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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Objectives

Review the key valuation methodologies and techniques Review merger consequences / pro-forma analysis including updates due
to recent accounting changes

Communicate JPMorgan standards Provide examples and rules of thumb to enhance valuation related
intuition and highlight common mistakes

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Why valuation is important?

Acquisitions How much should we pay to buy the company? Research Should our clients buy, sell or hold positions in a given security?

Divestitures How much should we sell our company/division for? Fairness opinions Is the price offered for our company/division fair (from a financial point of view)?

Valuation
Hostile defense Is our company undervalued/vulnerable to a raider Debt offerings New business presentations Various applications What is the underlying value of the business/assets against which debt is being issued? Public equity offerings For how much should we sell our company/division in the public market?

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Valuation methodologies
Valuation methodologies

Publicly traded comparable companies analysis

Comparable transactions analysis

Discounted cash flow analysis

Leveraged buyout/recap analysis

Other

Public Market Valuation Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium

Private Market Valuation Value based on multiples paid for comparable companies in sale transactions Includes control premium

Intrinsic value of business Present value of projected free cash flows Incorporates both short-term and long-term expected performance Risk in cash flows and capital structure captured in discount rate

Value to a financial/LBO buyer Value based on debt repayment and return on equity investment

Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model

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The valuation process


Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies

(1) Discounted Cash Flow


Analyzes the present value of a company's free cash flow.

(2) Publicly Traded Comparable Companies


Utilizes market trading multiples from publicly traded companies to derive value.

(3) Comparable Acquisition Transactions


Utilizes data from M&A transactions involving similar companies.

(4) Leveraged Buy Out


Used to determine range of potential value for a company based on maximum leverage capacity.

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The valuation summary is the most important slide in a valuation presentation


The science is performing each valuation method correctly, the art is using each method to develop a valuation recommendation
Price per share
$20.00 $26.75

$15.00 $15.00

$9.75 $10.00 $10.25

$5.00 $4.94

$5.00 $4.00 $4.00 $3.00

$5.00

$5.50 $6.00 $3.50

Implied offer = $8.46

$3.75

$0.00

52-week high/low

15.0x to 19.0x 2001E EBIT of $20.6

19.0x to 25.0x 2001E cash EPS of $0.16

15.0x to 20.0x 2002E cash EPS of $0.25

2.5x to 4.0x LTM revenue of $185.7

Mgmt. Case
12% to 15% Discount Rate EBIT exit mult. of 15.0x to 20.0x

Street Case
12% to 15% Discount Rate EBIT exit mult. of 15.0x to 20.0x

Public trading comparables

Transaction comparables

DCF analysis

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Trading comparables analysis as a valuation methodology


Valuation methodologies

Publicly traded comparable companies analysis

Comparable transactions analysis

Discounted cash flow analysis

Leveraged buyout/recap analysis

Other

Public Market Valuation Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium

Private Market Valuation Value based on multiples paid for comparable companies in sale transactions Includes control premium

Intrinsic value of business Present value of projected free cash flows Incorporates both short-term and long-term expected performance Risk in cash flows and capital structure captured in discount rate

Value to a financial/LBO buyer Value based on debt repayment and return on equity investment

Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model

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Trading multiples analysis is a key technique based on assumption that current market is right
Overview The right comps The right multiple Spreading the comp Deriving value

Pros

Cons

Difficult to identify 100% comparable companies Must make the difficult decision whether the company being analyzed is valued higher, lower or the same as the average of the sample May be short term divergences from fundamental value Stock market may reflect "sentiment and not the "true picture Thinly traded, small capitalization and poorly followed stocks may not reflect fundamental value Different accounting standards Different level of information according to national stock market requirements

Market values incorporate perception of all investors reflecting firm prospects, industry trends, business risk, market growth, etc. Basic tool for estimating market value Provides check for DCF Values obtained are reliable indicator of the value of firm for minority investment

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A primer: firm value vs. equity value


Overview The right comps The right multiple Spreading the comp Deriving value

Firm value

Market value of all capital invested in (often referred to as enterprise value or asset value)

business

(1)

The value of the total enterprise: market value of equity + net debt Equity value = Market value of the shareholders equity (often referred to as offer value) The market value of a companys equity (shares outstanding x current stock price) Firm value - net debt
(2)

Equity value

Assets

Liabilities and Shareholders Equity

Enterprise value

Enterprise Value

Net debt

Equity value

The value of debt should be a market value. It may be appropriate to assume book value of debt approximates the market value as long as the companys credit profile has not changed significantly since the existing debt was issued. 2 Net debt equals total debt + minority interest + preferred equity + capitalized leases + short-term debt - cash and cash equivalents.
1

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Firm value should take into consideration all relevant layers of capital
Overview

Im t e
The right comps The right multiple Spreading the comp Deriving value

Ce on m m t

Eyu q ve ua i l t Coo o nc mt k m s a rticelpl s ft k k en m c es e s u tl as o i Muoldues oc on n ld ou t D ice Os p tn i o Crl prdc o t efr sk ni re t * vb eeo e Crl d o te t ni e vb b e * D e b t Pr sk re tc eeo frd D e b t Cles a la p s i e t a Crl prdc o t efr sk ni re t * vb eeo e Crl d o te t ni e vb b e * M itrt ions n e r e i t y C a s h C a s h Mbets aasre rt l ci k eu e i E itrti ats q nsnl e u es fi i e fa t y i eax emltnim nl c f cu fr a e l r l i f l ry u co u Gl edoaao ve n ( rta iaa iofho ld k l , al) t m um u i e o e e f l y Icea vevbfuten n ( rta iaa iofho ld k l , al) t m um u i e o e e f l y Icea vevbfuten ean ( rtaiaa i cu o ve nl ld k l , al) aa fr a e um u i e l l i f l ry e f l o u Gl icea vevbnctnim a a iaa rt l ,f al ku ie e l Mve vb a a i hy rt l ,no ku r e Mvete Ai tercun D haaa R sect s h l li n o

n ic nhs anpenuaser ld e tl a( t t en c sc- a un a r t m nt ic tn t u m r d y Icer eseeeedormers mfrtnoa e o dnle to s a v ) h a l eu d o t c o r f ho n t o n en m v mhs e s e y Cro maii ten o t c o r f ho n t o n en m v mhs e s e y Cro maii ten

Note: Asterisk (*) implies you need to decide on placement based on whether the security is in-the-money or not - do not put it both places! 11

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Different multiples apply to equity value and firm value


Overview The right comps The right multiple Spreading the comp Deriving value

The defining difference lies in the treatment of debt and its associated cost
(interest expense)

A multiple that has debt in the numerator must have a statistic before interest
expense in the denominator

Equity value
Value for owners of business (after interest expense) Multiples of: Net income After tax cash flow Book value

Firm value
Value available to all providers of capital (before interest expense) Multiples of: Sales EBITDA EBIT

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The key steps for trading comparables


Overview The right comps The right multiple Spreading the comp Deriving value

Identify the right comparable companies Choose the right multiples for comparison purposes Spread the comp correctly Apply the comparable data to derive a value

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Key comparables must be in same business as target


Overview The right comps The right multiple Spreading the comp Deriving value

Consider the perspective of equity investors (can use equity research as a proxy) to what would they compare target? You want to indentify companies that closely resemble the composition and function of the company you are evaluating

Operational Industry Product Markets Distribution channels Customers Seasonality Cyclicality

Financial Growth prospects Size Margins Leverage Shareholder base (influence of a large shareholder)

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Go even further, and identify a limited group as closest comparables


Overview The right comps The right multiple

Example of criteria used


Business/ profit mix Market cap/sales Financial margins/growth Comments/ special issues

Country Company X

Spreading the comp Deriving value

Very relevant

Company Y

Company Z

Company A

Others

Company B

Company C

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Choosing the right multiples


Overview The right comps The right multiple Spreading the comp Deriving value

It is important to understand what metric the companies in a peer group trade off of (revenue, EBITDA, EPS, etc.)

Typical valuation measures include

Firm value multiples Firm value/sales Firm value/EBITDA Firm value/EBIT Equity value multiples (Equity value/net income) or (price/EPS (P/E)) Equity value/after-tax cash flow Equity value/book equity

Valuation multiple can be calculated on both a latest twelve months (LTM) and a forecasted basis Companies trade most typically off expected future performance (analysts estimates)

EPS estimates are available from I/B/E/S on Bloomberg Other income statement projections are found in equity research reports available from Market Data Services, Multex and Investext

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The selection/presentation of appropriate multiples is as important as the calculation of the comps


Overview The right comps The right multiple Spreading the comp Deriving value

Types of multiples used may differ significantly from industry to industry Use analyst research for choosing comps and multiples Seek guidance from more senior team members/industry group experts on which
multiples to use

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Determine multiples used by investors there are three commonly used multiples . . .
Overview The right comps The right multiple Spreading the comp Deriving value

M ue lp tl i Pen r/ r g i as cn ei

P r o s ie dnoalr dubesr a l s y s, t l y t i y c We iv rpu fwe/ea oryPt t r drE e aa s s i m o s rpvPu n uoc Se s sste f r e i i s Cnpe Eg ab vl ae i l a

C o n s itt bf nctg s d iea i o y rt on r f u De decn piealrdcn rt sru eit a , t a pa cp l r i c i y eo c ih neyam g e i cl ps l s nl c a yt i i i e Hsiv ccon a itt b e n se e e bo yr e a C drdlvg itt bf nx s s d iet ai o y r at n r f De digre cp o m s

Fv/B i aEA r leID m T u

oanlau oi y lnt do c i s r i r e Gticcdis oos nor n o c- t m s d ooy a f cr i s Grrsucpo nenlvg dntf re pe e a I edoe

Pgt /t r h Eo ow

oi s ri f r h ra Pt ow m / a ro z o NleEsgt pe rp oc st s ie d u ,om dui nt ne l sn s s r y r a Weidilcu sr es c t o

itt bf nctg s d iea i o y rt on r f u De decn piealrdcn rt sru eit a , t a pa cp l r i c i y eo c ih neyam g e i cl ps l s nl c a yt i i i e Hsiv ccon a itt b e n se e e bo yr e a C drdlvg o y ono a tl s ns n t a asu h w Na cesw slbc dalw h euic f o i ldnh u ne s d o a itt b e n se e e bo yr e a C drdlvg

Pcfw r/ s i al ch e o

ie dnoalr dubesr a l s y s, t l y t i y c We iv rpu iEe no u r p os iedc rc rfrt pa r of n r i e eo Ctf deeitn pe os li i c

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. . . supplemented by industry-specific ratios and other ratios


Overview The right comps The right multiple

Industry-specific examples
M u l t i p l e F ie rp m v a l u / p o P r o s Tr lnt ee cd or m iy d u s ta ri p ro e f ee Cw irh teis ich cg ao lua frtn os l ri ao /t h i u t rlg Ita m o rr to a n tt e li e c m o p Go ois dt fm ot rr m o ru e a ti u e a n os Ra fe lrs eh cr tm se c u n t a r k e et Uh es flc uw lik fl ii oc r h ce yx ch cb ai st t so s(& ir. m mi ife liia ae r .n pli o n tm a g b it l s i t y c o m p a n i e s ) C o n s Do po eft nc dm ep ne te ot no nr us m b i n eri ctt om ua nr ttk rn ye as nh da pr oe e i a l Ato sta uils mm efp so s c a m e p r o i a b l y sfr Ato sta uils mm efp so s c a m e p r o i a b l y sfr Dtn fsis iut cg uw liri th ti h ea no g h o u t ios Fc ipp lte se tdc os c iu ar uo rn et i d f m ei r x an wb hr iat co hi io m pl ci tf v e ri a ly p t a

F ie rb m v a ls u /e s u c r i b r
Spreading the comp Deriving value

F ie rn m v a l u / t o

O t h e r r a t i o s F ie rI m v a lT u / E B Ie na ee p e n d n t o f l e v e r dg D st td o rr te e d y i f e n ib dts en pg rc ep co ic ai tu io o n / l a n ic e Ft /ir E B Ie T D A s b t e r a i o V N tir u s e d b y n v e s t o s o Ha gr ho ln yf db ei ey d e n tt o n p i t ipl De ste tae od ru tcs er dc y c o n i n g i f ibn Nc edh pe rr ok fo ic ts a b ic l i t y es N tb fy a v o rt e d is n v e s o or D s t o r t e d y cr yy cP lf/ ic cE a lo iu tt y o n s ib Ate se us mt em sil cii or m pa sv t le ra a a r sds Sn m ec ce od uy n tn re y P / E s i l u ofb d/s oii m im ns at nr ti e c o p a n e s n d u
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F ie rl m v a ls u / s a e

P rl ik c e /u b o o v a e

Mt sh te og fw ti r eo nh u s d t h g h oiw cn otr mn pv ae ne ids ea sn th hi ag ta o o Bn ntm cis hs m an ro ki f o oe r t r a n s a ec ii n d u s t r e s Uii eis fin ue ltv fl n od rs cu at pr as i e nn t a sed fn ilt n a n c it a io s t i u i n s Ril f-b ln t ea cto trlo s ik lm oo g ti e p r o t y efu Cd nte cir o ie ro ef ce tu fn on rg as cc c an bie en tpu wts efn ee nre cn oc m at nr iio ei s d Co nit sn ef nr sm ua si po r n o s p e c t i v oe a v a i l a b l e

R es lr a t/ ie v e p in c e a r i n g

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Performance measures
Overview The right comps The right multiple Spreading the comp Deriving value

Comparing various statistics and performance measures among the companies in


your comparable universe can help shed light on why companies may trade the way they do

Growth rates

Margins / profitability

Gross margin EBITDA margin EBIT margin Net income margin Operating margin Return on total invested capital (industrial companies) Return on equity (financial institutions companies)

Capitalization / credit

Sales Operating income Net income

Leverage and liquidity ratios Coverage ratios Off-balance sheet debt/operating leases

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Spreading the comps correctly - JPMorgan standards


Overview The right comps The right multiple Spreading the comp Deriving value

Use diluted shares using the treasury method Calendarize forward estimates so that all companies are being compared for the
same twelve month time period

Pro forma companies financial results for announced transactions (acquisitions


and divestitures)

Forward estimates for EPS should be based on IBES or First Call medians, but
ensure you understand the components of these estimates Some analysts included in those mean/median calculations may not have updated their estimates even though there has been a significant change in the companys prospects

Forward estimates for sales, EBITDA and EBIT based on analyst research

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JPMorgan uses the treasury method to calculate fully diluted shares outstanding
Overview The right comps The right multiple Spreading the comp Deriving value
E x e r c i s e p r i c e I n t h e m o n e y ? S h a r e s i s s u e d u p o n e x e r c i s e 2 , 9 7 5 . 0 7 7 , 1 6 5 . 0 9 6 , 7 8 2 . 0 0 . 0 1 7 6 , 9 2 2 . 0 5 ,9 7 4 0 , 8 9 . 0 1 7 6 , 9 2 2 . 0 (. 1 4 3 , 5 2 2 5 ) 3 3 , 3 9 9 . 5 15 ,2 7 7 2 ,2 2 3 , 8 8 . P rr o c e e d s f o m e x e r c i s e $ 2 5 , 4 6 6 . 0 $ 1 ,3 9 2 8 , 3 5 . 4 $ 3 ,9 7 8 7 , 0 7 . 7 $ 0 . 0

The treasury method assumes all in-the-money options are exercised and the proceeds used to buy-back shares

Example
E x a m p lc e C o I n .
Te(0 osl K tsd/ aoe l hn0 btg) astQ sta i us ca1 a t1 rn i C Ep u r r e xr n ar t m pe lh e C o s a e i c 10 ,9 7 7 2 ,3 1 9 , 4 8 . $ 4 0 . 0

Issues/pitfalls

Break out each tranche of outstanding options and warrants separately Avoid double counting of options - do not include Total line in calculation! Equity value should be calculated using all options and warrants outstanding (not just exercisable) Stock splits Pro forma adjustments Note accounting convention for diluted EPS in financial statements uses average stock price over the prior year - not correct for calculating current shares outstanding

O u tg s t a n d i n T r a n c h e 1 T r a n c h e 2 T r a n c h e 3 T r a n c h e 4 T o t a l 2 , 9 7 5 . 0 7 7 , 1 6 5 . 0 9 6 , 7 8 2 . 0 1 1 0 , 9 7 5 . 0 2 8 7 , 8 9 7 . 0

T r e a s u r y s h a r e s p u r c h a s e d w i t h p r o c e e d s 6 3 6 . 7 4 8 , 2 0 8 . 8 9 4 , 6 7 7 . 0 0 . 0 1 4 3 , 5 2 2 . 5

$ Y 8 e . 5 s 6 $ Y 2 e 4 s . 9 9 $ Y 3 e 9 s . 1 3 $ N 5 o 7 . 0 0

Tuip oes tset ado l iuf s po ho i ano r xn e es sr sc e Tpp rh w e ur a ric sco uhe r ae ysd se s ad r t eh s Ieu ne crn rsd es mi nt to aa l tg hn a s Frn ue lts yo du ihn lag us et dd si t a

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Calculating the LTM (latest twelve months)


Overview The right comps The right multiple Spreading the comp Deriving value

Fiscal Year QT-1

Most Recent Period

Period Ending one year prior to most recent QT

Annual Example: General Electric LTM = 6/30/01


Annual (12/00) $129,853 + Six Months 10Q (6/01) $62,470 Six Months 10Q (6/00) $62,858 = LTM (6/01) $129,465

{
Q1 Q2 Q3

Q4

{
Q1 Q2
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ANNUAL

Total Revenue

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Calendarizing financial data


Overview The right comps The right multiple Spreading the comp Deriving value

When companies in the comparable universe have fiscal years ending at a date other than
that of the client or focus company, it is common to employ the technique of calendarization

Calendarization adjusts the financial data of one company to reflect results representative
of the period in time corresponding to the latest fiscal year of the client or focus company This insures that the financial data of both companies is truly comparable by eliminating seasonal or cyclical differences that may arise as a result of dissimilar fiscal year ends

Example: Client/Acquiror has fiscal year end (FYE) 12/31 while Target has FYE 10/31

Target FYE 2002E Net Income = $120, Target FYE 2003E Net Income = $150 Calendarize from 10/31/02 to 12/31/02:

Ideally could use quarterly estimates10 $120 2 $150 Target CY2002E Net Income = + = $100 + $25 = $125 However, availability and consistency are an issue 12 12

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Two approaches are widely utilized for developing forward estimates


Overview The right comps The right multiple Spreading the comp Deriving value

Bottoms-up approach

Use IBES median EPS estimate Build-up from EPS to EBIT / EBITDA using analyst estimates for shares outstanding, tax rate, interest expense, depreciation & amortization Advantages: Automatically reflects changes in earnings estimates as they are made by IBES Not tied to one specific equity analyst Disadvantages: Need to reality-check resulting EBIT and EBITDA Cannot foot directly to an analyst report

Top-down approach

Use IBES median EPS estimate Use a specific analyst report (or the average of a group of reports) for EBIT / EBITDA estimates Advantages: Easy to check Can cite specific source your estimate came from Disadvantages: Does not automatically update Will not necessarily reflect consensus

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Dealing with minority interest and equity in unconsolidated affiliates


Overview The right comps The right multiple Spreading the comp Deriving value

Minority interest

Minority interest represents the portion of a consolidated subsidiary which you do not own Need to make sure the numerator and denominator of a trading multiple are on an apples-to-apples basis Numerator: Add the minority interest (market value if available or book value) to firm value Denominator: Consolidated financial results Consider the following example: Market cap of $500MM Debt of $500MM Consolidated EBITDA of $100MM Minority interest of $50MM Firm Value = $1050, EBITDA = $100 FV / EBITDA = 10.5x

Equity interest

Equity interest in unconsolidated affiliates represents a minority stake you hold in another company Need to make sure the numerator and denominator of a trading multiple are on an apples-to-apples basis Numerator: Subtract the equity interest (market value if available or book value) from firm value (i.e. treat as cash) Denominator: Consolidated financial results (do not include equity interest) Consider the following example: Market cap of $500MM Debt of $500MM Consolidated EBITDA of $100MM Equity interest of $50MM Firm Value = $950, EBITDA = $100 FV / EBITDA = 9.5x
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Other standards when spreading comps


Overview The right comps The right multiple Spreading the comp Deriving value

Use income from continuing operations (i.e. income before discontinued operations, extraordinary charges/income and effect of change in accounting principles) Eliminate non-recurring items Restructuring charges Gains/losses on sale of assets One-time write-offs Read all footnotes and Management Discussion and Analysis (MD&A) sections Tax effect all adjustments, if they relate to an after-tax financial statistic and are tax-deductible Check MD&A and footnotes for actual tax impact if available Use marginal rate if tax impact not available Double-check your calculations!!! Reality check on multiples, margins, etc. (ruler check, brokerage report check) Dont assume model is always right!

