦ Project Cash Flows are prepared using management’s best estimate of company and industry factors (seasonality, cyclicality, etc.) or implied from the current stock price. Should reflect the period of abnormal growth based on competitive considerations.

◦ Terminal value is the portion of the firm value after the forecast horizon. It can often represent a significant percentage of the total firm value. Represents the value of assets in place.

◦ Discount rate

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• Forecast Free Cash Flow◦ Identify components of free cash flow◦ Develop integrated historical perspective◦ Determine forecast assumptions and scenarios◦ Calculate and evaluate the forecast

• Estimating the cost of capital◦ Develop target market value debt and equity weights◦ Estimate cost of debt◦ Estimate cost of equity

• Estimate Continuing (Terminal) Value◦ Determine the relationship between continuing value and DCF◦ Decide the forecast horizon◦ Discount to the present

• Calculating and interpreting results◦ Develop and test results◦ Interpret results within decision context

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• Free Cash Flow◦ EBITDA – (Taxes + CAPEX +/- Working Capital)◦ An example is shown below:

2005 2006 2007 2008 2009

EBIT 324 350 378 408 441

DEPRECIATION EXPENSE 12 15 18 21 24

AMORTIZATION EXPENSE 5 5 5 5 5

EBITDA 341 370 401 434 470

CAPITAL EXPENDITURES (10) (12) (14) (16) (18)

INCREMENTAL WORKING

CAPITAL(10) (10) (11) (12) (13)

CASH TAXES (65) (70) (76) (82) (88)

FREE CASH FLOW 256 278 300 325 351

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Fin 70410 M&A Fall 2007Source: PLI

• Issues◦ Adjustments (beware of solving for cash flows to

justify price)◦ Normalization

• Value Test

• Reverse Engineer◦ Firm◦ Peers

• Tie Into◦ Compensation◦ Covenants

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• Terminal Value◦ Terminal Value is the value of the cash flows after the forecast period.◦ The formula for calculating the terminal value is given below:

◦ After finding the terminal value, it must also be discounted at the same rate as the other cash flows.

◦ Beware of using EBITDA multiples – overstates due to take-over premiums

◦ On average, the Terminal Value accounts for over 80% of the total value.

◦ The credibility of management’s projections can be tested by remembering that the terminal value calculation is nothing more than applying a multiple to the final years cash flow (the implied multiple based on the WACC and growth rate = 1/[WACC-g]).

Terminal Value = FCFn * (1+g)

(WACC – g)

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:

WACC = Wd * Kd + We * Ke

Weighting

Total Debt

Total Equity

Total

Capitalization

USD %

1,254 75%

742 25%

1,996

After Tax Costs of Debt (use current

rates)

= (Risk Free Rate + Spread) ( 1-Tax Rate)

= (Rf + Rs) ( 1-T)

Cost of Equity (Rule of Thumb: 2*Rf)

= Risk Free + Beta (Equity Premium)

= Rf + B (Rm – Rf)

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Discounted Cash Flow Analysis (DCF) - OverviewDiscounted Cash Flow Analysis (DCF) - Overview

Advantages

• Theoretically, it is the most academically compelling valuation method.

• It is forward-looking and incorporates an expected operating strategy.

• Capital markets volatility has limited impact on the analysis.

• Recognizes the time value of money.

• Useful when there are not many comparable companies.

Disadvantages

• Highly sensitive to assumptions used (WACC, long term growth rate, terminal value, etc.).

• Forecasted future cash flows are uncertain.

• Terminal value can have a significant impact on valuation.

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• ABV is a cost based liquidation approach with mark to market adjustments◦ Balance sheets measure money spent, not value◦ Economic balance sheet needed (i.e. mark to market)

• Concept is to adjust for hidden assets and liabilities

• Potential Pitfall: Current Cost =/= Net Realizable Value

Hidden Assets Hidden Liabilities

• LIFO Reserve • Operating Leases

• PPE Appreciation • Underfunded Pension Plans

• Investment Appreciation • Underfunded Medical Benefit

• Overfunded Pension Plans • Guaranteed debt of others

• Net Operating Losses (NOL) • Contingencies (EPA, legal)

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20

Negative Synergies: Management as an off-balance sheet liability; conglomerate discount

Analysis: Earnings PEX Value

BU1BU2BU3BU4BU5

SOTPCurrent standalone value x

Gap

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• Multiples measure firm value by comparing it to other similar entities or transactions. The most common multiples are:

Comparable Public Trading Multiples

•Enterprise Value/EBITDA

Premiums:

