Pitchbook US template

1
Mergers Acquisitions (MA) DCF, Comparable
Valuation, and Merger Analysis Investmen
t Banking Primer March 2011
2
Introduction
1
1
Discounted cash flow analysis
2
6
Relative value analysis
3
56
Merger consequences
4
71
1
3
Valuation methodologies
Valuationmethodologies
Publicly tradedcomparablecompanies analysis
Comparable transactionsanalysis
Discountedcash flow analysis
Leveragedbuyout/recapanalysis
Other

• Public Market Valuation
• Value based on market trading multiples of
  comparable companies
• Applied using historical and prospective
  multiples
• Does not include a control premium

• Private Market Valuation
• Value based on multiples paid for comparable
  companies in sale transactions
• Includes control premium

• Intrinsic value of business
• Present value of projected free cash flows
• Incorporates both short-term and long-term
  expected performance
• Risk in cash flows and capital structure captured
  in discount rate

• Value to a financial/LBO buyer
• Value based on debt repayment and return on
  equity investment

• Liquidation analysis
• Break-up analysis
• Historical trading performance
• Expected IPO valuation
• Discounted future share price
• EPS impact
• Dividend discount model

2
4
The valuation process
Determining a final valuation recommendation is a
process of triangulation using insight from each
of the relevant valuation methodologies
(3) Comparable Acquisition Transactions Utilizes
data from MA transactions involving similar
companies.
(2) Publicly Traded Comparable Companies
Utilizes market trading multiples from publicly
traded companies to derive value.
(4) LeveragedBuy Out Used to determine range of
potential value for a company based on maximum
leverage capacity.
(1) DiscountedCash Flow Analyzes the present
value of a company's free cash flow.
3
5
The valuation summary is the most important slide
in a valuation presentation
The science is performing each valuation method
correctly, the art is using each method to
develop a valuation recommendation
Price per share
Implied offer 8.46
2.5x to 4.0xLTM revenueof 185.7
Mgmt. Case
Street Case
19.0x to 25.0x2005E cashEPS of 0.16
15.0x to 19.0x2005E EBITof 20.6
15.0x to 20.0x2006E cashEPS of 0.25
52-weekhigh/low
12 to 15 Discount RateEBIT exit mult. of 15.0x
to 20.0x
12 to 15 Discount RateEBIT exit mult. of 15.0x
to 20.0x
Transaction comparables
Public trading comparables
DCF analysis
4
6
A primer firm value vs. equity value
Liabilities and Shareholders Equity
Assets
Net debt, etc.
EnterpriseValue
Enterprisevalue
Equity value
1 The value of debt should be a market value. It
may be appropriate to assume book value of debt
approximates the market value as long as the
companys credit profile has not changed
significantly since the existing debt was issued.
5
7
Discounted cash flow analysis
Introduction
1
1
2
6
Relative value analysis
3
56
Merger consequences
4
71
6
8
Discounted cash flow analysis as a valuation
methodology
Valuationmethodologies
Publicly tradedcomparablecompanies analysis
Comparable transactionsanalysis
Discountedcash flow analysis
Leveragedbuyout/recapanalysis
Other

• Public Market Valuation
• Value based on market trading multiples of
  comparable companies
• Applied using historical and prospective
  multiples
• Does not include a control premium

• Private Market Valuation
• Value based on multiples paid for comparable
  companies in sale transactions
• Includes control premium

• Intrinsic value of business
• Present value of projected free cash flows
• Incorporates both short-term and long-term
  expected performance
• Risk in cash flows and capital structure captured
  in discount rate

• Value to a financial/LBO buyer
• Value based on debt repayment and return on
  equity investment

• Liquidation analysis
• Break-up analysis
• Historical trading performance
• Expected IPO valuation
• Discounted future share price
• EPS impact
• Dividend discount model

7
9
Overview of DCF analysis

• Discounted cash flow analysis is based upon the
  theory that the value of a business is the sum of
  its expected future free cash flows, discounted
  at an appropriate rate
• DCF analysis is one of the most fundamental and
  commonly-used valuation techniques
• Widely accepted by bankers, corporations and
  academics
• Corporate clients often use DCF analysis
  internally
• One of several techniques used in MA
  transactions others include
• Comparable companies analysis
• Comparable transaction analysis
• Leveraged buyout analysis
• Recapitalization analysis, liquidation analysis,
  etc.
• DCF analysis may be the only valuation method
  utilized, particularly if no comparable
  publicly-traded companies or precedent
  transactions are available

8
10
Overview of DCF analysis

• DCF analysis is a forward-looking valuation
  approach, based on several key projections and
  assumptions
• Free cash flows
• What is the projected operating and financial
  performance of the business?
• Terminal value
• What will be the value of the business at the end
  of the projection period?
• Discount rate
• What is the cost of capital (equity and debt) for
  the business?
• Depending on practical requirements and
  availability of data, DCF analysis can be simple
  or extremely elaborate
• There is no single correct method of performing
  DCF analysis, but certain rules of thumb always
  apply
• Do not simply plug numbers into equations
• You must apply judgment in determining each
  assumption

9
11
The process of DCF analysis

• Project the operating results and free cash flows
  of the business over the forecast period
  (typically 10 years, but can be 520 years
  depending on the profitability horizon)

