Session

The Mergers and Acquisitions Model-Building Process

Step 1. Value Acquirer and Target as Stand Alone Firms

Step 2. Value Acquirer and Target Firms, Including Synergy

Step 3. Determine Initial Offer Price for Target Firm Transaction

Step 4. Determine Combined Firms’ Ability to Finance

Commonly Used Discounted Cash Flow
Valuation Methods

• Zero Growth Model

• Constant Growth
Model

• Variable Growth
Model
Zero Growth Model

• Free cash flow is constant in perpetuity.

P0 = FCFF0 / WACC, where FCFF0 is free cash

flow to the firm and WACC is the weighted
average the cost of capital

P0 = FCFE0 / ke where FCFE0 is free cash flow

to equity investors and ke is the cost of
equity
 Constant Growth Model

• Cash flow next year (i.e., FCFF1, the first year of the
forecast period) is expected to grow at a constant rate.

FCFF1=FCFF0(1+g)

P0 = FCFF1 / (WACC-g), where g is the expected rate of

growth of FCFF1.

P0 = FCFE1 / (ke –g), where g is the expected rate of

growth of FCFE1.
Variable (Supernormal) Growth Model
• Cash flow exhibits both a high and a stable growth period.
• High growth period: The firm’s growth rate exceeds a rate that
can be sustained long-term.
• Stable growth period: The firm is expected to grow at a rate
that can be sustained indefinitely (e.g., industry average
growth rate).
• Discount rates: Reflecting the slower growth rate during the
stable growth period, the discount rate during the stable
period should be lower than doing the high growth period
(e.g., industry average discount rate).
Variable Growth Model Cont’d.
n
P0,FCFF = Σ FCFF0 x (1+gt)t + Pn
t=1 (1+ WACC)t (1+WACC)n

Where

Pn = FCFFn x (1 + gm)
(WACCm – gm)
FCFF0 = free cash flow to the firm in year 0
WACC = weighted average cost of capital through year n
WACCm = Weighted average cost of capital beyond year n
(Note: WACC > WACCm)
Pn = value of the firm at the end of year n (terminal value)
gt = growth rate through year n
gm = stabilized or long-term industry average growth rate beyond year n
(Note: gt > gm)
variable-growth model as follows:
Things to Remember…

• Zero growth model: Cash flow is expected to remain

constant in perpetuity.
• Constant growth model: Cash flow is expected to grow at a
constant rate.
• Variable (supernormal) growth model: Cash flow exhibits
both a high and a stable growth period.
• Total present value represents the sum of the
discounted value of the cash flows over both periods.
• The terminal value frequently accounts for most of the
total present value calculation and is highly sensitive to
the choice of growth and discount rates.