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Typical errors spreading comps


Overview The right comps The right multiple Spreading the comp Deriving value

Stock splits, dividends & repurchases Differences in fiscal year end (EPS estimate) Cash (long term investments) Recent acquisition and divestitures pro forma #s Changes in earnings estimates Non-recurring items Recent debt or equity offerings Take-over activity Re-statements Conversion of convertible securities since last reporting period Differences in international accounting treatment

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Using multiples to derive value


Overview

Generally a range of multiples are used to provide a valuation range for your target Multiply the companys sales, operating income, operating cash flow, net income, book value and other key operating statistics by the respective comparable company multiples

The right comps The right multiple Spreading the comp Deriving value

Subtract net debt from firm values

Example: Target company has 98 million shares outstanding, 4 million options outstanding with an exercise price of $25, net debt of $200 million and the following statistics. What equity value per share does each multiple imply?

$n m is l, l i o ep xe cr e p t sa ha a rt e d E P S Ne e to im n c E B I T E B IA T D S a l e s

T a r g e t s tt a tc i s i $ 2 . 5 0 $ 2 5 0 $ 4 0 0 $ 5 0 0 $ 2 ,0 5 0

Rm eu lall et vi ne tp fs re of m t o ca ol m p a rs b e 2 0 . 0 x 2 0 . 0 x 1 3 . 0 x 1 0 . 0 x 2 .x 0 0

Cea a ql ll ue c iv u tu ay t e $20 200 .xx 5.1 0 = 0 $2 20 .x= 5. 0 0 (0)0 $12 43 0 0. x = 0 (0)0 $12 50 0 0. x = 0 (00 = $x 222 ,0)0 5. 0 0

Il m p i e d e q u i t y v a l u e $ 5 ,0 0 0 $ 5 ,0 0 0 $ 5 ,0 0 0 $ 4 ,0 8 0 $ 4 ,0 8 0

Il m p i e d ea ql ue iv tu y pe e rr s h a $ 5 0 . 0 0 $ 5 0 . 0 0 $ 5 0 . 0 0 $ 4 8 . 0 9 $ 4 8 . 0 9

Note: different fullydiluted share count at different prices


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An example: Trading comparables


Overview The right comps The right multiple Spreading the comp Deriving value
4/19/02 stock price Market cap Firm value LTM EBITDA Firm value/ 2002E EBITDA 2003E EBITDA Price/ 2002E 2003E EPS EPS

$ millions, except per share data

Company

LTG 2003 PEG

McDonald's YUM Brands Wendys Jack in the Box Sonic Corp AFC Enterprises Papa Johns Median Mean

$28.60 61.49 36.78 31.40 28.06 34.28 29.98

$37,450 9,871 4,365 1,285 1,158 1,153 641

$45,950 12,007 4,709 1,548 1,271 1,361 729

11.5x 9.5 10.4 7.0 13.4 10.7 6.2


10.4x 9.8x

10.2x 8.9 9.5 6.5 11.8 8.8 6.2


8.9x 8.9x

9.5x 8.3 8.5 5.9 10.0 7.8 5.9


8.3x 8.0x

19.5x 16.9 19.4 13.7 23.6 20.1 13.3


19.4x 18.1x

17.8x 15.4 17.3 12.3 19.8 16.3 12.4


16.3x 15.9x

10.0% 12.5% 14.0% 15.5% 20.0% 20.0% 13.4%


14.0% 15.1%

1.78x 1.23 1.23 0.80 0.99 0.82 0.93


0.99x 1.11x

Note: Projections based on equity analyst research reports; all projections calendarized to 12/31 year-end 30

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Historical LTM EBITDA multiples


Overview The right comps The right multiple Spreading the comp Deriving value

Firm value/LTM EBITDA


17.0x 16.0x 15.0x 14.0x 13.0x 12.0x 11.0x
1 0.8x 1 .7x 1 1 .6x 1 1 0.9x 1 .6x 1 1 0.2x 9.0x 9.0x 8.2x 7.9x 7.2x 6.6x 6.6x 5.7x 5.9x 8.0x 7.2x 7.8x 7.4x 8.6x 8.5x 7.9x 7.9x 8.0x 7.8x 7.5x 6.4x 1 0.4x 1 0.4x 1 0.3x 9.5x 8.7x 8.6x 7.8x 7.1 x 7.5x 6.8x 9.8x 8.9x 8.3x 7.9x 6.7x 6.4x 5.9x 6.1 x 5.6x 5.6x 6.4x 6.1 x 5.3x 5.9x 6.2x 5.7x 8.1 x 8.1 x 7.2x 7.3x 6.3x 7.3x 7.4x 6.6x 6.0x 8.8x 7.6x 8.2x 9.5x 9.6x 1 .4x 1 1 4.0x 1 3.4x 1 x 3.1 1 3.0x 1 3.9x 1 6.3x 1 x 6.1 1 5.8x 1 x 6.1

MCD SONC WEN YUM JBX

5-yr avg. 12.8x 8.5x 8.1x 7.3x 7.0x

1 .5x 1

1 .2x 1

1 0.8x

1 .1 1x

1 .1 1x 1 x 0.1

10.0x 9.0x 8.0x 7.0x 6.0x 5.0x 1997 Q1 1997 Q2 1997 Q3 1997 Q4 1998 Q1 1998 Q2 1998 Q3 1998 Q4 1999 Q1 1999 Q2
9.0x 8.7x 8.1 x 8.6x 8.9x 8.5x 9.5x 9.2x 8.7x 7.4x

MCD SONC

8.5x

7.4x

7.7x 6.8x

WEN YUM

1999 Q3

1999 Q4

2000 Q1

2000 Q2

2000 Q3

2000 Q4

2001 Q1

2001 Q2

2001 Q3

2001 Q4

JBX

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Champion vs. peers


Overview
G( rt ) o 01 w0 h 0 Ci ho an m p Mls ca D o n d W es n d y Yr s Un M B a d Jit B a hx ce k o n S o n i c

The right comps The right multiple Spreading the comp Deriving value

Ctesw o ol gh ms rt p ao s e r 2c ss gh 0 otesw Q ol rt 1p a o m e r Swlsw y ie gh s de t t sr e ao m Uw nt igh tr o Esw a gh rg t nr i o n

(% 0 .) 3 (% 2 .) 5 (% 1 .) 9 1 . 9 % (. ) 1 8 9 %
1

(% 2 .) 2 (% 0 .) 8 1 . 1 % 4 . 8 % (. ) 1 1 2 %

2 . 1 % 5 . 6 % 7 . 7 % 5 . 6 % 1 4 . 1 %

1 . 0 % 5 . 0 % 0 . 8 % 0 . 2 % 1 0 . 3 %

3 . 0 % 0 . 1 % 1 0 . 4 % 7 . 9 % 8 . 4 %

1 . 8 % 7 2 . 0 % 8 . 8 % 8 . 4 % 1 9 . 0 %

Pn oi sn i g t i o C ynte on er mwo pod % a s Ieote ntn r tna % ri l o as Fa ar is % r e h Bo rdio as n tn p i 9 % 2 7 % 8 1 % F-o l eid a re m b l pri lfm a s t o dnr i rto fe ; f i ea t tda ri n a l t i o cm: ues sr e t b oa ym o a1 u l( ne gs 8 2 yd 9 rl s o ) Pst o ta oi e rm ; d e 1fsm 5 sm %ea ot y y b ir e ss ids ne t 2 8 % 5 6 % 1 2 1 % Sif i s tna , rgm o l ni e ced hnp irar l nd e tnk ea ert m e 1 6 % 3 4 % 8 9 % Ioeu nt mh ni ei v n a w v t nctg oo . dn iu si n Asnr p tae p ol e o a d l cm oe n rd sa un w o m e n 2 1 % 3 6 % 5 9 % Lrce ei h , ank d in ec Maiz e ,n a x d ia p c z n Q S R 8 1 % 0 % 9 4 % B ec rdu o nl a i. m n swa ac n nh d de is too aM c r se . c nd ott i nr n ca ee 13as 84rd t yo oe l tnpr hot s am ce i t o 1 7 % 0 % 6 7 % Udi n riuv qie en fm o. rt a Rl ea g in o sg tnn r ti e h S o u t& h M iw d e s t

Fieacio rceno n asi c n n f il d hn t a i

S tn rg o

S tn rg o

Fie rce a n h s fa dle i niiu n l f ts cf i i c a it T e nal hc l eo B sm 1 y i0 s n& t 00 e Ss rg u itn c ni c u e n s ad a rnC oKd uF n Pun iz trd z bs aa H . Mnu ua n l- d i tr et i ds b et td xe r pdie eo c v tf. ri a f c En xe pc eig rn i sgrtn tneo r itna o al ni ghc rt Ry o el we . n t arAn ceW q &d u a id LJS ooie nhv gn r ls

Va el rm yl s fnee rc b aes ha i s

S tn rg o

Cn o ty m m e a r

Sb tnn rgd or a r gn ei b ct u oo n t i hs rv at a e sso l h r oe p wd a yu s ee t a f r es taf w oo lke cn pc dr runo osp dao t et xi en c u o

Grd lbai o nh a w l b t lrsra attee g os e b s aihU n eV ds. ht gA Bhre e et lef h l tr wo srs eh ca t o hia d itct e s l rd oy rl a arim tpu a t eo m o tr Q h e S R s . Pm ri h e a ms u n ee a dt r d r u o o w upm ne a dr n eoc rf e r

Ipie m rs e s v tnnt ls u u ht rr de ai a on de n e.t g cS ar do gh T rtfm or i w m o Ha os r n t d o n inie nt n o e v w a v pc rut os da t W e n d y s hhde aeice vlers e n p a vtnlvo a . ed la B t u ie i e o bsse eto d b iot e tn -i o p pfm g rto a o ai fr n i g n pa otn p u li o

Sc s tnm rgpe oot o r s gh arta lsw e n od inie nt o v a v atig ds vn e. r i Cl uy rt r e n edr x ig pnm af no tiWs hea es t r to C bS am s a el . l fn p m rc rr ae a ho i g s l i sd i t po m f se e es n x in p a a d n o ice r nso r s ik e cs a.

Seg tnr s rgi oa n n gh rta on w d ss ate m e o r s gh art lsw e o d br rnte ies vy o es n x in p a a d n o icig ns rn e a rat or ya l e t y so ut p p r s pu rim e m vtn a la u i o

1 2

Based on adjusted EBIT Blended growth rate based on Company and Franchised unit comp store sales growth

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Transaction comparables analysis as a valuation methodology


Valuation methodologies

Publicly traded comparable companies analysis

Comparable transactions analysis

Discounted cash flow analysis

Leveraged buyout/recap analysis

Other

Public Market Valuation Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium

Private Market Valuation Value based on multiples paid for comparable companies in sale transactions Includes control premium

Intrinsic value of business Present value of projected free cash flows Incorporates both short-term and long-term expected performance Risk in cash flows and capital structure captured in discount rate

Value to a financial/LBO buyer Value based on debt repayment and return on equity investment

Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model

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Comparable transaction analysis


Assists investment bankers, clients, lenders to understand the:

Valuation of a company Structuring of a potential transaction Current state of M&A in a specific industry (number and relative value)

Examines a group of transactions to identify a median/range/trend of:


The multiple (of cash flow, operating profit, earnings or other industry metrics) paid for a target The premium paid to gain control of a target (control premium) Business fundamentals of a target (revenue/earnings growth, profitability) Technical transaction elements (deal protection, conditions to closing) Social issues (board seats, management) Other value drivers (synergies, tax benefits)

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Sources used to locate comparable transactions

Thompson Financial database (SDC) Locates targets based on SIC code, business description, industry Identifies transactions based on hostile vs. friendly, transaction size, announcement date, and several other deal elements The Comprehensive Summary Report is very helpful in hand-picking transactions since it includes a synopsis of the deal in addition to general information regarding both parties and the transaction Available on desktops and through the Business Research Center at (212) 622-4900 Senior bankers who work in the industry Will be able to point you toward previously used presentations or valuations Ensures you do not exclude any landmark deals or other deals they would specifically like to include Merger proxies for similar transactions Fairness opinions of financial advisors disclose the comparable transactions used in their valuation of the target Other sources include: JPMorgan transaction comps databases News runs Equity research reports

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Selecting comparable transactions


When valuing a company, key objective is to find the most comparable businesses

Similar industries with similar products or services Size, margins, relative market position, major potential liabilities

When seeking guidance regarding structure, the situation surrounding the acquisition is
crucial Scenarios could include: LBOs, bankruptcy-related acquisitions, hostile transactions, reverse mergers, divestitures, asset vs. stock acquisitions, form of consideration, Morris Trust transactions, and many others If possible, try to locate transactions in a similar industry as well

Some types of transactions should, generally, not be considered as a comparable


transaction Acquisitions of a minority interest (not a change of control transaction) Rumored or withdrawn transactions

Recent deals are typically a more accurate reflection of the values buyers are willing to
pay

Remember that some transactions are more relevant than others when selecting
a range of multiples for valuation
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Comparable transaction multiples analysis document checklist


Item General transaction information
SDC "Comprehensive Summary Report" Bloomberg transaction description Announcement press release SDC Bloomberg (TICKER <EQUITY> CACS) - click on deal Yahoo!, Dow Jones, target or acquirer websites Use to spot check your work; not extremely accurate but generally close; helpful for business descriptions and summary of transaction Use to spot check your work; not extremely accurate but generally close; helpful for key transaction dates Be sure it is the ORIGINAL announcement; excerpts are often reproduced throughout the day by other wire services; generally, the longest was issued first; INCLUDE ANNOUNCEMENT TIME as well Include only if transaction is closed Include only if necessary due to lack of detail in press release (target website may disappear) Helps gauge the Street reaction to the announcement; analysts might publish historical or projected estimates for private companies; may give ball park estimates; provides explanations of complex transaction structures and general street perspective Check both acquirer and target SEC filings during the period; print out the entire document Include if acquirer is paying in stock; include several days prior and post announcement; Bloomberg prices are more reliable;However Yahoo! Prices are unadjusted for stock splits, so print out BOTH Include if acquirer is paying in stock; check for stock splits or other relevant news Only for foreign acquirer; include several days prior and post announcement; be careful stock prices aren't already in US dollars Use for premiums analysis; include LTM period to show 52 week high Check for stock splits, substantial acquisitions, and other relevant news Use merger agreement if possible (latest share count available) ; otherwise 10Q or 10K Print out all relevant sections including: cover page, management discussion, financial statements and footnotes, exhibits index, and any other possibly relevant sections or exhibits Print out all relevant sections including: cover page, management discussion, financial statements and footnotes, exhibits index, and any other possibly relevant sections or exhibits Print out all relevant sections including: cover page, management discussion, financial statements and footnotes, exhibits index, and any other possibly relevant sections or exhibits Only for foreign target whose financials are in foreign currency; for operating statistics, use avg. over period; for balance sheet items, use spot rate as of that date Include research reports on target if public; if private, check research reports on acquirer

Source

Comments

Closing press release Target & Acquirer business descriptions A few equity research reports

Yahoo!, Dow Jones, target or acquirer websites Company websites MorganWise, First Call, Multex

Offer price*
Merger agreement Acquirer historical prices S4, Proxy, 8K, or potentially attached to other filings Bloomberg (TICKER <EQUITY> HP) AND Yahoo! unadjusted stock price listing Bloomberg (TICKER <EQUITY> CACS) Bloomberg, Oanda (www.oanda.com/convert/fxhistory)

Acquirer Bloomberg "Corporate Action Calendar" Historical exchange rates

Target financial and business information


Target Bloomberg historical prices Target Bloomberg "Corporate Action Calendar" Basic shares outstanding Options, warrants, and convertible securities Bloomberg (TICKER <EQUITY> HP) Bloomberg (TICKER <EQUITY> CACS) Merger agreement, latest 10Q or 10K, private company financial disclosures* 10K and ALL following 10Q's, private company financial disclosures* Latest 10Q, 10K, quarterly financial press release, private company financial disclosures* Latest 10K and 10Q quarterly financial press release, VentureSource, private company financial disclosures* Bloomberg, Oanda (www.oanda.com/convert/fxhistory)

Net debt

LTM operating statistics

Historical exchange rates

Projected financial performance

MorganWise, First Call, Multex, VentureSource

* Financial information as well as consideration paid for private targets is often overlooked; They can be published in an ammended 8K, an S4, a 10Q, a 10K or as an exhibit to other acquirer filings; When necessary, search for target's name in any acquirer filings from announcement through a few months post closing (Use Control + F) to be certain no financial disclosures have been missed.

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Calculating equity and firm value

Definitions of equity value and firm value similar to trading comparables: Equity value + Net debt Firm value Value received by the target / target shareholders (100%) Debt assumed by acquiror minus cash received Total value of business acquired (100%)

BE CAREFUL: Transaction value for a change of control transaction will differ from equity and/or firm value when >50% but <100% is acquired

Equity value: Cash consideration: (fully-diluted target shares @ offer price) x (cash consideration per share) Stock consideration: (fully-diluted target shares @ offer price) x (exchange ratio) x (price per acquiror share @ the closing price prior to announcement) Cash and stock consideration: (fully-diluted target shares @ offer price) x (cash consideration per share) plus (fully-diluted target shares @ offer price) x (exchange ratio) x (price per acquiror share @ the closing price prior announcement) Firm value: In all cases: Add the indebtedness and subtract the cash items that are to be transferred to the acquirer through the transaction to the target equity value Be careful not to add any convertible debt or preferred securities which were converted into common shares (and already included in the fully-diluted share count) May be appropriate to include certain other unfunded liabilities in the calculation of firm value for a transaction

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Other equity and firm value issues

Timing (announcement vs. closing) Typically want to assess what buyer was willing to pay for business, so most interested in valuation based on stock prices as of announcement date Information regarding shares outstanding, options, debt, cash as of most recent publicly disclosed source as of announcement date (i.e. 10-K, 10-Q, or Proxy, 8-K) However, if terms of the transaction change (exchange ratio, amount of cash consideration), should look to valuation on date of announcement of revised terms Valuing a deal with stock consideration as of the closing date will give a sense for how market reacted to value of two companies together Transaction fees Typically M&A fees/financing fees are not included in firm value of business acquired as they are not consideration received by seller However, in extreme cases (i.e., LBO/recap) it may be instructive to know amount of fees and indicate how they may have impacted business valuation Asset purchases Note that debt can be transferred with businesses/assets being sold and must be added to the consideration paid by the acquiror Other liabilities In some instances it may be appropriate to include the assumption of a non-debt other unfunded liability in firm value (such as an existing restructuring reserve) but never NWI / working capital items Earn-outs/purchase price adjustments

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LTM financial information issues

Time horizon LTM financial information should reflect what buyer bought the business off-of and is generally backward-looking (typically last twelve months of financial information available prior the announcement date) In certain industry-specific circumstances (i.e. technology, biotech) it is more useful to look at projected financial information as well (typically IBES consensus estimates / median of several analyst reports) However, the outlook of equity analysts may be quite different than the outlook of the buyer at the time of acquisition Adjustments Exclude impact of extraordinary items on a tax-affected basis Pro forma adjustments (i.e. acquisitions and divestitures) must be considered Currencies If target is foreign, most-commonly taught method is to apply average exchange rates over LTM period because it is the accounting convention Is this always appopriate for valuation purposes? Not necessarily Need to consider carefully / discuss with team-members in extreme cases (i.e. when currency has de-valued / re-valued substantially vs. US Dollar)

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Other general considerations

Synergies

Synergies are not generally incorporated into the financial information but it may be useful to consider their value when comparing transactions to each other Sometimes will indicate announced synergies as a % of sales, SG&A, SG&A + COGS, transaction value

Tax benefits

In certain cases (acquisition of assets, acquisition of stock with a 338(h)(10) election) a buyer will receive substantial benefits from depreciating / amortizing a write-up and receiving incremental tax deductions An acquiror can often justify a higher purchase price and multiples may be higher in such circumstances Can attempt to estimate the value of tax benefits received by acquiror but depends on a lot of unknown variables (discount rate, amortization period, tax basis) However, should know which transactions are tax-advantaged and which arent

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Most common errors


Unaffected stock prices (for premium analyses) Stock splits Proper interpretation of exchange ratio

Target share price / acquiror share price Using the correct acquiror share price

Most recent common shares outstanding (use the merger agreement if available) Use all outstanding, not exercisable, options and warrants and assume that all in-the-money securities are
exercised in this analysis

Check for warrants Repriced options New issuances of debt or equity since most recent 10Q or 10K Forgetting debt in an asset transaction Acquisitions or divestitures completed by the target over LTM period Exclude all extraordinary items - only tax affect those items that are tax deductible Publicly-available information only, please!

