VALUATION OF FIRMS IN

MERGERS AND ACQUISITIONS

OKAN BAYRAK
Definitions
 A merger is a combination of two or more
corporations in which only one corporation
survives and the merged corporations go out
of business.
 Statutory merger is a merger where the
acquiring company assumes the assets and
the liabilities of the merged companies
 A subsidiary merger is a merger of two
companies where the target company
becomes a subsidiary or part of a subsidiary
of the parent company
Types of Mergers
 Horizontal Mergers
- between competing companies
 Vertical Mergers
- Between buyer-seller relation-ship companies
 Conglomerate Mergers
- Neither competitors nor buyer-seller relationship
History of Mergers and
Acquisitions Activity in United
States
 The First Wave 1897-1904
- After 1883 depression
- Horizontal mergers
- Create monopolies
 The Second Wave 1916-1929
- Oligopolies
- The Clayton Act of 1914
 The Third Wave 1965-1969
- Conglomerate Mergers
- Booming Economy
 The Fourth Wave 1981-1989
- Hostile Takeovers
- Mega-mergers
 Mergers of 1990’s
- Strategic mega-mergers
Motives and Determinants of
Mergers
 Synergy Effect
NAV= Vab –(Va+Vb) – P – E
Where Vab = combined value of the 2 firms
Vb = market value of the shares of firm B.
Va = A’s measure of its own value
P = premium paid for B
E = expenses of the operation

- Operating Synergy
- Financial Synergy
 Diversification
 Economic Motives
- Horizontal Integration
- Vertical Integration
- Tax Motives
FIRM VALUATION IN
MERGERS AND ACQUISITIONS
 Equity Valuation Models
- Balance Sheet Valuation Models
• Book Value: the net worth of a company as shown on the
balance sheet.
• Liquidation Value: the value that would be derived if the firm’s
assets were liquidated.
• Replacement Cost: the replacement cost of its assets less
its liabilities.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-2

 Dividend Discount Models

D1 D2 D3
V0 = + + + .......
1 + k (1 + k ) (1 + k )
2 3

Where Vo = value of the firm

Di = dividend in year I
k = discount rate
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-3
 The Constant Growth DDM
D0 (1 + g ) D0 (1 + g )2
V0 = + + ......
1 +k (1 + k )2

And this equation can be simplified to:

D0 (1 + g ) D
V0 = = 1
k −g k −g

where g = growth rate of dividends.

FIRM VALUATION IN MERGERS
AND ACQUISITIONS-4
 Price-Earnings Ratio
P0 1  PVGO 
= 1+
E1 k  E / k 

where PVGO = Present Value of Growth Opportunity

P0 E (1 −b )
= 1
E1 k − ROExb

Implying P/E ratio

P0 1 −b
=
E1 k − ROExb
where ROE = Return On Equity
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-5
 Cash Flow Valuation Models
- The Entity DCF Model : The entity DCF model values the value of a company as
the value of a company’s operations less the value of debt and other investor claims,
such as preferred stock, that are superior to common equity
. Value of Operations: The value of operations equals the discounted value of
expected future free cash flow.

Net Operating Profit - Adjusted Taxes

Continuing Value =
WACC

. Value of Debt

. Value of Equity
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-6
 What Drives Cash Flow and Value?
- Fundamentally to increase its value a company must
do one or more of the following:
. Increase the level of profits it earns on its existing
capital in place (earn a higher return on invested
capital).
. Increase the return on new capital investment.
. Increase its growth rate but only as long as the return
on new capital exceeds WACC.
. Reduce its cost of capital.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-7

 The Economic Profit Model: The value of a

company equals the amount of capital invested plus a
premium equal to the present value of the value created each
year going forward.
Economic Pr ofit = Invested Capital x ( ROIC − WACC )
where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital

Economic Pr ofit = NOPLAT − ( Invested Capital x WACC )

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

STEPS IN VALUATION
 Analyzing Historical Performance

NOPLAT
Return on Investment Capital =
Invested Capital

Economic Profit = NOPLAT – (Invested Capital x WACC)

FCF = Gross Cash Flow – Gross Investments

STEPS IN VALUATION-2
 Forecast Performance
- Evaluate the company’s strategic position, company’s
competitive advantages and disadvantages in the
industry. This will help to understand the growth
potential and ability to earn returns over WACC.
- Develop performance scenarios for the company and
the industry and critical events that are likely to
impact the performance.
- Forecast income statement and balance sheet line
items based on the scenarios.
- Check the forecast for reasonableness.
STEPS IN VALUATION-3
 Estimating The Cost Of Capital

