# Additional materials to Topic 2 1. Rationale for

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Additional materials to Topic 2 1. Rationale for share-paid deals 2. Using Financial Modeling Techniques to Value and Structure M&As 3. Exercises

Prior to transaction Shareholders A Company A 100 % Shareholders B Company B 100 % 30. 03. 16 2 Rationale for share-paid deals

A acquires B for cash Shareholders A 100 % Company A Company B 100 % Shareholders B Cash A buys B, A’s equity remains unchanged 30. 03. 16 3 Rationale for share-paid deals

A issues new shares in exchange for B shares (contribution of shares) Shareholders A X % Company A 100 % Company B Shareholders B 1 -X % A’s equity rises by an amount equal to the value of B’s equity. B continues to exist as a subsidiary of A. 30. 03. 16 4 Rationale for share-paid deals

A issues new shares in exchange for assets and liabilities of B (contribution of assets) Shareholders A Company A X % Shareholders B Holding Company B 100 % 1 -X % B transfers its assets and liabilities to A. A’s equity rises by an amount equal to the value of B’s equity. The shareholders of B remain shareholders of B which is now a holding company. Depending on the amount of assets it has contributed, B can take control of A 30. 03. 16 5 Rationale for share-paid deals

A issues new shares in exchange for B shares and B dissolves (legal merger) Shareholders A Company A+B X % Shareholders B 1 -X % B ceases to exist. A’s equity rises by an amount equal to the value of B’s equity. 30. 03. 16 6 Rationale for share-paid deals

Relative value ratio (RVR) • The ratio of shareholders’ equity value of Co. A to shareholders’ equity value of Co. B is called relative value. • The relative value agreed between the 2 companies determines who would own how much of the new company. As a result, it would define the power each shareholder would will after the deal Value of shareholders’ equity agreed in the merger A (bidder) 450 B (target) 680 750 RVR is 1, 67 (750/450): in the AB the ex-shareholders of A would have 37, 5% and ex-shareholders of B – 62, 5% of equity 30. 03. 16 7 Rationale for share-paid deals

Exchange ratio (ER) • ER is the ratio of the number of shares of company A to be tendered for each company B share received Value of shareholders’ equity agreed in merger ($) Number of shares Value per share (market price) A (bidder) 4500000 100 B (target) 750 3750000 200 A issues 7500000 (750 M/100) new shares to exchange at 3750000 shares of B. The ER is 1 B share for 2 A shares (1\2) premerger B premerger A NN RVRER 30. 03. 16 8 Rationale for share-paid deals

Some ideas for calculating ratios • A is the bidder, B is the target. S is the value of synergies. The bidder issues x new shares to pay for the target. The acquisition seems reasonable if: A A A BA NV x. N SVV The premerger share price of a bidder Share price of the merged firm A A B N V SV x B A AB B N N V SV N x ER If B B BN V P and АА А N V P then BA B V S P P ER 1 30. 03. 16 9 Rationale for share-paid deals

Exercises • 1. ABC and DEF have entered into a share exchange agreement whereby ABC will pay a 40% premium over DEF’s premerger price. If premerger price of DEF was $40 and ABC’s one was $50, what RVR and ER would ABC need to offer? • 2. ABC has announced plan to acquire XYZ. ABC is trading for $25 per share and XYZ’s premerger value is approx. $4 billion. The projected synergies is assessed at $1 billion. What is the maximum ER ABC could offer? 30. 03. 16 10 Rationale for share-paid deals

M&A Model Building Process • Step 1: Value acquirer and target as standalone firm s • Step 2: Value acquirer and target firms including synergy • Step 3: Determine initial offer price for target firm • Step 4: Determine the combined firms’ ability to finance the transaction 30. 03. 16 11 Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 12 Step 1: Value Acquirer & Target as Standalone Firms • Understand determinants of profits and cash flow, i. e. , bargaining strength of – Customers (size, number, price sensitivity) – Current competitors (market share, differentiation) – Potential entrants (entry barriers, relative costs) – Substitutes (availability, prices, switching costs) – Suppliers (size, number, uniqueness) relative to industry participants. • Normalize 3 -5 years of historical financial information • Project normalized cash flow based on expected market growth and changes in profits/cash flow determinants. Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 13 Step 2: Value Acquirer & Target Firms Including Synergy • Estimate – Sources and destroyers of value – Implementation costs incurred to realize synergy • Consolidate acquirer and target projected financials including the effects of synergy • Estimate net synergy (consolidated firms less values of target and acquirer) Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 14 Adjusting Combined Acquirer/Target Company Projections For Estimated Synergy Year 1 Year 2 Year 3 Year 4 Year 5 Net Sales 1 $200 $220 $242 $266 $293 Cost of sales 2 $160 $176 $194 $213 $234 Anticipated Cost Savings Direct labor $2 $4 $6 $8 $8 Indirect labor $1 $2 $4 $4 $4 Purchased materials $2 $3 $5 $5 $5 Selling expenses $1 $3 $5 $5 $5 Total $6 $12 $20 $22 Cost of sales (incl. synergy) $154 $164 $174 $191 $212 Cost of sales/Net sales 77. 0% 74. 6% 71. 9% 71. 8% 72. 4% 1 Combined company net sales projected to grow 10% annually during forecast period. 2 Cost of sales before synergy assumed to be 80% of net sales during forecast period.