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General suggestions

Always check with JPMorgan databases and colleagues to see if work has already been done Be sure you have carefully double-checked all work before showing to a client!! Have all relevant documentation regarding the deal printed-out Flag where you got your information from Place all documents as well as a printout of the transaction comp model in a folder or binder If possible, coordinate with M&A research to import your transaction data into our firm database If a transaction is pending or is renegotiated, update the analysis to incorporate disclosures that were made subsequent to your analysis (e.g. S4, Proxy, research reports regarding transaction) Be sure to update your list of transactions regularly on active projects to ensure that you do not exclude the most recent, and possibly most relevant, transactions

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Output summary

Show any multiples or transactions that may be helpful for your analysis
but dont be afraid to base your conclusions off the multiples that are the most helpful

Spot check all outputs against your source documents for any obvious
errors

Check for consistency regarding units - inputs are in thousands except


per share values and outputs are in millions

Be careful of difference between not meaningful (NM) and information


that is unavailable (NA)

Try to include any other relevant information

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Transaction multiple analysis - example


$ millions
Firm value/ Date Apr-00 Aug-99 Oct-98 Oct-98 Apr-97 Sep-96 Feb-96 Jan-96 Aug-95 Jan-95 Aug-94 Acquirer Unilever Procter & Gamble Newell Clorox Procter & Gamble Gillette Unilever L'Oreal Henkel Colgate-Palmolive Johnson & Johnson Target SlimFast IAMS Rubbermaid First Brands Tambrands Duracell Helene Curtis Maybelline Hans Schwarzkopf Kolynos (AHP) Neutrogena Firm Pre-tax Tax value synergies benefit $2,300 2,300 6,383 2,019 1,985 7,801 906 764 888 1,040 906 NA $20 325 90 100 120 NA NA NA NA NA Sales EBITDA 3.8x 2.6 2.5 1.6 3.0 3.3 0.7 2.1 1.1 3.6 3.1 2.6x 3.6x 2.3x 17.2x 17.7 17.0 11.7 11.9 14.1 15.4 14.8 11.6 17.7 19.3 15.4x 17.7x 14.4x EBIT 18.4x 26.6 25.4 16.0 14.3 17.1 37.0 19.2 18.3 19.4 22.3 19.2x 19.4x 18.8x

Median overall Median tax benefit transaction Median non-tax benefit transaction

Estimated VFO multiples for SlimFast (based on the tax deductibility of the goodwill) were 2.9x sales, 13.0x EBITDA and 13.9x EBIT. Unilever presented post tax shield multiples in its public filings for the SlimFast acquisition. 2 Estimated VFO multiples for Kolynos were 3.0x sales, 14.8x EBITDA and 16.2x EBIT
1

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Comparable asset transactions - example


T o t a l tn r a n s a c t i o v a l u e $ M M $ 7 5 0 R e s e r v e v a l u e $ Me MR g i o n s $ G 7 u 5 ls 0 f C o a t o fn s h o re e / o s h o r 2 6 1 2 G 3 u 1 ls f C o a t o fn s h o re e / o s h o r 1 7 6 1 R 7 o 6 c k y M o u n t a i n s 4 6 8 3 R 5 o 1 c k y M o u n t a i n s I m p l i e d ru e s e r v e v a l e % R g a s / P r a t i o $ /c M f e 7 0 % 4 . 9 $ 2 . 0 8 6 9 1 0 0 8 0 6 . 0 1 5 . 0 1 2 . 8 1 . 5 2 1 . 1 5 0 . 7 6

A n n d a t e 2 / 2 0 / 0 1 1 / 3 1 / 0 1 9 / 2 0 / 0 0 8 / 2 8 / 0 0

B u y e r s A m e r a d a H e s s P u r e R e s o u r c e s E v e r g r e e n P a n C a n a d i a n

7 / 2 0 / 0 0 6 / 1 4 / 0 0 5 / 2 / 0 0 4 / 1 0 / 0 0 1 1 / 1 1 / 9 9 4 / 2 9 / 9 9 8 / 4 / 9 8

A p a c h e C o r p . A p a c h e C o r p . A l b e r t a E n e r g y W e s t p o r t B P A m o c o A p a c h e C o r p . V a s t a r R e s o u r c e s

S e l e r s L L O G E x p ln o r a t i o Io n ta e r n a t i n l P a p e r K L T G a s I n P c . / K & C L M o n t a n a P o w e r C o m p a n y O c c il d e n t a P e t r o l e u m C o l i n s & W a r e I n c . M c M u r y O i l E q u i t a b l e R e s o u r c e s R e p s o l Y P F S A R o y a l D u t c h / S h e l A t l a n t i c R i c h f i e l d

R e s e r v e s ( B c f e ) 3 6 0 . 0 1 5 2 . 3 1 5 3 . 0 4 6 0 . 1

P r o d u c t i o n ( B c f e ) 7 2 . 0 2 5 . 5 1 0 . 2 3 5 . 9

3 7 6 3 3 0 6 2 7 2 1 7 5 0 0 7 4 4 4 7 0

3 G 7 ur 6 ls f C o a to o f s h e 2 M 9 it 2 d -t C o n i n e n 5 R 4 o 8 c k y M o u n t a i n s 1 G 9 ur 7 ls f C o a to o f s h e 4 M 3 it 0 d -t C o n i n e n 7 G 3 ur 2 ls f C o a to o f s h e 4 G 5 ur 0 ls f C o a to o f s h e

2 9 9 . 9 5 0 1 . 9 7 6 4 . 8 1 3 9 . 0 5 2 6 . 0 7 6 3 . 8 3 6 3 . 0

5 6 . 1 2 3 . 4 5 1 . 1 3 1 . 6 6 2 . 1 1 0 0 . 2 8 7 . 6

6 7 6 7 9 5 8 1 4 8 4 6 6 0

5 . 3 2 1 . 5 1 5 . 0 4 . 4 8 . 5 7 . 6 4 . 1

1 . 2 5 0 . 5 8 0 . 7 2 1 . 4 2 0 . 8 2 0 . 9 6 1 . 2 4

H i g h M e d i a n M e a n L o w

$ 2 . 0 8 1 . 1 5 1 . 1 4 0 . 5 8

Source: John S. Herold, Inc.

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Premiums paid analysis - example


O ffer p ric e p re m iu m (d isco u n t) % A n n . D ate T arg et N am e 1/12/00 1/26/00 2/3/0 0 2/22/00 2/22/00 6/22/00 7/3/0 0 7/26/00 7/27/00 9/8/0 0 10 /3/00 10 /16 /0 0 10 /24 /0 0 10 /27 /0 0 11 /13 /0 0 12 /6/00 12 /21 /0 0 3/22/01 4/30/01 P recisio n R espons e C orp Interlea f Inc A n dover.ne t Inc IX ne t Inc(IP C Inform a tio n) M edscap e In c P S S W orld M e dical Inc A cq u iro r N a m e U S A N etw orks In c B ro adV isio n Inc V A Lin ux S ys tem s Inc G lo bal C ro ssin g Ltd M edicaL ogic Inc/ edsc ape Inc M F isher S cie ntific Intl Inc T -1 d a y 29.3% 40.0% 61.6% 18.1% 37.9% 20.1% 22.4% 27.9% 67.0% 57.0% 96.2% 43.3% 9.0% 46.3% 33.8% 12 0.0% 29.3% 28.9% 44.4% T -1 w ee k 31.5% 44.8% 87.2% 19.9% 47.8% 19.7% 30.2% 35.4% 55.9% 59.3% 94.0% 45.1% 28.5% 55.6% 22.4% 14 1.3% 2.1% 36.6% 51.5% T -4 w e ek 16.3 % 52.3 % 73.4 % 40.1 % 47.0 % 28.5 % 57.0 % 34.3 % 38.6 % 75.7 % 83.0 % 40.5 % 42.3 % 56.3 % 13.1 % 10 2.8 % -7.9% 24.8 % 50.7 % T -90 d ay s 44.1% 46.0% 42.6% 84.0% 48.3% 34.9% 36.6% 53.7% 51.6% 81.9% 85.9% 57.1% 25.6% 18.4% -17.8% 78.1% 13.3% 9.6% 34.6% E x ch an g e ratio prem iu m (d isco u n t) % T -1 d a y 29.3% 40.0% 61.6% 18.1% 37.9% 20.1% 22.4% 27.9% 67.0% 57.0% 96.2% 43.3% 9.0% 46.3% 33.8% 12 0.0% 29.3% 28.9% 44.4% T -1 w e ek 28.9 % 38.9 % 67.9 % 29.5 % 38.6 % 20.9 % 32.2 % 32.1 % 48.9 % 59.0 % 11 1.5 % 47.7 % 20.7 % 52.7 % 34.6 % 10 0.1 % 18.6 % 45.3 % 49.8 % T -4 w e ek 18 .2 % 46 .1 % 82 .2 % 41 .5 % 2.3% 19 .1 % 49 .8 % 39 .6 % 16 .0 % 76 .6 % 86 .3 % 51 .8 % 34 .2 % 51 .3 % 25 .7 % 89 .6 % 25 .9 % 37 .5 % 48 .1 % T -90 d ay s 29.7% 8.7% na 78.0% na 33.6% 10.6% 53.2% 40.1% 80.8% 65.0% 60.5% 35.6% 28.1% 1.0% 110.4% 65.1% 17.3% 48.7%

C ircle Interna tio nal G ro up IncE G L In c T elx on C orp A X E N T T echn olo gies Inc C yberonics Inc T herm oC ardiosystem s Inc S ym bol T echn olo gies Inc S ym an te c C orp M edtro nic Inc T h oratec L aboratories C orp

C oulter P harm aceuticals In c C orixa C orp B lu esto ne S o ftw are Inc A b out.com Inc A d aptiv e B ro ad ba nd C orp A cc ord N e tw orks Ltd G re at P lains S oftw are Inc K e nt Electronics C orp A uroraB ioscienc es C orp H ew lett-P ackard C o P R IM E D IA Inc W estern M ultiplex C orp P oly com Inc M icrosoft C orp A vne t Inc V ertex P h arm aceuticals Inc

M ed ian A verag e

37.9% 43.8%

44.8% 47.8%

42.3 % 45.7 %

44.1% 43.6%

37.9% 43.8%

38.9 % 46.2 %

41 .5 % 44 .3 %

40.1% 45.1%

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The JPMorgan M&A database can be used to locate precedent transactions


Project implemented by JPMorgan M&A Research Department and M&A Analysts

What information is available from the database? Transaction descriptions including transaction structure information (i.e. termination fees, collars, tax-elections, etc.) Target and acquiror descriptions Multiples (and underlying data used to calculate) What transactions are contained in the database? All U.S. deals > $1billion since 1998 (excluding FIG) Smaller deals in certain industries: Telecom (RBOC, LEC, CLEC, wireless, LD-Tier 1, LD-Tier 2, SSIXC, internet & related) Healthcare (pharmaceuticals, devices and products) Consumer (food, beverage and apparel) How do I access the database? On everyones desktop: Start Menu Main Menu Information MA Comps If you are prompted to add a password, your initial password is comps Refer to M&A webpage for detailed instructions on entering data
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Transactions in the database may be referenced by several criteria


.(A) Player Name: This field contains the legal name of the player. If the player is a division or subsidiary, only include the division name. (i.e. Duncan Hines, not Bestfoods in this field).

A D B G C A B G C H I J K D E E

(B) Player Description: This field contains the player description. It should be taken from a recent company release (10-K, 10-Q, 8-K, Annual Report). (C) Player Industry: Select the most appropriate industry for the target and acquiror companies. (D) Player Country: Select the home country of the target and acquiror companies from this list. (E) Player Classification: Select whether the player is Public, Private, or a Division/Subsidiary of another company.

(F) Ultimate Parent: Select the ultimate parent of the player. If the player is the parent organization, then use the player as the ultimate parent. (i.e. Bestfoods is the ultimate parent of Duncan Hines.) (G) SIC Code Lookup: Either enter the appropriate SIC code into this box and hit enter, or click the SIC Code Lookup button to navigate the lists to choose the appropriate SIC Code. (H) Announce Date: This field contains the official announcement date of the transaction (I) Completion Date: This field contains the official completion of the transaction. (J) Status: This field contains the status of the deal (K) Presentation Method: This field indicates the date the deal was spread. It could be spread at Announcement, Completion, when the deal was Revised, or spread based on Private Basis.

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Discounted cash flow analysis as a valuation methodology


Valuation methodologies

Publicly traded comparable companies analysis

Comparable transactions analysis

Discounted cash flow analysis

Leveraged buyout/recap analysis

Other

Public Market Valuation Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium

Private Market Valuation Value based on multiples paid for comparable companies in sale transactions Includes control premium

Intrinsic value of business Present value of projected free cash flows Incorporates both short-term and long-term expected performance Risk in cash flows and capital structure captured in discount rate

Value to a financial/LBO buyer Value based on debt repayment and return on equity investment

Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model

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Overview of DCF analysis


Overview Free cash flow Terminal value

Discounted cash flow analysis is based upon the theory that the value of a business is
the sum of its expected future free cash flows, discounted at an appropriate rate

DCF analysis is one of the most fundamental and commonly-used valuation techniques
WACC

Widely accepted by bankers, corporations and academics Corporate clients often use DCF analysis internally Comparable companies analysis Comparable transaction analysis Leveraged buyout analysis Recapitalization analysis, liquidation analysis, etc. One of several techniques used in M&A transactions; others include:

Other topics

DCF analysis may be the only valuation method utilized, particularly if no comparable publicly-traded companies or precedent transactions are available

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Overview of DCF analysis (contd)


Overview Free cash flow Terminal value WACC

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?

Other topics

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

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The process of DCF analysis


Overview Free cash flow Terminal value WACC

Projections/FCF

Project the operating results and free cash flows of the business over the forecast period (typically 10 years, but can be 520 years depending on the profitability horizon)

Other topics

Terminal value

Estimate the exit multiple and/or growth rate in perpetuity of the business at the end of the forecast period

Discount rate

Estimate the companys weighted-average cost of capital to determine the appropriate discount rate range

Present value

Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present

Adjustments

Adjust the resulting valuation for all assets and liabilities not accounted for in cash flow projections

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DCF theory and its application


Overview Free cash flow Terminal value WACC

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 assets value (including an estimated terminal value), discounted using an appropriate weighted-average cost of capital

The cash-flow streams that are discounted include:


Other topics

Unlevered or levered free cash flows over the projection period Terminal value at the end of the projection period

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 (our preferred approach), 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)

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The two basic DCF approaches must not be confused


Overview Free cash flow Terminal value WACC

DCF of unlevered cash flows (the focus of these materials)


Other topics

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

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Other considerations
Overview Free cash flow Terminal value WACC

Reliability of projections

DCF results are generally more sensitive to cash flows (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

Other topics

Remember that DCF valuations are based on assumptions and are therefore
approximate. Use several scenarios to bound the targets value. Generally, the best variables to sensitize are sales, EBITDA margin, WACC and exit multiples or perpetuity growth rate

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Always remember . . .
Overview Free cash flow Terminal value WACC

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)

Other topics

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

Always double-check with a calculator!


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The first step in DCF analysis is projection of unlevered free cash flows
Overview Free cash flow Terminal value WACC

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

Other topics

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 companys management Acquiring companys management Research analysts Bankers

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Projecting financial statements


Overview Free cash flow Terminal value WACC

Ideally projections should go out as far into the future as can reasonably be estimated to reduce
dependence on the terminal value

Most important assumptions:


Other topics

Sales growth: 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 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.)

Analyze projections for consistency


Sales increases usually require working capital increases Capex and depreciation should converge over time

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Free cash flow is the cash that remains for creditors and owners after taxes and reinvestment
Overview Free cash flow Terminal value WACC

Unlevered free cash flows can be forecast from a firms 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)

Other topics

Plus: Non-tax-deductible goodwill amortization Less: Taxes (at the marginal tax rate) Equals: Tax-effected EBITA Plus: Deferred taxes1 Plus: Depreciation and any tax-deductible amortization Less: Capital expenditures Plus/(less): Decrease/(increase) in net working investment Equals: Unlevered free cash flow
1

Although beyond the scope of our current discussions, you should only include actual cash taxes paid in the DCF. Depending on the firm and industry, you may want to adjust for the non-cash (or deferred) portion of a firms tax provision. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue for your analysis 62

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Example: Calculating unlevered free cash flows


Overview Free cash flow Terminal value WACC

Stand-alone DCF analysis of Company X $ millions


Fiscal year ending December 31, 2000 2001P 2002P 2003P $484.0 96.8 14.5 82.3 32.9 $49.4 $532.4 106.5 16.0 90.5 36.2 $54.3 16.0 20.0 10.0 40.3 (40.3) $0.0 $585.6 117.1 17.6 99.6 39.8 $59.7 17.6 22.0 8.5 46.8 $46.8 $644.2 128.8 19.3 109.5 43.8 $65.7 19.3 24.2 7.0 53.8 $53.8

1998 Net sales EBITDA $400.0 80.0 12.0 68.0 27.2 $40.8

1999 $440.0 88.0 13.2 74.8 29.9 $44.9

2004P $708.6 141.7 21.3 120.5 48.2 $72.3 21.3 26.6 5.5 61.4 $61.4

2005P $779.5 155.9 23.4 132.5 53.0 $79.5 23.4 29.3 4.0 69.6 $69.6

Other topics

Less: Depreciation EBITA Less: Taxes at marginal rate Tax-effected EBITA Plus: Depreciation Plus: Deferred taxes Less: Capital expenditures Less: Incr./(decr.) in working capital Unlevered free cash flow Adjustment for deal date Unlevered FCF to acquirer

Key assumptions: Deal/valuation date = 12/31/01 Marginal tax rate = 40%

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Valuing the incremental effects of changes in projected operating results


Overview Free cash flow Terminal value WACC

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

Other topics

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

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Once unlevered free cash flows are calculated, they must be discounted to the present
Overview

The standard present value calculation takes into account the cost of capital by attributing
Free cash flow Terminal value WACC

greater value to cash flows generated earlier in the projection period than later cash flows

Pnle rea= et u sv

F 1 C F (r 1 + )
1

F 2 C F (r 1 + )
2

F 3 C F (r 1 + )
3

+ .. .

