Using Financial Modeling Techniques to Value and Structure Mergers &

Acquisitions
 M & A an d O th er
R e s tr u c t u ri n g
A c ti v i ti e s

M & A M & A P roce ss Deal A lte r n a t iv e

E n v ir o n m e n t S t ru c tu r i n g R e s tr u c t u r in g
S tr a t e g ie s

M o ti v a ti o n s B u s in e s s & P u b l ic & D iv e s t i t u r e s ,
fo r M & A A c q u i s itio n P l a n s P r iv a t e C o m p a n y S p i n - O ff s , &
V a l u a ti o n C a rv e - O u t s

C o m m o n T a ke o ver S e a r c h T h ro u g h F in a n c ia l B an kru p tcy &

T a c ti c s a n d C l o s i n g A c t i v it i e s M o d e lin g L iq u id a t io n
D e fe n s e s T e c h n iq u e s

A l t e r n a t iv e
S t r u c tu r e s

T a x & A c c o u n ti n g
Is s u e s
 Learning Objectives

• Primary learning objective: Provide students with a basic understanding of how

to use financial models to value and structure M&As
• Secondary learning objectives: Provide students with a knowledge of
– How to estimate the value of synergy;
– Commonly used relationships in building M&A valuation models; and
– How to use models to estimate the purchase price range, initial offer price
for a target firm, and to evaluate the feasibility of financing the proposed
offer price.
 M&A Model Building Process

• Step 1: Value acquirer and target as standalone

firms
• Step 2: Value acquirer and target firms including
synergy
• Step 3: Determine initial offer price for target
firm
• Step 4: Determine the combined firms’ ability to
finance the transaction
 Step 1: Value Acquirer & Target as Standalone Firms

• Understand specific firm and industry competitive dynamics

• Normalize 3-5 years of historical financial information
• Project normalized cash flow based on
– Expected market growth
– Competitive industry dynamics
 Step 2: Value Acquirer & Target Firms Including Synergy

• Estimate
– Sources and destroyers of value
– Implementation costs incurred to realize synergy
• Consolidate acquirer and target projected financials including the effects of
synergy
• Estimate net synergy (consolidated firms less values of target and acquirer)
 Adjusting Combined Acquirer/Target Company
Projections For Estimated Synergy
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales1 $200 $220 $242 $266 $293
Cost of sales2 $160 $176 $194 $213 $234
Anticipated Cost Savings
Direct labor $2 $4 $6 $8 $8
Indirect labor $1 $2 $4 $4 $4
Purchased materials $2 $3 $5 $5 $5
Selling expenses $1 $3 $5 $5 $5
Total $6 $12 $20 $23 $23
Cost of sales (incl. synergy) $154 $164 $174 $190 $211
Cost of sales/Net sales 77.0% 74.6% 71.9% 71.4% 72.0%
1
Combined company net sales projected to grow 10% annually during forecast period.
2
Cost of sales before synergy assumed to be 80% of net sales during forecast period.
 Step 3: Determine Initial Offer Price for Target Firm

• Estimate minimum and maximum purchase price range

• Determine amount of synergy willing to share with target shareholders

• Determine appropriate composition of offer price

 Step 4: Determine Combined Firms’ Ability to Finance Transaction

• Estimate impact of alternative financing structures

• Select financing structure that
– Meets acquirer’s required financial returns and desired financial structure;
– Meets target’s primary financial and non-financial needs;
– Does not raise borrowing costs; and
– Is supportable by the combined firms.
 Calculating EPS and Post-Merger Share Price

Acquiring Company is considering

the acquisition of Target Acquiring Target
Company in a share for share Company Company
transaction in which Target
Company would receive Net $281,500 $62,500
$84.30 for each share of its Earnings
common stock. Acquiring
Company does not expect any
change in its price/earnings Shares 112,000 18,750
multiple after the merger. Outstanding
Selected data are presented
as follows: Market $56.25 $62.50
Price Per
Share
 Calculating EPS and Post-Merger Share Price: Solution

• Exchange ratio = Price per share offered for Target Company/ Price
per share for Acquiring Company = $84.30 / $56.25 = 1.5
• New shares issued by Acquiring Company = 18,750 (shares of Target
Company) x 1.5 (share exchange ratio) = 28,125
• Total shares outstanding of the combined firms = 112,000 + 28,125 =
140,125
• Post merger EPS of the combined firms = ($281,500 + $62,500) /
140,125 = $2.46
• Pre merger P/E = Pre-merger price per share / pre-merger EPS =
$56.25 / $2.51 = 22.4
• Post-merger share price = Post-merger EPS x Pre-merger P/E = $2.46
x 22.4 = $55.10 (as compared to $56.25 pre-merger share price)

Note: Example assumes no increase in EPS due to synergy for simplicity.