- Liquidity

- Control

• Price/Earnings Ratio

•Price / Book Ratio

Comparable Transaction Multiples

• Deal Value / EBITDA Adjustments:

- Size

- Timing• Premium / Discounts

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• Why multiples are easy to calculate and used by many market analysts, there are some shortfalls:◦ The approach is inexact and can be skewed by outliers◦ Each firm is unique and it is therefore difficult to find

real comparables (companies or transactions)◦ Companies often manage around them

• Multiples are useful for:◦ Validation of DCF approach◦ Private company analysis◦ Segment valuation for multi-segment businesses

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Comparable Company Analysis (“Comps”) - OverviewComparable Company Analysis (“Comps”) - Overview

Advantages

• Provides an objective comparison of companies accounting for industry trends, risk factors and profitability expectations.

• Usually represented as forward looking, but also can be viewed as backward looking.

• Effective way of determining company valuation when no control premium is involved.

Disadvantages

• Putting together a list of truly comparable companies can often be difficult.

• Issues that are specific to a particular company may limit the strength of the valuation analysis.

• Does not account for control premiums or synergies gained in an acquisition.

• Analysis is focused on current market conditions, industry trends and growth prospects and ignores longer term issues.

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Precedent Transactions Analysis (“Precedents”) - OverviewPrecedent Transactions Analysis (“Precedents”) - Overview

Advantages

• Based on public information

•Information is based on historical information.

• Provides index of premiums paid by buyers and accepted by sellers.

• Important to know price that was paid for similar assets in determining present value of a comparable asset for sale.

Disadvantages

• Public data can be limited.

• Hard to know all the factors and motives that went into formulation of acquisitions prices.

• The fact that a particular multiple was paid in the past does not necessarily mean it still applies today.

• Market conditions at the time of a transaction can have a large impact on valuation.

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• International Valuation

• Real Option Valuation

• LBO Valuation

• Projection Credibility

• Restructuring Context

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• International Valuation creates a number of additional issues. There are two basic ways to handle international valuation: ◦ Value (and then present value) the cash flows in local currency

at local rates and then spot into the home currency.◦ Convert the local cash flows into the home currency and

discount those cash flows.

• Other issues to be aware of:◦ Cash flows depend on foreign inflation and exchange rate◦ The appropriate tax rate depends on the different tax laws in

the home and the foreign country◦ There are two relevant interest rates (foreign and domestic)◦ Political risk

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• DCF analysis was originally intended for passive investments where there is a direct cash flow to analyze (dividends).

• When valuing business acquisitions (or real assets), DCF fails to account for indirect cash flows. There are cash flows which arise due to the sequential interdependence between acquisitions / projects (i.e. an initial acquisition may have unattractive direct cash flows when viewed in isolation, but may be attractive when considering that it allows for a future opportunity to undertake another valuable investment / project.

• To overcome this shortfall, it is useful to think of a firm’s value in two parts. The first part is the DCF of the assets already in place, and the second is the value of the opportunity (or option) to invest in potentially valuable future projects.

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Merger Type Financial Strategic

Cash Flows Direct Indirect

Asset Base Existing Future

Technique DCF Option Pricing

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• The following table classifies the factors involved in determining a firm’s value under the real option valuation approach:

• By failing to use the real option value approach, the value of the strategic acquisitions involving indirect cash flows will be understated by a DCF analysis.

Analogy: valuing a convertible bond by only analyzing its coupon yield. Internet Firms: Today’s real options become tomorrow’s cash cows.

• Usefulness depends on market conditions:◦ Financial Buyers◦ Strategic Buyers

• Approach: Maximize utilization of debt capacity

• Evaluate against expected ROI on required equity

Purchase Price = (D/EBITA)*EBITDA + (1-D/Cap)[Cap/D*(D/EBITDA)*EBITDA)]

max

Maximum Debt Required Equity

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Assets Liabilities &

Equity

Past Investment

Decisions

1. Operations

(Assets in Place)

Debt Claims

Future Investment

Decisions

2. Opportunities

(Real Options)

3. Equity Claims Securities Issues

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Problems Recommended

valution MethodLess

Formal

More

Formal

Operations

(Assets

in

Place)

Adjusted

Present

Value

Sales

Multiples

Book

Value

Multiples

EBIT

Multiples

Cash

Flow

Multiples

WACC

Based

DCF

Monte

Carlo

Simulation

Opportuni-

ties

(Real

Options)

Simple

Option

Pricing

Installed

Base

Multiples

Customer,

Subscriber

Multiples

Decisions

Trees

Simulation:

Scenario

Analysis

Fancy Option

Pricing

Equity

Claims

Equity

Cash

Flow

Net

Income

Multiples

P/E

Ratio’s

WACC-

based

DCF

minus Debt

Simulation:

Scenario

Analysis

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• Finding a valuation range:

◦ Use many estimators.◦ Exercise the estimators to get many estimates.◦ Scrutinize the assumptions and “key bets”.◦ Assess hidden options.◦ Consider unquantifiable factors.◦ Triangulate.

