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

The First Wave 1897-1904

States
-

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
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

Operating Synergy
Financial Synergy

Diversification
Economic Motives

Horizontal Integration
Vertical Integration
Tax Motives

= premium paid for B

= 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:
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

= 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 )
D1

kg
kg

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
E1 (1 b)

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 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.

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 Investme nts

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

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

= the market value of interest-bearing debt

kp

= the after-tax cost of capital for preferred stock

= market value of the preferred stock

ks

= the market determined opportunity cost of equity capital

= 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

k s r f E ( rm ) rf
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

. 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)
k s r f E ( F1 ) r f 1 E ( F2 ) r f 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
-

STEPS IN VALUATION-7
Calculating and Interpreting Results
- Calculating And Testing The Results
- Interpreting The Results Within The

Decision Context

HP-COMPAQ MERGER CASE

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,

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%