B P S
WACC = kb (1- Tc ) + k p + k s
V V V
where
kb = the pretax market expected yield to maturity on non-callable, non convertible debt
Tc = the marginal taxe rate for the entity being valued
B = the market value of interest-bearing debt
kp = the after-tax cost of capital for preferred stock
P = market value of the preferred stock
ks = the market determined opportunity cost of equity capital
S = the market value of equity

- Develop Target Market Value Weights

- Estimate The Cost of Non-equity Financing
- Estimate The Cost Of Equity Financing
STEPS IN VALUATION-4
 Estimating The Cost Of Equity Financing
- CAPM

ks = r f +  E (rm ) − r f  β

where rf = the risk-free rate of return

E(rm) = the expected rate of return on the overall market portfolio
E(rm)- rf = market risk premium
В = the systematic risk of equity

. Determining the Risk-free Rate (10-year bond rate)

. Determining The Market Risk premium 5 to 6 percent rate is used for the US
companies
. Estimating The Beta
STEPS IN VALUATION-5
 The Arbitrage Pricing Model (APM)

ks = rf +  E ( F1 ) − r f  β 1 +  E ( F2 ) − r f  β 2 + ....
where E(Fk ) = the expected rate of return on a portfolio that mimics the kth factor and is
independent of all others.
Beta k = the sentivity of the stock return to the kth factor.
STEPS IN VALUATION-6
 Estimating The Continuing Value
- Selecting an Appropriate Technique
. Long explicit forecast approach
. Growing free cash flow perpetuity formula
. Economic profit technique
Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC − WACC )
CV = +
WACC WACC (WACC − g )
where
Economic Profit T+1 = the normalized economic profit in the first year after the explicit
forecast period.
NOPLAT T+1 = the normalized NOPLAT in the first year after the explicit forecast period.
g = the expected growth rate of return in NOPLAT in perpetuity
ROIC = the expected rate of return on net new investment.
WACC = weighted average cost of capital
STEPS IN VALUATION-7
 Calculating and Interpreting Results
- Calculating And Testing The Results
- Interpreting The Results Within The
Decision Context
HP-COMPAQ MERGER CASE
The HP/Compaq merger. By The Numbers:
HIGH-END
High-endUnix Servers: Worldwide(2000) High-end Unix servers: US (2000)
Factory Factory
Revenues ($m) MarketShare Revenues ($m) Market Share
Hewlett-Packard 512 11.4% Hewlett-Packard 124 6.1%
Compaq 134 3.0% Compaq 66 3.3%

ClosestRival: Sun Microsystems with factory revenues of Closest Rival: Sun Microsystems with factory
$2.1 billion and a 47.1%market share revenues of $1.2 billion and a 60.1% market share

MID-RANGE
Mid-rangeUnix servers: Worldwide(2000) Mid-rangeUnix servers: US (2000)
Factory Factory
Revenues ($m) MarketShare Revenues ($m) Market Share
Hewlett-Packard 3,673 30.3% Hewlett-Packard 1552 28.2%
Compaq 488 4.0% Compaq 296 5.4%

ClosestRival: Sun Microsystems with $2.8 billion in MarketLeader: Sun Microsystems with revenues of $1.7
factory revenue and a 23.5%market share billion and a 30.5%market share)

PERSONAL COMPUTERS
PC Shipments: Worldwide(inthousands of units) PC Shipments: US(inthousands of units)
Hewlett- Hewlett-
Packard Compaq Packard Compaq
Units (q2/01) 2,065 3,590 Units (q2/01) 991 1,332
Share(q2/01) 6.9% 12.1% Share(q2/01) 9.4% 12.7%
Units (q2/00) 2,260 4.011 Units (q2/00) 1,221 2,293
Share(q2/00) 7.4% 13.2% Share(q2/00) 10.7% 20.1%
Growth -8.6% -10.5% Growth -18.8% --21.3%

