VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS

OKAN BAYRAK

DefinitionsA merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business. Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company

Types of Mergers Horizontal Mergers

- between competing companiesVertical Mergers

- Between buyer-seller relation-ship companiesConglomerate Mergers

- Neither competitors nor buyer-seller relationship

History of Mergers and Acquisitions Activity in United States The First Wave 1897-1904

After 1883 depressionHorizontal mergersCreate monopoliesThe Second Wave 1916-1929

OligopoliesThe Clayton Act of 1914The Third Wave 1965-1969

Conglomerate MergersBooming EconomyThe Fourth Wave 1981-1989

Hostile TakeoversMega-mergersMergers of 1990s

Strategic mega-mergers

Motives and Determinants of Mergers Synergy Effect

Operating SynergyFinancial SynergyDiversification Economic Motives

Horizontal Integration Vertical Integration Tax Motives

NAV= Vab (Va+Vb) P E

WhereVab = combined value of the 2 firms

Vb= market value of the shares of firm B.

Va= As measure of its own value

P = premium paid for B

E= expenses of the operation

FIRM VALUATION IN MERGERS AND ACQUISITIONS Equity Valuation Models

Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the balance sheet.Liquidation Value: the value that would be derived if the firms assets were liquidated. Replacement Cost: the replacement cost of its assets less its liabilities.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-2Dividend Discount Models

Where Vo= value of the firm

Di= dividend in year I

k= discount rate

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FIRM VALUATION IN MERGERS AND ACQUISITIONS-3The Constant Growth DDM

And this equation can be simplified to:

where g = growth rate of dividends.

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FIRM VALUATION IN MERGERS AND ACQUISITIONS-4Price-Earnings Ratio

where PVGO = Present Value of Growth Opportunity

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Implying P/E ratio

where ROE = Return On Equity

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FIRM VALUATION IN MERGERS AND ACQUISITIONS-5Cash Flow Valuation Models

The Entity DCF Model : The entity DCF model values the value of a company as the value of a companys operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity . Value of Operations: The value of operations equals the discounted value of expected future free cash flow.

. Value of Debt

. Value of Equity

FIRM VALUATION IN MERGERS AND ACQUISITIONS-6What Drives Cash Flow and Value?

- Fundamentally to increase its value a company must do one or more of the following:. Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital).. Increase the return on new capital investment.. Increase its growth rate but only as long as the return on new capital exceeds WACC.. Reduce its cost of capital.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-7The Economic Profit Model: The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.

where ROIC = Return on Invested Capital

WACC = Weighted Average Cost of Capital

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where NOPLAT = Net Operating Profit Less Adjusted Taxes

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STEPS IN VALUATIONAnalyzing Historical Performance

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FCF=Gross Cash Flow Gross Investments

Economic Profit=NOPLAT (Invested Capital x WACC)

STEPS IN VALUATION-2Forecast Performance

Evaluate the companys strategic position, companys competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC.Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance.Forecast income statement and balance sheet line items based on the scenarios.Check the forecast for reasonableness.

STEPS IN VALUATION-3Estimating The Cost Of Capital

Develop Target Market Value WeightsEstimate The Cost of Non-equity Financing Estimate The Cost Of Equity Financing

where

kb= the pretax market expected yield to maturity on non-callable, non convertible debt

Tc= the marginal taxe rate for the entity being valued

B= the market value of interest-bearing debt

kp= the after-tax cost of capital for preferred stock

P= market value of the preferred stock

ks= the market determined opportunity cost of equity capital

S= the market value of equity

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STEPS IN VALUATION-4Estimating The Cost Of Equity Financing

CAPM

. Determining the Risk-free Rate (10-year bond rate) . Determining The Market Risk premium 5 to 6 percent rate is used for the US companies . Estimating The Beta

whererf

= the risk-free rate of return

E(rm)

= the expected rate of return on the overall market portfolio

E(rm)- rf = market risk premium

= the systematic risk of equity

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STEPS IN VALUATION-5The Arbitrage Pricing Model (APM)

whereE(Fk)= the expected rate of return on a portfolio that mimics the kth factor and is

independent of all others.

Beta k= the sentivity of the stock return to the kth factor.

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STEPS IN VALUATION-6Estimating The Continuing Value

Selecting an Appropriate Technique. Long explicit forecast approach . Growing free cash flow perpetuity formula. Economic profit technique

STEPS IN VALUATION-7Calculating and Interpreting Results

Calculating And Testing The ResultsInterpreting The Results Within The Decision Context

HP-COMPAQ MERGER CASE

The HP/Compaq merger. By The Numbers:

HIGH-END

High-end Unix Servers: Worldwide (2000)

FactoryRevenues ($m)

Market Share

Hewlett-Packard

512

11.4%

Compaq

134

3.0%

Closest Rival: Sun Microsystems with factory revenues of $2.1 billion and a 47.1% market share

High-end Unix servers: US (2000)

FactoryRevenues ($m)

Market Share

Hewlett-Packard

124

6.1%

Compaq

66

3.3%

Closest Rival: Sun Microsystems with factory revenues of $1.2 billion and a 60.1% market share

MID-RANGE

Mid-range Unix servers: Worldwide (2000)

FactoryRevenues ($m)

Market Share

Hewlett-Packard

3,673

30.3%

Compaq

488

4.0%

Closest Rival: Sun Microsystems with $2.8 billion in factory revenue and a 23.5% market share

