DECEMBER 2004 oe Mos eee IT =| Sspmorgan[For any pitchbook or presentation including advisory, equity or debt security or loan product or combinations thereof, [NOT for use in faimess/ valuation or Commercial Bank presentations.) “Thi presentation was prepares exeuniely forthe beet ana item| eof the sMoran client to whom tS rectly adored and deere ning Such Cet’ suas, the *Compary’in oer to asst the Carpany h evaluating. ona preliminary boss, the fade of a pssble rasacton oF tNansscoor ae coee not carry ght 2 pubicaon or scl, in whol om par, wo any ether party. Th resonator i for dco purposes ony and neompletewitteut reference to, and shed be viewed yin cnjunction with the orl tiefirg eroded by .PNergan. Nether ths Dresenetin or ay of hs contents may be diced ose fr any cher purpose wlio Ue rer wile consent of JPMorgan The inioratin In this presentatin Isbased upon any management forecasts supple to ws and elects preva conditions and ou views asf ts date, sill which are acorcngy subject tacharge JPlergan's ons and elma comtitike Plergn's pret an shul be regarded as inate, preliminary ed or dssitie pups cry In preparing Us presetation, we hve lied qn alas, witha nsepenaent verity, the ecwracy and completeness fl iformaticn vakoble fram pub sources or which wos proved ts or on bei of the Compory or which wae ones reviewed ty es. nado, of analytes ar nt and do net purport tobe appa of the assets, stock or business of he Company o ny ther enuiy. -PNergsn makes no representations ast the actual value which my be ecaved i comacton wth 3 rasacton morte lal tx oF Sccourting tects of consunmating a ansact. Ules expressly contemplates hetey, the hfrmtlon nth sesetaton does oo eke lnk account the effeds of a posse wareaction or Yareactns involving an actual or poteeal change of convl, which may have gnicat valuation and other tes Noteftstanding anything herent the crtary, the Company and wach of Rs employes, rereuntatves or other agents ray lose wo any an all perm, lhe inate of any hind the U.S. federal te! state came tar Westen ad the U.S fedetl on sate nce ox tite ot te Trarsoctons contemplated hereby an al teria any Ke (clude cpiore or other tx aayae) that ate povided to he Company reat to Such ta rentment ane tae strictore Meola ar ach Wester andr ektture rate 09 U5. eceal orate come toe Rrstepy prvi tthe Campa by sPMorea, 1 erzan's licks erobiitemployec ram fering, Sect x inet, afevorable research ating oF speci pce trae, or fering te change @ racing or price target, to asubject company 3s consideration or indczment forthe recap of buses or for eampersavon. Pers alsaproMbNs ts Feseatc analysts rom being compersated fo uvoiemert I mvestnereSarkrgtaveacbers excet to te exert that suc partcpation&wiended 2 benef estore forza ta rarketing name for estment banking business of Parga Chase & Co. and its subsides ware, secutive, syndicated Loan ‘ranging fnsrca adssory an other investmen banking activities are performed by a cirbnaton of J. Magan Securities he, JP. oan ple, 5LP. Morgan Secures Lid. and the approgiataly leased subsidiaries of JPhargan Chase & Co. av sia-Pactic a lending, etvatives and cher “ervinetlbnking actives re pevtrmed by JPicgon Chae Bank, NA Maran deal Lenn members yt enaaytes of aya the egos entities. “This presentation does ot contitte #cammiment by any JPMorai entity to nderwrite, subscribe fro place any scutes of to eter or range cect cr toroid anyother serves, Sse ttorganAgenda Discounted cash flow analysis. 