Source: Robert F. Bruner

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$0

$50

$100

$150

$200

$250

OptionOption

DCF

Peer P/E

Breakup

Transaction P/E

Mkt. Price

Source: Robert F. Bruner

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D C F E s t i m a t e s

V e n t u r e C a p i t a l / P r i v a t e

E q u i t y A p p r o a c h

M u l t i p l e s E s t i m a t e s• p e e r f i r m s• c o m p a r a b l e

t r a n s a c t i o n s R a n g e o f I n t r i n s i c

V a l u e

T r i a n g u l a t i o n a m o n g t h e e s t i m a t e s

C a s h F l o w s

eedd wkw)t1(iWACC

O p t i o n - b a s e d E s t i m a t e s

C u r r e n t M a r k e t V a l u e

B o o k V a l u e

L i q u i d a t i o n V a l u e

R e p l a c e m e n t V a l u e

F r e e C a s h F l o w a p p r o a c h

A d j u s t e d P r e s e n t V a l u e a p p r o a c h

R e s i d u a l C a s h F l o w a p p r o a c h

FMFe RRRk

E/D)t1(1uL

T e r m i n a l V a l u e s

gk

)g1(CFTV

C o s t o f C a p i t a l

Source: Robert F. Bruner

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Overview of Valuation Methodology

Summary of Valuation Methodology Valuation Method

Descrption

Comments

Comparable Company Trading Analysis

Provides Company’s implied vale in the public equity markets through analysis of comparable companies’ trading and operating statistics

Does not include control premium “Fully Distributed” trading value Apply multiples derived from similar or “comparable”

publicly traded companies to company’s operating statistics

Reliability depends on the level of comparability of other publicly traded companies

o Industry o Range of products o Revenue base (size) o Geographical presence o Profitability o Growth

A change of control premium may be applied to estimate private market value

Precedent Transactions Analysis

Provides private market benchmark in a “change of control” scenario

Does include control premium Apply multiples derived from similar or “comparable”

precedent M&A Transactions o Company’s operating data

Reliability depends on number of recent precedent transactions and their degree of comparability, as well as the relative supply and demand for a certain type of asset at the time of the transaction

Market cycles and volatility may also affect valuation

Discounted Cash Flow Analysis

Theoretical valuation Project the Company’s future operating cash flows for

five ears or more and calculate the present value of those cash flows and of the terminal value methodology

This analysis is heavily dependent on cash flow and growth characteristics of the company, and the terminal value assumption

Leverage Buyout Analysis Determine the range of prices that a financial buyer would be willing to pay for an asset assuming a range of target rates of return

This analysis is heavily dependent on the cash flow profile of the asset exit value assumption

Other Check if there are any other sources of value in a particular transaction

Net operating loss carryforwards (“NOLs”) Synergies Off balance sheet items Break-up value

Different valuation techniques might apply

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M&A Accretion/Dilution Analysis - OverviewM&A Accretion/Dilution Analysis - Overview

Advantages

• Relative Ownership Analysis- Intuitive and straightforward

- Preliminary approach to understand how the companies combine.

• Accretion/Dilution Analysis-Determines effect of the transaction- Primarily focused on EPS

• Value Creation Analysis- Assesses market reaction.

Disadvantages

• Relative Ownership Analysis

- Provides information on transaction consideration that should be further analyzed by accretion/dilution analysis.

• Accretion/Dilution Analysis

- Evaluating synergies can be very subjective

• Value Creation Analysis

- It can be difficult to understand how he market may react to long term strategic objectives.

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Vr = Standalone + Va Vp = Pre-Bid Price + Premium NVA = Va - Premium

◦ Tie into management compensation to projected synergies and real option value

◦ Ensure liquidity available for business plan tied to this

Source: Robert F. Bruner

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• Although there is no right answer, the results of the different valuation methodologies are a useful starting point for structuring a transaction.

The cash flows used for the valuation should be

the same cash flows used for structuring the

transaction

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