Marketleader: Dell Computer Corp. with a 24%market

share and a 9.8%growth in the same period.
LAPTOPS/NOTEBOOKS SMART HANDHELDS
Worldwideshipments of portablecomputers
(thousands of units) Shipments Share
Hewlett- (in000s) 2000 Rank
Packard Compaq
Hewlett-Packard 254 3.8% 4
Units(q4/00) 318 817
Compaq 129 1.9% 9
Share(q4/00) 4.5% 11.6%
Units(q4/99) 139 739 MarketLeader: Palmwitha52.9%marketshareand
3.53millionunits.
HP-COMPAQ MERGER CASE-2
 Arguments About The Merger
- Supporters
. HP-COMPAQ will become the leader in most of the
sub-sectors
. Ability to offer better solutions to customer’s demands
. New strategic position will make it possible to increase
R&D efforts and customer research
. Decrease in costs and increase in profitability
. Financial strength to provide chances to invest in new
profitable areas
HP-COMPAQ MERGER CASE-3
 Arguments About The Merger
- Opponents
. Acquiring market share will not mean the leadership
. No new significant technology capabilities added to HP
. Large stocks will increase the riskiness of the
company (Credit rating of the HP is lowered after the
merger announcement)
. Diminishing economies of scale sector which both
companies have already a great scale.
HP-COMPAQ MERGER CASE-4
 Valuation Process
- Relative Historical Stock Price Performance
Historical Exchange Ratios
Period ending August 31, Average Exchange Ratio Implied Premium (%)
2001
August 31 2001 0.532 18.9
10-Day Average 0.544 16.3
20-Day Average 0.568 11.3
30 Day Average 0.573 10.3
3 Months Average 0.557 13.7
6 Months Average 0.584 8.2
9 Months Average 0.591 7.1
12 Months Average 0.596 6.1
HP-COMPAQ MERGER CASE-5
 Comparable Public Market Valuation Analysis

Firm Values As a Multiple of Revenue EBITDA and LTM EBIT

Firm Values as a Multiple of
Companies LTM Revenue LTM EBITDA LTM EBIT
Compaq 0.5 X 5.7 X 9.8 X
HP 1.0 X 12.4 X 19.8 X
Selected Group 0.2-2.1 X 5.3-18.2 X 8.9-19.9 X

Closing Stock Prices As a Multiple of EPS

Closing Stock Price as a Multiple of
Companies 2001 EPS 2002 EPS 2003 EPS
Compaq 34.3 X 18.4 X 14.0 X
HP 35.7 X 19.2 X 12.5 X
Selected Group 18.5-57.3 X 10.7-27.1 X 9.3-19.5 X
HP-COMPAQ MERGER CASE-6
 Similar Transactions Premium Analysis
 Salomon Smith Barney's analysis resulted in a range of premiums of:
- (8)% to 46% over exchange ratios implied by average prices for the 10
trading days prior to announcement, with a median premium of 23%.
- (7)% to 58% over exchange ratios implied by average prices for the 20
trading days prior to announcement, with a median premium of 23%.
- (12)% to (29) over exchange ratios implied by average prices for the 1
trading days prior to announcement with a median premium of 15%.

Based on its analysis, Salomon Smith Barney determined a range of

implied exchange ratios of 0.585x to 0.680x by applying the range of
premiums for other transactions to the closing prices of Compaq and HP
on August 31, 2001 and the average historical exchange ratio for Compaq
and HP for the 10-day period ending on August 31, 2001, as appropriate.
HP-COMPAQ MERGER CASE-7
 Contribution Analysis
Percentage Contribution Analysis
Percentage
Period Contribution
Compaq HP
Revenues LTM 46.0 54.0
2001 Estimated 44.0 56.0
2002 Estimated 44.0 56.0
2003 Estimated 44.0 56.0
LTM 45.7 54.3
2001 Estimated 38.1 61.9
2002 Estimated 36.9 63.1
2003 Estimated 32.7 67.3
Net Income 2001 Estimated 32.3 67.7
Next Four Fiscal Q 31.6 68.4
2002 Estimated 32.7 67.3
2003 Estimated 29.2 70.8
At Market Equity Value 31.7 68.3
HP-COMPAQ MERGER CASE-8
 Pro Forma Earnings Per Share Impact to Compaq

Accretion/Dilution Analysis
EPS EPS
Accretion/Dilution 2002 2003
Compaq stand-alone 0.67 0.88
HP stand-alone 1.21 1.86
Combined entity pro-forma, excluding proj. synergies 0.74 1.09
Combined entity pro-forma, including proj. synergies 1.05 1.51
Accretion/(Dilution) to Compaq, excluding proj. synergies 11% 24%
Accretion/(Dilution) to Compaq, including proj. synergies 57% 71%