• Estimate the exit multiple and/or growth rate in
  perpetuity of the business at the end of the
  forecast period

• Estimate the companys weighted-average cost of
  capital to determine the appropriate discount
  rate range

• Determine a range of values for the enterprise by
  discounting the projected free cash flows and
  terminal value to the present

• Adjust the resulting valuation for all assets and
  liabilities not accounted for in cash flow
  projections

10
12
DCF theory and its application

• DCF theory The value of a productive asset is
  equal to the present value of all expected future
  cash flows that can be removed without affecting
  the assets value (including an estimated
  terminal value), discounted using an appropriate
  weighted-average cost of capital
• The cash-flow streams that are discounted include
• Unlevered or levered free cash flows over the
  projection period
• Terminal value at the end of the projection
  period
• These future free cash flows are discounted to
  the present at a discount rate commensurate with
  their risk
• If you are using unlevered free cash flows (our
  preferred approach), the appropriate discount
  rate is the weighted-average cost of capital for
  debt and equity capital invested in the
  enterprise in optimal/targeted proportions
• If you are using levered free cash flows, the
  appropriate discount rate is simply the cost of
  equity capital (often referred to as flows to
  shareholders or dividend discount model)

11
13
The two basic DCF approaches must not be confused

• DCF of unlevered cash flows (the focus of these
  materials)
• Projected income and cash-flow streams are free
  of the effects of debt, net of excess cash
• Present value obtained is the value of assets,
  assuming no debt or excess cash (firm value or
  enterprise value)
• Debt associated with the business is subtracted
  (and excess cash balances are added) to determine
  the present value of the equity (equity value)
• Cash flows are discounted at the weighted-average
  cost of capital
• DCF of levered cash flows (most common in
  valuation of financial institutions)
• Projected income and cash-flow streams are after
  interest expense and net of any interest income
• Present value obtained is the value of equity
• Cash flows are discounted at the cost of equity

12
14
Other considerations

• Reliability of projections
• DCF results are generally more sensitive to cash
  flows (and terminal value) than to small changes
  in the discount rate. Care should be taken that
  assumptions driving cash flows are reasonable.
  Generally, we try to use estimates provided by
  analysts from reputable Wall Street firms if the
  client has not provided projections
• Sensitivity analysis
• Remember that DCF valuations are based on
  assumptions and are therefore approximate. Use
  several scenarios to bound the targets value.
  Generally, the best variables to sensitize are
  sales, EBITDA margin, WACC and exit multiples or
  perpetuity growth rate

Hence, always present a range for the valuation!
13
15
Always remember

• Three key drivers
• Projections and incremental cash flows (unlevered
  free cash flow)
• Residual value at end of the projection period
  (terminal value)
• Weighted-average cost of capital (discount rate)
• Avoid pitfalls
• Validate and test projection assumptions
• Determine appropriate cash flow stream
• Thoughtfully consider terminal value methodology
• Use appropriate cost of capital approach
• Carefully consider all variables in calculation
  of the discount rate
• Sensitize appropriately (base projection
  variables, synergies, discount rates, terminal
  values, etc.)
• Footnote assumptions in detail
• Think about other value enhancers and detractors

Always double-check with a calculator!
14
16
The first step in DCF analysis is projection of
unlevered free cash flows

• Calculation of unlevered free cash flow begins
  with financial projections
• Comprehensive projections (i.e., fully-integrated
  income statement, balance sheet and statement of
  cash flows) typically provide all the necessary
  elements
• Quality of DCF analysis is a function of the
  quality of projections
• Often required to fill in the gaps
• Confirm and validate key assumptions underlying
  projections
• Sensitize variables that drive projections
• Sources of projections include
• Target companys management
• Acquiring companys management
• Research analysts
• Bankers

15
17
Projecting financial statements

• Ideally projections should go out as far into the
  future as can reasonably be estimated to reduce
  dependence on the terminal value
• Most important assumptions
• Sales growth Use divisional, product-line or
  location-by-location build-up or simple growth
  assumptions
• Operating margins Evaluate improvement over
  time, competitive factors, SGA costs
• Synergies Estimate dollars in Year 1 and
  evaluate margin impact over time
• Depreciation Should conform with historic and
  projected capex
• Capital expenditures Consider both maintenance
  and expansion capex
• Changes in net working capital Should correspond
  to historical patterns and grow as the business
  grows
• Should show historical financial performance and
  sanity check projections against past results.
  Be prepared to articulate why projections may or
  may not be similar to past results (e.g. reasons
  behind margin improvements, increased sales
  growth, etc.)
• Analyze projections for consistency
• Sales increases usually require working capital
  increases
• CAPEX and depreciation should converge over time

16
18
Free cash flow is the cash that remains for
creditors and owners after taxes and reinvestment

• Unlevered free cash flows can be forecast from a
  firms financial projections, even if those
  projections include the effects of debt
• To do this, simply start your calculation with
  EBIT (earnings before interest and taxes)
• EBIT (from the income statement)
• Plus Non-tax-deductible goodwill amortization
• Less Taxes (at the marginal tax rate)
• Equals Tax-effected EBITA
• Plus Deferred taxes1
• Plus Depreciation and any tax-deductible
  amortization
• Less Capital expenditures
• Plus/(less) Decrease/(increase) in net working
  investment
• Equals Unlevered free cash flow