F n C F (r 1 + )
n

Other topics

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 socalled mid-year convention, which takes into account the fact that free cash flows occur during the year

JPMorgan standard

F 1 C F F 2 C F F 3 C F F n C F Pnle rea= et u sv + + + + This approach moves each cash+ 1 from the+ 2 of the applicable period to the flow end (r 0 1 . + 5 ) (r . 1 5 ) (r . 1 5 ) .. . ( r n5 1 -. + 0 ) middle of the same period (i.e., cash flows are moved closer to the present)

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It is important to differentiate between the transaction date and the mid-year convention
Transaction date: 01/01

Year

0.5

1.5

2.5

3.5

First cash flow, mid-year 1 Discounting = CF1 + (1+r)0.5 (1+r)1.5 CF2

Second cash flow, mid-year 2 CF3 + (1+r)2.5 +

Third cash flow, mid-year 3 .

Transaction date: 06/30


Period 1 CF to buyer

Year

0.5

0.75

1.5

2.5

3.5

First cash flow, mid-period 1 Discounting = CF1 + (1+r)(0.75-0.5)

Second cash flow, mid-year 2 CF2 + (1+r)(1.5-0.5) (1+r)(2.5-0.5) CF3

Third cash flow, mid-year 3 + .


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Practice exercise
Transaction date: 09/30

Period 1 CF to buyer

Year

0.5

0.75

1.5

2.5

3.5

1st flow, mid-period 1 Discounting = CF1 + (1+r)(0.875-0.75)

2nd cash flow, mid-year 2 CF2 + CF3

3rd cash flow, mid-year 3 + (1+r)(2.5-0.75) .

(1+r)(1.5-0.75)

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Example: Discounting free cash flows


Overview Free cash flow Terminal value WACC

Stand-alone DCF analysis of Company X $ millions


1998 Net sales EBITDA Less: Depreciation EBITA Less: Taxes at marginal rate Tax-effected EBITA Plus: Depreciation Plus: Deferred taxes Less: Capital expenditures Less: Incr./(decr.) in working capital Unlevered free cash flow Adjustment for deal date Unlevered FCF to acquirer Memo: Discounting factor Discounted value of unlevered FCF Discounted value of FCF 2001P2005P $400.0 80.0 12.0 68.0 27.2 $40.8 1999 $440.0 88.0 13.2 74.8 29.9 $44.9

Fiscal year ending December 31, 2000 2001P 2002P 2003P $484.0 96.8 14.5 82.3 32.9 $49.4 $532.4 106.5 16.0 90.5 36.2 $54.3 16.0 20.0 10.0 40.3 (40.3) $0.0 0.0 $0.0 189.6 $585.6 117.1 17.6 99.6 39.8 $59.7 17.6 22.0 8.5 46.8 $46.8 0.5 $44.6 $644.2 128.8 19.3 109.5 43.8 $65.7 19.3 24.2 7.0 53.8 $53.8 1.5 $46.7

2004P $708.6 141.7 21.3 120.5 48.2 $72.3 21.3 26.6 5.5 61.4 $61.4 2.5 $48.4

2005P $779.5 155.9 23.4 132.5 53.0 $79.5 23.4 29.3 4.0 69.6 $69.6 3.5 $49.9

Other topics

Formula
Key assumptions: Deal/valuation date = 12/31/01 Marginal tax rate = 40% Discount rate = 10%

$189.6 =

$46.8 (1+.10)0.5

$53.8 (1+.10)1.5

$61.4 (1+.10)2.5

$69.6 (1+.10)3.5

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Terminal value can account for a significant portion of value in a DCF analysis
Overview

Terminal value represents the businesss value at the end of the projection period; i.e., the portion of the
Free cash flow Terminal value WACC

companys 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 in a steady-state/normalized manner)

Terminal (or Exit) multiple method Assumes that the business is valued/sold at the end of the terminal year at a multiple of some financial metric (typically EBITDA) Growth in perpetuity 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. It is essential to review the implied multiple/growth rate for sanity check purposes

Other topics

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? What percentage of total value comes from the terminal value?

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Terminal multiple method


Overview Free cash flow Terminal value WACC

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

Other topics

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

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Most common error: The final year is not normalized


Overview Free cash flow Terminal value WACC

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

Other topics

Treat the terminal value cash flow as a separate, critical forecast


Growth rate Consistent with long-term economic 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

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Example: Terminal multiple method


Overview Free cash flow Terminal value WACC

Stand-alone DCF analysis of Company X $ millions


1998 Net sales EBITDA Less: Depreciation EBITA Less: Taxes at marginal rate Tax-effected EBITA Plus: Depreciation Plus: Deferred taxes Less: Capital expenditures Less: Incr./(decr.) in working capital Unlevered free cash flow Adjustment for deal date Unlevered FCF to acquirer Memo: Discounting factor Discounted value of unlevered FCF Discounted value of FCF 2001P2005P EBITDA in 2005P Exit multiple Firm value at exit Discounted terminal value Total present value to acquirer $400.0 80.0 12.0 68.0 27.2 $40.8 1999 $440.0 88.0 13.2 74.8 29.9 $44.9

Fiscal year ending December 31, 2000 2001P 2002P 2003P $484.0 96.8 14.5 82.3 32.9 $49.4 $532.4 106.5 16.0 90.5 36.2 $54.3 16.0 20.0 10.0 40.3 (40.3) $0.0 0.0 $0.0 189.6 $155.9 7.0x 1,091.3 745.4 $934.9 $585.6 117.1 17.6 99.6 39.8 $59.7 17.6 22.0 8.5 46.8 $46.8 0.5 $44.6 $644.2 128.8 19.3 109.5 43.8 $65.7 19.3 24.2 7.0 53.8 $53.8 1.5 $46.7

2004P $708.6 141.7 21.3 120.5 48.2 $72.3 21.3 26.6 5.5 61.4 $61.4 2.5 $48.4

2005P $779.5 155.9 23.4 132.5 53.0 $79.5 23.4 29.3 4.0 69.6 $69.6 3.5 $49.9

Other topics

Key assumptions: Deal/valuation date = 12/31/01 Marginal tax rate = 40% Discount rate = 10% Exit multiple of EBITDA = 7.0x

Formula

($155.9 * 7.0x) $745.4 = (1+.10)4


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Example: Terminal multiple method (contd)


Overview Free cash flow Terminal value WACC
Discount rate 8% 9% 10% 11% 12%

Stand-alone DCF analysis of Company X $ millions, except per share data


A Discounted FCF 20012005 $196.8 193.1 189.6 186.1 182.7 + B Discounted terminal value at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $687.5 $802.1 $916.7 662.6 773.1 883.5 638.9 745.4 851.8 616.2 718.9 821.6 594.5 693.5 792.6 = C Firm value at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $884.4 $999.0 $1,113.6 855.8 966.2 1,076.7 828.4 934.9 1,041.4 802.3 904.9 1,007.6 777.2 876.3 975.3

Other topics

D Net debt 12/31/01 $100.0 100.0 100.0 100.0 100.0

= Equity value at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $784.4 $899.0 $1,013.6 755.8 866.2 976.7 728.4 834.9 941.4 702.3 804.9 907.6 677.2 776.3 875.3

E Equity value per share 1 at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $19.17 $21.97 $24.77 $18.47 $21.17 $23.87 $17.80 $20.41 $23.01 $17.16 $19.67 $22.18 $16.55 $18.97 $21.39

Discount rate 8% 9% 10% 11% 12%

Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method Note: DCF value as of 12/31/01 based on mid-year convention
1

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Growth in perpetuity method


Overview Free cash flow Terminal value WACC

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 grow 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;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

Other topics

Academic formula

JPM recommended method

This step is taken because the perpetuity growth formula is based on the principle that the terminal value of a business is the value of its next cash flow, divided by the difference between the discount rate and a perpetual growth rate 74

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Growth in perpetuity method (contd)


Overview Free cash flow Terminal value WACC

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
Other topics

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

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Example: Growth in perpetuity method


Overview Free cash flow Terminal value WACC

Stand-alone DCF analysis of Company X $ millions


1998 Net sales EBITDA Less: Depreciation EBITA Less: Taxes at marginal rate Tax-effected EBITA Plus: Depreciation Plus: Deferred taxes Less: Capital expenditures Less: Incr./(decr.) in working capital Unlevered free cash flow Adjustment for deal date Unlevered FCF to acquirer Memo: Discounting factor Discounted value of unlevered FCF Discounted value of FCF 2001P2005P Value 2006PTotal present value to acquirer $400.0 80.0 12.0 68.0 27.2 $40.8 1999 $440.0 88.0 13.2 74.8 29.9 $44.9 Fiscal year ending December 31, 2000 2001P 2002P 2003P $484.0 96.8 14.5 82.3 32.9 $49.4 $532.4 106.5 16.0 90.5 36.2 $54.3 16.0 20.0 10.0 40.3 (40.3) $0.0 0.0 $0.0 189.6 733.7 $923.3 $585.6 117.1 17.6 99.6 39.8 $59.7 17.6 22.0 8.5 46.8 $46.8 0.5 $44.6 $644.2 128.8 19.3 109.5 43.8 $65.7 19.3 24.2 7.0 53.8 $53.8 1.5 $46.7 2004P $708.6 141.7 21.3 120.5 48.2 $72.3 21.3 26.6 5.5 61.4 $61.4 2.5 $48.4 2005P $779.5 155.9 23.4 132.5 53.0 $79.5 23.4 29.3 4.0 69.6 $69.6 3.5 $49.9

Other topics

Key assumptions: Deal/valuation date = 12/31/01 Marginal tax rate = 40% Discount rate = 10% Perpetuity growth rate = 3%

Formula

$69.6 * (1 + .03) $733.7 = (.10 - .03)*(1+.10)3.5


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Example: Growth in perpetuity method (contd)


Overview Free cash flow Terminal value WACC
Discount rate 8% 9% 10% 11% 12%

Stand-alone DCF analysis of Company X $ millions, except per share data


A Discounted FCF 20012005 $196.8 193.1 189.6 186.1 182.7 + B Discounted terminal value at perpetuity growth rate of 2.5% 3.0% 3.5% $991.0 $1,095.4 $1,223.0 811.9 883.8 968.9 681.5 733.7 794.0 582.6 622.0 666.7 505.1 535.8 570.1 = C Firm value at perpetuity growth rate of 2.5% 3.0% 3.5% $1,187.8 $1,292.2 $1,419.8 1,005.0 1,077.0 1,162.0 871.1 923.3 983.6 768.7 808.1 852.8 687.9 718.5 752.8

Other topics

D Net debt 12/31/01 $100.0 100.0 100.0 100.0 100.0

= Equity value at perpetuity growth rate of 2.5% 3.0% 3.5% $1,087.8 $1,192.2 $1,319.8 905.0 977.0 1,062.0 771.1 823.3 883.6 668.7 708.1 752.8 587.9 618.5 652.8

E Equity value per share 1 at perpetuity growth rate of 2.5% 3.0% 3.5% $26.59 $29.14 $32.26 $22.12 $23.88 $25.96 $18.84 $20.12 $21.59 $16.34 $17.31 $18.40 $14.37 $15.12 $15.95

Discount rate 8% 9% 10% 11% 12%

Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method Note: DCF value as of 12/31/01 based on mid-year convention
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Terminal multiples and perpetuity growth rates are often considered side-by-side
Overview Free cash flow Terminal value WACC

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:


g = [(WACC*terminal value) / (1+WACC)0.5 - FCFn] / [FCFn + (terminal value / (1 + WACC)0.5)]

Other topics

To go from the growth-in-perpetuity approach to an implied exit multiple:


multiple = [FCFn * (1 + g)(1 + WACC)0.5] / [EBITDAn * (WACC - g)]

These formulas adjust for the different approaches to discounting terminal value
when using the mid-year convention

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Terminal multiple method and implied growth rates


Overview Free cash flow Terminal value WACC
Discount rate 8% 9% 10% 11% 12%

Standalone Company X DCF analysis $ in millions


A + B Discounted Discounted terminal value FCF at 2005P EBITDA multiple of 20012005 6.0x 7.0x 8.0x $196.8 $687.5 $802.1 $916.7 193.1 662.6 773.1 883.5 189.6 638.9 745.4 851.8 186.1 616.2 718.9 821.6 182.7 594.5 693.5 792.6 = C Firm value at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $884.4 $999.0 $1,113.6 855.8 966.2 1,076.7 828.4 934.9 1,041.4 802.3 904.9 1,007.6 777.2 876.3 975.3

Other topics

Terminal value as percent of total firm value 6.0x 7.0x 8.0x 78% 80% 82% 77% 80% 82% 77% 80% 82% 77% 79% 82% 76% 79% 81%

Discount rate 8% 9% 10% 11% 12%

D Net debt 12/31/01 $100.0 100.0 100.0 100.0 100.0

= Equity value at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $784.4 $899.0 $1,013.6 755.8 866.2 976.7 728.4 834.9 941.4 702.3 804.9 907.6 677.2 776.3 875.3

E Equity value per share 1 at 2005P EBITDA multiple of 6.0x 7.0x 8.0x $19.17 $21.97 $24.77 $18.47 $21.17 $23.87 $17.80 $20.41 $23.01 $17.16 $19.67 $22.18 $16.55 $18.97 $21.39 Implied perpetuity growth rate at 2005P EBITDA multiple of 6.0x 7.0x 8.0x 0.2% 1.3% 2.1% 1.1% 2.2% 3.0% 2.0% 3.1% 3.9% 2.9% 4.0% 4.8% 3.8% 4.9% 5.8%

At a 9% discount rate and an 8.0x exit multiple the price is $23.87 and the implied terminal growth rate is 3.0%
Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method Note: DCF value as of 12/31/01 based on mid-year convention
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Perpetuity growth rate and implied terminal multiples


Overview Free cash flow Terminal value WACC
Discount rate 8% 9% 10% 11% 12%

Standalone Company X DCF analysis $ in millions


A + Discounted FCF 20012005 $196.8 193.1 189.6 186.1 182.7 B Discounted terminal value at perpetuity growth rate of 2.5% 3.0% 3.5% $991.0 $1,095.4 $1,223.0 811.9 883.8 968.9 681.5 733.7 794.0 582.6 622.0 666.7 505.1 535.8 570.1 = C Firm value at perpetuity growth rate of 2.5% 3.0% 3.5% $1,187.8 $1,292.2 $1,419.8 1,005.0 1,077.0 1,162.0 871.1 923.3 983.6 768.7 808.1 852.8 687.9 718.5 752.8

Other topics

Terminal value as percent of total firm value 2.5% 3.0% 3.5% 83% 85% 86% 81% 82% 83% 78% 79% 81% 76% 77% 78% 73% 75% 76%

Discount rate 8% 9% 10% 11% 12%

D Net debt 12/31/01 $100.0 100.0 100.0 100.0 100.0

= Equity value at perpetuity growth rate of 2.5% 3.0% 3.5% $1,087.8 $1,192.2 $1,319.8 905.0 977.0 1,062.0 771.1 823.3 883.6 668.7 708.1 752.8 587.9 618.5 652.8

E Equity value per share 1 at perpetuity growth rate of 2.5% 3.0% 3.5% $26.59 $29.14 $32.26 $22.12 $23.88 $25.96 $18.84 $20.12 $21.59 $16.34 $17.31 $18.40 $14.37 $15.12 $15.95 Implied EBITDA exit multiple at perpetuity growth rate of 2.5% 3.0% 3.5% 8.6x 9.6x 10.7x 7.4 8.0 8.8 6.4 6.9 7.5 5.7 6.1 6.5 5.1 5.4 5.8

At a 9% discount rate and a terminal growth rate of 3.0%, the price is $23.88 and the implied exit multiple is 8.0x
Based on 40.0 million basic shares outstanding and 2.0 million options with a weighted exercise price of $8.13 calculated using the treasury method Note: DCF value as of 12/31/01 based on mid-year convention
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Choosing the discount rate is a critical step in DCF analysis


Overview Free cash flow Terminal value WACC

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 (WACC) will be used as a foundation for setting
the discount rate

Other topics

The WACC is 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

The WACC is related to the risk of the investment, not the risk or creditworthiness of the
investor

In valuing a company, always use the riskiness of its cash flows or comparable companies in estimating a weighted average cost of capital. Never use the acquirers cost capital unless, by some chance, it is engaged in an extremely similar line of business. However, if a business is small relative to an acquirors, sometimes ti may be appropriate to consider the use of the acquirors WACC in performing the valuation. The additional value created by using the acquirors WACC can be viewed as a synergy to the acquiror in the context of the transaction.

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The cost of equity is the major component of the WACC


Overview Free cash flow Terminal value WACC

JPMorgan estimates the market cost of equity at approximately 10%

The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation) JPMorgan estimates the cost of equity using the capital asset pricing model Risk-free rate based on the 10 year bond yield Incorporates the undiversifiable risk of an investment (beta) Equity risk premium reflects expectations of todays market Ct oi sy tq o f e u = Re ir st k fa e e r + B e t a xEp qr ue ii m tkm yi r u s A pe px rt t or pa r i a e ra f eve t br ur e ro ni e s k x r a t e x x Es su tt i ie m a d n g ve ah rtn isu oie us c q 5 . 0 0 %

Other topics

L ro oe nt n gu - r t n e r m ee qs utt in i tv n ye im n tye or dk at a s m

L re oif ns gk - t r ee r m rfrt) an tr(= eb oe ea t 0 u =

Af do jm ur s tt e n cn ot rio r e l a t o + sr tm ot c k a k e rs e t u r n + Pt re ea ds id c te b + 1 . 0 0

= 1o 0n -b yd ey ai re l d (a) ae nr ng ue la a v Fa ov rkg m aa re ee tr = = 4 . 9 7 % 9 . 9 7 %

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JPMorgan estimates the equity risk premium at 5.0%


Overview Free cash flow Terminal value WACC

Equity risk premiums is estimated based on expected returns and recent historical returns Equity premiums
Rolling average over 10-year bond
14%

Equity returns less 10-year bond yield


Arithmetic average

12%

Rolling 30 years

3n 0d yi en ag r s e 1 9 9 4
Rolling 50 years

E q u is tk y r i p% r( e) m i u m 2 . 7 3 . 4 4 . 4 4 . 7 5 . 2 6 . 2 5 . 8 5 . 0

Other topics

10%

Percent

8%

1 9 9 5 1 9 9 6

6%

Rolling 40 years

1 9 9 7 1 9 9 8 1 9 9 9

4%

2%
19 55 19 58 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97 20 00

2 0 0 0 2 0 0 1

Year

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JPMorgan uses predicted betas to calculate the cost of equity


Overview Free cash flow Terminal value WACC

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 firms return and
Other topics

market returns and are often distorted

Distribution of predicted and historical betas for 5,600 publicly-traded companies


# of companies
800 600 400 200 0 (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0

# of companies
800 600

Predicted betas Supermarkets 0.78 Food 0.52 Utilities 0.43 Cellular 1.62 Internet 2.09
0.2 1.0 1.9 2.6

Predicted betas

400 200

Historical betas
3.5 4.0

0 (0.5)

Beta

Beta

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JPMorgan uses the long-term cost of debt in estimating WACC


Overview Free cash flow Terminal value WACC

The long-term cost of debt is used because the cost of capital is normally
applied to long-term cash flows

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

Other topics

JPMorgan uses the companys normalized cash tax rate

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The cost of equity and debt are blended together based on a target capital structure
Overview

Free cash flow Terminal value WACC

The target capital structure reflects the companys rating objective Firms generally try 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 firms equity and debt position Most 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

Other topics

WACC formula

Illustrative SYSCO Weighted Average Cost of Capital calculation


Cost of equity
C ol s tp o ft c a i a 1o 0n --( yd e a r T b Mm ae rk km ei tp ru ir s (ard xre )(ti) Bd ep tr c ct ue e n Ae dkm jdm uti sp ta er m re u C o s tu o ft e q i y = A v g ) 4 . 9 7 % 5 . 0 0 % 0 . 6 2 3 . 1 0 % 8 . 0 7 %

Cost of debt
C o s t o f d e b t (d ) T a x s h i e l
1

6 . 2 5 % 2 . 1 9 % 4 . 0 6 %

Target capital structure


(Assumes current = optimal)

A fs tt e rd -e tf a x c o o b t

Debt/total capital2 = 6.1%

Nominal WACC = 7. 82%


Assumes 35% marginal tax rate 2 Total capital = debt + market value of equity
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The cost of a firms equity should be adjusted for size


Overview Free cash flow Terminal value WACC

Investors typically expect higher returns when investing in smaller companies Increased risk Lower liquidity Betas vary very little by size

Size premium by market cap


Based on historical returns analysis
5.2% 3.1% 2.5% 1.9% 1.7% 1.4% 1.1% 0.8% 0.0%

Other topics

$0100

$100250 $250500 $500700

$700 1,000

$1,000 1,500

$1,500 2,500

$2,500 5,000

$5,000+

Historical equity returns suggest higher return required by investors in smaller companies P/E growth ratios (PEG) tend to decline with size Empirical data combined with judgement should be applied when estimating the cost of equity for smaller firms

Market cap ($MM)

Size premium by market cap


Based on PE/growth (PEG)
2.2% 1.6% 1.1% 0.8%

0.0% $100500 $5001,000 $1,0002,500 $2,5005,000 $5,000+

Market cap ($MM)

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Predicted betas declined substantially in several industries, although food distribution has been increasing over the last few years

Overview Free cash flow Terminal value WACC

Predicted betas are declining in


industries whose fundamentals do not appear to have changed

Predicted betas for various industries1


1.20 1.10 1.00

Other topics

JPMorgan believes that current


predicted betas do not fully represent the equity risk of investments in these sectors

0.90 0.80 0.70 0.60


Food retail Pharma Food dist.

