cIM Assignment Cover Sheet

Module: Introduction to Finance (Make up assignment)

Professor: Kevin O’Connell
Assignment: Merger & Acquisition Evaluation Report
Professor Assignment Evaluation Grid:

Criterion Very Good Good Satisfactory Unsatisfactory N/A

Comprehension of key issues
Analysis
Structure & presentation
Conclusions & recommendations
References & citation
Other:

Professor comments:

Grade: /20

Declaration of Authorship
“I (We) hereby declare that I (we) have neither given nor received unauthorized help on this assignment,
that all work is my (our) own unless otherwise stated, and that all sources used in the preparation of this
assignment have been properly cited.”

Name of participant/participants: Anh Tho Andres

Assignment Question: Project Evaluation Report of a Merger & Acquisition, case of Lenovo/IBM

Organisation of the Report:

1) Introduction and Summary

2) Reason for the acquisition
3) Estimated valuation of the merger (in the press)
4) My estimations of the valuation based on an NPV analysis
5) What will Lenovo offer as return on investment in ten years?
6) My opinion on this deal

The case is about Lenovo’s acquisition of IBM’s personal computer business. The report is an analysis for
internal use as an investment analyst based on the following considerations: Why do companies invest in a new
acquisition? What is the methodology for valuation of the acquisition? What other added-value apart from
financial gains do acquisitions bring to the buyer? What is the impact on the financial market, on shareholder’s
value when an acquisition deal is made public?

1) Summary:

In 2015, Lenovo was ranked top firm among the Fortuna 500, employing more than 19’000 people
worldwide. From a small Chinese company founded in 1984, employing 11 engineers in Beijing, Lenovo
(originally named Legend Company) has become the top employer and world leader in consumer
electronics products. In 1994, Legend was listed on the Hongkong Stock Exchange and in 2003
rebranded as Lenovo. In 2004, the company dominated the world market with more than 25% of
market share in 2004. Its acquisition of IBM’s PC Division in May 2005 was a major boost for the
development of the Chinese industry. Thanks to the new line of products, Lenovo has over US$13
billion in annual reserves and is expanding its infrastructure to develop its markets worldwide. In this
study, we propose a scenario in which the company is considering to make a further acquisition of IBM
tablets.

2) Reason for the acquisition:

There are many reasons for acquisition of a new business: a) the need for diversification and b) the
need for growth on return of investment.

a) Need for diversification: For an expanding market like China, and the Asia Pacific region, the need
for tablet is higher as compared to desktop and notebook. When investing in the IBM PC business
and iconic ThinkPad brand in 2005, Lenovo has leveraged itself to be the no. 1 PC maker. With the
market for PC and desktop declining due to the mobility of the job market and consumer
behavior1, and the growth of 20% in tablet demand (20.7 per cent of the world’s population own a
tablet device in 2014), the company needs to diversify by adding the tablet line to its existing lines
of products in order to maintain growth.

1
Statistics on global shipments show that an increase from 230 million tablets in 2014 to 406.8 million by 2017.
 Industry outlook: Indeed, the need for further investment is justified with potential growth of the
global demand, for instance, the one on consumer electronics per market is still very strong (19-23 mio
units in Western Europe, 63-65 mio units in Asia Pacific, 5.4-5.5 mio units in Japan) and well as the
remaining Chinese market potential where the company already has 25% market share.

Desktop PC (Europe) Desktop PC (Japan) Desktop PC (Asia Pacific)

b) Need for growth

The company’s financial year reports during the period of 2004-5 to 2015 shows a net profit of
approximately 129 million US Dollars. The table below shows the general curve of development of the
company. As compared to Apple revenue which reaches 234 billion US Dollars by 2016, Lenovo‘s
annual revenue by 2016 is 45 billion US Dollars, that is about 1/6 of Apple. This means that there is
room for Lenovo products.
 Growth’s curve of Lenovo during 2004-2016 Growth’s curve of Apple during same period

3) Estimated valuation of the merger (in the press)

According to the same source of statistics, revenue from desktop PC and laptop sales to private
consumers in Germany during the period 2005 to 2015 amounted roughly to 870 million Euro2,
compared to roughly 3.39 billion Euros generated by notebook sales of the same year. On a global
scale, it is estimated that sales may reach up to US$ 8.68 bn during the period from 2010 to 2019,
assuming the sales price per pc unit remains around US$ 1000, that of the laptop at US$ 1200 and the
price of tablet and smartphone at US$ 700.

Based on the published information that Lenovo has paid US$ 1’250 Mio plus US$ 0.5 Mio debt for the
IBM takeover. We will base on this figure to work out on the report on the assumptions that :

 The initial investment is US$ 1’750 Mio. Current year 0 is set at 2010.
 The period under study is 10 years (2010 and 2019).
 Projected sales: US$ 3’123 Mio, 36% global market share
 Average price for a desktop is set at US$ 1000, laptop at US$ 1200 and tablet at US$ 700.
 Revenues are based on US$ (except the dividend prices in original currency in HKD cents, but
which should have no incident in the NPV calculation).

4) My estimations of the valuation based on an NPV analysis

NPV: Firms use NPV analysis when making acquisitions. The Net Present Value (NPV) of an investment
is the present value of the expected cash flows, less the cost of the investment.
If NPV is >0, the investment is worth considering.