1 Although beyond the scope of our current
discussions, you should only include actual cash
taxes paid in the DCF. Depending on the firm and
industry, you may want to adjust for the non-cash
(or deferred) portion of a firms tax provision.
The tax footnote in the financial statements will
give you a good idea of whether this is a
meaningful issue for your analysis
17
19
Example Calculating unlevered free cash flows
Stand-alone DCF analysis of Company X millions
Key assumptions Deal/valuation date
12/31/04 Marginal tax rate 40
18
20
Valuing the incremental effects of changes in
projected operating results

• In performing DCF analysis, we often need to
  determine the incremental impact on value of
  certain events or adjustments to the projections,
  including
• Synergies achievable through the MA transaction
• Revenue
• Cost
• Capital expenditures
• Expansion plans
• Cost reductions
• Change in sales growth
• Margin improvements
• These incremental effects can be valued by
  discounting them independently (net of taxes) or
  by adjusting the DCF model and simply measuring
  the incremental impact

19
21
Once unlevered free cash flows are calculated,
they must be discounted to the present

• The standard present value calculation takes into
  account the cost of capital by attributing
  greater value to cash flows generated earlier in
  the projection period than later cash flows
• Since most businesses do not generate all of
  their free cash flows on the last day of the
  year, but rather more-or-less continuously during
  the year, DCF analyses often use the so-called
  mid-year convention, which takes into account
  the fact that free cash flows occur during the
  year
• This approach moves each cash flow from the end
  of the applicable period to the middle of the
  same period (i.e., cash flows are moved closer to
  the present)

20
22
It is important to differentiate between the
transaction date and the mid-year convention
Transaction date 01/01
Year
0
1
2
3
0.5
1.5
2.5
3.5
First cash flow, mid-year 1
Second cash flow, mid-year 2
Third cash flow, mid-year 3
CF1
CF2
CF3
Discounting
.



(1r)0.5
(1r)1.5
(1r)2.5
Transaction date 06/30
Period 1 CF to buyer
Year
0
1
2
3
0.75
1.5
2.5
3.5
0.5
First cash flow, mid-period 1
Second cash flow, mid-year 2
Third cash flow, mid-year 3
CF1
CF3
CF2
Discounting
.



(1r)(0.75-0.5)
(1r)(2.5-0.5)
(1r)(1.5-0.5)
21
23
Practice exercise
Transaction date 09/30
Period 1 CF to buyer
Year
0
1
2
3
0.75
1.5
2.5
3.5
0.5
1st flow, mid-period 1
2nd cash flow, mid-year 2
3rd cash flow, mid-year 3
CF1
CF3
CF2
Discounting
.



(1r)(0.875-0.75)
(1r)(2.5-0.75)
(1r)(1.5-0.75)
22
24
Example Discounting free cash flows
Stand-alone DCF analysis of Company X millions
46.8
53.8
61.4
69.6
Formula
189.6



(1.10)1.5
(1.10)2.5
(1.10)3.5
(1.10)0.5
Key assumptions Deal/valuation date
12/31/04 Marginal tax rate 40 Discount rate
10
23
25
Terminal value can account for a significant
portion of value in a DCF analysis

• Terminal value represents the businesss value at
  the end of the projection period i.e., the
  portion of the companys total value attributable
  to cash flows expected after the projection
  period
• Terminal value is typically based on some measure
  of the performance of the business in the
  terminal year of the projection (which should
  depict the business operating in a
  steady-state/normalized manner)
• Terminal (or Exit) multiple method
• Assumes that the business is valued/sold at the
  end of the terminal year at a multiple of some
  financial metric (typically EBITDA)
• Growth in perpetuity method
• Assumes that the business is held in perpetuity
  and that free cash flows continue to grow at an
  assumed rate
• A terminal multiple will have an implied growth
  rate and vice versa. It is essential to review
  the implied multiple/growth rate for sanity check
  purposes
• Once calculated, the terminal value is discounted
  back to the appropriate date using the relevant
  rate
• Attempt to reduce dependence on the terminal
  value
• What is appropriate projection time frame?
• What percentage of total value comes from the
  terminal value?

24
26
Terminal multiple method

• This method assumes that the business will be
  valued at the end of the last year of the
  projected period
• The terminal value is generally determined as a
  multiple of EBIT, EBITDA or EBITDAR this value
  is then discounted to the present, as were the
  interim free cash flows
• The terminal value should be an asset (firm)
  value remember that not all multiples produce an
  asset value
• Note that in the exit multiple method terminal
  value is always assumed to be calculated at the
  end of the final projected year, irrespective of
  whether you are using the mid-year convention
• Should the terminal multiple be an LTM multiple
  or a forward multiple?
• If the terminal value is based on the last year
  of your projection then the multiple should be
  based on an LTM multiple (most common)
• There are circumstances where you will project an
  additional year of EBITDA and apply a forward
  multiple

25
27
Most common error The final year is not
normalized

• Consider adding a year to the projections which
  represents a normalized year
• A steady-state, long-term industry multiple
  should be used rather than a current multiple,
  which can be distorted by contemporaneous
  industry or economic factors
• Treat the terminal value cash flow as a separate,
  critical forecast
• Growth rate
• Consistent with long-term economic assumptions
• Reinvestment rate
• Net working investment consistent with projected
  growth
• Capital expenditures needed to fuel estimated
  growth
• Depreciation consistent with capital expenditures
• Margins
• Adjusted to reflect long-term estimated
  profitability
• Normalized tax rate

