Puneet Merger Acquisition

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: its liabilities.

the replacement cost of its assets less

FIRM VALUATION IN MERGERS AND ACQUISITIONS-2  Dividend Discount Models

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

D0 (1 + g ) D = 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.

Continuing Value = . Value of Debt . Value of Equity

Net Operating Profit - Adjusted Taxes WACC

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 Return on Investment Capital =

Economic Profit

FCF

=

=

NOPLAT Invested Capital

NOPLAT – (Invested Capital x WACC)

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 -

CV =

Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC − WACC ) + 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 Revenues ($m) MarketShare Hewlett-Packard

512

11.4%

Compaq

134

3.0%

Factory Revenues ($m) Market Share Hewlett-Packard Compaq

124

6.1%

66

3.3%

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

MID-RANGE Mid-rangeUnix servers: Worldwide(2000)

Mid-rangeUnix servers: US (2000)

Factory Revenues ($m) MarketShare Hewlett-Packard Compaq

3,673

30.3%

488

4.0%

ClosestRival: Sun Microsystems with $2.8 billion in factory revenue and a 23.5%market share

Factory Revenues ($m) Market Share Hewlett-Packard Compaq

1552

28.2%

296

5.4%

MarketLeader: Sun Microsystems with revenues of $1.7 billion and a 30.5%market share)

PERSONAL COMPUTERS PC Shipments: Worldwide(inthousands of units)

PC Shipments: US(inthousands of units)

HewlettPackard

Compaq

HewlettPackard

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%

Compaq

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) HewlettPackard

Compaq

Units(q4/00)

318

817

Share(q4/00)

4.5%

11.6%

Units(q4/99)

139

739

Shipments (in000s)

Share 2000

Rank

Hewlett-Packard

254

3.8%

4

Compaq

129

1.9%

9

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

0.2-2.1 X

5.3-18.2 X

8.9-19.9 X

Selected Group

Closing Stock Prices As a Multiple of EPS Closing Stock Price as a Multiple of Companies

2001 EPS

2002 EPS

Compaq

34.3 X

18.4 X

14.0 X

HP

35.7 X

19.2 X

12.5 X

18.5-57.3 X

10.7-27.1 X

9.3-19.5 X

Selected Group

2003 EPS

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 Period Revenues

Net Income

At Market

LTM 2001 Estimated 2002 Estimated 2003 Estimated LTM 2001 Estimated 2002 Estimated 2003 Estimated 2001 Estimated Next Four Fiscal Q 2002 Estimated 2003 Estimated Equity Value

Percentage Contribution Compaq HP 46.0 54.0 44.0 56.0 44.0 56.0 44.0 56.0 45.7 54.3 38.1 61.9 36.9 63.1 32.7 67.3 32.3 67.7 31.6 68.4 32.7 67.3 29.2 70.8 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%