Using a predicted beta adjusted to


reflect historical levels over a longer time frame (up to 510 years) is appropriate

0.50 0.40

Packaged food

0.30 Jan-95

Oct-96

Jul-98

Apr-00

Jan-02

Typically between three and five large-cap companies were used to develop these industry predicted betas Source: Barra
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Historical analysis suggests current predicted betas may understate cost of equity in food distribution
Overview Free cash flow Terminal value Company WACC SYSCO Ahold Other topics Other food distributors Performance Food Group International Multifoods United Natural Foods Fleming Companies Nash Finch SuperValu Median $1,482 5102 352 825 391 3,276 $696 18.4% 107.4% 31.1% 298.9% 97.8% 69.0% 78.9% 0.68 0.39 0.57 1.02 0.24 0.56 0.56 0.61 0.46 0.63 0.69 0.31 0.66 0.62 0.70 0.60 0.63 0.78 0.43 0.75 0.66 0.82 0.73 0.64 0.87 0.54 0.84 0.77 0.61 0.23 0.47 0.35 0.15 0.39 0.37 0.54 0.27 0.52 0.23 0.19 0.46 0.36 0.62 0.35 0.53 0.26 0.26 0.52 0.43 0.73 0.43 0.54 0.30 0.33 0.58 0.48 0.47 0.66 1.46 0.19 (0.09) 0.30 0.39 Predicted beta (levered) Market cap $17,358 14,903 Debt/ equity 6.7% 96.8% Current 0.62 0.64 5 yr avg. 0.67 0.66 10 yr. avg. 0.79 0.82 1992 1997 0.91 0.97 Predicted beta (unlevered) Current 0.59 0.40 5 yr avg. 0.64 0.41 10 yr. 1992 avg. 1997 0.76 0.50 0.87 0.60 Current hist. beta 0.55 0.76

$ millions

Note: Share prices as of July 3, 2002 Source: Barra as of May 30, 2002

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The appropriate cost of capital will depend on the entity which is being valued
Overview Free cash flow Terminal value WACC

For illustrative purposes


R i sU O kn l e v e r e d pR C C t i m a e l l e v e r e d o s t o f o s t o f p r e mad i u m bb ee t t / e q u i t y b e e q t a u f i t y i n a n c i n g 5 . 0 % 0 . 7 0 5 . 0 %0 6 . 5 %. 7 0 5 . 0 %0 7 . 0 %. 7 0 5 . 0 %0 7 . 5 %. 7 0 2 0 % 0 . 8 0

C o m p a n y S Y S C O $ 1 B N t a r g e t $ 5 0 M t a r g e t

W A C

9 . 0 % 6 . 2 5 %8 . 2 %

2 0 % 09 . 8. 0%0 0 1 0 . 3 % 6 . 2 5 % 8 7 . 5 %. 3 % 9 . 3 % 2 0 % 09 . 8. 0%% 8 0 1 0 . 6 % 6 . 2 5 % . 8 . 0 4 % 9 . 7 % 2 0 % 09 . 8. 0%0 0 1 . 0 % 6 . 2 5 %8 8 . 5 %. 4 % 1 0 . 1 %

Other topics

$ 2 0 M t a r g e t

SYSCO WACC sensitivity


10% 0.65 Levered beta 0.70 0.75 0.80 0.85 7.8% 8.1% 8.3% 8.5% 8.8% Debt/equity 20% 30% 7.5% 7.7% 7.9% 8.2% 8.4% 7.3% 7.5% 7.7% 7.8% 8.0% 40% 7.0%

$1BN target WACC sensitivity1


10% 0.70 Levered beta 0.75 0.80 0.85 0.90 9.1% 9.4% 9.7% 10.0% 10.3% Debt/equity 20% 30% 8.7% 9.0% 9.3% 9.6% 9.8% 8.4% 8.7% 8.9% 9.2% 9.4% 40% 8.2%

$200MM target WACC sensitivity2


10% 0.70 Levered beta 0.75 0.80 0.85 0.90 9.8% 10.1% 10.5% 10.8% 11.2% Debt/equity 20% 30% 9.4% 9.8% 10.1% 10.4% 10.7% 9.1% 9.4% 9.7% 10.0% 10.3% 40% 8.9% 9.1% 9.4% 9.7% 10.0%

7.2% 7.4% 7.6% 7.8%

8.4% 8.7% 8.9% 9.1%

Note: Assumes 35% marginal tax rate 1 Assuming an equity risk premium of 6.5% 2 Assuming an equity risk premium of 7.5%

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Most common errors in calculating WACC


Overview Free cash flow Terminal value WACC

Cost of equity

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

Other topics

Target capital structure

The actual, not target, capital structure is used WACC calculated based on book weights

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Valuing synergies
Overview Free cash flow Terminal value WACC Other topics

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 Raw material discounts/purchasing power Sales and marketing overlap Corporate overhead reductions Distribution cost reductions Facilities consolidation Tax savings

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

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

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Sensitivity analysis is vital when presenting the results of DCF analysis


Overview Free cash flow Terminal value WACC Other topics

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

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

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Companies with multiple businesses are often valued on a sum-of-the-parts basis


Overview Free cash flow Terminal value WACC Other topics

This approach is sometimes referred-to as a break-up valuation


Particularly common when the company is believed to be undervalued by the public Better accounts for discrepancies in market conditions facing the businesses

The methodology requires estimating financial results for each business (EBIT, EBITDA
and/or net income), which can then be used with appropriate multiples or growth rates in order to arrive at a firm value for each part before the results are summed

Completing a sum-of-the-parts valuation can be more challenging than a straightforward


(single-business/consolidated) DCF analysis Typically less detailed financial data is publicly-available for segments Often assumptions must be made about how to allocate expenses, especially those that are clearly shared across businesses (like corporate-level SG&A) Need to consider different characteristics of each business segment (discount rate, terminal value assumptions, etc.)

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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LBO analysis provides another perspective on M&A transactions


Overview

Example

A leveraged buyout is an acquisition transaction in which much of the purchase


price is funded with debt

This type of capital structure enables financial sponsors to leverage returns on


their relatively small equity investment, as cash flows generated during the investment period are used to pay down debt

Financial sponsors profit by exiting three to five years after the transaction

Sell the target to another buyer Take the target public Recapitalize the target

Assumptions regarding the investment transaction, the exit and the period
between the acquisition and the exit are critical to determining an appropriate capital structure and potential returns to equity

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LBO analysis can play an important role in many M&A engagements


Overview

Example

M&A clients include both financial sponsors and strategic players


Financial sponsors typically pursue M&A transactions with different perspectives and objectives (e.g., a shorter investment horizon) Strategic buyers sometimes behave like financial investors (i.e., acquiring with the expectation of selling in several years)

Financial sponsors generally analyze a transaction using LBO methodologies in


the first instance (and DCF, comparable companies/transactions analyses thereafter)

LBO analysis provides another data point for strategic players that may chiefly rely
on DCF analysis

LBO valuation may be useful from a competitive point of view, as strategic players
vie with financial sponsors for the same assets

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The process of LBO analysis


Overview

Example

Projections

Develop an integrated model of the business that projects EBITDA and cash available for debt repayment over the investment horizon (typically 35 years)

Terminal value

Estimate the multiple at which the sponsor can be expected to exit the investment at the end of the investment period

Pro forma capitalization

Determine a transaction structure and a pro forma capital structure that result in realistic financial coverage

IRR

Calculate returns (IRR) to the equity sponsor

Adjustments

Tweak the transaction/capital structure as needed to achieve harmony (if possible) between IRR, leverage and valuation

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The initial steps in an LBO analysis are identical to those in a DCF analysis
Overview

Example

The same financial projections developed for a DCF analysis can be used to build
a basic LBO model

Free cash flows are expected to be used to service debt, with positive flows to
equity typically coming at exit Amount and predictability of free cash flows dictate whether a company is an attractive or viable LBO target

Cash flows are not discounted Terminal value drives valuation, and is calculated on the basis of multiples

Multiple of exit-year EBITDA is generally used to bound the valuation of the enterprise in any possible exit scenario

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Pro forma capitalization and transaction structure are set forth in sources and uses
Overview

Example

Sources should show the entire pro forma capitalization of the company, including:

New debt New equity Rolled-over debt and equity

Uses of funds should address all parts of the targets existing capital structure, as well
as transaction-related leakage: Refinancing existing debt Transaction expenses Equity purchase price Debt and equity to be rolled-over

Sources must equal uses


Any debt or equity that is rolled-over shows up under both sources and uses Always depict every part of the capitalization, whether it changes pro forma or not

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LBO models are driven by the characteristics of the sources of capital for the transaction
Overview

Components of capital
Example

Senior debt
Revolving Term Sample inputs 30%50% of total capital LIBOR + 200-400 58 years

Typically supplied by an investment or commercial bank Usually secured / most restrictive covenants Amortizing 5- to 8-year tenor First in line at liquidation Lowest coupon

Subordinated debt
Sample inputs Senior/sub notes 25%35% of total Discount notes capital T + 350650 710 years

Typically supplied by an investment or commercial bank or a mezzanine fund Riskier debt / typically unsecured Primarily bullet structures Typical tenor is 10-year High coupon Typically supplied by an investment or commercial bank or a mezzanine fund (often sponsor-affiliated) Multiple forms: Convertible debt, exchangeable debt, convertible preferred stock, PIK securities and warrants Expected IRR in the 15% 20% range Typically supplied by a financial sponsor Highest risk / cost of capital Sometimes stapled to high-yield paper to attract broader investor group Minimum annual returns >20%

Mezzanine securities
Sample inputs Sub. debt (conv.) 0%35% total capital High teens/low 20s Preferred stock 710+ years PIK Warrants

Common equity
Sample inputs 20%40% of total capital 20%-30% IRR 57 year horizon

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Internal rate of return (IRR) is the key return benchmark utilized by financial investors
Overview

Example

IRR represents the implied discount rate at which the net present value of cash flows
equals zero The math underlying IRR is highly complex Excel and financial calculators effectively back into IRR by narrowing a series of guesses at the appropriate rate When calculating IRR, cash outflows (e.g., initial investment) are always negative, and cash inflows (e.g., exit proceeds) are always positive

Keep in mind that there may be cash flows to the sponsor prior to exit

These flows must be factored into the calculation of IRR in the period in which they are received

Remember that equity sits at the bottom of the capital structure

Debt must be paid-off or refinanced for holders of equity to receive any return on their investment

IRR is also driven by the investors pro forma equity ownership percentage

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Together, IRR and credit ratios serve as gauges of the transaction structures viability
Overview

Example

Key credit ratios include:


Total debt to EBITDA Senior debt to EBITDA EBITDA to total interest EBITDA less capital expenditures to total interest

Both providers of debt and equity have minimum requirements for participating in a
transaction Debt covenants typically require periodic certification of financial ratios Equity sponsors generally will not invest without comfort as to likely returns

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Structural benchmarks vary across industries and reflect current market conditions
Overview

Example

M&A professionals require input from colleagues actively involved in debt capital
markets in order to develop reasonable assumptions regarding capital structures in LBO analyses

Guidance received from debt-market participants could include, for example:


EBITDA coverage (EBITDA/total interest expense) of not less than 2.0x EBITDA capital expenditures coverage [(EBITDA CAPEX)/interest expense] of not less than 1.2x Total debt/EBITDA of not more than 4.55.5x Senior debt/EBITDA of not more than 3.04.0x Senior bank term loan completely repaid in 57 years Bank debt not to exceed 60% of the initial capitalization Pure equity of not less than 25% Ability to convey growth prospects to banks and high-yield investors

Always remember that markets are dynamic

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IRR drivers
Overview

Three important factors drive IRRs: 1) De-levering 2) Operating improvement and 3) Multiple expansion (arbitrage)
No operating Operating At improvement/ improvement/ purchase No arbitrage No arbitrage EBITDA Purchase multiple EBITDA on Purchase date Firm value at Purchase date Debt at purchase (5x EBITDA) Equity value invested 7.0x $100 $700 500 200 Operating improvement and arbitrage

Example

EBITDA Exit multiple EBITDA at Exit Firm value at Exit Debt (after paydown of $75 per yr) Equity value at exit IRR (5-Year exit)

7.0x $100 700 125 575 23.5%

7.0x $128 896 125 771 31.0%

8.0x $128 1,024 125 899 35.1%


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Sample LBO valuation analysis


Overview

$ millions

Example

Assumes management promote of 5% Valuation as at 12/31/01 3 Leverage based on bank/bond case


1 2

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Stand-alone LBO analysis of Company X


Overview

$ millions
U s ff ns s o ud e Mim cs blac in u ah a ne m Rinne x t g eiodb e ac eis sn r et f in R oesn rdb o vr eio et llRinne x t g u.db e ac eis sb et f in R oesbdb o vr u. et llRinne x t g ezdb e ac eis m . et f in z R oemzdb o vr e . et llz E it pr hs p e q y u ae r u c ic T nat nes r sc f e a io R oeeuy o vr qit llTt lue o ss a Su e of ns or s f ud c Fne udd C me o it d mt Aon m t u %ft t l oo a Aon m t u %ft t l oo a $ 6 . 0 0% $ . 8 6 . 0 0% . 8 0% . 0 7. 5 0 9% . 4 21 7. 1 3. % 7 5 21 7. 1 3. % 4 0 5. 3 2 7% . 4 5. 3 2 6% . 7 3. 0 0 4% . 2 3. 0 0 3% . 8 4. 9 9 6% . 9 4. 9 9 6% . 3 22 9. 6 4. % 0 5 22 9. 6 3. % 6 7 2. 0 0 2% . 8 2. 0 0 2% . 5 $ 72 2. 8 10 % $ 0. 0 77 9. 8 10 % 0. 0 EI D B A T cvr g oe e a 00 . x 7 25 . x 5 00 . x 5 08 . x 2 07 . x 4 Tr e m ( er) ya s 7 . 0 7 . 0 9 . 0 8 . 0 9 . 0 I t rs n et e rt a e 90 . % 0 90 . % 0 1. 0 2 % 0 1. 0 2 % 0 1. 0 6 % 0 Wrn a at r s ( d ss %i h) l C he a fe s ( ot) pi s n Aon m t u 5 . 0 20 0. 0 6. 0 0 3. 0 0 40 0. 0 7 . 8 2. 0 0 $ 72 2. 8 $ %ft t l oo a 0% . 7 2. % 7 7 0% . 0 8% . 3 4% . 2 0% . 0 0% . 0 5. % 5 3 1% . 1 2% . 8 10 % 0. 0

Example

E t g ah a ne x in cs blac is R oe e lvr v S iot r lon e r e as n m N sbdb e u. et w R oesbdb o vr u. et llN mzdb e e . et w z N euy e qit w R oeeuy o vr qit llTt lsu e o or s a c

20 . % 0 20 . % 5 15 . % 2 00 . % 0

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Stand-alone LBO analysis of Company X (contd)


Overview

$ millions
5 e r le e dre rn toe u a v rio sp e -y a v re tu s q ity t a u ric s E it m ltip o E IT A x u le f B D 6 x .5 7 x .0 2 .9 7 % 3 .2 0 % 2 .6 5 % 2 .9 7 % 2 .6 3 % 2 .8 5 % 2 .7 1 % 2 .9 3 % 1 .9 9 % 2 .1 2 %

Example

$ Eu q ity p rc a e u hs p e ric

2 .7 % 5 8 30 5 .0 35 7 .0 40 0 .0 45 2 .0 40 5 .0

6 x .0 2 .5 5 % 2 .2 3 % 2 .2 1 % 1 .3 9 % 1 .6 7 %

7 x .5 3 .4 2 % 3 .0 0 % 2 .9 7 % 2 .9 5 % 2 .1 4 %

8 x .0 3 .4 4 % 3 .0 2 % 2 .8 9 % 2 .8 7 % 2 .0 6 %

N we u re u du d r v rio ss c re e q ity q ire n e a u tru tu s T ta in l le e g o l itia v ra e 4 5 .2 x 4 0 .5 x 29 6 .2 $ 22 4 .6 $ 24 9 .2 27 6 .6 39 1 .2 22 9 .6 34 4 .2 37 1 .6 39 6 .2 32 4 .6

Eu q ity p rc a e u hs p e ric

$ 9 .5 22 9 $ 30 5 .0 35 7 .0 40 0 .0 45 2 .0 40 5 .0

4 0 .0 x 25 9 .8 $ 30 2 .8 35 4 .8 30 7 .8 35 9 .8

4 5 .7 x 26 1 .0 $ 21 4 .0 26 6 .0 21 9 .0 36 1 .0

5 0 .0 x 19 8 .4 24 1 .4 29 3 .4 24 6 .4 29 8 .4

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Stand-alone LBO analysis of Company X (contd)


Overview

$ millions
Equity ownership summary % basic shares 93.6% 0.0% 6.4% 100.0% % diluted shares 92.4% 1.3% 6.3% 100.0%

Example

Acquirer/new equity investors New mezz. lenders Roll-over equity holders

Other assumptions Tax rate LTM (2001) EBITDA Non-financing trans. exp. Maximum senior leverage Maximum total leverage EBITDA exit multiple Interest on cash balances Terminal equity value EBITDA Exit multiple of EBITDA Firm value Less: Debt Plus: Cash Less: Refinancing fees Plus: Dividends Equity value

$ $

40.0% 106.5 1.0 3.25x 4.50x 7.0x 5.0%

$ $

2002P 117.1 $ 7.0x 819.9 $ 382.0 5.0 442.9 $

2003P 128.8 $ 7.0x 901.9 $ 351.4 5.0 555.5 $

2004P 2005P 2006P 141.7 $ 155.9 $ 170.0 7.0x 7.0x 7.0x 992.1 $ 1,091.3 $ 1,190.0 311.4 260.6 198.5 5.0 5.0 5.0 685.7 $ 835.7 $ 996.5