 Model Worksheet Layout1

Assumptions Section

Historical Period Forecast Period

Refers to model template contained on CDROM accompanying textbook.

1
 Using M&A Model Template1
• Model worksheet layout: Assumptions (top panel); historical period
data (lower left panel); forecast period data (lower right panel).
• Displaying Microsoft Excel formula results on a worksheet:
– On Tools menu, click Options, and then click the View Tab.
– To display formulas in cells, select the formulas check box; to
display the formula’s results, clear the check box.
• In place of existing historical data, fill in the data in cells not
containing formulas. Do not delete existing formulas in “historical
period” unless you wish to customize the model.
• Do not delete or change formulas in the “forecast period” cells
unless you wish to customize the model. To replace existing data,
change the forecast assumptions at the top of the spreadsheet.

1 Refers to model template found on CDROM accompanying textbook.

 Model Historical Data Input Requirements:
Income Statement

• Net sales
• Depreciation expense
• Total cost of sales
• Sales expense
• General and administrative expense
• Amortization of intangibles
• Other expense (income) net
• Interest income
• Interest expense
• Taxes
 Model Historical Data Input Requirements:
Balance Sheet

• Cash
• Other current assets
• Gross fixed assets
• Accumulated depreciation and amortization
• Other assets
• Current liabilities
• Existing long-term debt
• Other liabilities
• Common Stock
• Retained earnings
• Shares outstanding
 Model Balance Sheet Adjustment
Mechanism Methodology

• Separate current assets into operating and non-operating

assets.
• Operating assets include minimum operating cash
balances and other operating assets (e.g., receivables,
inventories, and assets such as prepaid items).
• Current non-operating assets are investments (i.e., cash
generated in excess of minimum operating balances
invested in short-term marketable securities).
• The firm issues new debt whenever cash outflows exceed
cash inflows.
• The firm’s investments increase whenever cash outflows
are less than cash inflows.
 Model Balance Sheet Adjustment
Mechanism Illustration

Assets Liabilities
Current Operating Assets Current Liabilities (CL)
Cash Needed for Operations (C) Other Liabilities (OL)
Other Current Assets (OCA)
Total Current Operating Assets (TCOA)
Short-Term (Non-Oper.) Investments (I) Long-Term Debt (LTD)
Net Fixed Assets (NFA) Existing Debt (ED)
Other Assets (OA) New Debt (ND)
Total Assets (TA) Total Liabilities (TL)
Shareholders’ Equity (SE)
Cash Outflows Exceed Cash Inflows: If (TA – I)>(TL – ND) + SE, ΔND > 0 (i.e., the
firm must borrow), otherwise ΔND = 0
Cash Outflows Less Than Cash Inflows: If (TA – I) < (TL – ND) + SE, ΔI > 0 (i.e.,
the firm’s non-operating cash increases), otherwise ΔI = 0
Cash Outflows Equal Cash Inflows: If (TA – I) = (TL – ND) + SE = 0, ΔND=ΔI= 0
 Hints on Using Financial Models

• Turn on Excel’s Iteration Command to accommodate

“circular references” inherent in the model.
– For example, Δ cash and investments affects interest
income, which in turn impacts net income and Δ cash
and investments.
• To turn on the iteration command,
– On the menu bar, click on Tools >>> Options >>>
Calculations
– Select iteration and specify the maximum number of
iterations and the amount of change.
 Things to Remember…

• Financial modeling facilitates the process of valuation, deal

structuring, and selection of the appropriate financing plan.
• The process entails the following four steps:
– Valuing the acquirer and target firms as standalone
businesses using multiple valuation methods
– Valuing consolidated acquirer and target firms including the
effects of net synergy
– Determining the initial offer price for the target firm from
within the price range defined by the minimum and
maximum purchase prices
– Determining the combined firms’ ability to finance initial offer
price