The formula for NPV can be written as: NPV = –C0 + PV

The formula for future value of an investment over many periods can be written as:
T
FV = C0 × (1 + r)

2
Rate of exchange estimated at 1 Euro : 1.30 USD.
Assumptions:

 C0 is cash flow at date 0 (2010) is US$ 1’750 Mio

 r is the appropriate interest rate should be less than 5.7% so that NPV is positive
 T is the number of periods over which the cash is invested (10 years)

Findings:

a. The table below shows that US$ 1744 is nearest to the cash offered at the deal, provided the rate of
return is set at 6.

FV potential sales 2019 Rate of return (r) Initial capital needed (C0)
in US$ Mio in US$ Mio
3123 3 2323
3123 4 2110
3123 5 1917
3123 6 1744

b. NPV analysis for different level of interest rates show that NPV is positive if interest rate <= 5.7%

R interest rate in PV (Potential Co (capital NPV (Net Present

% sales) in US$ invested) in US$ Value) in US$ Mio
Mio Mio

4 2094 1750 344

5 1894 1750 144
5.7 1750 1750 0.42
6 1714 1750 -36
10 1149 1750 -601

c. The duration to achieve the sales depends on the variable r (interest rate), the FV is reached after
10 years with an initial investment of US$ 1’750 at the interest rate of 5.7. This means the higher
the rate r is, the shorter the investment period, for example it takes 15 years if r is 4, and 6 years if
r is 10.

R interest rate FV (Potential Co (capital Duration (T)

in % sales) in US$ invested) in US$ in years
Mio Mio

4 3123 1750 15
5 3123 1750 12
5.7 3123 1750 10
6 3123 1750 10
10 3123 1750 6
d. What rate of return on investment should we get to achieve the target FV?

Based on the assumption that the FV of potential sales in 2019 is US$ 3’123 Mio in 10 years (2019),
and Lenovo has invested US$ 1750 Mio, what rate of return must Lenovo earn on the investment
to reach this amount, the answer is The answer is that the rate of return on investment is 5.96%,
according to the formula
T
FV = C0 × (1 + r)

Where C0 is cash flow at date 0 (2010) is 1750 Mio, FV (2019) is US$ 3123 Mio, and T is the number
of periods over which the cash is invested ( 10 years).

e. What return of investment is deposit in the bank vs. investment?

If Lenovo places this amount of US$ 1’750 Mio in a bank deposit where interest is 5.96% interest
p.a., the FV will be US$ 3’088 Mio in 2019. This means that the investment should bring an
additional income of 3123 – 3088 = 34.57 Mio. However, in reality the average interest rate given
by bank is only around 1.83% p.a. that means FV (2019) would be US$ 2’084 Mio. So that would
mean that the investment should bring an additional income of US$ 1’040 Mio instead of
depositing the money in the bank.

f. Compounding an investment m times a year for T years provides for future value of wealth:
mT
 r
FV  C0  1  
 m

For example, if Lenovo invest USD 1750 Mio for 10 years at 1.83% compounded monthly, semi-
annually, quarterly, or annually this investment will give different results:

m value Duration FV in USD mio Difference vs

compounded annually
in USD mio

Annually (m=1) (T=10) 2098 0

Semi-annually (T=10) 2100 1.73
(m=2)
Quarterly (m=4) (T=10) 2101 2.6
Monthly (m=12) (T=10) 2101 3.18

g. Effective Annual Rates of Interest

A reasonable question to ask in the above example is “what is the effective annual rate of interest
on that investment?”

If invested monthly, there are 2 advantages: a) cash flow upfront reduced. b) higher return.
5) What will Lenovo offer as return on investment in ten years?

According to the stock listing on 2010, the price of stock is 5.5 HKD cts, with expected growth of 10,
20, 30, 40% per year for the next ten years are shown as follows:

r 40% 30% 20% 10%

FV(2019) 113.64 58.32 28.38 12.97

6) My opinion on this deal

a) Added value :

o Brand Name (IBM, NEC, Motorola Mobility, ThinkPad, IdeaPad, Ideacentre, Yoga line,
ThinkCentre)
o Know-how (design, development, production, distribution network, research, financing)
o Diversification (PC, tablets, smartphones, workstations, servers, electronic devices, IT
software, smart televisions)
o Internationalisation
 Operations in 60 countries (Facilities, Research Centres, Joint-ventures)
 Sales network in 160 countries
o World ranking / Financial Institutions
 World largest personal computer vendor by unit sales
 Listed on Hong Kong Stock Exchange
 Hang Seng China-Affiliated Corporations Index

b) Impact on the financial markets

o Shareholder’s value increase due to the trust on the brand and many developments have
been able following the first purchase of IBM PC units.

Here are a few milestones on the acquisition of 8 businesses after its purchase of IBM for
the last decade:

 In 2005: Lenovo bought IBM's PC division.

 In 2006: Lenovo rolled out its own branded PCs.
 In 2011, Lenovo formed a joint-venture with NEC / Compaq and later acquired
Medion.
 In 2012, Lenovo formed a storage joint venture with EMC.
 In 2012, the Yoga convertible was launched.
 In 2014, Lenovo became no. 1, and began pushing smartphones outside of China.
 In 2014, Lenovo acquired Motorola Mobility and IBM's x86 server division.

c) Conclusion: my recommendations
o Yes, because NPV : positive
o Potential for further development : positive
o Synergies of company core competences : positive
o Risk : low