1. Using Financial Modeling Techniques to Value and Structure Mergers & Acquisitions

2. Tact is for people not witty enough to be sarcastic. --Anonymous

3. Course Layout: M&A & Other Restructuring Activities Part IV: Deal Structuring & Financing Part II: M&A Process Part I: M&A Environment Payment & Legal Considerations Public Company Valuation Financial Modeling Techniques M&A Integration Business & Acquisition Plans Search through Closing Activities Part V: Alternative Strategies Accounting & Tax Considerations Business Alliances Divestitures, Spin-Offs & Carve-Outs Bankruptcy & Liquidation Regulatory Considerations Motivations for M&A Part III: M&A Valuation & Modeling Takeover Tactics and Defenses Financing Strategies Private Company Valuation Cross-Border Transactions

4. 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.

5. 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

6. Step 1: Value Acquirer & Target as Standalone Firms Use the 5-forces model to understand determinants of profits and cash flow, i.e., bargaining strength of –Customers (size, number, price sensitivity) –Current competitors (market share, differentiation) –Potential entrants (entry barriers, relative costs) –Substitutes (availability, prices, switching costs) –Suppliers (size, number, uniqueness) relative to industry participants. Normalize 3-5 years of historical financial information Project normalized cash flow based on expected market growth and changes in profits/cash flow determinants.

7. Applying the 5-Forces Model to Project Acquirer and Target Firm Financial Performance How have the following factors affected revenue growth and profit margins in the acquirer and target firms’ industry historically? –Customers (size, number, price sensitivity) –Current competitors (market share, differentiation) –Potential entrants (entry barriers, relative costs) –Substitutes (availability, prices, switching costs) –Suppliers (size, number, uniqueness) How will these factors change (if at all) to impact future revenue growth and profit margins of these firms? –Customers (size, number, price sensitivity) –Current competitors (market share, differentiation) –Potential entrants (entry barriers, relative costs) –Substitutes (availability, prices, switching costs) –Suppliers (size, number, uniqueness) Key questions: 1.How might changes in the bargaining power of customers and suppliers relative to the acquirer and target firms impact product pricing, costs, and profit margins? 2.How might substitutes and new entrants affect product pricing and profit margins?

8. 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)

9. Adjusting Combined Acquirer/Target Company Projections For Estimated Synergy Year 1Year 2Year 3Year 4Year 5 Net Sales 1 $200$220$242$266$293 Cost of sales 2 $160$176$194$213$234 Anticipated Cost Savings Direct labor$2$4$6$8 Indirect labor$1$2$4 Purchased materials$2$3$5 Selling expenses$1$3$5 Total$6$12$20$22 Cost of sales (incl. synergy)$154$164$174$191$212 Cost of sales/Net sales77.0%74.6%71.9%71.8%72.4% 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.

10. Discussion Questions 1. How would you adjust the combined firm’s income statement for cost savings due to improved worker productivity? (Hint: Determine the line item most directly affected by the improvement in productivity.) 2.How would you adjust the combined firm’s income statement for additional revenue generated from cross- selling (i.e., Acquirer selling its products to the target’s customers and vice versa)? 3.How would you reflect the expenses incurred in implementing the worker productivity improvement and cross-selling programs on the combined firm’s income statement?

11. 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

12. Calculating Initial Offer Price (PV IOP ) 1.PV MIN = PV T or PV MV, whichever is greater for a stock purchase (liquidation value of net acquired assets for an asset purchase) 2.PV MAX = PV MIN + PV NS, where PV NS = PV SOV – PV DOV 3.PV IOP = PV MIN + αPV NS, where 0 ≤ α ≤ 1 Offer price range = (PV T or MV T ) < PV IOP < (PV T or MV T ) + PV NS Where PV MIN = PV minimum purchase price PV T = PV standalone value of target firm PV MV = Market value target firm PV MAX = PV maximum purchase price PV NS = PV of net synergy PV SOV = PV of sources of value PV DOV = PV of destroyers of value α = Portion of net synergy shared with target company shareholders Offer price per share = PV IOP / Target’s fully diluted shares outstanding 1 How is “α” determined? 1 Fully diluted shares outstanding includes basic shares plus shares resulting from exercising “in the money” options and conversion of convertible debt and preferred stock.

