VALUATON OF FRMS N

MERGERS AND ACQUSTONS

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
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
- Operating Synergy
- Financial Synergy
Diversification
Economic Motives
- Horizontal ntegration
- Vertical ntegration
- Tax Motives
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
FRM VALUATON N
MERGERS AND ACQUSTONS
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.
FRM VALUATON N MERGERS
AND ACQUSTONS-2
Dividend Discount Models
2
0
2
.......
( ) ( )
D D D
J
k k k



Where V
o
value of the firm
D
i
dividend in year I
k discount rate
FRM VALUATON N MERGERS
AND ACQUSTONS-3
The Constant Growth DDM
2
0 0
0 2
( ) ( )
......
( )
D g D g
J
k k





And this equation can be simpliIied to:
0
0
( ) D g D
J
k g k g

where g growth rate oI dividends.
FRM VALUATON N MERGERS
AND ACQUSTONS-4
Price-Earnings Ratio
0

! !JCO
E k E k






where PVGO Present Value oI Growth Opportunity
0

( ) ! E b
E k ROExb

Implying P/E ratio

0

! b
E k ROExb

where ROE Return On Equity
FRM VALUATON N MERGERS
AND ACQUSTONS-5
,sh FIow V,Iu,tion ModeIs
- The Entity DF ModeI : 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
. V,Iue of Oper,tions: The value of operations equals the discounted value of expected
future free cash flow.
. V,Iue of Debt
. V,Iue of Equity
Net Operating Profit - Adjusted Taxes
Continuing Value
WACC
FRM VALUATON N MERGERS
AND ACQUSTONS-6
What Drives Cash Flow and Value?
- Fundamentally to increase its value a company must
do one or more of the following:
. ncrease the level of profits it earns on its existing
capital in place (earn a higher return on invested
capital).
. ncrease the return on new capital investment.
. ncrease its growth rate but only as long as the return
on new capital exceeds WACC.
. Reduce its cost of capital.
FRM VALUATON N MERGERS
AND ACQUSTONS-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.
Pr ( ) Economic ofit Invested Capital x ROIC WACC

where ROIC Return on Invested Capital
WACC Weighted Average Cost oI Capital
Pr ( ) Economic ofit AO!A1 Invested Capital x WACC

where NOPLAT Net Operating ProIit Less Adjusted Taxes
ValueInvested Capital+Present Value of Projected Economic Profit
STEPS N VALUATON
n,Iyzing Historic,I Perform,nce

NOPLAT
Return on Investment Capital
Invested Capital

FCF Gross Cash Flow - Gross Investments
Economic Profit NOPLAT - (Invested Capital x WACC)
STEPS N VALUATON-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 N VALUATON-3
Estim,ting The ost Of ,pit,I
- Develop Target Market Value Weights
- Estimate The Cost of Non-equity Financing
- Estimate The Cost Of Equity Financing
(- )
b c p s
B ! $
WACC k 1 k k
J J J


where
kb the pretax market expected yield to maturity on non-callable, non convertible debt
Tc the marginal taxe rate Ior the entity being valued
B the market value oI interest-bearing debt
kp the aIter-tax cost oI capital Ior preIerred stock
P market value oI the preIerred stock
ks the market determined opportunity cost oI equity capital
S the market value oI equity
STEPS N VALUATON-4
Estimating The Cost Of Equity Financing
- CAPM
. 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
( )
s f m f
k r E r r .





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
B the systematic risk of equity
STEPS N VALUATON-5
The Arbitrage Pricing Model (APM)

( ) ( ) ....
s f f f
k r E F r E F r . .




where E(
F
k) the expected rate oI return on a portIolio that mimics the k
th
Iactor and is
independent oI all others.
Beta k the sentivity oI the stock return to the k
th
Iactor.
STEPS N VALUATON-6
Estimating The Continuing Value
- Selecting an Appropriate Technique
. Long explicit forecast approach
. Growing free cash flow perpetuity formula
. Economic profit technique
T T
Economic ProIit (NOPLAT )( / )( )
CV
( )
# #

where
Economic ProIit T the normalized economic proIit in the Iirst year aIter the explicit
Iorecast period.
NOPLAT T the normalized NOPLAT in the Iirst year aIter the explicit Iorecast period.
g the expected growth rate oI return in NOPLAT in perpetuity
ROIC the expected rate oI return on net new investment.
WACC weighted average cost oI capital
STEPS N VALUATON-7
Calculating and nterpreting Results
- Calculating And Testing The Results
- nterpreting The Results Within The
Decision Context
HP-COMPAQ MERGER CASE
The HP/omp,q merger. By The Numbers:
h|Ch-EN0
h|gh-end Un|x 8ervers: wor|dw|de (2000}

Factory
Revenues ($m} Harket 8hare
hew|ett-Packard 512 11.1
ompaq 131 3.0

|osest R|va|: 3ur V|crosyslers W|lr laclory reverues ol
S2.1 o||||or ard a 1Z.1 rar|el srare
h|gh-end Un|x servers: U8 (2000}

Factory
Revenues ($m} Harket 8hare
hew|ett-Packard 121 .1
ompaq 3.3

Closest Rival: Sun Microsystems with Iactory
revenues oI $. billion and a 60. market share
H|0-RANCE
H|d-range Un|x servers: wor|dw|de (2000}

