Valuation of firm 1

VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS

Motives and Determinants of Mergers Synergy Effect

Operating Synergy Financial Synergy Diversification Economic Motives - Horizontal Integration - Vertical Integration 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

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

31 20 2 3 . . . . . . .

1 ( 1 ) ( 1 )DD D

Vk k k

W h e r e V o = v a l u e o f t h e f i r m

D i = d i v i d e n d i n y e a r I

k = d i s c o u n t r a t e

FIRM VALUATION IN MERGERS AND ACQUISITIONS-3 The Constant Growth DDM

20 0

0 2

( 1 ) ( 1 ) . . . . . .1 ( 1 )

D g D gV

k k

A n d t h is e q u a t io n c a n b e s im p lif ie d to :

0 10

(1 )D g DV

k g k g

w h e re g = g ro w th ra te o f d iv id e n d s .

FIRM VALUATION IN MERGERS AND ACQUISITIONS-4 Price-Earnings Ratio

0

1

1 1/

P PVGOE k Ek

where PVGO = Present Value of Growth Opportunity

0 1

1

(1 )P E bE k ROExb

Implying P/E ratio

0

1

1P bE k ROExb

where ROE = Return On Equity


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.

. Value of Debt

. Value of Equity

Net Operating Profit - Adjusted TaxesContinuing Value = 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.


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 of Capital Pr ( )Economic ofit NOPLAT Invested Capital x WACC

where NOPLAT = Net Operating Profit Less Adjusted Taxes

V a l u e = I n v e s te d C a p i ta l+ P r e s e n t V a lu e o f P r o j e c t e d E c o n o m ic P r o f i t

STEPS IN VALUATION Analyzing Historical Performance

NOPLATReturn on Investment Capital = Invested Capital

FCF = Gross Cash Flow – Gross Investments

Economic Profit = NOPLAT – (Invested Capital x WACC)

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

- Develop Target Market Value Weights- Estimate The Cost of Non-equity Financing - Estimate The Cost Of Equity Financing

( 1 - )b c p sB P S

W A C C k T k kV V V

w h e r e

k b = t h e p r e t a x m a r k e t e x p e c t e d y i e l d t o m a t u r i t y o n n o n - c a l l a b l e , n o n c o n v e r t i b l e d e b t

T c = t h e m a r g i n a l t a x e r a t e f o r t h e e n t i t y b e i n g v a l u e d

B = t h e m a r k e t v a l u e o f i n t e r e s t - b e a r i n g d e b t

k p = t h e a f t e r - t a x c o s t o f c a p i t a l f o r p r e f e r r e d s t o c k

P = m a r k e t v a l u e o f t h e p r e f e r r e d s t o c k

k s = t h e m a r k e t d e t e r m i n e d o p p o r t u n i t y c o s t o f e q u i t y c a p i t a l

S = t h e m a r k e t v a l u e o f e q u i t y

STEPS IN VALUATION-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 fk 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

В = the systematic risk of equity

STEPS IN VALUATION-5 The Arbitrage Pricing Model (APM)

1 1 2 2( ) ( ) . . . .s f f fk r E F r E F r

w h e r e E ( F k ) = t h e e x p e c t e d r a t e o f r e t u r n o n a p o r t f o l i o t h a t m i m i c s t h e k t h f a c t o r a n d i s

i n d e p e n d e n t o f a l l o t h e r s .

B e t a k = t h e s e n t i v i t y o f t h e s t o c k r e t u r n t o t h e k t h f a c t o r .

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

T+1 T+1Economic Profit (NOPLAT )( / )( )CV = + ( )

g ROIC ROIC WACCWACC 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-end Unix Servers: Worldwide (2000)

Factory

Revenues ($m) Market Share Hewlett-Packard 512 11.4% Compaq 134 3.0%

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

High-end Unix servers: US (2000)

Factory


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

MID-RANGE Mid-range Unix servers: Worldwide (2000)

Factory

Revenues ($m) Market Share Hewlett-Packard 3,673 30.3% Compaq 488 4.0%

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

Mid-range Unix servers: US (2000)

Factory


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

PERSONAL COMPUTERS PC Shipments: Worldwide (in thousands of units)

Hewlett- Packard Compaq

Units (q2/01) 2,065 3,590 Share (q2/01) 6.9% 12.1% Units (q2/00) 2,260 4.011 Share(q2/00) 7.4% 13.2% Growth -8.6% -10.5%

PC Shipments: US(in thousands of units)


Units (q2/01) 991 1,332 Share (q2/01) 9.4% 12.7% Units (q2/00) 1,221 2,293 Share(q2/00) 10.7% 20.1% Growth -18.8% --21.3%

Market leader: Dell Computer Corp. with a 24% market share and a 9.8% growth in the same period.

LAPTOPS/NOTEBOOKS SMART HANDHELDS

Worldwide shipments of portable computers (thousands of units)


Units(q4/00) 318 817 Share(q4/00) 4.5% 11.6% Units(q4/99) 139 739

Shipments (in 000s)

Share 2000 Rank

Hewlett-Packard 254 3.8% 4 Compaq 129 1.9% 9

Market Leader: Palm with a 52.9% market share and 3.53 million units.

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,

2001

Average Exchange Ratio Implied Premium (%)

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




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

Contribution

Period 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

Accretion/Dilution

EPS

2002

EPS

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%

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Valuation of firm 1