13. Calculating Offer Price Per Share and Target’s Equity Value Under Alternative Payment Scenarios All Stock Transaction: Offer Price Per Share = Share Exchange Ratio 1 x Acquirer’s Share Price = Offer Price Per Target Share x Acquirer’s Share Price Acquirer’s Share Price Equity Value = Offer Price Per Share x Target’s Fully Diluted Shares Outstanding All Cash Transaction: Offer Price Per Share = Cash Offer Per Target Share Equity Value = Cash Offer Per Target Share x Target’s Fully Diluted Shares Outstanding Cash and Stock Transaction: Offer Price Per Share = Cash Offer Per Share + (Share Exchange Ratio x Acquirer’s Share Price) Equity Value = [Cash Offer Per Share + (Share Exchange Ratio x Acquirer’s Share Price)] x Target’s Fully Diluted Shares Outstanding 1 When share exchange ratios (SERs) are fixed, the value of the transaction can change due to fluctuations in the acquirer’s share price. Assume the SER is 2 and the acquirer’s share price is $50, the offer price per share is $100. However, if the acquirer’s share price falls to $40 or increases to $60 before closing, the offer price is $80 and $120, respectively. Under a floating SER, the dollar value of the offer price per share is fixed and the number of shares exchanged varies with the value of the acquirer’s share price. Acquirer share price changes require re-estimating the SER. For example, if the acquirer’s share price falls to $40, the number of new acquirer shares issued to preserve the $100 offer price is 2.5 (i.e., $100/$40); if the acquirer’s share price rises to $60, the new SER would be 1.6667 (i.e., $100/$60). Fixed SERS are most common because the risk of changes in the offer price is shared equally by the acquirer (i.e., if acquirer’s share price rises) and the target (i.e., if the acquirer’s share price falls).

14. Calculating the Target’s Fully Diluted Shares Outstanding and Adjusting Equity Value (If Converted Method) Assumptions about TargetComment Basic Shares Outstanding2,000,000 In-the-Money Options 1 150,000Exercise Price = $15/share Convertible Debt (Face value = $1000; convertible into 50 shares of common stock) Preferred Stock (Par value = $20; convertible into one share of common at $24 per share $10,000,000 $5,000,000 Implied conversion price = $20 (i.e., $1000/50) Preferred shares outstanding = $5,000,000 / $20 = 250,000 Offer Price Per Share$30Purchase price for each target share outstanding Total Shares Outstanding 2 = 2,000,000 + 150,000 + ($10,000,000/$1000) x 50 + 250,000 = 2,000,000 + 150,000 + 500,000 +250,000 = 2,900,000 Adjusted Target Equity Value 3 = 2,900,000 x $30 -150,000 x $15 = $87,000,000 - $2,250,000 = $84,750,000 1 An option whose exercise price is below the market value of the firm’s share price. 2 Total shares Outstanding = Issued Shares + Shares from “in the money” options and convertible securities. 3 Purchase price adjusted for new acquirer shares issued for convertible shares or debt less cash received from “in the money” option holders.

15. Step 4: Determine Combined Firms’ Ability to Finance Transaction Estimate impact of alternative financing structures (e.g., debt/ratio ratios) 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’ operating cash flows.

16. Calculating Post-Merger Earnings Per Share (EPS) Will the transaction be transaction be dilutive or accretive to the acquirer’s EPS? Acquirer is considering the acquisition of Target in which Target would receive $84.30 for each share of its common stock. Acquirer wishes to assess the impact of alternative forms of payment on post-merger EPS. Acquirer believes that any synergies in the first year following closing would be fully offset by costs incurred in combining the two businesses. Selected data are presented as follows: Pre-Merger Data AcquirerTarget Net Earnings $281,500,000$62,500,000 Shares Outstanding 112,000,00018,750,000 EPS$2.51$3.33 Market Price Per Share $56.25$62.50

17. Calculating Post-Merger EPS in a Share for Share Exchange 1 1. Share exchange ratio = Price per share offered for Target / Price per share for Acquirer = $84.30 / $56.25 = 1.5 2. New shares issued by Acquirer = 18,750,000 (shares of Target) x 1.5 (share exchange ratio) = 28,125,000 3.Total shares outstanding of the combined firms = 112,000,000 + 28,125,000 = 140,125,000 4.Post-merger EPS of the combined firms = ($281,500,000 + $62,500,000) / 140,125,000 = $2.46 (versus $2.51 for Acquirer prior to the merger) Implication: EPS for the combined firms is diluted $.05 during the first full year following closing. 1 Target has no convertible preferred stock or debt outstanding, and its employees have no “in the money” options..

