Applied Corporate Finance

Case 1: Canadian Pacific’s Bid for Norfolk Southern

Spring Semester 2021/2022

Professor: Rui Silva

Group 25:
Constança Collares Pereira, 39086
Henrique Oliveira, 39342
Isabel Alvim, 39088
João Pereira Coutinho, 46545
Mariana Calça e Pina, 39368
Teresa Soromenho, 39092
1. In times of economic growth and great difficulty in meeting the demands for rail capacity, a merger between Canadian
Pacific Ltd.'s (CP) and Norfolk Southern (NS) would offer the best opportunity to improve efficiency and increase volume,
without the need for additional infrastructure. This merger would result in major improvements in the current operating
performance in terms of cost savings, capacity utilization, and customer service. Moreover, a merger would allow both
railways to provide an end-to-end service to customers, without disruptions – this would increase velocity, decrease costs and,
finally, improve services without increasing rates.
Furthermore, it would also allow for revenue synergies that should be explicitly considered when valuing the offer. Regarding
the estimated Pre-Merger Operational Improvements, a $1.260B per year by 2021 should be expected – from fuel efficiency,
train productivity, and labor productivity. It was also projected a $495 million per year by 2021, as Post-Merger Combination
Synergies, and Additional Tax Savings of $200 million per year.
Considering that the North American railroad industry is regulated by the Surface Transportation Board (STB), the proposed
merger should comply with the STB’s requirements. To address these concerns, CP should not only guarantee the same high
levels of competition – achieved by operating in different geographic regions – but also avoid “bottleneck pricing”. This
would be achieved by giving shippers the chance to connect railroads according to their preferences, and by allowing
competitors to access their railroad, in case the entity is not pricing at competitive prices or is not providing an adequate
service.

2. There are two different methods we can use to evaluate NS’s cash flows on a stand-alone basis. The first one, is the
Weighted Average Cost of Capital (WACC). Using an average market leverage of the last 5 years and computing its average,
we get to 20%. This way, we assumed the firm is targeting, with a 20% on debt (D/V) and 80% on equity (E/V). To first
compute the WACC per se, we need to find βA (asset Beta). To do that, we need to take the average of βE (equity Beta) of NS
and its comparable companies, and re-lever it based on the fixed leverage ratio we are assuming. As for the risk-free rate and
the market risk premium we used the 30-year US Treasury rate (2,9%) and the 30-year premium of Welch (2001) survey that
averaged 5.5%, respectively. Once we collected this data, we computed the expected returns, re and rd, based on the CAPM.
$ $
Finally, the WACC was obtained using the following formula: 𝑟!"## = 𝑟 + 𝑟 ∗ (1 − 𝑡# ).
$%& $ $%& &

We then determined the free cash flows (FCF) of the investment between 2016 and 2021 and computed the value of the
investment by discounting the FCF’s by the WACC. We estimated an Enterprise Value of $31 007; Equity Value of $21 511
and per share value of $71.4. In addition, we performed a sensitivity analysis to understand how the per share value and
EV/EBITDA multiple would change, when changing the WACC and the growth rate. As there were no big discrepancy, we
are confident of our NS valuation. (Table 1, Table 2)
The second and last method we used was the Adjusted Present Value (APV). Here, we assumed a permanent debt. Firstly, we
forecasted the cash flows from running the business as an all-equity firm for 5 years to then discount them using the
appropriate rate, ra, that was computed in the WACC Valuation together with the remaining risk of returns. After accounting
for the terminal value and discounting it as a perpetuity with a grow rate of 2,5% (growth rate of the last forecasted CF’s), we
got to an Enterprise Value of $33 061; Equity Value of $23 565 and per share value of $78. (Table 3)
To conclude, and looking at the valuation multiples, Norfolk seems to trade at lower EBITDA multiple (7.9) than most
comparables. In fact, this multiple is an important indicator to understand if the company is overvalued or undervalued. As
we said, for NS, the value of this ratio is low and lower than the average ratio. As such, NS seems to be undervalued, and
hence, a good candidate for acquisition. (Table 4)