6 Relative value analysis 56 Merger consequences aa) SsemorganValuation methodologies Gir ed eae ein 1 *Public Market 1 Private Market intrinsic" value Value toa 1 Liguidation Valuation” Valuation” of business financiai/LB0 analysis buyer 1 Value based on 1 Value based on 1 Present value of yes 1 Break-up analysis market trading multiples paid for projected free 1 Value based on multiples of ‘comparable cash flows debt repayment Historical trading comparable companies N10 tee both and return on perteemance companies, transactions poe sombe equity investment Expected IPO 1 Apptied using f Includes contrat long-term sabia historical and premium expected ecnnsceuntea fucure prospective perfomance shate ie multiples an 1 Risk in eash flows = BPS impact 5 18 Does not include a ‘and capital S control premium structure captured f= Dividend discount . in discount rate model SsemorganThe valuation process Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies (1) Discounted (2) Publicly Traded (3) Comparable (4) Leveraged ‘Cash Flow Comparable ‘Acquisition Analyzes the Companies Transactions present value of Utiizes market Utilizes data from range of potential ‘a companys free trading multiples MBA transactions value for a cash flow. from publicly involving simitar| company based on traded companies companies. ‘maximum leverage to derive value. capacity. SsemorganThe valuation summary is the most important slide ina valuation presentation The science is performing each valuation method correctly, the art is using each method to develop a valuation recommendation Price per share 2075 2000 ee eo eee ETE SsemorganAprimer: firm value vs. equity value Firm value = arket value of all capital invested in a business!” {often referred to as “enterprise value” or “firm value” or “asset value”) ‘The value of the total enterprise: market value of equity + (total debt + Capitalized Leases - Cash and Cash equivalents) + Minority Interest + Preferred Equity Total debt includes all Long term debt, Current portion of Long term debt, short term debt and overdrafts Equity value = Market value of the shareholders’ equity {often referred to as “offer value") The market value of a company’s equity (shares outstanding x current stock price) Assets Liabilities and Shareholders’ Equity Net debt, ete. Enterprise = Value CRC "The vale of debt should be a market value. it may be appropriate to assume book vale of debt approximates the market value as long 2s the company’s creitprofie has ot changed significant since the existing debt was issued. SrpmorganAgenda Introduction: 4 Relative value analysis 56 Merger consequences 7" SsemorganDiscounted cash flow analysis as a valuation methodology GIerer ome Lannie gs Dede analysis = “Public Market “Private Market “Intrinsic” value Value toa 1 Liquidation valuation” valuation” ‘of businese tinaneial/LE0 analysis buyer = Value based on 1 Value based on 1 Present value of ve 1 Break-up analysis market trading multiples paid for projected free = Value based on multiples of ‘comparable cash flows debt repayment s Historical trading ‘comparable ‘companies in sale ‘and return on Dern "= Incorporates both companies twansections | aa lileeea equity investment Expected PO © | w Applied using s inctudes controt teng:term amie historical and premium expected Discounted future prospective performance aie pie multiples eee : 1 Rsk in cashflows 1S impact 18 Does not elude a and enpital = cantrol premium structure captured = Dividend discount in discount rate model SsemorganOverview of DCF analysis 1 Discounted cash flow analysis is based upon the theory that the value of a business is the SUiioflits expected future! fresieashifloWs, 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 M&A 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 SsemorganOverview of DCF analysis ato = 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 SsemorganThe process of DCF analysis = '® Project the operating results and free cash flows of the business Projections/FCF over the forecast period (| = Estimate the exit multiple and/or growth rate in perpetuity of the Terminal value business at the end of the forecast period = Estimate the company's Waighited-aVerave cOstlGf capital to Discount rate determine the appropriate discount rate range '™ Determine a range of values for the enterprise by discounting the Present value projected free cash flows and terminal value to the present '@ Adjust