26
28
Example Terminal multiple method
Stand-alone DCF analysis of Company X millions
Key assumptions Deal/valuation date
12/31/04 Marginal tax rate 40 Discount rate
10 Exit multiple of EBITDA 7.0x
(155.9 7.0x)
Formula
745.4
(1.10)4
27
29
Example Terminal multiple method (contd)
Stand-alone DCF analysis of Company X millions,
except per share data
Note DCF value as of 12/31/01 based on mid-year
convention 1 Based on 40.91 million diluted
shares outstanding
28
30
Growth in perpetuity method

• This method assumes that the business will be
  owned in perpetuity and that the business will
  grow at approximately the long-term macroeconomic
  growth rate
• Few businesses can be expected to have cash flows
  that truly grow forever be conservative when
  estimating growth rates in perpetuity
• Take free cash flow in the last year of the
  projection period, n, and grow it one more year
  to n11 this free cash flow is then capitalized
  at a rate equal to the discount rate minus the
  growth rate in perpetuity
• To ensure that the terminal year is normalized,
  ABC models are set up to project one year past
  the projection year and allow for normalizing
  adjustments this FCFn1 is then discounted by
  the perpetuity formula

JPM recommended method
Academic formula

• Terminal value (FCFn1)/(WACC g)
• where FCFn1 FCF in year after projections
  g growth rate in perpetuity WACC
  weighted-avg. cost of capital
• PV of terminal value terminal
  value/(1WACC)n-0.5

Terminal value (FCFn (1 g))/(WACC
g) where FCFn FCF in final projected period
g growth rate in perpetuity WACC
weighted-avg. cost of capital PV of terminal
value terminal value/(1WACC)n-0.5
1 This step is taken because the perpetuity
growth formula is based on the principle that the
terminal value of a business is the value of its
next cash flow, divided by the difference between
the discount rate and a perpetual growth rate
29
31
Growth in perpetuity method (contd)

• Note that when using the mid-year convention,
  terminal value is discounted as if cash flows
  occur in the middle of the final projection
  period
• Here the growth-in-perpetuity method differs from
  the exit-multiple method
• Typical adjustments to normalize free cash flow
  in Year n include revising the relationship
  between revenues, EBIT and capital spending,
  which in turn affects CAPEX and depreciation
• Working capital may also need to be adjusted
• Often CAPEX and depreciation are assumed to be
  equal

30
32
Example Growth in perpetuity method
Stand-alone DCF analysis of Company X millions
Key assumptions Deal/valuation date
12/31/04 Marginal tax rate 40 Discount rate
10 Perpetuity growth rate 3
69.6 (1 .03)
Formula
733.6
(.10 - .03)(1.10)3.5
31
33
Example Growth in perpetuity method (contd)
Stand-alone DCF analysis of Company X millions,
except per share data
Note DCF value as of 12/31/04 based on mid-year
convention 1 Based on 40.91 million diluted
shares outstanding
32
34
Terminal multiples and perpetuity growth rates
are often considered side-by-side

• Assumptions regarding exit multiples are often
  checked for reasonableness by calculating the
  growth rates in perpetuity that they imply (and
  vice versa)
• To go from the exit-multiple approach to an
  implied perpetuity growth rate g
  (WACCterminal value) / (1WACC)0.5 - FCFn /
  FCFn (terminal value / (1 WACC)0.5)
• To go from the growth-in-perpetuity approach to
  an implied exit multiple multiple FCFn (1
  g)(1 WACC)0.5 / EBITDAn (WACC - g)
• These formulas adjust for the different
  approaches to discounting terminal value when
  using the mid-year convention

33
35
Terminal multiple method and implied growth rates
Standalone Company X DCF analysis millions
At a 9 discount rate and an 8.0x exit multiple
the price is 23.87 and the implied terminal
growth rate is 3.0
Note DCF value as of 12/31/04 based on mid-year
convention 1 Based on 40.91 million diluted
shares outstanding
34
36
Perpetuity growth rate and implied terminal
multiples
Standalone Company X DCF analysis millions
At a 9 discount rate and a terminal growth rate
of 3.0, the price is 23.88 and the implied exit
multiple is 8.0x
Note DCF value as of 12/31/04 based on mid-year
convention 1 Based on 40.91 million diluted
shares outstanding
35
37
Choosing the discount rate is a critical step in
DCF analysis

• The discount rate represents the required rate of
  return given the risks inherent in the business,
  its industry, and thus the uncertainty regarding
  its future cash flows, as well as its optimal
  capital structure
• Typically the weighted average cost of capital
  (WACC) will be used as a foundation for setting
  the discount rate
• The WACC is always forward-looking and is
  predicted based on the expectations of an
  investment's future performance an investor
  contributes capital with the expectation that the
  riskiness of cash flows will be offset by an
  appropriate return
• The WACC is typically estimated by studying
  capital costs for existing investment
  opportunities that are similar in nature and risk
  to the one being analyzed
• The WACC is related to the risk of the
  investment, not the risk or creditworthiness of
  the investor¹