18. Calculating Post-Merger EPS in an All Cash Transaction 1.Purchase price = $84.30 x 18,750,000 = $1,580,625,000 2.Assume Acquirer borrowed the entire purchase price at 8% interest with the principal repaid in 10 years 3.Annual interest expense =.08 x $1,580,625,000 = $126,450,000 4.Post merger EPS of the combined firms = ($281,500,000 + $62,500,000 - $126,450,000 (1 -.4)) / 112,000,000 = $2.39 (versus $2.51 for Acquirer before the merger) Implication: EPS of the combined firms is diluted by $.12 during the first full year following closing due to the annual interest expense 1 Assumes the firm’s marginal tax rate is 40 percent.

19. Calculating Post-Merger EPS in a Cash & Stock Transaction Assume purchase price equals 1 share of Acquirer stock (@ $56.25) and $28.05 ($84.30 offer price - $56.25) in cash and that the cash portion of the purchase price is financed at 8% annual interest with the principal due in 10 years 1 1.New shares issued by Acquirer = 18,750,000 (shares of Target) 2.Total shares outstanding of the combined firms = 112,000,000 + 18,750,000 = 130,750,000 3.Post-merger EPS of the combined firms = ($281,500,000 + $62,500,000 - $42,075,000 (1 -.4)) / 130,750,000 = $2.44 (versus $2.51 for Acquirer before the merger) Implication: EPS of the combined firms is diluted by $.07 during the first full year following closing. Therefore, under these assumptions, EPS dilution is smallest in an all stock deal. 1 Annual interest is computed as follows:.08 x $28.05 x 18,750,000 (Target shares) = $42,075,000

20. Model Worksheet Layout 1 Assumptions Section Historical PeriodForecast Period 1 Refers to model template contained on CDROM accompanying textbook.

21. Using M&A Model Template 1 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.

22. 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). 1 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. 1 Minimum cash balances determined by analyzing the firm’s cash conversion cycle or by computing the average ratio of cash balances to net revenue over some prior period times current net revenue..

23. Model Balance Sheet Adjustment Mechanism Illustration AssetsLiabilities Current Operating Assets Cash Needed for Operations (C) Other Current Assets (OCA) Total Current Operating Assets (TCOA) Short-Term (Non-Oper.) Investments (I) Net Fixed Assets (NFA) Other Assets (OA) Total Assets (TA) Current Liabilities (CL) Other Liabilities (OL) Long-Term Debt (LTD) Existing Debt (ED) New Debt (ND) 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) 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

24. Estimating Interest Expense I EXP = ((D EOY + D BOY )/2) x i, where D EOY = D BOY - D PRP where D EOY = End of year debt balance D BOY = Beginning of year debt balance D PRP = Annual principal repayment I EXP = Dollar value of annual interest expense i = Weighted average interest rate

25. Debt Repayment Schedule Total Debt 12/31/05 20062007 Maturity Schedule Maturing Amount Interest RateMaturing Amount Interest Rate Long-Term Debt $690,71000$190,7105.5% Medium Term$540,500$30,5007.5%$30,0007.5% Mortgage Debt$42,380$69410.15%$76710.15% Total$1,273,590$31,1947.559%$221,4775.787% Remaining Balance 1/1/06Ending Balance Interest RateEnding Balance Interest Rate Long-Term Debt $690,710 5.5%$500,0005.5% Medium Term$540,500$510,0007.5%$480,0007.5% Mortgage Debt$42,380$41,68610.150%$40,91910.15% Total$1,273,590$1,242,3966.477%$1,020,9196.627%

26. Hints on Using Financial Models Ensure Excel’s Iteration Command is “on” to accommodate “circular references” inherent in financial models. –For example, To turn on the iteration command, –On the menu bar, click on Tools >>> Options >>> Calculations –Select Automatic and Iteration –Set maximum number of iterations to 100 and the maximum amount of change to.01. Cash & Investments x Interest Rate Affects Net Income Net income Affects Cash & Investments

27. 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