the resulting valuation for all assets and liabilities not Adjustments accounted for in cash flow projections ued Ssemorgan 0DCF theory and its application ao 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 asset's value (including an estimated terminal value), discounted using an appropriate weighted- average cost of capital 1 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 i= 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 (GUflpreferred|appreaeh), 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) Ssetnorgan nThe two basic DCF approaches must not be confused ato = 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 2Other considerations = Reliability of projections 1 DGR esis are weiner ally iriore Sensitive tO EaBHMIOWS (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 1m Remember that DCF valuations are based on assumptions and are therefore approximate. Use several scenarios to bound the target’s value. orem cee U Cec Ssemorgan BAlways remember... ato m 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 DEVEL PERCE 5 | Sremorgan “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 company’s management ‘Acquiring company’s management Research analysts Bankers Ssemorgan asProjecting financial statements = Ssemorgan § Ideally projections should go/6Ut as fai into ithe future asian reasonably be to reduce dependence on the terminal value = Most important assumpti ‘Sal6S'FOWER: Use divisional, product-line or location-by-location build-up or simple growth assumptions Operating margins: Evaluate improvement over time, competitive factors, SG&A costs s 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.) m Analyze projections for consistency Sales increases usually require working capital increases 16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 firm’s 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 taxes! Plus: Depreciation and any tax-deductible amortization Less: Capital expenditures o Plus/(less): Decrease/(increase) in net working investment $ Equals: Unlevered free cash flow " Atgeuonneynd ine se of out ant sre, you sed ny ate at ca os pln te SCF. Sapencng nthe Hm a oy, you may nat taut SremorganExample: Calculating unlevered free cash flows — Fiscal year ending Bocember 31, mmor___2002 2003200 20052006 2007 2008 Net sales $4000 $440.0 Sa. $532.4 $885.6 Some $7086 $7795 EBITDA 800 O68 TUS NTT BBN? HB es: Depreciation mo 82 4S OKA ira 608 SOS GSO HS Less: Taxes at marginal rate m2 89 2D ‘Tax-etfected E8ITA sos 9 4 $543 S887 STS Pus: Depreciation %0 16 Pus: Deferred taxes Less: Capital expenditures mo 0k HHO Less: Inc. /(dect)n worng captal 100 85 7.0 55. 40 = Unevered free cashflow 42 GOR : Adjustment for deal date (03) a = - - Unlevered FCF to acquirer 500 fase SB SoA See = Koy assumptions: Deal/valuation date = 12/31/04 ‘Marginal tx rate» 40% Ssemorgan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 M&A transaction Revenue Cost Capital expenditures Expansion plans Cost reductions Change in sales growth Margin improvements 1m 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. Ssemorgan ;se] Once unlevered free cash flows are calculated, they must =m 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 FCF, FCF, FC; FCF, (ar)! (ten? (ur? (tery Present value = = 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 “mmidiVeareonvention)” which takes into account the fact that free cash flows occur during the year FCF, FCF; FCF; FCF, : JPeorgan > Present value = ++, +—*_ sane (toy (tay (tory? we (terror ® 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) Ssemorgan 20It is important to differentiate between the transaction date and the mid-year convention L I i i 2 I T T T Yer 0 os 1 15 2 25 3 35 First cashflow, Second cash flow, Third cashflow, mid-year 1 mid-year 2 mid-year 3 a, CF, CF; Discounting = + + ‘ (ores (avey' (tarp ener 2 Period 1 CF to buyer L | | | . = r T T T Yer 0 0m 4 15 2 25 3 35 First cash flow, Second cashflow, Third