1 In valuing a company, always use the riskiness
of its cash flows or comparable companies in
estimating a weighted average cost of capital.
Never use the acquirers cost capital unless, by
some chance, it is engaged in an extremely
similar line of business. However, if a business
is small relative to an acquirors, sometimes ti
may be appropriate to consider the use of the
acquirors WACC in performing the valuation. The
additional value created by using the acquirors
WACC can be viewed as a synergy to the acquiror
in the context of the transaction.
36
38
ABC estimates the cost of equity using the
capital asset pricing model

• The Capital Asset Pricing Model (CAPM) classifies
  risk as systematic and unsystematic. Systematic
  risk is unavoidable. Unsystematic risk is that
  portion of risk that can be diversified away, and
  thus will not be paid for by investors
• The CAPM concludes that the assumption of
  systematic risk is rewarded with a risk premium,
  which is an expected return above and beyond the
  risk-free rate. The size of the risk premium is
  linearly proportional to the amount of risk
  taken. Therefore, the CAPM defines the cost of
  equity as equaling the risk-free rate plus the
  amount of systematic risk an investor assumes
• The CAPM formula follows
• Cost of equity Risk-free rate (beta market
  risk premium)re rf ß (rm - rf)
• There is also an error term in the CAPM formula,
  but this is usually omitted

37
39
The cost of equity is the major component of the
WACC

• The cost of equity reflects the long-term return
  expected by the market (dividend yield plus share
  appreciation)
• Risk-free rate based on the 10 year bond yield
• Incorporates the undiversifiable risk of an
  investment (beta)
• Equity risk premium reflects expectations of
  todays market
• The market risk premium (rm - rf i.e., the
  spread of market return over the risk-free rate)
  is periodically estimated by MA research based
  on analysis of historical data

38
40
ABC estimates the equity risk premium at 5.0
Equity risk premiums is estimated based on
expected returns and recent historical returns
Equity premiums Rolling average over 10-year bond
Equity returns less 10-year bond yield Arithmetic
average
39
41
Beta

• Beta provides a method to estimate an asset's
  systematic (non-diversifiable) risk
• Beta equals the covariance between expected
  returns on the asset and on the stock market,
  divided by the variance of expected returns on
  the stock market
• A company whose equity has a beta of 1.0 is as
  risky as the overall stock market and should
  therefore be expected to provide returns to
  investors that rise and fall as fast as the stock
  market a company with an equity beta of 2.0
  should see returns on its equity rise twice as
  fast or drop twice as fast as the overall market
• Returning to our CAPM formula, the beta
  determines how much of the market risk premium
  will be added to or subtracted from the risk-free
  rate
• Since the cost of capital is an expected value,
  the beta value should be an expected value as
  well
• Although the CAPM analysis, including the use of
  beta, is the overwhelming favorite for DCF
  analysis, other capital asset pricing models
  exist, such as multi-factor models like the
  Arbitrage Pricing Theory

40
42
ABC uses predicted betas to calculate the cost of
equity

• Predicted betas are constructed to adjust for
  many risk factors, incorporating firms earnings
  volatility, size, industry exposure, and leverage
• Predicted betas are more consistent and less
  volatile than historical betas
• Historical betas only measure the past
  relationship between a firms return and market
  returns and are often distorted
• Projected betas can be obtained from Barra or an
  online database (e.g., IDD)
• Barra predicted betas can be found through the
  Investment Bank Home Web page1
• Note that Bloomberg betas are based on historic
  prices and are therefore not forward-looking
• Impute unlevered beta for private company from
  public comparables

Distribution of predicted and historical betas
for 5,600 publicly-traded companies
Predicted betas
Supermarkets 0.78
Cellular 1.62
Food 0.52
Internet 2.09
Utilities 0.43
41
43
Delevering and relevering beta

• Recalling our previous discussion regarding the
  difference between asset values and equity
  values, a similar argument exists for betas. The
  predicted equity beta, i.e., the observed beta,
  included the effects of leverage. In the course
  of performing a variance analysis, which looks at
  different target capitalizations, the equity beta
  must be delevered to get an asset, or unlevered,
  beta. This asset beta is then used in the CAPM
  formula to determine the appropriate cost of
  capital for various debt levels
• The formula follows
• ?U ?L/1 ((1 T) (Debt/Equity))
• Where
• ?U unlevered (asset) beta
• BL leveraged beta
• T marginal tax rate
• To relever the beta at a target capital
  structure
• ?L ?U1 ((1 T) (Debt/Equity))

42
44
Delevering and relevering beta (contd)

• Note that ABC MA sometimes uses a factor, tau,
  in place of the marginal tax rate, T
• Tau, currently equal to 0.26, represents the
  average blended benefit a shareholder gets from a
  company borrowing (reflects many factors)
• The value of Tau is derived by researchers using
  complicated statistical analyses
• Although the delevering/relevering methodology is
  standard for WACC analyses, the formula does not
  produce a highly accurate result
• Remember the fundamentals the market charges
  more for equity of companies that are financially
  risky
• Exercise
• 1. Levered Beta 1.25, T 40, D/E 0.75 What
  is the Beta Unlevered?
• 2. Find the levered Beta at a D/E 1.0

43
45
The cost of a firms equity should be adjusted
for size
Size premium by market capBased on historical
returns analysis