2
3. In order to understand what the PV of the projected merger benefits is, we had to measure the value of the main synergies:
the pre-merger operational synergies, the post-merger combination synergies and the tax savings that were achieved by a
lower effective tax rate. On the excel, we started by calculating the relevant Cash Flows and we then discounted them using
the WACC. Finally, we performed a sensitivity analysis to allow us to get better conclusions – even if we had made different
assumptions, the final result would not change much (Table 6). The total merger benefits comprised of around $19.414bn,
while the pre-merger benefits were responsible for more than 60% of the total synergies projected - by merging both
companies, CP is mainly exploiting the revenues coming from operational improvements from NS, that will yield higher
returns than the possible combined synergies. When looking at the overall net present value of merger benefits ($19.414bn)
— pre-merger operational improvements ($12.113bn), post-merger combination synergies ($4.336bn) and tax savings
($2.965) — and the CP’s initial proposal, we believe these values to be reasonable, as there seems to be a big margin for
operational improvements in NS and the majority of the projected benefits comes from operational improvements in the target
company (which had previously seen its profits dropping) (Table 5). Moreover, the positive impact of the combined synergies
from the merger are quite obvious.
However, we should be careful with our conclusions, since the synergy numbers were provided by CP, hence, they can be
biased, as their objective is for NS to accept the offer. We should cross-check these estimates and not fully rely on them.

4. Now that we have analyzed the NPV of merger benefits, we can also look at the market reaction to this merger. As people
started listening to the rumors of a merger, both NS and CP stock prices went up due to the attractive potential for higher
dividends arising from synergies between the companies. While NS increased by 11%, CP increased by almost half (6%) and
that aligns with the expected market reaction in a scenario like this, where the target company (shareholders) captures a major
part of the new market capitalization (McKinsey, 2004) by enjoying the premium price that the acquirer is willing to pay.
When the initial offer happened, both stock prices increased again (both by 6%). The fluctuations of these two major periods,
when multiplied by the number of shares of each company, can serve as an estimate of both companies’ total market
capitalization caused by this merger. This estimate results in $6.867bn which is less than a third of the total NPV of $19.414bn
computed in Question 3, which means that either our estimate is not truly representative of the market, or the market is
undervaluing the potential of this merger (or even both).
One reason for this estimate not to be trustworthy is that there might be a merger premium in the periods close to the rumors’
period that is being neglected. Another reason is that this estimate assumes that the merger has happened, but the market
doubts that. The market could indeed be undervaluing this merger as NS made sure to spread that it was not interested, which
means that price increases caused by the merger are being lower than they could. Finally, the regulation of STB that defined
strict rules to accept a merger can also cause the market to expect lower probability of closing the deal. (Table 7, Table 8)

5. On the 17th of November of 2015, CP made its first offer of a cash price of $46,72 per share and a conversion ratio of 0.348.
With this offer, and with the merger synergies having a present value of $19 441bn, the CP-NS enterprise value will be
$81 100M – equal to the sum of the stand-alone enterprise values plus the previously calculated present value of the merger
benefits. By subtracting the value of debt, which is made up of the sum of both debts plus the Merger Debt, we arrived at a
combined equity value of $51 045M, implying that each NS-CP stock will cost $191,98.
To calculate the value of the offer, one should multiply the stock exchange ratio (0,348) by the merged company's share price
($192) and add the compensation cash of $46,72, yielding a value of $113,53 per NS share. However, on December 8, CP
revised its offer, lowering it to $32,86 in cash (13,86 less than the initial offer) and increasing the conversion ratio to 0.451
(increased by 0,103). With this new offer, the enterprise value of the merged company remains the same – $80 941M – but
the merger debt is lower as it offers less cash per NS share. As so, the equity value of NS-CP increases to $55 196M, resulting
3
in a share price of $185,89, which means that an investor who owned one NS share valued at $80, would now own 0,451 CP-
NS equities worth $83,84 (185,89 x 0,451). This reflects an increase in value as a result of merger benefits. Hence, when the
cash compensation is factored in, the revised offer is worth $116,7 per NS share.
Assuming that all the merger benefits are realized, this new offer will increase the company's value by 46 percent when
compared to the value it has if it does not accept the offer. If, on the other hand, the merger advantages were not expected to
be realized by investors, the NPV would not be reflected in the new company's stock market valuation, implying that its share
would sell for $121, instead of the present share price of CP. In this case, NS stockholders would be worse-off since 0,451 of
a post-merger share would now be worth $54,35 instead of $83,84. Overall, it is vital that the merger advantages are realized
for NS shareholders to profit from owning CP-NS shares in the future, so they can absorb the true value produced by the
merger. (Table 9 and Table 10)