30. 03. 16 15 Discussion Questions 1. How would you adjust the combined firm’s income statement for cost savings due to improved worker productivity? (Hint: Determine the line item most directly affected by the improvement in productivity. ) 2. How would you adjust the combined firm’s income statement for additional revenue generated from cross-selling (i. e. , Acquirer selling its products to the target’s customers and vice versa)? 3. How would you reflect the expenses incurred in implementing the worker productivity improvement and cross-selling programs on the combined firm’s income statement? Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 16 Step 3: Determine Initial Offer Price for Target Firm • Estimate minimum and maximum purchase price range • Determine amount of synergy willing to share with target shareholders • Determine appropriate composition of offer price Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 17 Calculating Initial Offer Price (PV IOP ) 1. PV MIN = PV T or PV MV , whichever is greater for a stock purchase (liquidation value of net acquired assets for an asset purchase) 2. PV MAX = PV MIN + PV NS , where PV NS = PV SOV – PV DOV 3. PV MAX = PV MIN + PV NS 4. PV IOP = PV MIN + α PV NS , where 0 ≤ α ≤ 1 Offer price range = (PV T or MV T ) < PV IOP < (PV T or MV T ) + PV NS Where PV MIN = PV minimum purchase price PV T = PV standalone value of target firm PV MV = Market value target firm PV MAX = PV maximum purchase price PV NS = PV of net synergy PV SOV = PV of sources of value PV DOV = PV of destroyers of value α = Portion of net synergy shared with target company shareholders How is “ α ” determined? Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 18 Step 4: Determine Combined Firms’ Ability to Finance Transaction • Estimate impact of alternative financing structures • Select financing structure that – Meets acquirer’s required financial returns and desired financial structure; – Meets target’s primary financial and non-financial needs; – Does not raise borrowing costs; and – Is supportable by the combined firms. Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 19 Calculating EPS and Post-Merger Share Price Acquiring Company is considering the acquisition of Target Company in a share for share transaction in which Target Company would receive $84. 30 for each share of its common stock. Acquiring Company does not expect any change in its price/earnings multiple after the merger. Selected data are presented as follows: Acquiring Company Target Company Net Earnings $281, 500 $62, 500 Shares Outstanding 112, 000 18, 750 Market Price Per Share $56. 25 $62. 50 Using Financial Modeling Techniques to Value and Structure M&As

30. 03. 16 20 Calculating EPS and Post-Merger Share Price: Solution 1. Exchange ratio = Price per share offered for Target Company/ Price per share for Acquiring Company = $84. 30 / $56. 25 = 1. 5 2. New shares issued by Acquiring Company = 18, 750 (shares of Target Company) x 1. 5 (share exchange ratio) = 28, 125 3. Total shares outstanding of the combined firms = 112, 000 + 28, 125 = 140, 125 4. Post merger EPS of the combined firms = ($281, 500 + $62, 500) / 140, 125 = $2. 46 5. Pre merger P/E = Pre-merger price per share / pre-merger EPS = 56. 25 / ($281, 500/112, 000) =$56. 25/$2. 51 = 22. 4 6. Post-merger share price = Post-merger EPS x Pre-merger P/E = $2. 46 x 22. 4 = $55. 10 (as compared to $56. 25 pre-merger share price) Note: Example assumes no increase in EPS due to synergy for simplicity. Using Financial Modeling Techniques to Value and Structure M&As

Exercises Exercise 1. ABC is considering the acquisition of DEF in a share-for-share transaction in which DEF would receive $50. 00 for each share of its common stock. ABC does not expect any changes in P/E after the deal • Using the information provided calculate the following: Purchase price premium Share-exchange ratio New shares issued by ABC Total shares of the combined company Postmerger EPS of the combined company Premerger EPS of the ABC Postmerger share price 30. 03.

Information of Firms ABC DEF Earnings available for common stock $150000 $30000 Shares of common stock outstanding 60000 20000 Market price per share $60. 00 $40. 00 30. 03. 16 22 Exercise 2. Bidder is considering buying Target – a small biotech firm that develops products licensed to the “Big Pharma”. R&D costs are expected to generate negative CFs during the first two years of the forecast period of (-$10 mn) and (-$5 mn) respectively. Licensing fees would generate positive CFs: year 3 — $5 mn, year 4 — $10 mn and year 5 — $15 mn. After the 5 th year CF would grow at 5% annually (competition is severe). The discount rate is 20% for the first 5 years and then drop to 10%. PV NS is $30 mn. Calculate the minimum and maximum purchase price for Target.

Exercise 3 • Using the Excel-based model, what would be the initial offer price if the amount of synergy shared with the target firm shareholders was 50%? • What is the offer price and what would the ownership distribution be if the percentage of synergy shared increased to 80% and the composition of the purchase price were all acquirer stock? 30. 03.