• Investors typically expect higher returns when
  investing in smaller companies
• Increased risk
• Lower liquidity
• Betas vary very little by size
• Historical equity returns suggest higher return
  required by investors in smaller companies
• P/E growth ratios (PEG) tend to decline with size
• Empirical data combined with judgement should be
  applied when estimating the cost of equity for
  smaller firms

Market cap (mm)
0100
100250
250500
500700
700-1,000
1,0001,500
1,5002,500
2,5005,000
5,000
Size premium by market capBased on PE/growth
(PEG)
Market cap (mm)
44
46
ABC uses the long-term cost of debt in
estimating WACC

• The long-term cost of debt is used because the
  cost of capital is normally applied to long-term
  cash flows
• Using the long-term cost of debt removes any
  refinancing costs/risks from the valuation
  analysis
• To the extent a company can fund its investments
  at a lower cost of debt (with the same risk),
  this value should be attributed to the finance
  staff
• ABC uses the companys normalized cash tax rate

45
47
The cost of equity and debt are blended together
based on a target capital structure

• The target capital structure reflects the
  companys rating objective
• Firms generally try to minimize the cost of
  capital through the appropriate use of leverage
• The percentage weighting of debt and equity is
  usually based on the market value of a firms
  equity and debt position
• Most firms are at their target capital structure
• Adjustments should be made for seasonal or
  cyclical swings, as well as for firms moving
  toward a target
• Using a weighted average cost of capital assumes
  that all investments are funded with the same mix
  of equity and debt as the target capital structure

WACC formula
Illustrative SYSCO weighted average cost of
capital calculation
Target capital structure (Assumes current
optimal) Debt/total capital2 6.1
Nominal WACC 7. 82
1 Assumes 35 marginal tax rate 2 Total capital
debt market value of equity
46
48
Example Calculating WACC based on
comparable companies
Target WACC analysis as of 1/1/01
Macroeconomic assumptions
Industry beta analysis
Target WACC calculation
1 Risk-free rateyield-to-maturity of 10-year
U.S. Treasury bond as of 1/1/01 (Source
Bloomberg) 2 Source ABC MA research 3 Source
Barra predicted betas 4 Unlevered betaLevered
beta/(1 (total debt/market value of
equity)(1-tax rate)). Assumes beta of debt
equals zero
47
49
The appropriate cost of capital will depend on
the entity which is being valued
For illustrative purposes
SYSCO WACC sensitivity
1bn target WACC sensitivity¹
200mm target WACC sensitivity²
Note Assumes 35 marginal tax rate 1 Assuming an
equity risk premium of 6.5 2 Assuming an equity
risk premium of 7.5
48
50
DCF in-class exercise

• The Forecasted EBITDA and FCF for the next three
  years (2005, 2006, 2007) are
• EBITDA (US mm) 450, 500, 550
• FCF (US mm) 250, 261, 277
• Other assumptions
• Perpetuity growth rate of 3.0
• Terminal exit multiple of 7.5x
• Unlevered beta of 0.80
• Risk free rate 4.6
• Market risk premium 6
• Cost of debt 6.2
• Marginal tax rate 35
• Market value of equityUS 4,541mm
• Net debt US 2,524mm

49
51
DCF in-class exercise (contd)

• Calculate
• The cost of equity
• WACC
• PV of FCF
• NPV of company Perpetual growth method
• PV of Exit multiple method
• What if we use end period discounting in
• Perpetual growth method
• Exit multiple method
• What is the valuation if we need to value the
  company as on March 31, 2005?
• Use Exit/Perpetual growth methods using mid year
  conventions
• Use Exit/Perpetual growth methods using end year
  conventions

50
52
Most common errors in calculating WACC

• Cost of equity
• Equity risk premium based on very long time frame
  (post 1926 Ibbotson data)
• Substitute hurdle rate (goal) for cost of capital
• Use of historical (or predicted) betas that are
  clearly wrong
• Investment specific risk not fully incorporated
  (e.g., country risk premiums)
• Incorrect releveraging of the cost of equity
• Cost of equity based on book returns, not market
  expectations
• Target capital structure
• The actual, not target, capital structure is used
• WACC calculated based on book weights

51
53
Valuing synergies

• When two businesses are combined, the term
  synergies refers to the changes in their
  aggregate operating and/or financial results
  attributable to their being operated as a
  combined enterprise. Synergies can take many
  forms
• Revenue enhancements
• Cost savings
• Raw material discounts/purchasing power
• Sales and marketing overlap, Corporate overhead
  reductions
• Distribution cost reductions, Facilities
  consolidation
• Tax savings
• Merger related expenses (restructuring,
  additional CAPEX, integration expenses)
• The value of achievable synergies is often a key
  element in whether to proceed with a proposed
  transaction
• Calculate synergies for both the acquiring
  company and the target
• Remember incremental cash flow
• Synergies are generally valued by toggling
  pre-tax changes to various financial statement
  line items into a DCF model of the combined
  enterprise and simply measuring the incremental
  impact

52
54
Valuing synergies

• Sources of synergy projections
• Management
• Research
• Estimates from comparable transaction ( of
  sales, increase in EBITDA margin etc.)
• DCF with synergies
• Valued separately from standalone DCF
• Run sensitivity on synergy valuations
• Other considerations
• Timeline for achieving synergies
• Run as sensitivity various cases of realization
  e.g., 25, 50, 75, 100 realization
• Tax impact
• Costs incurred to achieve synergies