cash flow, 2 mid-period mid year 2 mid yeor 3 2 or, c, cA Dicomtngs stg (enero (tanyd9) (tony 8057 S.emorgan nPractice exercise Potiod 1 CF to buyer — i i 1 1 i T T T Year 0 os 1 15 2 25 3 35 ‘sttlow, 2nd cash flow, 3d cash flow, rmid-period 1” mid-year 2 mid-year 8 oF, cr, cr, Discounting= = + ——*_ » 24 (egersom ——(antsem —CaNesO7™ Ssemorgan 2Deavaluation sate = 12/31/04 ‘Marginal tax rate = 40% Discaunt rate = 108 Ssemorgan Example: Discounting free cash flows =a err re iene Fuca your encing December 3, 2001 20cm maou nese aah oer OP Net sates 0.0 $40.0 $4B.0 S522 S856 —Soaa2 SOR STIS ters 0 80H SIRT 89 Les: Depreciation no 2 seo ten ema 0 7483S 80S 25 Less Tanes at marginal rate m2 9 na 2 Tow etectea BTA wos 49 Sane S543 50.7 $057 Sn S798 Pus: Depreciation wo 7A Fis: Deere aes Less Captal expences rs a a Less cr. n worsing capita oo 8s rosa Unleverd re cath how a rT? jsent fr del date 0.9 Uniewred FF once soo sea Sse Sola Meme: counting factor oo oss Discounted value of unlevered FCF foo sue STS a8 Discounted valu of FF 205-208 1296 Formula $189.6 = $46.8 $53.8 oh $61.4 ‘ $69.6 (1+. 10)05 (1+.10)'5 (1+.10)25 (1+. 107-5 ny mmuiptionTerminal value can account for a significant portion of value in a DCF analysis = Terminal value represents the business’s value at the end of the projection period; i.e., the portion of the company’s 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 ) Terminal or “Exe)multiple metned Assumes that the business is valued/sold at the end of the terminal year at a multiple of some financial metric (typically EBITDA) ronan pErBETAIE, 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 the implied multiple/ growth rate for sanity check purposes essential to r Itis ™ 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? Sremorgan ‘What percentage of total value comes from the terminal value? 24Terminal multiple method ato = 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 Ssemorgan 2sMost common error: The final year is not normalized aoe 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 1 Treat the terminal value cash flow Bla Separate) eriticallYorseast Growth rate Consistent with lenigiterm/economie 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 Ssemorgan 26=x Example: Terminal multiple method a fea year nding Decor, Pe ee ae Te ee ee ee Trae s00 —$0d ead — Ss Sass Seu — Sn srs tai foo sk} tek toes HSS tes! eprcaten oma aso eo ern 0 4s 3S Leet aves arg rate m2 > ae ena nse ‘ocefeceataa sos say Sida? ST SaaS fis Dprecaten eo We 33a Fs: beerad es Te Ga expends momo 28 Aes mer ae) rg capa a re rc eT (hice ect ow 3) Maa ‘potest fore ee a3) =e = = Uneverd FEF vacaurer 00a aia oro scontng factor ous Sa Dict ait floes FEF fo sea? sea Ducted vf Fr TP 200° ioe tao cee sus fe mute 7 Fea oat so Ticnrted tral vale wa ‘oa present ake oats sus Key assumptions: Deal/valuation date» 12/31/04 ‘Marginal tax rate = 40% Discount rate = s0% Est multiple of EBTDA = 7.08 Ssemorgan Formula mmm 6745.4 = ($155.9 * 7,0x) (1410)Example: Terminal multiple method (cont'd) Discounted Discounted terminal value Fem value Fer at 2008P EBITDA multiple of a 2008? EBITDA multiple of Discount rate 2005-2008 6.0 7.0 oe 0 7.08 8.0 8% 5156.8 $07.5 SBR. «SOI67 sea $9990 §1,1136 9% 193.1 62.6 mas ‘ae 255.8 9662 4,076.7 0% 189.6 eo a4 934.9 1081.4 u% 186.4 616.2 79 NG 2023 49 ,007.6 2% 1.7 545 698.5 26 m2 87539783 Net debt Discount rate 1231/04 8% $100.0 9% 100.0 0% 1100.0 u% 100.0 me 100.0 Ssemorgan Equity value at 2008P EBITDA multiple of 6.0% S744 735.8 mB m2. ora 7.08 $899.0 86.2 a9 2049 776.3 © 80x $1,013.86 976.7 om 907.6 375.3 uit value par share! 2008? EBITDA mutipe of 6. 70% 808 si.) S297 2477 Sigg Sua7 23.87 sis 20a, S230 sin $1967 $22.18 $1635 sms? $39 28== 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 graw 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 n+1;' 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, JPMorgan models are set up to project one year past the projection year and allow for normalizing adjustments; this FCFn+1 is then discounted by the perpetuity formula a ‘Terminal value = (FCF, * (1 + 9))/{WACC — 9) ‘Terminal value = (FCF,,.,)/(WACC — g) =| were CF, = FCF inal poet he Ch, = FCF yeaa poet oF. ne Fe ene reepeae . 