Factory
Revenues ($m} Harket 8hare
hew|ett-Packard 3,Z3 30.3
ompaq 188 1.0

|osest R|va|: 3ur V|crosyslers W|lr S2.8 o||||or |r
laclory reverue ard a 23.5 rar|el srare
H|d-range Un|x servers: U8 (2000}

Factory
Revenues ($m} Harket 8hare
hew|ett-Packard 1552 28.2
ompaq 29 5.1

Harket Leader: 3ur V|crosyslers W|lr reverues ol S1.Z
o||||or ard a 30.5 rar|el srare)
PER80NAL 0HPUTER8
P 8h|pments: wor|dw|de (|n thousands of un|ts}

hew|ett-
Packard ompaq
Un|ts (q2|01} 2,05 3,590
8hare (q2|01} .9 12.1
Un|ts (q2|00} 2,20 1.011
8hare(q2|00} Z.1 13.2
Crowth 8. 10.5

P 8h|pments: U8(|n thousands of un|ts}

hew|ett-
Packard ompaq
Un|ts (q2|01} 991 1,332
8hare (q2|01} 9.1 12.Z
Un|ts (q2|00} 1,221 2,293
8hare(q2|00} 10.Z 20.1
Crowth 18.8 21.3

Harket |eader 0e|| Corpuler Corp. W|lr a 21 rar|el
srare ard a 9.8 groWlr |r lre sare per|od.
LAPT0P8|N0TE00K8 8HART hAN0hEL08
wor|dw|de sh|pments of portab|e computers
(thousands of un|ts}

hew|ett-
Packard ompaq
Un|ts(q4|00} 318 81Z
8hare(q4|00} 1.5 11.
Un|ts(q4|99} 139 Z39


8h|pments
(|n 000s}
8hare
2000 Rank
hew|ett-Packard 251 3.8 1
ompaq 129 1.9 9

Harket Leader: Pa|m w|th a 52.97 market share and
3.53 m||||on un|ts.
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
istorical Exchange Ratios
Period ending August
200
Average Exchange Ratio Implied Premium ()
August 200 0.52 .9
0-Day Average 0.544 .
20-Day Average 0.5 .
0 Day Average 0.57 0.
Months Average 0.557 .7
Months Average 0.54 .2
9 Months Average 0.59 7.
2 Months Average 0.59 .

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. X
P .0 X 2.4 X 9. X
Selected Group 0.2-2. X 5.-.2 X .9-9.9 X


Closing Stock Prices As a Multiple of EPS
Closing Stock Price as a Multiple of
Companies 200 EPS 2002 EPS 200 EPS
Compaq 4. X .4 X 4.0 X
P 5.7 X 9.2 X 2.5 X
Selected Group .5-57. X 0.7-27. X 9.-9.5 X

HP-COMPAQ MERGER CASE-6
$imiI,r Tr,ns,ctions Premium n,Iysis
$,Iomon $mith B,rney's ,n,Iysis resuIted in , r,nge of premiums of:
- (8)% to 46% over exch,nge r,tios impIied by ,ver,ge prices for the 10
tr,ding d,ys prior to ,nnouncement, with , medi,n premium of 23%.
- (7)% to 58% over exch,nge r,tios impIied by ,ver,ge prices for the 20
tr,ding d,ys prior to ,nnouncement, with , medi,n premium of 23%.
- (12)% to (29) over exch,nge r,tios impIied by ,ver,ge prices for the 1
tr,ding d,ys prior to ,nnouncement with , medi,n premium of 15%.
B,sed on its ,n,Iysis, $,Iomon $mith B,rney determined , r,nge of
impIied exch,nge r,tios of 0.585x to 0.680x by ,ppIying the r,nge of
premiums for other tr,ns,ctions to the cIosing prices of omp,q ,nd HP
on ugust 31, 2001 ,nd the ,ver,ge historic,I exch,nge r,tio for omp,q
,nd HP for the 10-d,y period ending on ugust 31, 2001, ,s ,ppropri,te.
HP-COMPAQ MERGER CASE-7
Contribution Analysis
Percentage Contribution Analysis
Percentage
Contribution

Period
Compaq P
Revenues LTM 4.0 54.0
200 Estimated 44.0 5.0
2002 Estimated 44.0 5.0
200 Estimated 44.0 5.0
LTM 45.7 54.
200 Estimated . .9
2002 Estimated .9 .
200 Estimated 2.7 7.
Net Income 200 Estimated 2. 7.7
Next Four Fiscal Q . .4
2002 Estimated 2.7 7.
200 Estimated 29.2 70.
At Market Equity Value .7 .

HP-COMPAQ MERGER CASE-8
Pro Forma Earnings Per Share mpact to Compaq

AccretionDilution Analysis

AccretionDilution
EPS
2002
EPS
200
Compaq stand-alone 0.7 0.
P stand-alone .2 .
Combined entity pro-forma excluding proj. synergies 0.74 .09
Combined entity pro-forma including proj. synergies .05 .5
Accretion(Dilution) to Compaq excluding proj. synergies 24
Accretion(Dilution) to Compaq including proj. synergies 57 7