53
55
Sensitivity analysis is vital when presenting the
results of DCF analysis

• Recall that DCF valuation is highly sensitive to
  projections and assumptions
• So-called sensitivity tables chart the output
  based on ranges of input variables
• It is common to use a 3x3 table (i.e., showing
  three different values for each of two input
  variables) to enable the reader to triangulate
  to the appropriate inferences
• Since DCF results are by their nature
  approximate, depicting sensitivity tables enables
  users of DCF output to assess the degree of
  fuzziness in the results
• As shown in our previous examples, DCF analyses
  using exit multiples and perpetuity growth rates
  generally show sensitivities for the method used
  to calculate terminal value and a range of
  discount rates
• Sensitivities can be shown for any variable in
  the model (including financial projections)
• Judge which sensitivities would be useful to
  decision makers

54
56
Companies with multiple businesses are often
valued on a sum-of-the-parts basis

• This approach is sometimes referred-to as a
  break-up valuation
• Particularly common when the company is believed
  to be undervalued by the public
• Better accounts for discrepancies in market
  conditions facing the businesses
• The methodology requires estimating financial
  results for each business (EBIT, EBITDA and/or
  net income), which can then be used with
  appropriate multiples or growth rates in order to
  arrive at a firm value for each part before the
  results are summed
• Completing a sum-of-the-parts valuation can be
  more challenging than a straightforward
  (single-business/consolidated) DCF analysis
• Typically less detailed financial data is
  publicly-available for segments
• Often assumptions must be made about how to
  allocate expenses, especially those that are
  clearly shared across businesses (like
  corporate-level SGA)
• Need to consider different characteristics of
  each business segment (discount rate, terminal
  value assumptions, etc.)

55
57
Relative value analysis
Introduction
1
1
Discounted cash flow analysis
2
6
3
56
Merger consequences
4
71
56
58
Introduction to relative valuation

• Relative valuation is utilized to illustrate how
  the value of one company compares to another
  company
• Typically, relative valuation analysis is
  utilized in the context of stock-for-stock
  exchanges to determine the appropriate exchange
  ratio offered to shareholders in a transaction
• The exchange ratio reflects the number of
  acquiror shares offered for each target share
• So if you are a target shareholder and you are
  offered an exchange ratio of 0.500x, you are
  being offer 1/2 of an acquiror share for each
  share of the target you own
• Several relative valuation approaches exist
• Historical trading and exchange ratio analysis
• Contribution analysis
• Relative multiple and discounted cash flow
  analysis
• Valuation of synergies

57
59
Historical trading and exchange ratio analysis

• Historical exchange ratio analysis Illustrates
  the relative movement in stock prices (and
  implied exchange ratios, aka natural exchange
  ratios) looking back over a certain timeframe
• Calculated simply as the target share price on a
  given date divided by the acquiror share price on
  the same date
• Does not include any premium to the target
• Provides a historical benchmark to justify the
  contemplated exchange ratio
• Issues to consider when analyzing data include
• Liquidity of shares / trading volume (small vs.
  large cap)
• Relative market attention / analyst coverage
• Multiple expansion of one of the companys peer
  group versus the other over the selected time
  horizon

58
60
Illustrative historical trading and exchange
ratio analysis
Historical exchange ratio
of acquiror shares per target share
At 12 per share 0.347x
More favorable to Target Less favorable to
Target
Current 0.194x
Source
1 Represents average exchange ratio over the
trailing period ended June 27, 2002 2 Closing
prices as of June 27, 2002 3 Assumes acquirors
current price of 34.60 per share
59
61
Contribution analysis

• Compares the relative equity valuation of two
  parties to their respective contribution to a
  combined companys financial performance
• Typical firm value metrics would include
• Revenues
• EBITDA
• EBIT
• Unlevered free cash flow measures
• Industry-specific (i.e. customers, reserves,
  etc.)
• Typical equity value metrics would include
• Net income
• Levered free cash flow measures
• Cautionary note contribution analysis does not
  measure the growth and risk profile of the two
  companies financial performance and differing
  multiples may be justifiablie when assessing
  relative value

60
62
Relative contribution analysis
millions
1 As of 2/6/02 net debt for ACQUIROR as of
12/31/01 (per press release) and for TARGET as of
9/30/01 (per 10-Q) pro forma for acquisitions 2
2001A for ACQUIROR based on company press
release other estimates based on ABC Equity
Research 3 Based on I/B/E/S consensus estimates
ACQUIROR 2002E EPS based on company guidance
TARGET EPS estimates based on I/B/E/S consensus
estimates post 1/29/02
61
63
Sample contribution analysis
25,308
58,042
8,803
8,573
3,000
3,398
Offer 35.0
ImpliedER .4340x .4340x .8046x .6606x .6956x .703
6x
62
64
Calculating the implied exchange ratio
Implied exchange ratio (equity value metrics)
Company statistics
63
65
Calculating the implied exchange ratio (contd)
Company statistics
Implied exchange ratio (firm value metrics)
64
66
Class exercise
Company statistics

• Calculate the contribution based on the EBITDA
  and the Net income
• What is the implied exchange ratio?

