Analysis

In given case, we have agreed valuation of target firm but the form of payment to parent of target
firm is hybrid of debt funded dividends plus stock for stock exchange. GM proposed to exchange 141
Million shares of itself to gain control of Pilsbury. This is a fixed share equity for equity transaction ,
in this case there is the risk of selling a undervalued share to Diageo for GM and for Diageo has the
risk of receiving a overvalued share since it’s value might recede in coming future.

At current price of 38$, they would be issuing equity worth 5.385 Billion $ along with issuance of
debt worth 5 Billion $ which makes the deal worth 10 Billion $, while Diageo wanted payment to the
tune of $10.5 billion. There is a price gap that needs to be bridged and CVR is the proposed method
of doing so.

GM Perspective on deal
In this case, GM has lot to gain from Pillsbury’s portfolio since they are also in business of frozen
foods and expect synergies from transaction through supply chain efficiencies, merchandising and
marketing. GM can also get higher bargaining power by being the 5th largest company among
competitors. This would be a strategic gain for GM since Pillsbury is a competitor to GM which
means greater pricing power.

This is supposed to lead to pre tax savings of 25 Mn, 220 Mn , 400 Mn in coming years. We can
calculate WACC of this firm and then try to estimate the synergies that can be derived from this
transaction. Current WACC of GM stands at 9.185% but it will take additional debt of 5.142 Bn which
will affect it’s cost of capital.

We take prime lending rate as cost of debt and calculate cost of equity with beta of 0.65 with
current market cap as 11 Bn $, Debt of GM stands at 739 Million $ since LT D/E is 6.719%. We take
price of 41$ in December 2000 as average of given price range – 40 to 42 $ per share. Pre-merger
WACC comes as 8.99%. We can expect the hurdle rate for investors to remain same but cost of
equity will go up since it will take more credit risk due to extra debt of 5.142 Bn, cost of equity
changes to 10.82%, which changes the WACC to 9.76% for the overall firm.

With this discount rate we find the value of synergy derived from per tax savings and post-tax
savings of 507.9 Mn $ and 330 Mn $ respectively for next 3 years.

GM will take Pillsbury as wholly owned subsidiary in future and has lot to gain from this transaction.
We try to estimate the total cost of this transaction to GM and see what price they might end up
paying in different scenarios and see if they can bridge the gap using CVRs.

In this case, Earnouts are difficult to implement since they are more useful in privately traded and
smaller firm with simpler terms but Pillsbury is a large firm with many shareholders and moreover
earnouts cannot be traded in market since they are signed on terms of milestones or certain
performance benchmarks but the biggest problem with earnouts is integration of firms, given the
synergies and complimentary nature of firms , Integration is a priority hence earnouts are not the
most viable option. Earnouts are buyer biased since they end up sharing risks of transaction with
seller with lower up front money paid , in this case , we are not dealing with the shareholders but
with parent company Diageo whose shareholders have no intention of realising any performance
benchmarks and want their deal to be done as soon as possible since they want to focus on their
beverage business. This means that seller is not interested in lower pay out upfront, the case would
be different if GM was dealing with Pillsbury directly where it can ask for performance benchmarks.
Due to this earnouts is not a viable option since Seller wants their share price upfront , with GM
more eager to acquire Pillsbury and Diageo wanting to sell off Pillsbury asap.

We need to design a bridge that will give fair price but puts the onus of upfront payment on
acquirer. In this case, CVR would be best option since Seller will be given payment upfront. However,
if there is a price fluctuation then money from a fixed escrow will be moved to GM’s account. Gm
values deal at 10Bn $, with 5 Bn $ in equity financed by 141 Mn shares at 35.46$ and remaining 5Bn
in debt which will be given as dividends. Diageo wanted 10.5 Bn $, which meant 5.5 Bn $ in equity at
39$ per share. GM believed it’s shared to be undervalued and wanted to ensure that it wasn’t giving
away its share only to find out its price increase in future. If GM is willing to pay out the shares at
39$ then it will end up paying 10.5 Bn $ to Diageo upfront, but if price of GM goes up then it would
have given it’s shares for cheap , hence if they can receive upside of price appreciation too then the
deal becomes more fair.

In given structure , GM in case of appreciation ends up paying no more than 10.3 bn $

(All values in
GM (Price Paid) Million)
Shares
Variation of Price Diluted 141
Deal CVR Final Price Profit/Loss on
Price Equity Debt Price adjustment Paid deal
33.5 4723.5 5000 9723.5 0.45 9723.95 634.05
34 4794 5000 9794 0.45 9794.45 563.55
34.5 4864.5 5000 9864.5 0.45 9864.95 493.05
35 4935 5000 9935 0.45 9935.45 422.55
35.5 5005.5 5000 10005.5 0.45 10005.95 352.05
36 5076 5000 10076 0.45 10076.45 281.55
36.5 5146.5 5000 10146.5 0.45 10146.95 211.05
37 5217 5000 10217 0.45 10217.45 140.55
37.5 5287.5 5000 10287.5 0.45 10287.95 70.05
38 5358 5000 10358 0 10358 0
38.5 5428.5 5000 10428.5 70.5 10358 0
39 5499 5000 10499 141 10358 0
39.5 5569.5 5000 10569.5 211.5 10358 0
40 5640 5000 10640 282 10358 0
40.5 5710.5 5000 10710.5 352.5 10358 0
41 5781 5000 10781 423 10358 0
41.5 5851.5 5000 10851.5 493.5 10358 0
42 5922 5000 10922 564 10358 0
42.5 5992.5 5000 10992.5 634.5 10358 0
42.55 5999.55 5000 10999.55 641.55 10358 0
43 6063 5001 11064 642 10422 -64
43.5 6133.5 5002 11135.5 642 10493.5 -135.5
44 6204 5003 11207 642 10565 -207
44.5 6274.5 5004 11278.5 642 10636.5 -278.5
45 6345 5005 11350 642 10708 -350
In case of depreciation of price, It ends up paying exactly the same amount deducting 450,000$.