6. On December 4, 2015, CP had its initial offer to acquire the firm´s shares for $46.72 in cash and a fixed exchange of 0.348
CP shares for each NS share rejected by NS board of directors. They said the offer to be “grossly inadequate” and CEO
Squires believed that there would be a high probability that it would be rejected by the STB and doubted the overall value of
the merger. CP quickly came back with a revised offer to $32.86 in cash and 0.451 CP shares for each NS share.
On top of this on December 16, CP “sweetened the offer” to include 0.451 units of a Contingent Value Right (CVR). The
CVR works as a long-run insurance against a drop in CP-NS share value that had a measurement period of 18 months ending
on October 2017, two months before CP expected to receive the final regulatory decision. It would be highly liquid so that
NS shareholders could choose to hold to maturity or sell it after the transaction. At its maturity each CVR would receive a
cash payment of $175 less the CP-NS share price. As shown in Figure 1 the CVR sweetens the deal by acting as a safety net
for NS shareholders in case CP-NS share price is not as high as initially thought. (Figure 1)

7. Following our analysis and expectations regarding CP’s sweetened bid to NS – considering the CVR security – we believe
that the reasoning behind the NS shareholder’s decision should not be based solely on the CVR, as its effect on the value of
the revised offer is negligible.
The CVR works as a guarantee against unfavorable situations, such as negative market fluctuations on the CP-NS share price
or an eventual regulatory block by the STB board. Its existence reveals a CP’s strong feeling of confidence on the merger
benefits.
Considering a scenario where all the merger benefits exist, the CP-NS share price would be $185.89. In this situation, an NS
shareholder would have the right to 0.451 of this value – $32.86 and $83.84 for cash and share value, respectively – reaching
a total of $116.70. This would imply an increase of 45.9% in value per NS share. (Table 10)
On the other hand, within a scenario of zero synergies, the CP-NS share price would significantly decrease to $121. This
would imply an increase of just 9% in value per NS share. However, as we are considering the ‘sweetened’ offer, each NS
shareholder would have the right to benefit from the CVR security – At maturity, each CVR would receive a cash payment
equal to $175 minus the CP-NS share price at maturity up to a maximum cash payment of $25. (Table 10)
From our analysis, NS should accept the deal, as the benefits seem high and confident enough. Nonetheless, we would
recommend further analysis (as the estimates were given by CP) and should keep in mind that there is risk of a regulatory
block from STB and risk of not achieving 100% synergies.
According to some research, we acknowledged the merger CP-NS was not successful. One of the reasons behind this result
might be the agency problems, as the deal would bring major control to the CP managers over the NS shareholders. It is also
relevant to bear in mind that all the benefits and projections provided were carried out by CP, the most interested in the
merger.
4
Appendix

Table 1 – WACC Stand Alone Valuation

Projected (period ending 12/31)

2016 2017 2018 2019 2020 2021
Revenue $10 698 $11 175 $11 671 $12 191 $12 557 $12 871
Growth rate (%) 0,5% 4,5% 4,4% 4,5% 3,0% 2,5%