65
67
Relative multiple and discounted cash flow
valuation

• Compares the ranges suggested by stand-alone
  valuations of two companies on a multiples or
  discounted cash flow basis
• Step 1 Valuation the acquiror and the target
  separately
• Step 2 Create a relative value summary
• Need to consider which ends of the range it is
  appropriate to compare when determining an
  appropriate exchange ratio / ownership percentage
• High/Low and Low/High
• High/High and Low/Low

66
68
Sample relative value football field Target
valuation
Price per share
Street case DCF
Implied offer1 8.46
Highest public comp price
Lowest public comp price
Mgmt. Case
Street Case3
19.0x to 25.0x2001E cashEPS of 0.16
15.0x to 19.0x2001E EBITof 20.6
2.5x to 4.0xLTM revenueof 185.7
15.0x to 20.0x2002E cashEPS of 0.25
52-weekhigh/low
12 to 15 Discount RateEBIT exit mult. of 15.0x
to 20.0x
12 to 15 Discount RateEBIT exit mult. of 15.0x
to 20.0x
Transaction comparables2
Public trading comparables
DCF analysis
1 Based on the offer exchange ratio of 0.311x and
Pedros closing price 27.19 as of 7/12/01 2
Certain of the multiples implied by precedent
transactions have been adjusted by indexing them
to the movement in an index of stock prices of
companies comparable to Pablo 3 Based on IBES EPS
growth estimate and average margin estimates of
brokerage reports
67
69
Sample relative value football field Acquiror
valuation
Price per share
DCF
Highest public comp price
Lowest public comp price
Current 27.19
52-weekhigh/low
Discount rate 9 to 13EBITDA with exit
multiple of 11.0x to 13.0x
Sum-of-the-parts
12.0x to 15.0x2001E EBIT of 239
10.0x to 12.0x2001E EBITDAof 346
19.0x to 25.0x2001E EPSof 1.18
DCF analysis2
Public company analysis
Comparable diversified company analysis
1 Comparable diversified company analysis and
public company analysis are based on brokerage
report estimates 2 Based on management projections
68
70
Relative valuation summary
Less favorable to Acquiror
Exchange ratio1
High/Low
Low/High
5.00/20.50
3.00/33.00
High/Low
Low/High
5.50/30.75
3.50/43.25
Offer 0.311x
More favorable to Acquiror
Discounted Cash Flow Analysis
1 Exchange ratio ranges computed by taking the
high/low equity value per share of Target using
various valuation methodologies over the low/high
valuation of the acquiror using various valuation
methodologies
69
71
Merger of Equals transactionsexample
in millions
1 Premium to target share price one day prior to
announcement Source Press releases, SEC filings,
SDC
70
72
Merger consequences
Introduction
1
1
Discounted cash flow analysis
2
6
Relative value analysis
3
56
4
71

• Accretion/(dilution) review
• Pro forma balance sheet analysis review

71
73
Introduction

• Pro forma analysis provides both acquirers and
  targets insight into the income statement and
  balance sheet impact of a transaction
• Revenue, EBITDA or earnings impact
• Capitalization, leverage and credit capacity
  impact
• Valuable tool for both acquirer and target
• Indicates buyers ability to pay
• Suggests most appropriate form of consideration
  to offer
• Allows buyer to predict or manage market reaction
  to announcement
• Demonstrates landscape of competing buyers
• Balance sheet and income statement impact go
  hand-in-hand
• Both driven by form and amount of consideration

72
74
Merger consequences
Introduction
1
1
Discounted cash flow analysis
2
6
Relative value analysis
3
56
4
71

• Accretion/(dilution) review
• Pro forma balance sheet analysis review

73
75
Overview of accretion/(dilution) analysis

• Accretion/(dilution) primarily measures the
  impact of a merger or acquisition on the income
  statement of a potential buyer
• Accretion/(dilution) analysis can be based on
  revenue, EBITDA, earnings, after-tax cash flow,
  and dividends per share
• EPS is most commonly used form of
  accretion/(dilution) analysis
• Industry will typically dictate which are the
  most relevant metrics (e.g. wireless telecom
  companies may prefer to show EBITDA)
• Two methods exist for calculating
  accretion/(dilution)
• Top down integrated merger model
• Bottom up transaction-adjusted, estimate-based
  model
• Key measures for accretion/(dilution)
• Dollar and percent change of acquirer earnings
  per share
• Pre-tax synergies required for break-even impact
  to EPS
• Pro forma ownership when stock is used as an
  acquisition currency
• Pro forma leverage/capitalization¹

1 Note that capitalization will change when stock
is used and net debt leverage levels will change
when cash is used
74
76
Purpose of accretion/(dilution) analysis

• Accretion/(dilution) analysis can be used to
  determine
• The capacity of the acquirer (or potential
  acquirers) to pay a premium for a target
• Optimal form of consideration (cash, stock, other
  securities, combination)
• Used by both buyers and sellers
• Buyers identify highest price they can afford to
  pay and what currency to offer
• Buyers evaluate how much competing bidders can
  afford to pay
• Sellers evaluate what price potential buyers can
  afford to pay and in what currency
• In the context of a divestiture, sellers also
  evaluate their break-even sale price and required
  currency
• Typically, ABC performs sensitivity analyses to
  find break-even points where the offer price for
  a target results in no incremental earnings or
  losses to acquirers earnings per share

75
77
Two primary methods exist to compute
accretion/(dilution)

76
78
Sample transaction assumptions
Transaction description