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Stand-alone LBO analysis of Company X (contd)


Overview

$ millions
Rrs n eiy enow t t t eq u u Ea2 /4 x t1 1 i / 0 t 3 Ea2 /5 x t1 1 i / 0 t 3 Ea2 /6 x t1 1 i / 0 t 3 Rrs mn lnr enoea e d t t z i ee u zn s Ea2 /4 x t1 1 i / 0 t 3 Ea2 /5 x t1 1 i / 0 t 3 Ea2 /6 x t1 1 i / 0 t 3 Cisits rdtt i e ac t s Soe/ BA er bED n dt I i T Tldt ED o e/ B A t b I a T EDttlitrs BA a e t I /o ne T (BAaxttlitrs EDce/o ne I - p) a e t T Aog t ls ci n 2x .5 5 3x .0 8 N A N A 22 0P 0 2x .3 1 3x .6 2 2x .3 8 2x .0 3 23 0P 0 1x .9 6 2x .3 7 3x .0 3 2x .8 6 24 0P 0 1x .6 2 2x .0 2 3x .6 9 3x .1 2 25 0P 0 0x .2 8 1x .7 6 4x .1 9 3x .9 9 26 0P 0 0x .8 3 1x .7 1 6x .8 3 5x .5 2 $ 21 0P 0 (9 4) . 9 (9 4) . 9 (9 4) . 9 $ 22 0P 0 8 $ . 0 8 . 0 8 . 0 23 0P 0 8 $ . 0 8 . 0 8 . 0 24 0P 0 6 6 . 4 8 $ . 0 8 . 0 25 0P 0 6 8 . 3 8 $ . 0 26 0P 0 IR R 2% 0 . 7 1% 9 . 9 1% 9 . 4 $ 21 0P 0 (9 ) 2. 2 6 (9 ) 2. 2 6 (9 ) 2. 2 6 22 0P 0 23 0P 0 $ 24 0P 0 6. 3 3 8 25 0P 0 $ 7. 7 2 4 26 0P 0 IR R 2% 9 . 4 2% 7 . 5 2% 5 . 8

Example

9. 2 1 1

7 0 . 3

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Stand-alone LBO analysis of Company X (contd)


Overview

$ millions
S u m m a r y fin a n c in g s c h e d u le E B IT D A D e p r e c ia t io n & a m o r t iz a t io n N o r m a liz e d E B IT In te r e s t e x p e n s e I n t e r e s t in c o m e T a x a b le in c o m e L e s s : In c o m e ta x e s In c o m e a fte r ta x e s P lu s : D e p r e c ia tio n P lu s : P I K n o n - c a s h in te r e s t L e s s : C a p it a l e x p e n d itu r e s L e s s : I n c r . / ( d e c r . ) in w o r k in g c a p it a l C a s h a v a ila b le f o r d e b t s e r v ic e M e m o : P e r io d R e v o lv e r B a la n c e a t b e g in n in g o f p e r io d P lu s : B o r r o w in g s ( r e p a y m e n t s ) B a la n c e a t e n d o f p e r io d In te r e s t S e n io r t e r m lo a n s B a la n c e a t b e g in n in g o f p e r io d P lu s : B o r r o w in g s L e s s : M a n d a to ry p a y m e n ts L e s s : O p t io n a l p a y m e n t s B a la n c e a t e n d o f p e r io d In te r e s t $ 2002P 1 1 7 .1 $ 1 7 .6 9 9 .6 4 1 .4 0 .3 5 8 .4 2 3 .4 3 5 .1 1 7 .6 2 2 .0 8 .5 2 2 .1 $ 1 2003P 1 2 8 .8 $ 1 9 .3 1 0 9 .5 3 9 .0 0 .3 7 0 .8 2 8 .3 4 2 .5 1 9 .3 2 4 .2 7 .0 3 0 .6 $ 2 2004P 1 4 1 .7 $ 2 1 .3 1 2 0 .5 3 5 .8 0 .3 8 4 .9 3 4 .0 5 0 .9 2 1 .3 2 6 .6 5 .5 4 0 .1 $ 3 2005P 1 5 5 .9 $ 2 3 .4 1 3 2 .5 3 1 .7 0 .3 1 0 1 .0 4 0 .4 6 0 .6 2 3 .4 2 9 .3 4 .0 5 0 .7 $ 4 2006P 1 7 0 .0 2 5 .0 1 4 5 .0 2 6 .6 0 .3 1 1 8 .6 4 7 .4 7 1 .2 2 5 .0 3 0 .0 4 .0 6 2 .2 5

Example

$ $ $

$ 1 6 .6 1 6 .6 $ 0 .7 $

1 6 .6 $ 8 .1 2 4 .7 $ 1 .9 $

2 4 .7 $ (1 .4 ) 2 3 .4 $ 2 .2 $

2 3 .4 $ ( 1 2 .0 ) 1 1 .4 $ 1 .6 $

1 1 .4 (1 1 .4 ) 0 .5

$ $

2 7 1 .1 $ 3 8 .7 2 3 2 .3 $ 2 2 .7 $ 3 8 0 .7 $ 2 4 8 .9 1 3 1 .7 $ 0

2 3 2 .3 $ 3 8 .7 1 9 3 .6 $ 1 9 .2 $ 4 1 8 .7 $ 2 1 8 .3 2 0 0 .4 $ 0

1 9 3 .6 $ 3 8 .7 1 5 4 .9 $ 1 5 .7 $ 4 6 0 .6 $ 1 7 8 .3 2 8 2 .4 $ 0

1 5 4 .9 $ 3 8 .7 1 1 6 .2 $ 1 2 .2 $ 5 0 6 .7 $ 1 2 7 .5 3 7 9 .1 $ 0

1 1 6 .2 3 8 .7 1 2 .1 6 5 .4 8 .2 5 5 2 .5 6 5 .4 4 8 7 .1 0

M a x im u m s e n io r le v e r a g e $ R e v o lv e r + s e n io r d e b t b a la n c e a t e n d o f p d . D iff e r e n c e $ R e c a p y e a r? (1 = y e s , 0 = n o )

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Stand-alone LBO analysis of Company X (contd)


Overview

$ millions
N ew sub. debt B a la n c e a t b e g i n n i n g o f p e r i o d P lu s : B o r r o w in g s L e s s : M a n d a to r y p a y m e n ts L e s s : O p tio n a l p a y m e n t s B a la n c e a t e n d o f p e r i o d In te r e s t R o ll - o v e r s u b . d e b t B a la n c e a t b e g i n n i n g o f p e r i o d P lu s : B o r r o w in g s L e s s : M a n d a to r y p a y m e n ts L e s s : O p tio n a l p a y m e n t s B a la n c e a t e n d o f p e r i o d In te r e s t N ew m ezz. debt B a la n c e a t b e g i n n i n g o f p e r i o d P lu s : B o r r o w in g s L e s s : M a n d a to r y p a y m e n ts L e s s : O p tio n a l p a y m e n t s B a la n c e a t e n d o f p e r i o d In te r e s t C ash B a la n c e a t b e g i n n i n g o f p e r i o d P lu s : F r e e c a s h flo w L e s s : M in im u m c a s h b a la n c e L e s s : M a n d a to r y d e b t re p a y m e n ts C a s h a v a ila b le ( n e e d t o f in a n c e ) N e t c h a n g e in c a s h C a s h a t e n d o f p e r io d I n te r e s t in c o m e o n a v g . c a s h S u m m a ry B e g in n in g D e b t B a la n c e E n d in g D e b t B a la n c e $

2002P 5 3 .2 $ 5 3 .2 $ 6 .4 $

2003P 5 3 .2 $ 5 3 .2 $ 6 .4 $

2004P 5 3 .2 $ 5 3 .2 $ 6 .4 $

2005P 5 3 .2 $ 5 3 .2 $ 6 .4 $

2006P 5 3 .2 5 3 .2 6 .4

Example

$ $

$ $

3 0 .0 $ 3 0 .0 $ 3 .6 $

3 0 .0 $ 3 0 .0 $ 3 .6 $

3 0 .0 $ 3 0 .0 $ 3 .6 $

3 0 .0 $ 3 0 .0 $ 3 .6 $

3 0 .0 3 0 .0 3 .6

$ $

4 9 .9 $ 4 9 .9 $ 8 .0 $

4 9 .9 $ 4 9 .9 $ 8 .0 $

4 9 .9 $ 4 9 .9 $ 8 .0 $

4 9 .9 $ 4 9 .9 $ 8 .0 $

4 9 .9 4 9 .9 8 .0

$ $ $

5 .0 $ 2 2 .1 5 .0 3 8 .7 ( 1 6 .6 )$ 5 .0 $ 0 .3 $

5 .0 3 0 .6 5 .0 3 8 .7 ( 8 .1 ) 5 .0 0 .3

$ $ $

5 .0 4 0 .1 5 .0 3 8 .7 1 .4 5 .0 0 .3

$ $ $

5 .0 5 0 .7 5 .0 3 8 .7 1 2 .0 5 .0 0 .3

$ $ $

5 .0 6 2 .2 5 .0 3 8 .7 2 3 .4 5 .0 0 .3

4 0 4 .2 $ 3 8 2 .0

3 8 2 .0 $ 3 5 1 .4

3 5 1 .4 $ 3 1 1 .4

3 1 1 .4 $ 2 6 0 .6

2 6 0 .6 1 9 8 .5

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Introduction to relative valuation

Relative valuation is utilized to illustrate how the value of one company compares to another company Typically, relative valuation analysis is utilized in the context of stock-for-stock exchanges to determine
the appropriate exchange ratio offered to shareholders in a transaction

The exchange ratio reflects the number of acquiror shares offered for each target share

So if you are a target shareholder and you are offered an exchange ratio of 0.500x, you are being offer 1/2 of an acquiror share for each share of the target you own

Several relative valuation approaches exist


Historical trading and exchange ratio analysis Contribution analysis Relative multiple and discounted cash flow analysis Valuation of synergies

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Historical trading and exchange ratio analysis

Historical exchange ratio analysis Illustrates the relative movement in stock prices (and implied
exchange ratios, aka natural exchange ratios) looking back over a certain timeframe

Calculated simply as the target share price on a given date divided by the acquiror share price
on the same date Does not include any premium to the target

Provides a historical benchmark to justify the contemplated exchange ratio Issues to consider when analyzing data include

Liquidity of shares / trading volume (small vs. large cap) Relative market attention / analyst coverage Multiple expansion of one of the companys peer group versus the other over the selected time horizon

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Illustrative historical trading and exchange ratio analysis

Historical exchange ratio


# of acquiror shares per target share
More favorable to Target

C u r e n t s t o c k p r i c e A c q u i r o r $ 3 4 . 6 0

T a r g e t $ 6 . 7 0

C u r e n t m a r k e t c a p i t a l i z a t i o n A c q u i r o r $ 2 7 4 . 8

T a r g e t $ 8 9 . 7

At $12 per share = 0.347x

Less favorable to Target

Current = 0.194x

Represents average exchange ratio over the trailing period ended June 27, 2002 Closing prices as of June 27, 2002 3 Assumes Acquirors current price of $34.60 per share
1 2

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Contribution analysis

Compares the relative equity valuation of two parties to their respective contribution to a
combined companys financial performance

Typical firm value metrics would include


Revenues EBITDA EBIT Unlevered free cash flow measures Industry-specific (i.e. customers, reserves, etc.)

Typical equity value metrics would include


Net income Levered free cash flow measures

Cautionary note: contribution analysis does not measure the growth and risk profile of the
two companies financial performance and differing multiples may be justifiablie when assessing relative value

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Relative contribution analysis


$ millions
Implied equity value ACQUIROR TARGET $18,150 70.3% $58,042 $18,150 70.3% $7,653 29.7% $7,653 29.7% 0.4340x Implied exchange ratio 0.4340x

ACQUIROR Market value % contribution Firm value1 % contribution EBITDA 2001E % contribution 2002E % contribution Net income 2002E % contribution 2003E % contribution $1,790 59.7% $2,018 59.4% $5,275 59.9% $5,320 62.1% $18,150 70.3% $38,450 66.2%

TARGET $7,653 29.7% $19,592 33.8%

Total $25,803

$3,528 40.1% $3,253 37.9%

$8,803

$14,482 56.1%

$11,322 43.9% $10,087 39.1%

0.8046x

$8,573

$15,716 60.9%

0.6606x

$1,210 40.3% $1,380 40.6%

$3,000

$15,397 59.7%

$10,406 40.3% $10,477 40.6%

0.6956x

$3,398

$15,326 59.4%

0.7036x

As of 2/6/02; net debt for ACQUIROR as of 12/31/01 (per press release) and for TARGET as of 9/30/01 (per 10-Q); pro forma for acquisitions 2001A for ACQUIROR; based on company press release; other estimates based on JPMorgan Equity Research 3 Based on I/B/E/S consensus estimates; ACQUIROR 2002E EPS based on company guidance; TARGET EPS estimates based on I/B/E/S consensus estimates post 1/29/02
1 2

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Sample contribution analysis


Target
$25,308

Acquiror
$58,042 $8,803 $8,573 $3,000 $3,398

Relative ownership Exchange ratio 0.5385x Target 35.0% Acquiror 65.0%

56.1% 70.3% 70.3%

60.9%

59.7%

59.4%

43.9% 29.7% 29.7%

39.1%

40.3%

40.6%

Offer = 35.0%

Market value

Firm value

2002E EBITDA

2003E EBITDA

2002E Net Income

2003E Net Income

Implied ER

.4340x

.4340x

.8046x

.6606x

.6956x

.7036x

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Calculating the implied exchange ratio


Company statistics
A q ir r cuo C rre t s a p e u n h re ric F lly ilu ds a c u t u -d te h re o n F lly ilu dmrk t c p u -d te a e a Ntd b e et E IT A BD N t in o e e cm Tr e ag t C rre t s a p e u n h re ric F lly ilu ds a c u t u -d te h re o n F lly ilu dmrk t c p u -d te a e a Ntd b e et E IT A BD N t in o e e cm $4 5 1 .8 55 1 75 ,6 3 1 ,9 9 13 35 ,2 3 11 ,2 0 Imlie e c a g ra b s do n t p d x h n e tio a e n e in o e(3 8/ 5 5 cm 5 1) N tu l e c a g ra b s do c rre t a ra x h n e tio a e n u n s a p e ($ 4 5/ $ 4 2 h re ric s 1 .8 3 .2 ) 0 96 .6 5 x $4 2 3 .2 51 3 1 ,1 0 85 2 ,3 0 00 52 ,3 0 19 ,7 0 % f n t in o ec n u db o e c m o trib te y F lly ilu d a q iro s a s u -d te c u r h re P fo as a so ts n in toy ld ro rm h re u ta d g ie 5 .7 o n rs ip 9 % we h Imlie s a sis u dtota e p d h re s e rg t C rre t ta e s a so ts n in u n rg t h re u ta d g a q iro cu r 5 .7 9% 50 3 88 8 38 5 55 1

Implied exchange ratio (equity value metrics)

0 30 .4 4 x

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Calculating the implied exchange ratio (contd)


Company statistics
A q ir r cuo C rre t s a p e u n h re ric F lly ilu ds a c u t u -d te h re o n F lly ilu dmrk t c p u -d te a e a Ntd b e et E IT A BD N t in o e e cm Tr e ag t C rre t s a p e u n h re ric F lly ilu ds a c u t u -d te h re o n F lly ilu dmrk t c p u -d te a e a Ntd b e et E IT A BD N t in o e e cm $4 5 1 .8 55 1 75 ,6 3 1 ,9 9 13 35 ,2 3 11 ,2 0 $4 2 3 .2 51 3 1 ,1 0 85 2 ,3 0 00 52 ,3 0 19 ,7 0 C m in dfirmv lu obe ae C m in de u v lu o b e q ity a e % B D c n u db E IT A o trib te y F v lu b s do E IT A irm a e a e n B D cn u n o trib tio Im lie e u v lu p d q ity a e A a% f to l e u v lu s o ta q ity a e a q iro cu r 5 ,0 2 84 2 ,8 3 50 6 .1 2% 3 ,0 4 64 1 ,7 4 54 6 .0 1% 51 3 89 6 38 3 55 1 0 66 .6 0 x

Implied exchange ratio (firm value metrics)

F lly ilu d a q iro s a c u t u -d te c u r h re o n P fo as a so ts n in toy ld ro rm h re u ta d g ie 6 .0 a q iro o n rs ip 1 % c u r we h Im lie s a sis u dtota e p d h re s e rg t F lly ilu dta e s a c u t u -d te rg t h re o n Im lie e c a g ra b s do p d x h n e tio a e n E IT A(3 8/ 5 5 B D 3 1) N tu l e c a g ra b s do c rre t a ra x h n e tio a e n u n s a p e ($ 4 5/ $ 4 2 h re ric s 1 .8 3 .2 )

0 30 .4 4 x

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Relative multiple and discounted cash flow valuation

Compares the ranges suggested by stand-alone valuations of two


companies on a multiples or discounted cash flow basis Step 1: Valuation the acquiror and the target separately Step 2: create a relative value summary

Need to consider which ends of the range it is appropriate to compare


when determing an appropriate exchange ratio / ownership percentage High/Low and Low/High High/High and Low/Low

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Sample relative value football field: Target valuation

Price per share


$20.00 $26.75

$15.00 $15.00

Street case DCF


$9.75 $10.25

$10.00

$5.00 $4.94

$5.00 $4.00 $4.00 $3.00

$5.00

$5.50 $6.00 $3.50

Implied offer1 = $8.46

Highest public comp price


$0.00

$3.75

Lowest public comp price


52-week high/low 15.0x to 19.0x 2001E EBIT of $20.6 19.0x to 25.0x 2001E cash EPS of $0.16 15.0x to 20.0x 2002E cash EPS of $0.25 2.5x to 4.0x LTM revenue of $185.7

Mgmt. Case
12% to 15% Discount Rate EBIT exit mult. of 15.0x to 20.0x

Street Case3
12% to 15% Discount Rate EBIT exit mult. of 15.0x to 20.0x

Public trading comparables

Transaction comparables2

DCF analysis

Based on the offer exchange ratio of 0.311x and Pedros closing price $27.19 as of 7/12/01 Certain of the multiples implied by precedent transactions have been adjusted by indexing them to the movement in an index of stock prices of companies comparable to Pablo. (see p. 22 for additional detail) 3 Based on IBES EPS growth estimate and average margin estimates of brokerage reports
1 2

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Sample relative value football field: Acquiror valuation

Price per share


$60.60
$50.00

$43.25

DCF
$40.00

Highest public comp price

$33.00 $29.25
$30.00

$28.00 $26.50

$29.50 $30.75

$20.00

$21.28

$21.00

$22.50

$20.50

Lowest public comp price

$10.00

Current = $27.19

$0.00

52-week high/low

10.0x to 12.0x 2001E EBITDA of $346

12.0x to 15.0x 2001E EBIT of $239

19.0x to 25.0x 2001E EPS of $1.18

Sum-of-the-parts

Discount rate 9% to 13% EBITDA with exit multiple of 11.0x to 13.0x

Comparable diversified company analysis

Public company analysis

DCF analysis2

1 2

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Relative valuation summary

Less favorable to Acquiror

Exchange ratio1
1.000x

0.750x

High/Low $5.00/$20.50

Low/High $3.00/$33.00 High/Low $5.50/$30.75 Low/High $3.50/$43.25 0.488x


0.441x 0.311x

0.500x
0.313x

0.476x

Offer: 0.311x

0.250x
0.219x

0.244x 0.179x 0.182x 0.091x


Natural exchange Public ratio comparables to Public comparables (Sum of Parts & Diversified)