'WACC = weighted-avg. cost of capital WACC ‘weighted-avg. cost of capital PV of terminal value = terminal value/(1+WACC)™* > PV of terminal value = terminal value/(1+WACC "°° "nse tehennecae the pepe a fda sda he prc hte emia vale Busnes the ae ft ee cs Nan ed Ne Ssettorgan 29Growth in perpetuity method (cont'd) ae = 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 Ssemorgan 20Example: Growth in perpetuity method Perret s Fecal year ending December 31, yoo 2002 00s oP 200s 2006 moe 208 Net sales $00.0 40.0 «$480 SSA SBS Son StS TID eBsTO% 40.0 =. Less: Depreciation mo 82 as tet era 0 ~~ 48 a23~«90S~C« SSCS SCS Les: Taxes at marginal rate v2 9 293828280 “Tavceffectea tBiTA wos sug Sad Sa) 97 S657 SAS Pus: Depreciation wo 763A Px: Deterted taxes Lest: Capital expenatres 20 202 Lest Inert n woking apt wo 8s os s Unlevere fee cashflow ws eb MO Adjustment for dea date (0.3) Unlevered FCF to acquirer 00 8 sa Sa —~ 7" ‘Memo: Discounting factor 00 05 1S 28 as q Dcounted valve of unlevered FCF $00 HST Sak SRD Dcaunted valve of FCF 200-2008" 1895 ¢ PV of Terminal Value mz ©] rotator value wo acaurer a ay ssamptins Faeries nin =e Discount rate = 105 6 * (1 + S Perpetuity growth rate = 3% Formula em $733.6 = ———___—_ aaa Sreaorgin caeExample: Growth in perpetuity method (cont'd) ee es ee Discounted terminal value Fem value at perpetuity growth rate of at perpetuity gomth rate of 2.5% 3.0% 2.58 254 3.0% 15% WoO S4085.4 $1 223.0 SU1878 $129.2 $7,419.8 Bits BB 9689 10050 10770 1,102.0 eons 7a 7940 ert 923.3 983.6 5826 5206.7 7087 08.1 e528 505.1 538.8 570.1 6819 785 78 = Eauity value Equity value per share! Net eee at pemetity growth rate of at perpetuity gowth rate of Discantrate 12/31/04 25% 3.0K 3.58 25% 3.0% 38% 3% 3100.0 $rpe7 8 $102 S1319.8 $u659 914 $3226 = o% 100.0 050 970 4.0620 S212 haw 525.96 10% 100.0 mit 93.3 ae3.6 sist soz 52.59 8 1s 100.0 6687 708.1 7528 Stead S731 S840 1% 100.0 5o7.9 615 08.8 SM37 $15.12 $15.98 Sremorgan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: To go from the growth-in-perpetuity approach to an implied exit multiple: multiple = [FCF, * (1 + g)(1 + WACC)°5] / [EBITDA, * (WACC - g)] (WACC* terminal value) / (1+WACC)%5- FCF,] / [FCF + (terminal value / (1 + WACC)*5)] '® These formulas adjust for the different approaches to discounting terminal value When using the mid-year convention SsemorganTerminal multiple method and implied growth rates roan ne Discounted Discounted terminal value Fim vatue "Ferminal value a percent Discount Fer at 2008P EBITDA multiple of _at 2008 EBITDA multiple of of total firm value rate 2005-2008, 6.0 70x 8.0K 6.0, Tk 8.0K 6c 7.0e Be a $1968 $07.5 $8.1 $916.7 sia $998.0 $1,113.6 AOR % 1931 62.5771 BRS 55.8 966.2 1,006.7 TT 8% Be 108 1896 6389 705.4 BLS 284 9349 1041.4 TT BON Bt oy 1864 612 7189 BING 02.3 904.9 1,007.6 7h 7% ate 12% 1827 55 6935 726 m2 6a "95.3 aKa Eauityvae Ecuity value per share’ | implied perpetuity row rate Dincount Nek bk NEP EIPOK udp ok at 2UAPEBTDA up of | "ak 200BPEBTDA mute ot a rate 12/31/04 6.0% 7.0% 8.0 6.05 7.0% 8.0 te ot a % oad 75588662 9787 Sig? SRT 8887 108 1000 aaa gare Sie Sanat S08 i toad 7023 04d ors Snts Stor Ste 3 At a 9% discount rate and an 8.0x exit multiple the price PEE ae a Che me ie CEng Ssemorgan 34Perpetuity growth rate and implied terminal multiples Discounted Discounted terminal value Frm value [Fermin valve ws percent] Discount Fer atperpetuty growth rate of _at perpetuity growth rate of ‘of total firm value rate 2005-2008, 25% 30% 3.5K 1 OK 3.58 25x 30u 3.5% a $1968 $991.0 $1,0954 Si.22h.0 $1878 $1,202.2 S1.419.8 aL Bet % 1931 B19 "888 968.9 140050 1,077.0 1,162.0 ay RK BK 108 1896 ees 73R7 7940 ari (923.3 988.6 