Operating expenses $6 397 $6 570 $6 808 $7 049 $7 139 $7 440

EBIT $3 210 $3 470 $3 683 $3 915 $4 118 $4 118

Operating ratio 70% 69% 68% 68% 67% 68%

EBIAT $2 054 $2 221 $2 357 $2 506 $2 636 $2 636

Depreciation $1 091 $1 135 $1 180 $1 227 $1 300 $1 313
Capital expenditures $2 070 $1 910 $1 930 $1 930 $1 949 $1 969
Net working capital ($128) ($134) ($140) ($146) ($151) ($154)
Change in NWC $63 ($6) ($6) ($6) ($4) ($4)

FCF
1 012 1 452 1 613 1 809 1 990 1 983

Terminal Value 0 0 0 0 $0 $37 513

Discounted FCF (WACC) $938 $1 246 $1 283 $1 334 $1 360 $25 002
Enterprise Value $31 163
Debt $9 496
Equity Value $21 667

# Outstanding shares 301,4

Share price $71,9
EV/EBITDA 7,5

Table 2 – Sensitivity Analysis

$ / Share TV Growth Rate

$71,9 2,40% 2,50% 2,60%
WACC 7,700% 74,7 76,4 78,1
7,920% 70,4 71,9 73,4
8,140% 66,3 67,7 69,1

EV / EBITDA TV Growth Rate

$7,5 2,40% 2,50% 2,60%
WACC 7,700% 7,7 7,9 8,0
7,920% 7,4 7,5 7,6
8,140% 7,1 7,2 7,3

5
Table 3 – APV Stand Alone Valuation

Projected (period ending 12/31)

2016 2017 2018 2019 2020 2021

Revenue $10 698 $11 175 $11 671 $12 191 $12 557 $12 871
Growth rate (%) 0,5% 4,5% 4,4% 4,5% 3,0% 2,5%

Operating expenses $6 397 $6 570 $6 808 $7 049 $7 139 $7 440

EBIT $3 210 $3 470 $3 683 $3 915 $4 118 $4 118

Operating ratio 70% 69% 68% 68% 67% 68%

EBIAT $2 054 $2 221 $2 357 $2 506 $2 636 $2 636

Depreciation $1 091 $1 135 $1 180 $1 227 $1 300 $1 313
Capital expenditures $2 070 $1 910 $1 930 $1 930 $1 949 $1 969
Net working capital ($128) ($134) ($140) ($146) ($151) ($154)
Change in NWC $63 ($6) ($6) ($6) ($4) ($4)

FCF
1 012 1 452 1 613 1 809 1 990 1 983

Terminal Value 0 0 0 0 $0 $35 744

Discounted FCF (WACC) $936 $1 240 $1 274 $1 320 $1 343 $23 529
PV Tax Shield $3 419
Enterprise Value $33 061
Debt $9 496
Equity Value $23 565

# Outstanding shares 301,4

Share price $78
EV/EBITDA $8,0

Table 4 – Valuation By Multiples

Ticker CNI CP CSX KSU NSC UNP Average

EBITDA $5 047 $2 586 $4 926 $1 086 $4 140 $10 491
EV $54 152 $29 592 $36 331 $12 260 $32 523 $88 971
EV/EBITDA $11 $11 $7 $11 $8 $8 9,5

6
Table 5 – Projected Merger Benefits

Projected Merger Benefits

1 2 3 4 5 6
2016 2017 2018 2019 2020 2021
Pre-Merger Operational Improvements
Increase in EBIT $214 $529 $844 $1 $1 $1 260
159 260
Incremental Taxes (on p.7) 36% $77 $191 $304 $417 $454 $454
EBIAT $137 $339 $540 $742 $806 $806
Terminal Value 2,50% $15
255
Incremental Pre-Merger FCF $137 $339 $540 $742 $806 $16
061
Discount Rate and Factor 7,9% 0,93 0,86 0,80 0,74 0,68 0,63
Present Value $127 $291 $430 $547 $551 $10
167
PV Pre-Merger Operational $12 113
Improvements
62%