0.162x

0.237x

0.217x 0.073x
Contribution analysis

0.000x

0.081x

0.074x

More favorable to Acquiror

Transaction Street Street Mgmt. Mgmt. comparables to case/Mgmt. case case/Mgmt. case case/Mgmt. case case/Mgmt. case Public with $40 mm of with $40 mm of comparables synergies synergies (Sum of Parts & Diversified)

Discounted Cash Flow Analysis

Exchange ratio ranges computed by taking the high/low equity value per share of Target using various valuation methodologies over the low/high valuation of the acquiror using various valuation methodologies

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MoE transactions - example


$ in millions
Acquiror pro forma ownership 58.0% 59.0% 66.3% 63.0% 58.5% 58.8% 51.0% 67.0% 57.0% 47.0% 50.0% 63.8% 53.5% 64.1% 60.0% 58.0% 53.6% 60.0% 52.8% 55.0% Acquiror/ target Board Split 9/9 14/6 8/8 11/3 9/8 8/8 9/9 7/3 NA 5/5 7/7 13/12/2 7/7 4/3/5 13/9 6/6 7/7 4/4/1 5/5 8/8

Ann. date 3/19/01 6/20/00 5/17/00 5/16/00 2/21/00 1/17/00 12/21/99 9/27/99 6/30/99 5/17/99 1/5/99 1/15/99 12/9/98 12/2/98 8/11/98 5/7/98 2/25/98 12/8/97 5/12/97 3/7/96

Target Billiton PLC Seagram Compass Group PLC Lycos Inc. Norwich Union PLC SmithKline Beecham Pharmacia & Upjohn VIAG AG Banca Commerciale Italiana SpA Hoechst AirTouch Communications Banco Central Hispanoamericano Astra AB Synthelabo SA Amoco Chrysler Corp General Accident Swiss Bank Guinness PLC Ciba-Geigy AG

Acquiror BHP Ltd Vivendi Granada group PLC Terra Networks (Telefonica SA) CGU PLC Glaxo Wellcome Monsanto VEBA AG Banca Intesa Spa Rhone Poulenc Vodafone group PLC Banco de Santander SA Zeneca Group plc Sanofi SA British Petroleum Daimler-Benz AG Commercial Union Union Bank of Switzerland Grand Metropolitan Sandoz AG

Transaction value $11,511 40,428 8,089 6,188 11,858 75,961 26,486 13,153 15,940 21,918 60,287 11,320 32,199 11,234 55,040 40,467 11,152 22,765 15,970 29,000

Premium1 20.9% 22.8% 3.4% 58.3% (12.2%) (2.3%) (7.1%) 6.8% 8.5% (9.9%) 40.6% (3.6%) 9.8% 5.7% 22.7% 38.0% (4.2%) 0.3% 1.3% 9.5%

NewCo Chairman Acquiror Acquiror Acquiror Acquiror Acquiror Acquiror Acquiror Acquiror Acquiror Target Target Joint Target Acquiror Joint Joint Acquiror Acquiror Joint Target

CEO

Accounting regime United Kingdom France United Kingdom Spain United Kingdom United Kingdom United States United States Italy France United Kingdom Spain United Kingdom France United Kingdom United States United Kingdom IAS United Kingdom IAS

Acquiror Acquiror Joint Target Target Target Target Joint Joint Target Acquiror Target Acquiror Joint Acquiror Joint Target Target Acquiror Acquiror

Source: Press releases, SEC filings, SDC 1 Premium to target share price one day prior to announcement

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Introduction

Pro forma analysis provides both acquirers and targets insight into the
income statement and balance sheet impact of a transaction Revenue, EBITDA or earnings impact Capitalization, leverage and credit capacity impact

Valuable tool for both acquirer and target


Indicates buyers ability to pay Suggests most appropriate form of consideration to offer Allows buyer to predict or manage market reaction to announcement Demonstrates landscape of competing buyers

Balance sheet and income statement impact go hand-in-hand

Both driven by form and amount of consideration

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Overview of accretion/(dilution) analysis

Accretion/(dilution) primarily measures the impact of a merger or acquisition on the income statement of a potential buyer Accretion/(dilution) analysis can be based on revenue, EBITDA, earnings, after-tax cash flow, and dividends per share EPS is most commonly used form of accretion/(dilution) analysis Industry will typically dictate which are the most relevant metrics (for example, Radio may focus on ATCF while wireless telecom companies may prefer to show EBITDA) Two methods exist for calculating accretion/(dilution) Top down: integrated merger model Bottom up: transaction-adjusted, estimate-based model Key measures for accretion/(dilution) Dollar and percent change of acquirer earnings per share Pre-tax synergies required for break-even impact to EPS Pro forma ownership when stock is used as an acquisition currency Pro forma leverage/capitalization

Note that capitalization will change when stock is used and net debt leverage levels will change when cash is used

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Purpose of accretion/(dilution) analysis

Accretion/(dilution) analysis can be used to determine


The capacity of the acquirer (or potential acquirers) to pay a premium for a target Optimal form of consideration (cash, stock, other securities, combination)

Used by both buyers and sellers


Buyers identify highest price they can afford to pay and what currency to offer Buyers evaluate how much competing bidders can afford to pay Sellers evaluate what price potential buyers can afford to pay and in what currency In the context of a divestiture, sellers also evaluate their break-even sale price and required currency

Typically, JPMorgan performs sensitivity analyses to find break-even points where


the offer price for a target results in no incremental earnings or losses to acquirers earnings per share

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Two primary methods exist to compute accretion/ (dilution)


To ow pn d Iedgoi pt nt m dt rc tr emhe g rr e od a e l je e w bcedhsm a stnsw e ln e cf tet a h a an ea l t o ftgce t cie oeqaeb rrt un o d aa rd m , i h n r ca on m p y Bu op tm t o Etasnst Pmeat S tb ai h e e dlsa si a y cie ung o s irde mce t t ba ar nq a r ptnjsfipf rcsu oa o ,dgm j i ai r c e t o n t o icetnoa n natnt r t rs - e ea a r d m ce l i l esno x edm ps ic ea e n n

Description

Benefits

rie tctpe o mu it o vor c d aa u Pssce rf ciem o dps mon bca n i e e mdaw fc a b- a lt c t d n e t po d s o R ipfey n ocfwa tn trs ipo e h h mn t e l l ts a ii o oc itep ae m ntxsdic ee en o r e nt e sn n lanceoa e d rlssa r aahbc l u y le Cactywn st p pr sts hm ro tii e a oas e c fm c i t i n a t

unudno ik itteot o c n es f a i t r a Qdivmin ate ci o c r rv e dea it ip li m u c v t lxaitta e ns c il a hn by Felsa icr muo no ubs ot lpy r ra tl e p ie r e tg a rt e s

Considerations

iiu fi ti ot f loeno f t f l ra c i yp c e Dtencr mceder ua rngo lpqs t tf tl uars ie i a r ceai otva m ns pels i y t i e e t w tu ls s eih g i ot sc h e i m , h a Rn ah lo murlojc obasbo ro,e s t es au t rt e utnqin nitosa c yu b e re l r a t e o ap s tn sis uo m

ike lypr s rm ro s - ii oa o fn s Rvipgfm aiavrda ns ooetg a neu- i lsdr ntn y - r s ipou mae a cr cq t i t r ai pre d yno oe b par a e rit Mapfal whqcttg h eu rirn e aee i i r cr d s e is a t r ipdhno mb t sn a yr a c t at t ec e i u uie s e s szoel, teod s a bt f t s r Mcm ad jites otno o n atr sn nted r as vr ne c u h t ai

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Sample transaction assumptions

Transaction description
Acquirer buying target with the following transaction assumptions:

Transaction closes 12/31/02 Advisory fees of 0.25% of transaction value Financing fees of 1.0% on debt issued (amortized as deferred financing fees over 7 years) Interest rates assumptions Tranche I ($300MM maximum senior debt): 7.0% Tranche II (subordinated debt): 12.5%

Interest rate earned on existing cash: 3.0% Tax rate on incremental earnings and expenses (including net interest expense): 35% Dividend policy of acquirer remains unchanged 50% of excess purchase price allocated to goodwill (approximately $70 million) Remaining 50% of excess purchase price allocated to asset write-up and depreciated over 20 years Target's existing debt not refinanced

Target
Cae uh rsr r ri ee np t c Stn hun asg r td ea s i o Ma api rcz kilt ei o t ta an N/0 e6 tb/ d3 e0 t 2 ( ) Fe iv ra m l u Epe a e: rsh nrr i s na g 2 0 0 2 E 2 0 0 3 E 2 0 0 4 E De(u iesa: vpea inhn drrn da l ) Il gv pnM m ds(u ) pseia$ i r i n nM e i d a: d da l o d, s $ 1 2 . 2 5 4 1 . 5 0 0 $ 5 0 8 . 4 5 0 0 . 0 $ 1 ,8 0 0 . 4 $ 1 . 2 0 0 . 9 5 1 . 4 5 $ 0 . 4 8 $ 1 9 . 2

Acquirer
Cae u ri rsr rh ee np t c Stn h sg a ti run ea sd o Ma api rcz kilt ei o t ta an N// e( 0 tb 2 d3 e0 t ) 6 Fe iv ra m l u Epe a e: rsh nrr i s na g 2 0 0 2 E 2 0 0 3 E 2 0 0 4 E De(u iesa vpea inhn drrn da l ) : Il gv pnM m dsa$ psei(u ) i r i n nM e i d a: d da l o d, s $ 2 0 . 0 3 5 8 . 6 6 9 $ 1 ,. 1 7 5 1 7 5 0 . 0 $ 1 ,. 9 2 5 1 $ 1 . 5 6 1 . 6 8 1 . 8 0 $ 0 . 8 5 $ 4 4 . 6

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Key adjustments to pro forma income statement


The applicability of most income statement adjustments depends on the consideration issued to the seller and the way the acquiror funds an acquisition
Ct oi no sn ia d e r At dn jm u s t e Ainez f-f c at tt nf m eaeti r i on a n ro xg i a Nt afat ocdeti ni v ez -u ir m dl s on ee y ro d o i b a AntDsiu f-irnAse tt ca f atp e eD e r mr ta e& w x l o r m Anncb f-iroae tt tsan eetsd r en t a tr t x i o Ane f ce f-irdnad tt tscm eedr s r e t ou a tu h x i o s Anlsoer f-ir()ninf tt ts gdsl ees nd r e ai h at i v o x o dt a Ays f-se tt n ee r r ag xi Tigia raom ani pt n o ie s dr c wn t l m o Cpaies h rrfdh a ou d n- ll s gf y a eo ur i m e n t X X X X X X X X X X X X X X X X X X X S t o c k C a s h X M i x X

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What is in a consensus estimate?


While First Call or I/B/E/S estimates may provide a perceived Street consensus, they introduce some degree of uncertainty

First Call and I/B/E/S consensus estimates are based on an aggregation of research analysts estimates, with little discretion applied to mean and median calculations

Quality of estimates and analysts varies dramatically across consensus samples Modeling conventions are often not explained or apparent Analysts may be assuming different projected share counts, rather than net income

Some estimates included in consensus numbers are out-dated


May not reflect updated company guidance or recent financial results May not reflect abrupt changes to underlying industry economics May not reflect recent M&A transactions or securities offerings

Items embedded in consensus estimates are not always clearly explained or uniform across samples

Fully diluted share assumptions and treatment of options and convertibles may vary Interest expense Tax rates Accounting policies Stock-based compensation and amortization of intangibles other than goodwill

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Transaction assumptions are the foundation of all sound analysis

Choose an appropriate closing date reflecting available information and transaction structure Timing of process requirements for closing (share registration, shareholder votes, etc.) Timing of regulatory requirements for closing (HSR review, etc.) Seasonality of industry economics and impact on estimates or calendarization Capital structures should best reflect current circumstances Equity currency should be reviewed in context of recent share price and larger equity market performance Cash deals should reflect reasonable interest rates and lending market capacity Pro forma leverage and interest coverage levels should be consistent with acquirers desired credit rating Both advisory and financing fees have a meaningful impact on pro forma financials Although equity analysts tend to look through some extraordinary charges, advisory and other one-time fees will impact the cash balance used in the transaction and subsequent annual interest expense Amortization of financing fees will impact EPS over the immediate future of the combined entity Tax rate on incremental earnings and expenses should reflect acquirors and targets combined tax efficiencies and adjustments should be made to post-transaction tax expenses for potential NOLs assumed by an acquirer

ALWAYS CLEARLY DESCRIBE TRANSACTION ASSUMPTIONS


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Sample transaction 100% stock consideration


Earnings impact

Assumptions
A q ire s a p e c u r h re ric : 20 P 0 3 /E 20 P 0 4 /E A q ire s a so ts n in c u r h re u ta d g T rg t s a p e a e h re ric : 20 P 0 3 /E 20 P 0 4 /E T n a tio a s m g2 %p m m ra s c n s u in 5 re iu O r p e(a u in 2 %p m m ffe ric ss m g 5 re iu ) S a sa q ire h re c u d Im lie e c a g ra (T ) p d x h n e tio /A S a sis e h re su d T xra o in re e ta e p n e : a te n c m n l x e s s $0 3 2 .0 1 .0 2 x 1 .1 1 5 .6 9 8 6 $2 5 1 .2 1 .9 2 x 8 .4

Earnings impact
Fr i msxp rh d iu nlo eep a a gs iin cte r t e l , se a AieP crr S q E u Aieec e crr tn q ni o u m TeP at S r E g Teec e at tn r ni o g m At e dm js n u t s A-xanema f ranc fe o tn t t f ng arzo e i i t i i N ecl as fe oa o di evr em tn n u do arzo - t i y d b t i i A-xDf mer -p f ra &oa t ie t t D r s wu e A s t A-xtrsnn tnb f ra et t si d tti e r a e e n oa c t o A-xtrsecnmh f ra et di f c tti e u r a e n dt os o A-xtrso g oiiesra f ra etls a n ddol t t i e s i d nhf l e n ( )n v t A-xnis f rayre t t se e g Tstnoilarzoo pm rn i gd ma (rm e a c ow o tn i a n a o l t i i i t r ) Ordin te u s hec r t o Tlase t nic e o dt notn t j m eo au t s m Poatn e rfr nic om o e m Poaa otng rfr srs t an om eu d h si Poa S rfr E om P A tniu )$ c i / ltn) c odi ( r ( o e A tniu )% c i / ltn ) c odi ( r ( o e Payris bk e r-xn e rav e se t ee t go - n (0 $) . 0 0 . 0 (.) 2 3 (.) 0 0 (.) 0 1 (.) 0 2 0 . 0 0 . 0 0 . 0 (.) 2 5 $5 1. 3 2 93 15 . 1 $8 1 . 4 (0) $9 . 1 (1 ) 1% . 5 $9 2 6 . (0 $) . 0 0 . 0 (.) 2 3 (.) 0 0 (.) 0 1 (.) 0 3 0 . 0 0 . 0 0 . 0 (.) 2 7 $3 1. 6 2 93 15 . 1 $9 1 . 7 (0) $1 . 0 (.% 0) 6 $ 1 . 5 23 0 0 $8 1 . 6 9 8 . 3 $5 0 . 9 3 9 . 4 24 0 0 $0 1 . 8 1. 0 5 7 $5 1 . 4 6 0 . 2

u s e d

$5 1 1 .3 4 .4 8 2 6 0 6x .7 4 3 .4 6 2 6 3 .0 5 %

Should be calculated using the offer price not current target price Used to fund transaction expenses and advisory fees of $2.9 million
1

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Considerations for a stock transaction

P/Es and relative valuations play a meaningful role in accretion/(dilution) analysis High P/E of an acquirer may imply stock may be cheap acquisition currency, relative to lower P/E stock or the implied debt P/E A number of issues will play an important role in the optics, attitudes and receptivity of principals and investors in a transaction Exchange ratios should not be grossly inconsistent with historical relative trading performance of acquirer and target Purchase price and pro forma ownership should take into account contribution analysis Flow back and sell-off of acquirer stock could meaningfully affect acquirers share prices on announcement/closing Cross-shareholder analysis Whether acquirer and target are included in the same indexes, if any Fund limitations on owning international stocks and/or stocks not listed on local exchanges Dividend policy implications of receiving acquirer stock

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Sample transaction 100% cash consideration


Earnings impact

Assumptions
T rg t s a p e a e h re ric : O r p e(a s m g2 % re iu ) ffe ric s u in 5 p m m S a sa q ire h re c u d D b is u dtofu da q is n et s e n c u itio : E u p rc a e w c s q ity u h s d ith a h T n a tio fe s ra s c n e F a c gfe s in n in e C s b la c u e intra s c n ah a ne s d n a tio T ta d b ra e o l e t is d D b a c tio : e t llo a n T nh I ra c e T n h II ra c e In re t R te : te s a s T nh I ra c e T n h II ra c e In re t ra o fo g n c s b la c te s te n re o e a h a n e T xra o in re e ta e rn g a te n c m n l a in s $2 5 1 .2 1 .3 51 4 .4 8 26

Earnings impact
F rs mneepsrd iu i ii sxpeh a g nlo, ct r a t e l ea A ieP c rr S q E u A iee c e c rr tnm q ni o u TeP at S r E g Teec e a t ti o r nnm g Ase dt n j m u t s A- x aige o an f rai n f a rzi t t f c em t e nn t o i Ndubaiofe o an o ecl d r e m t n dt e v y a rzi - i s t o i A- xDfoaere f ra &rm tw-p t t DA s i u e s t A- xtrsn ncn b f raneor st dt t t i e t taao e e i A- xtrsecn mh e f raneduor c ud t t i e t dt fo a s e i s A- xtrslsg o iie sra f rane( sa nv nhfl t t i e t o) i dddo l e n t A- x n is f rayre t t se e g Tst n oila rzi nrmm rnc gdl ma ( i p e aao ow o t o a n i t o i i t r ) O rdt n teec s h uo r i Tlase t nic e o dt n o tnm t j m eo au t s Poa tic e rfr nnm om o e Poaa otng rfr srsuai om e t d h s n PoaP rfr E om S Aeniun$ c t /dt ) ) c i (l i ( ro o Aeniun% c t /dt ) ) c i (l i ( ro o Ptx n i s b kv r- seeoe- e e yr t ra n a g e 23 0 0 $8 1 . 6 9 8 . 3 $5 0 . 9 3 9 . 4 24 0 0 $0 1 . 8 1. 0 5 7 $5 1 . 4 6 0 . 2

$ 5 .3 60 2 .9 6 .6 (0 ) .0 $ 5 .8 69

$ 0 .0 30 39 5 .8

7% .0 1 .5 2% 3% .0 3 .0 5%

(0 $) . 6 0 . 0 (.) 2 3 (2 4) . 9 0 . 0 0 . 4 0 . 0 0 . 0 0 . 0 (5 4) . 4 $. 9 2 4 56 89 . 6 $7 1 . 5 (0 ) $0 . 1 (.% 6) 1 $ 9 . 1

(0 $) . 6 0 . 0 (.) 2 3 (4 4) . 8 0 . 0 0 . 8 0 . 0 0 . 0 0 . 0 (7 4) . 0 $8 1. 1 9 56 89 . 6 $3 2 . 0 $3 0 . 2 1% 2 . 5 N M

Should be calculated using the offer price not current target price

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Considerations for a cash transaction

Use multiple tranches of debt where appropriate Reflects capital structure and market capacity limitations for larger deals Varying interest rate on debt tranches will impact interest expense on offer price increases or decreases Note that depending on debt mix, stock may be more or less appropriate as an acquisition currency Financing assumptions should reflect both acquirers stand-alone and combined debt capacity and ratings circumstances Debt coverage and capitalization statistics should be included to highlight potential ratings issues and support interest rate assumptions Current and recent ratings history of acquirer should be reviewed to confirm ability to issue debt securities Covenants of existing acquirer debt should be considered Review transaction and pro forma financials with ratings advisory and DCM teams to determine appropriate rates Use existing acquirer cash sparingly, if at all Existing cash is likely used to meet working capital funding requirements Minimum cash balance may be required for debt covenants Opportunity cost of using cash on hand should always be contemplated and reflected in interest expense Restricted cash considerations

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Sample transaction 50% cash / 50% stock consideration


Earnings impact

Mixed consideration assumptions


Target share price: Offer price (assuming 25% premium) Shares acquired Shares issued Debt issued to fund acquisition: Equity purchased with cash Transaction fees Financing fees Cash balance used in transaction Total debt raised Debt allocation: Tranche I Tranche II Interest Rates: Tranche I Tranche II Interest rate foregone on cash balance Tax rate on incremental earnings $12.25 15.31 42.468 16.233

Earnings impact
F rs mnee psr d iu i ilo, xpe hea gen li s ct r a t a Aur P c ie S qr E Aur enm c ie ti c e qr n o T eP a tE r S g T eenm a tni c e r t o g As es dt n j m u t Arafncgemzi n fe x ai f ao a t - i n e r to t n t i Ndui l ai o/oee o ec ed r t r e n dtb v y hf s AraDA m e rep fe xD foa twt - &r s i u t s t Arai trs naaodt fe x e tot ncne t - ne r s t b t i Arai trs ecnochs fe x e tdui f msud t - ne dtor a e t Arai trsl s g odddhta fe x e t( s a ni i e s r l t - ne o) i v n o l t n f Arasei s fe xy r e t - ng t T stogdl aozi nrmm) rnc nowm a ( i p e aa o il r too a n i t i i t r Orec n te dto hr u s i T la s es ni c e o d t nt enm t j m ot o a u t Pfr aenm r o ni c e omt o Pfr aheosnn r o s rsut dg o m a t ai Pfr aP ro E om S Arto(iun$ cen l to() c i /d i ) Arto(iun% cen l to( ) c i /d i ) Ptxy ri s baen r- seet r kv e ng oe- e a 23 0 0 $6 18 . 93 8 . $9 05 . 34 9 . 24 0 0 $8 10 . 1. 07 5 $4 15 . 62 0 .

