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 1990s
- Strategic mega-mergers
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 = As 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 firms
assets were liquidated.
Replacement Cost: the replacement cost of its assets less
its liabilities.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-2
Dividend Discount Models



3 1 2
0
2 3
.......
1 (1 ) (1 )
D D D
V
k k k
= + + +
+ + +
Where V
o
= value of the firm
D
i
= dividend in year I
k = discount rate
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-3
The Constant Growth DDM

2
0 0
0 2
(1 ) (1 )
......
1 (1 )
D g D g
V
k k
+ +
= + +
+ +


And this equation can be simplified to:
0 1
0
(1 ) D g D
V
k g k g
+
= =


where g = growth rate of dividends.
FIRM VALUATION IN MERGERS
AND ACQUISITIONS-4
Price-Earnings Ratio






0
1
1
1
/
P PVGO
E k E k
(
= +
(



where PVGO = Present Value of Growth Opportunity
0 1
1
(1 ) P E b
E k ROExb

Implying P/E ratio

0
1
1 P b
E 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 companys 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 Taxes
Continuing 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.

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.






Pr ( ) Economic ofit InvestedCapital x ROIC WACC =

where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital
Pr ( ) Economic ofit NOPLAT I nvested 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





NOPLAT
Return 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 companys strategic position, companys
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 s
B P S
WACC k T k k
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
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 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
= the systematic risk of equity
STEPS IN VALUATION-5
The Arbitrage Pricing Model (APM)
1 1 2 2
( ) ( ) ....
s f f f
k r E F r E F r | |
( (
= + + +


where E(Fk) = the expected rate of return on a portfolio that mimics the k
t h
factor and is
independent of all others.
Beta k = the sentivity of the stock return to the k
t h
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

T+1 T+1
Economic Profit (NOPLAT )( / )( )
CV = +
( )
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-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
Revenues ($m) Market Share
Hewlett-Packard 124 6.1%
Compaq 66 3.3%

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
Revenues ($m) Market Share
Hewlett-Packard 1552 28.2%
Compaq 296 5.4%

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)

Hewlett-
Packard Compaq
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)

Hewlett-
Packard Compaq
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 customers 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
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
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%