Profit/Loss on Transaction for GM

800

600

400

200

-200

-400

This essentially ensures that it doesn’t end up over paying for this deal in case it’s stock is
undervalued which is most likely to happen since it’s price is going to shoot up due to synergies and
the fact that it is valued at maximum of 42.25 $ by Merrill Lynch and at 46 $ using DCF analysis. This
means that , GM believes it’s stock to appreciate in future , hence it would be willing to pay upfront
for Pillsbury which will additionally bring in 0.33 Bn $ in after tax synergies of just 3 years , hence it
would end up costing 10.35-0.33 ~ 10 Bn dollars , which is exactly they want, hence, CVR seems like
a good option from point of view of GM

For Diageo, we can see that it will also end up receiving 10.3 Bn $ which is less than agreed price but
in case of appreciation it will lose upside only till 642 Mn dollar i.e. till price of underlying is 42.55 $
after which it will gain all the upside of appreciation since it owns 33% of GM. Hence after 42.55 $ ,
it’s gains will be higher than GM’s , hence GM stands to benefit more since in case of appreciation
on first anniversary of deal, GM would have sold a under-valued equity at 38$.

Profit/Loss on deal for Diageo

800

600

400

200

0
36

40
33.5
34
34.5
35
35.5

36.5
37
37.5
38
38.5
39
39.5

40.5
41
41.5
42
42.5
42.55
43
43.5
44
44.5
45

-200

-400

-600

-800
This arrangement is possible only if we can arrange for a CVR that can allow for such payoff , in this
case due to CVR , GM is able to gain upside of 642 Mn $ and allow for it to cover losses to the same
tune in case it’s undervalued, however , it does lose any upside if price goes beyond 42.55 $, which is
reflected as loss in above diagram.

CVR adjustment
800
CVR Adjustment
600
400
200
0

Share Price

GM would be losing some upside but it will end up paying exacty what they want if price appreciates
also but that would have happened otherwise too, hence, CVR is able to solve one of the problems.
For Diageo , this deal is much more favourable which can be confirmed from below table-
Profit/Loss for Profit/Loss for
Price GM Digeo
33.5 634.05 -634.95
34 563.55 -564.45
34.5 493.05 -493.95
35 422.55 -423.45
35.5 352.05 -352.95
36 281.55 -282.45
36.5 211.05 -211.95
37 140.55 -141.45
37.5 70.05 -70.95
38 0 0
38.5 0 0
39 0 0
39.5 0 0
40 0 0
40.5 0 0
41 0 0
41.5 0 0
42 0 0
42.5 0 0
42.55 0 0
43 -64 127.45
43.5 -135.5 269.45
44 -207 411.45
44.5 -278.5 553.45
45 -350 695.45
We see loss for GM since it sold an undervalued share a summation of absolute value is equal to
the total upside of appreciation in price, which is enjoyed by Diageo more after price of 42.25$ ,
moreover , the downside is equally bad for both of them.

This would make sense to implement since GM is more favourable to payment as long as it is not
losing all of upside of an undervalued stock. This means that we can treat this contract as a option
that gives constant payout above 42.55$. This option “covers” GM’s upside and downside with
possible gain in a given range. Hence this is a collar option, which can be constructed as going
short on stocks and shorting put option at higher strike price and by going long on a call option of
lower price, with underlying as GM stocks.

Collar = Short Stocks + Short Put (K=42.55) + Long call (K=38)

We first need to calculate the five parameters of Black-Scholes for CVR. We have strike rate of all
these options along with duration, interest rate and share price , with implied volatility missing.

We can calculate implied volatility from Exhibit 4 , Using K=40 , S=35 , Rf=5.43% , T= 92 days and
Price of call = 0.5$. We only need to back calculate volatility. We did it from online
resources(appendix)

Call Option_ Vol=26.6% (Option expiring on 21 October)

Put Option_Vol=34.4% (same duration)

Call Option_ Vol=39.26% (Option expiring on 20 Jan)

Taking average volatility from above, we use volatility of 0.3342.

We can calculate price of this CVR as selling Put option at K=42.55 and going long on call at K=38$

Selling Put option – calculated from Black Scholes (on 14th July,2000)

K= 42.55, Vol=33.42%, S=38, Rf=5.43%, T=365 days , Price of Put option = 6.4256

Long on Call Option

K= 38, Vol=33.42%, S=38, Rf=5.43%, T=365 days , Price of Call option = 5.9779
Hence, we sell put options @6.42 and buy call options @5.98 to cover our position , hence ,
this CVR will give us 0.044 $ per share.
Appendix