$325.1 2.9 3.3 (0.0) $331.3

$300.0 31.3

(0) $3 . 0 . 0 (.) 2 3 (6) 12 . 0 . 0 0 . 1 0 . 0 0 . 0 0 . 0 (8) 17 . $9 1. 11 79 40 .2 $5 19 . (09 $0 .) (.% 5) 1 $9 9 .

(0) $3 . 0 . 0 (.) 2 3 (6) 19 . 0 . 0 0 . 2 0 . 0 0 . 0 0 . 0 (9) 13 . $6 1. 46 79 40 .2 $9 16 . $1 06 . 8% . 6 N M

7.0% 12.5% 3.0% 35.0%

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The role of P/E valuations in accretion/(dilution)

For stock-for-stock deals, accretion or dilution potential will usually be evident by simply comparing the P/E multiples of the acquirer and the target If the acquirer has a higher P/E than the target, the deal will be accretive because the acquirer is buying more EPS than the target shareholders are accepting as consideration If the acquirer has a lower P/E than the target, the deal will be dilutive because the acquirer is buying less EPS than the target shareholders are accepting as consideration Remember to take the premium into account when calculating the targets P/E Utility of comparison will also depend on transaction assumptions regarding goodwill impairment or other asset amortization For 100% cash transactions, the cost of debt (interest payments) and cost of acquiring the targets earnings will determine the accretive or dilutive impact of a transaction Where the inverse cost of debt (1/(after-tax cost of debt)) is greater than the P/E of the target, the deal will be accretive Where the inverse cost of debt is lower than the P/E of the target, the deal will be dilutive

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Presenting accretion/(dilution) with sensitivities

Sensitivities provide the total picture of a transactions potential impact; relevant sensitivities to demonstrate may include Premium (discount) Consideration offered (% of stock/% of cash) Acquirers stock price Earnings per share Synergies Interest rate(s) on debt issued Sensitivities should reflect consideration specifics Purchase price and ownership (stock)
2003 synergies to break-even ($MM)
Stock consideration 100.0% (6.4%) 10.0% 50.0% NM 5.8 15.0 28.2 41.7 62.5% $2.2 9.3 17.3 28.8 41.9 75.0% $6.3 13.8 22.3 34.3 46.6 87.5% $10.4 18.3 27.2 39.9 52.8 100.0% $14.4 22.8 32.1 45.3 58.9

2003 accretion / (dilution) (% per share)


Stock consideration 50.0% 10.0% 1.0% (3.0%) (7.7%) (14.1%) (20.2%) 62.5% (1.1%) (4.6%) (8.4%) (13.5%) (19.0%) 75.0% (3.0%) (6.5%) (10.2%) (15.2%) (19.9%) 87.5% (4.8%) (8.3%) (11.9%) (16.8%) (21.3%)

Premium

Premium

20.0% 30.0% 40.0% 50.0%

(9.8%) (13.4%) (18.1%) (22.5%)

20.0% 30.0% 40.0% 50.0%

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Relevant sample transaction sensitivities

Stock deals

2003 accretion / (dilution) (% per share)


Acquirer stock price $19.00 10.0% (8.1%) (11.6%) (15.2%) (20.0%) (24.4%) $20.03 (6.4%) (9.8%) (13.4%) (18.1%) (22.5%) $21.00 (5.0%) (8.3%) (11.8%) (16.5%) (20.9%) $22.00 (3.5%) (6.8%) (10.3%) (15.0%) (19.3%) $23.00 (2.2%) (5.5%) (8.9%) (13.5%) (17.8%)

2003 accretion / (dilution) (% per share)


Pre-tax synergies realized 2003 $5.0 10.0% (4.2%) (7.7%) (11.3%) (16.1%) (20.6%) $10.0 (2.0%) (5.5%) (9.2%) (14.1%) (18.7%) $15.0 0.2% (3.3%) (7.1%) (12.1%) (16.8%) $20.0 2.5% (1.2%) (5.0%) (10.1%) (14.9%) $25.0 4.7% 1.0% (2.9%) (8.1%) (13.0%)

Premium

20.0% 30.0% 40.0% 50.0%

Premium

20.0% 30.0% 40.0% 50.0%

Cash deals

2003 accretion / (dilution) (% per share)


Interest rate on senior debt (Tranche I) 6.5% 10.0% 3.1% (2.4%) (8.4%) (17.1%) (25.9%) 7.0% 2.1% (3.4%) (9.4%) (18.1%) (26.9%) 7.5% 1.1% (4.3%) (10.4%) (19.1%) (27.9%) 8.0% 0.1% (5.3%) (11.4%) (20.1%) (28.9%) 8.5% (0.9%)

2003 accretion / (dilution) (% per share)


Blended interest rate (%) 11.0% 10.0% (2.3%) (7.7%) (13.8%) (22.5%) (31.3%) 10.5% (0.1%) (5.5%) (11.6%) (20.3%) (29.1%) 10.0% 2.1% (3.4%) (9.4%) (18.1%) (26.9%) 9.5% 4.2% (1.2%) (7.2%) (15.9%) (24.7%) 9.0% 6.4% 1.0% (5.1%) (13.7%) (22.6%)

Premium

Premium

20.0% 30.0% 40.0% 50.0%

(6.3%) (12.4%) (21.1%) (29.9%)

20.0% 30.0% 40.0% 50.0%

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Synergies and transaction related costs

Synergies For top-down modeling simplicity, assume synergies come from cost-savings unless told otherwise Revenue synergies Incremental revenues may have costs associated with them that need to be reflected in any synergy calculations (e.g variable margins on incremental revenues) Equity markets heavily discount or, in many cases, disregard revenue synergies, as they are typically difficult to quantify and accurately project Synergies are typically realized gradually over time and should be phased in accordingly It may be prudent to risk-adjust any expected synergies to account for ability to realize them and/or for negative synergies (i.e., integration costs) Consider the cash flow impact of synergies One-time charges and expenses Acquiring companies will incur one-time merger-related costs due to reorganization, severance packages One-time charges are disclosed in SEC filings From a valuation perspective, the Street looks through one-time charges Include the net interest impact of cash changes

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Additional items to consider

Tax benefits In assuming additional options are exercised under premium scenarios a tax shield will be generated based on the implied deductible compensation expense generated from the vesting / exercise of options at a discount to the acquisition price Asset write-ups have tax implications1 Acquirers may be forced to pay interest on interest In using cash and thereby raising debt, an acquirer will incur future interest and amortization payments that may require additional borrowing AccretionOne calculation method Asset write-ups and additional depreciation expenses While asset write-ups will reduce goodwill generated in a transaction, they will increase annual depreciation expenses based on the incremental increase in depreciable assets Limiting asset write-ups will reduce negative impact of increased depreciation expenses In some cases, asset write-downs may impact EPS accretion / dilution Impact of dividends paid by acquirer Additional cash will be necessary to fund new dividends paid and should be reflected in incremental expenses Dividend accretion/(dilution) analysis may be relevant to determine appropriate premium

Write-ups create a deferred tax liability (equal to the write-up multiplied by the tax rate) 146

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Summary considerations for EPS accretion/(dilution) analysis

EPS-based accretion/(dilution) is only a back-of-the-envelope exercise and is not a substitute for an integrated merger model Does not necessarily reflect cash flow implications and debt pay-down capabilities of combined company EPS estimates should be used with caution First Call and I/B/E/S estimates are consensus numbers that do not always reflect consistent underlying assumptions Small differences in EPS figures can have dramatic impact on net income ($0.05 per share on 200 million shares reflects a $10 million variance in net income) Share count of target must be a dynamic number Share count should increase (decrease) with offer price to reflect additional (reduced) shares underlying in-the-money options Negative net income targets CANNOT create meaningful accretion Accretion/(dilution) should always be sanity-checked Relative P/Es Acquirers cost of debt vs. cost of targets earnings Accretion/(dilution) should always be checked with your calculator

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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Overview of pro forma balance sheet analysis


Pro forma balance sheet analysis provides a means of assessing the impact of a potential
transaction on an acquirers cost of borrowing, market access, and financial flexibility

Two methods exist for demonstrating balance sheet impact:


Top down: integrated merger model with income statement, balance sheet and cash flow statement (preferred) Bottom up: transaction-adjusted, LTM-based model

Pro forma balance sheet analysis relies primarily upon a comparison of an acquirers pre- and
post-acquisition credit metrics

Key credit metrics include:


Pretax Interest Coverage EBITDA Interest Coverage Funds from Operations to Interest Funds from Operations to Debt Debt to EBITDA Debt to Book Capitalization

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Significance of pro forma balance sheet analysis


Pro forma balance sheet analysis is critical in determining

The debt-financed acquisition capacity of an acquirer (or competing bidders) Required equity component of an offer to ensure a particular rating outcome Financing implications of a particular transaction structure (cost of capital and market access) In a divestiture, the pro forma credit rating of the seller and the minimum level of cash consideration needed Buyers identify highest price they can afford to pay and how much cash can be offered Buyers evaluate how much other competitive bidders can afford to pay Sellers evaluate how much potential buyers can afford to pay and how much cash to demand

Used by both buyers and sellers


Typically, JPMorgan performs sensitivity analyses to address relevant inflection points


where the offer price for a target results in meaningful changes to a combined capital structure

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Credit ratings as a key financing decision driver


A companys corporate credit rating determines its

Cost of borrowing Breadth and depth of access to the capital markets Financial flexibility (liquidity/covenant constraints)

Pro forma balance sheet analysis allows potential acquirers to assess leverage breakpoints and
their associated ratings outcomes in order to develop a comprehensive financing plan

Significant debt-financed transactions can erode credit profile and can lead to a ratings
downgrade

The determination of potential financing structures is often bound by the trade-offs between
maximizing EPS subject to limiting ratings pressure

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Sample transaction 100% cash consideration

Acquirer Balance sheet: Total debt Shareholders equity value Minority interest Income statement: LTM EBITDA LTM EBIT LTM interest expense Capitalization: Debt/equity Debt/total capitalization1 Coverage ratios: Debt/LTM EBITDA Debt/LTM EBIT LTM EBITDA/interest LTM EBIT/interest $800.0 950.0 0.0

Target $575.0 525.0 0.0

Adjustments $659.8 (525.0) 0.0

Pro forma $2,034.8 950.0 0.0

$226.0 176.0 55.0

$119.0 94.0 40.0

42.6

$345.0 270.0 137.6

84.2% 45.7%

109.5% 52.3%

214.2% 68.2%

3.5x 4.5 4.1 3.2

4.8x 6.1 3.0 2.4

5.9x 7.5 2.5 2.0

Note: excludes lease-related leverage and hybrid securities 1 Includes minority interest 152

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Sample transaction 100% stock consideration

Acquirer Balance sheet: Total debt Shareholders equity value Minority interest Income statement: LTM EBITDA LTM EBIT LTM interest expense Capitalization: Debt/equity Debt/total capitalization1 Coverage ratios: Debt/LTM EBITDA Debt/LTM EBIT LTM EBITDA/interest LTM EBIT/interest $800.0 950.0 0.0

Target $575.0 525.0 0.0

Adjustments $0.0 125.3 0.0

Pro forma $1,375.0 1,600.3 0.0

$226.0 176.0 55.0

$119.0 94.0 40.0

0.0

$345.0 270.0 95.0

84.2% 45.7%

109.5% 52.3%

85.9% 46.2%

3.5x 4.5 4.1 3.2

4.8x 6.1 3.0 2.4

4.0x 5.1 3.6 2.8

Note: excludes lease-related leverage and hybrid securities 1 Includes minority interest 153

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Pro forma balance sheet sensitivities

Similar to EPS analysis, sensitivities provide the whole picture Sensitivities should demonstrate the impact of changes to
relevant metrics

Debt / total capitalization


Stock consideration 0.0% 25.0% 62.4% 62.6% 62.8% 63.2% 63.5% 50.0% 57.4% 57.3% 57.2% 57.0% 56.8% 75.0% 52.5% 52.0% 51.5% 50.7% 50.0% 100.0% 47.5% 46.6% 45.7% 44.4% 43.2% 10.0% 67.3% 67.9% 68.5% 69.4% 70.3%

Consideration (stock vs. cash) Estimates (EBITDA) Assumptions (premium, interest rates, etc.)
Premium

20.0% 30.0% 40.0% 50.0%

Debt / EBITDA
Stock consideration 0.0% 10.0% 5.66x 5.82 6.00 6.25 6.50 25.0% 5.24x 5.36 5.49 5.68 5.88 50.0% 4.83x 4.91 4.99 5.12 5.25 75.0% 4.41x 4.45 4.49 4.56 4.62 100.0% 3.99x 3.99 3.99 3.99

EBITDA / interest
Stock consideration 0.0% 10.0% 2.63x 2.54 2.45 2.34 2.23 25.0% 2.89x 2.81 2.73 2.62 2.51 50.0% 3.19x 3.13 3.06 2.97 2.88 75.0% 3.39x 3.37 3.35 3.32 3.29 100.0% 3.63x 3.63 3.63 3.63 3.63

Premium

30.0% 40.0% 50.0%

Premium

20.0%

3.99

20.0% 30.0% 40.0% 50.0%

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Agenda

Introduction Trading comparables Transaction comparables Discounted cash flow analysis LBO analysis Relative value analysis Merger consequences

Accretion/(dilution) review Pro forma balance sheet analysis review

Appendix

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JPMorgan estimates the cost of equity using the capital asset pricing model
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

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

The CAPM formula follows:


Cost of equity = Risk-free rate + (beta * market risk premium) re = rf + * (rm - rf)

There is also an error term in the CAPM formula, but this is usually omitted

Where re = rf = rm = =

the required market return on the equity of the company the risk-free rate the return on the market the companys projected (leveraged) beta

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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 multi-factor models like the Arbitrage Pricing Theory

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Using the capital asset pricing model


The yield-to-maturity on the 10-year U.S. Treasury note is generally used to approximate the risk-free rate

Long-term cost of debt is used, because the cost of capital is normally applied to long-term cash flows Obtain from Bloomberg or a similar source

Projected betas can be obtained from Barra or an online database (e.g., IDD)

Barra predicted betas can be found through the Investment Bank Home Web page1 Note that Bloomberg betas are based on historic prices and are therefore not forward-looking Impute unlevered beta for private company from public comparables

The market risk premium (rm - rf; 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 The current MRP assumption is 4.0%

In the Investment Banking menu, select more, then Financial Database Services, then Barra Betas 158

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Delevering and relevering beta


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, includes 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

The formula follows:

To relever the beta at a target capital structure:

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Delevering and relevering beta (contd)

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

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Example: Calculating WACC based on comparable companies


Target WACC analysis as of 1/1/01
Mooms m n a e n i aup s c c oc s t r i o
R-ert ik e e sf a r
1 2

50 .% 4 4% . 0

PeeTgmi aaa rj cdae antx t ot r t r l re g

40 0% .

Emdaeqyspm s a m tei rkr i m t t r u i eu i e k t

I dtyea ls ns ban i ur t a s y
Pjcd r ee ot Cpaeopy o abc a m l m r n Cpy oaA m n Cpy oaB m n Cpy oaC m n Cpy oaD m n Aa vg ee r lveba erde e t 16 . 0 00 . 9 00 . 9 09 . 8 04 . 9
3

Ndt e e/ t b mc. ka t p . 12 7% . 10 8% . 43 0% . 8% . 6 20 1% .

Ta e/ oldt t b me iy k qt t u . 25 2% . 22 2% . 74 8% . 11 0% . 33 3% . T rt aa xe 00 . 4 00 . 4 00 . 4 00 . 4 00 . 4

Uve n ed l r e ba 4 e t 03 . 9 09 . 7 01 . 6 04 . 8 09 . 7

Ct f oo s lvee iy erd u e qt 9% . 6 9% . 0 9% . 0 9% . 0 9% . 1

Ct f oo s uerd u n e e iy lve qt 9% . 1 8% . 6 7% . 8 8% . 8 8% . 6

TgW cca n ae A aui r t C l lt C o


Om pa t l i dt ae e/ r t b k m ciaa n atlzi pi t o 30 0% . 40 0% . 50 0% . 60 0% . 70 0% . Ns o: t e
1 2 3 4

Om pa t l i dt e/ b e iy qt u 49 2% . 67 6% . 1.% 00 0 1.% 50 0 2.% 33 3 Se t 1y pa o -r rd 0 Ta rs p r si ( ) eu b e 1. 70 5 2. 00 0 3. 00 0 4. 00 0 5. 00 0 Cn oty ur rkrm i p im s eu 00 .% 0 00 .% 0 00 .% 0 00 .% 0 00 .% 0

Ptx re a l ntr oe gm ct f e oo b s dt 7% . 1 7% . 4 8% . 4 9% . 4 14 0% .

Ledeaui g er basm ve t s n uerdeo ne b f lve t a 09 . 7 10 . 0 11 . 1 17 . 2 11 . 5 11 . 9 Ct f oo s lvee iy erd u e qt 9% . 4 9% . 8 15 0% . 14 1% . 10 3% . Tg ae rt n ia A onW ml C C 7% . 9 7% . 7 7% . 8 8% . 0 8% . 3

R-ert =et- aryf1y r . .Tar bdsf1/1 oc Bmg i k e eyl - mi o0eU r syo ao/ 0( ue l ob ) sf a i d t t - a S eu n r o u 1 Sr : o e r SrePraMrs rh oc JM n&ea u: o g A ec Sre a pdeba oc Bar i tdes u: r e r c t UvebaLede/( +oldt/mea oqy ( -art).Auebafdteazo n ede=er ba 1( t e a tvu fei ) 1tx e s m eoe ql e. l r t ve t e t a b r le u * k t a) s s t b u r s

161

August 2002

Confidential Internal use only

Corporate Finance M&A Bootcamp Materials