7 KK oy 1864 5826 6220 6467 787 0852.8 rn 12% 1827 5051 5358 570.1 ors 785 752.8 TOBY 6% OE EEE es Euity value Equity vale per share! lnmpiod EBITDA exit mutiple Discount Net debt -——_at petpetuty gromth rate of |_at perpetuity srowth rate of. at perpetuity growth rate of rate___12/31/04, 25% 3.0% 3.5 25% 303.58 25% 3.0% 3.5% oa 000 “$7,087-8 $1,1927 $7,310.8 2659 S28.14 $32.26 Box 8. TO 9% 100.0 905.0 977.0 1,062.0 S22:12 $23.88+) 925.96 74 80 8 10% 1000 TA 33 BS siese 20.12 | 521.59 e489 5 11% 100.0 687 7081 752.8 Sieae Sarat [$1840 57a | 65 E 12% 1000 5879 6185 652.8 si4a7 $15.12 | 515.95, saga | 58 3 Dit eee ee Ra eerie eR 2 the price is $23.88 and the implied exit multiple is 8.0x Ssemorgan 35Choosing the discount rate is a critical step in ae 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 (WAC) will be used as a foundation for setting the discount rate 1 The WACC fs 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 > m The WACC is related to the risk of the investment, not the risk or creditworthiness of the investor’ a canpiy. snes see ists sexs ow compare companies n etimatng waged meray ct of cpa. Neve wee a apts eis, bysare aes, evemaged onary st Ue of es Hower abuse oma resets aeqe'y sarin) Sremorgan 36JPMorgan estimates the cost of equity using the capital asset pricing model Sspmorgan m 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 1 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 1 The CAPM formula follo k-free rate + (beta * market risk premium) Cost of equity ret Bm the required market return on the equity of the company the risk-free rate the return on the market the company’s projected (leveraged) beta There is also an error term in the CAPM formula, but this is usually omitted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 today’s market 1 The market risk premium (f,,- rj i-e., the spread of market return over the risk-free rate) is periodically estimated by M&A research based on analysis of historical data Cost of equity = Riskfreerate + Beta x Equity risk premium ecm tnen Pen anyaica ec ead eeucnacs eee al iieniccmonct return above risk free Cor icine oraene cs (beta=0) Beresic returns ra = 10-year bond yield {annual average) Predicted betas x Estimated using various techniques For market average = 4.97% + 1.00 x 5.00% - 9.97% Ssemorgan 38JPMorgan estimates the equity risk premium at 5.0% fog 30 years — Roling 40 years —Reling $0 years 12% 10% 6% 1955 1959 1963 1968 1972 1976 1980 1984 1988 1993 1997 2001 S.emorgan 27 aa 44 a7 52 62 58 50. Fr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 mult models like the Arbitrage Pricing Theory 40J PMorgan uses predicted betas to calculate the cost of a 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 firm’s return and market returns and are often distorted = Projected betas can be obtained from Barra or an ontine database (e.9., IDD) Barra predicted betas can be found through the Investment Bank Home Web page! Note that Bloomberg betas are based on historic prices and are therefore not forward-looking Impute unlevered beta for private company from public comparables 0) ewer] Mt 5 tial = fee : fe = s 2) ee / tes ° SA! (63) 10)5) 60 05 19,15 20.25 0 35 40 eo BOF te Ssemorgan aDelevering and relevering beta Ssemorgan = 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 m= The formula follows: By= BLL = ((1 -T) * (Debt/Equity))] Where: AU = unlevered (asset) beta BL = leveraged beta T = marginal tax rate 1 To relever the beta at a target capital structure: Be ET + ((1-T) * (Debt/Equity))]Delevering and relevering beta (cont'd) = Note that JPMorgan M&A 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 m 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 Sremorgan aThe cost of a firm’s equity should be adjusted for size © Investors typically expect higher returns when investing in smaller companies Increased risk Lower liquidity = Betas vary very little by size %8- S1- Fes $500- 00 Sym. 0 