1 2 3 4 5 6
2016 2017 2018 2019 2020 2021
Post-Merger Combination Synergies
Increase in EBIT $0 $0 $124 $248 $371 $495
Incremental Taxes (on p.7) 36% $0 $0 $45 $89 $134 $178
EBIAT $0 $0 $79 $158 $238 $317
Terminal Value 2,50% $5 993
Incremental Post-Merger FCF $0 $0 $79 $158 $238 $6 310
Discount Rate and Factor 7,9% $0,93 $0,86 $0,80 $0,74 $0,68 $0,63
Present Value $0 $0 $63 $117 $162 $3 994
PV Post-Merger Operational $4 336
Improvements

1 2 3 4 5 6
2016 2017 2018 2019 2020 2021
Tax Synergies:
Increase in EBIT (on p.7) $0 $200 $200 $200 $200
Terminal Value 2,50% $3 783
Incremental Pre-Merger FCF $0 $0 $200 $200 $200 $3 983
Discount Rate and Factor 7,9% $0,93 $0,86 $0,80 $0,74 $0,68 $0,63
Present Value $0 $0 $159 $147 $137 $2 522

PV Tax Synergies 2964,86

PV of Total Merger Benefits $19 414
# shares outstanding (p.8) 301,4
PV of Total Merger Benefits / Share $64

7
Table 6 – Sensitivity Analysis

PV of Total Merger Benefits TV Growth Rate

$19 414,1 2,40% 2,50% 2,60%
WACC 7,700% $19 761 $19 963 $20 173
7,920% $19 226 $19 410 $19 601
8,140% $18 732 $18 901 $19 075

PV of Total Merger Benefits / Share TV Growth Rate

$64,4 2,40% 2,50% 2,60%
WACC 7,700% $66 $66 $67
7,920% $64 $64 $65
8,140% $62 $63 $63

Table 7 – Stock price changes

Period Timeline NS Stock Price CP Stock Price

Beg % Δ Market % Δ Market
Event Beg End Beg End
End Change Value Change Value
11/06 - 11/09 Rumors 79,87 88,62 11% 2 637,25 134,31 142,18 6% 1 267,07
11/17- 11/18 Initial Offer 86,97 92,49 6% 1 663,73 138,58 146,65 6% 1 299,27

Table 8 – Market Value Variations

CP Δ Total Δ
NS Δ Market NS % of Δ CP % of Δ
Market Market
Value Market Value Market Value
Value Value
Merger Rumors $2 637,25 $1 267,07 $3 904,32 68% 32%
Initial CP Offer $1 663,73 $1 299,27 $2 963,00 56% 44%
Total $4 300,98 $2 566,34 $6 867,31 63% 37%

Table 9 – Value Initial Offer

NS - CP (0% NS - CP (100%
CP NS
synergies) synergies)

Share Price 134 80 119 191,88

#shares outstanding 161 301,4 266 266
Debt Outstanding 6 477 9 496 15 973 15 973
Merger Benefits - - 0 19 414
Enterprise Value 28 051 33 608 61 659 81 073
- Debt Outstanding -6 477 -9 496 -15 973 -15 973
- Merger Debt - - -14 081 -14 081
Equity Value 34 528 43 104 31 605 51 019

Value of Offer ($, per NS share) 100% synergies 0% synergies

Cash 46,72 32,86
Value of Shares 66,77 41,36
Value of Offer 113,49 74,22
% Increase in Value 41,9% -7,2%
8
Table 10 – Value of Revised Offer

NS - CP (0% NS - CP (100%
CP NS
synergies) synergies)

Share Price 134 80 121 185,89

#shares outstanding 161 301,4 297 297
Debt Outstanding 6 477 9 496 15 973 15 973
Merger Benefits - - 0 19 414
Enterprise Value 28 051 33 608 61 659 81 073

- Debt Outstanding -6 477 -9 496 -15 973 -15 973

- Merger Debt - - -9 904 -9 904
Equity Value 34 528 43 104 35 782 55 196

Value of Offer ($, per NS share) 100% synergies 0% synergies

Cash 32,86 32,86
Value of Shares 83,84 54,35
Value of Offer 116,70 87,21

% Increase in Value 45,9% 9,0%

Figure 1 – With CVR Payoff VS Without CVR Payoff