SOO Historical equity returns suggest higher fcc “2m "See "Too Yoon “ts0n “aime “S00 $5900- return required by investors in smaller companies Per 2 P/E growth ratios (PEG) tend to decline with size = Empirical data combined with judgement should be applied when estimating the cost 5 = of equity for smaller firms ow s100soo ssans.om §1,0002,500 §2.005.000 $5 ,0n0- Sremorgan a4J PMorgan uses the long-term cost of debt in ia estimating WACC 1 The long-term cost of debt is used because the cost of capital is normally applied to long-term cash flows 1 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 = JPMorgan uses the company’s normalized cash tax rate SsemorganThe cost of equity and debt are blended together based on a target capital structure 1 The target capital structure reflects the company’s rating objective Firms generally ry 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 firm’s equity and debt position Host 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 Cr Where: T= Marginal tax rate E =|farKetValUsjof equity Tr. = Return on equity D-\Market valuelof debt ry = Return on debt rage cost of capital cae ost of equity Cost of debit {Cost of capital est of debt 6.25% SOsjenr Thon (Ava) 4am (-) Tax sie! 29% Market risk premium 5.00% (feta (cutrent predicted) oa Target capil siractire _ftertax cost of debt 4.06% Adqisted market premium Tor Koncnsteenrar eed Ber cost of equity » om Ssemorgan 46Example: Calculating WACC based on comparable companies Eee rs Macroeconomic assumptions Rk tee rate! 50% Projected Target marginal tax rate 0.0% Estimated market equty rk premium 40% Es ga a — Ta oe — ee a Eisen eer aes | = Shere amt meer te sas Gaels | = = ee aoe fant ord ei oS or capitalization Optimal debt/equity (bp) premium debt __ beta of 0.79 equity WACC “| ae anne on on = 1 Rote ateytste matany a 10 year US. Trew banda 1/1/01 Gowe Beane ‘hevred breed tet ( (ltl det art alin fous nt). Amma cfd gure Ssemorgan aThe appropriate cost of capital will depend on the entity which is being valued For ilustrative purposes Rsk Unlevered —_Optimal_—_—Re-levered Cost of castot | Company premium beta __debesequtty beta feaulty financing _|__ WAC Sysco 5.0% 0.70 20% 0.80 9.0% 6.15% 82 S108 target 5.0%6.5% 0.70 20% 080 9.0K-102% 6.257.508 | B94 $500mm target 5007.08 0.70 ov 0.80 9.0%-10.6% © 6.25%-ROK | BAK OTY 200mm target 5.007.56 0.70 20x 0.80 9.0%-11.0% 6.25%-8.500 | B.4K-10.1% PU ECs mar Tenens am a we Se Govan rz 73 725 fon su oo om sa ford om oan om oie = 0.85] 8.8% 8.4% 8.0% 7.85 os 10.3% 9.8% 9.4% 9.1% o ‘19.26 107K 10.3% 10.0% ‘Rasaneg my Yiax roman 3% Ascii an a etn Ssemorgan aeDCF in-class exercise 1 The Forecasted EBITDA and FCF for the next three years (2005, 2006, 2007) are EBITDA (US Smm): 450, 500, 550 FCF (US Smm): 250, 261, 277 1 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 equity=US $4,541mm Net debt= US $2,524mm Ssemorgan «9DCF in-class exercise (cont'd) = 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 discount Perpetual growth method Exit multiple method ‘What is the valuation if we need to value the company as on March 31, 20052 Use Exit/Perpetual growth methods using mid year conventions Use Exit/Perpetual growth methods using end year conventions Ssemorgan 50Most common errors in calculating WACC Cost of equity 1 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 1m WACC calculated based on book weights Ssemorgan PyValuing synergies Ey = 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) 1m 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 5 m 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 Ssemoroan 22Valuing synergies ey 1 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 ze 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 Ssemorgan 33Sensitivity analysis is vital when presenting the results of a DCF analysis ey = 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 m 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, Ssemorgan Pr