Mid-range Unix servers: US (2000)

Factory Revenues ($m)

Market Share

Hewlett-Packard

1552

28.2%

Compaq

296

5.4%

Market Leader: Sun Microsystems with revenues of $1.7 billion and a 30.5% market share)

PERSONAL COMPUTERS

PC Shipments: Worldwide (in thousands of units)

Hewlett-Packard

Compaq

Units (q2/01)

2,065

3,590

Share (q2/01)

6.9%

12.1%

Units (q2/00)

2,260

4.011

Share(q2/00)

7.4%

13.2%

Growth

-8.6%

-10.5%

PC Shipments: US(in thousands of units)

Hewlett-Packard

Compaq

Units (q2/01)

991

1,332

Share (q2/01)

9.4%

12.7%

Units (q2/00)

1,221

2,293

Share(q2/00)

10.7%

20.1%

Growth

-18.8%

--21.3%

Market leader: Dell Computer Corp. with a 24% market share and a 9.8% growth in the same period.

LAPTOPS/NOTEBOOKS

SMART HANDHELDS

Worldwide shipments of portable computers (thousands of units)

Hewlett-Packard

Compaq

Units(q4/00)

318

817

Share(q4/00)

4.5%

11.6%

Units(q4/99)

139

739

Share(q4/99)

2.4%

13.%

Growth

129.2%

10.4%

Market leader: IBM with 932,000 units and a 13.3% market share

Shipments(in 000s)

Share 2000

Rank

Hewlett-Packard

254

3.8%

4

Compaq

129

1.9%

9

Market Leader: Palm with a 52.9% market share and 3.53 million units.

Source: IDC

HP-COMPAQ MERGER CASE-2Arguments About The Merger

Supporters. HP-COMPAQ will become the leader in most of the sub-sectors . Ability to offer better solutions to customers demands . New strategic position will make it possible to increase R&D efforts and customer research . Decrease in costs and increase in profitability. Financial strength to provide chances to invest in new profitable areas

HP-COMPAQ MERGER CASE-3Arguments About The Merger

- Opponents. Acquiring market share will not mean the leadership . No new significant technology capabilities added to HP . Large stocks will increase the riskiness of the company (Credit rating of the HP is lowered after the merger announcement) . Diminishing economies of scale sector which both companies have already a great scale.

HP-COMPAQ MERGER CASE-4Valuation Process

Relative Historical Stock Price Performance

Historical Exchange Ratios

Period ending August 31, 2001

Average Exchange Ratio

Implied Premium (%)

August 31 2001

0.532

18.9

10-Day Average

0.544

16.3

20-Day Average

0.568

11.3

30 Day Average

0.573

10.3

3 Months Average

0.557

13.7

6 Months Average

0.584

8.2

9 Months Average

0.591

7.1

12 Months Average

0.596

6.1

HP-COMPAQ MERGER CASE-5Comparable Public Market Valuation Analysis

Firm Values As a Multiple of Revenue EBITDA and LTM EBIT

Firm Values as a Multiple of

Companies

LTM Revenue

LTM EBITDA

LTM EBIT

Compaq

0.5 X

5.7 X

9.8 X

HP

1.0 X

12.4 X

19.8 X

Selected Group

0.2-2.1 X

5.3-18.2 X

8.9-19.9 X

Closing Stock Prices As a Multiple of EPS

Closing Stock Price as a Multiple of

Companies

2001 EPS

2002 EPS

2003 EPS

Compaq

34.3 X

18.4 X

14.0 X

HP

35.7 X

19.2 X

12.5 X

Selected Group

18.5-57.3 X

10.7-27.1 X

9.3-19.5 X

HP-COMPAQ MERGER CASE-6Similar Transactions Premium Analysis Salomon Smith Barney's analysis resulted in a range of premiums of:

- (8)% to 46% over exchange ratios implied by average prices for the 10 trading days prior to announcement, with a median premium of 23%.- (7)% to 58% over exchange ratios implied by average prices for the 20 trading days prior to announcement, with a median premium of 23%. - (12)% to (29) over exchange ratios implied by average prices for the 1 trading days prior to announcement with a median premium of 15%.

Based on its analysis, Salomon Smith Barney determined a range of implied exchange ratios of 0.585x to 0.680x by applying the range of premiums for other transactions to the closing prices of Compaq and HP on August 31, 2001 and the average historical exchange ratio for Compaq and HP for the 10-day period ending on August 31, 2001, as appropriate.

HP-COMPAQ MERGER CASE-7Contribution Analysis

Percentage Contribution Analysis

Period

Percentage Contribution

Compaq

HP

Revenues

LTM

46.0

54.0

2001 Estimated

44.0

56.0

2002 Estimated

44.0

56.0

2003 Estimated

44.0

56.0

LTM

45.7

54.3

2001 Estimated

38.1

61.9

2002 Estimated

36.9

63.1

2003 Estimated

32.7

67.3

Net Income

2001 Estimated

32.3

67.7

Next Four Fiscal Q

31.6

68.4

2002 Estimated

32.7

67.3

2003 Estimated

29.2

70.8

At Market

Equity Value

31.7

68.3

HP-COMPAQ MERGER CASE-8Pro Forma Earnings Per Share Impact to Compaq

Accretion/Dilution Analysis

Accretion/Dilution

EPS

2002

EPS

2003

Compaq stand-alone

0.67

0.88

HP stand-alone

1.21

1.86

Combined entity pro-forma, excluding proj. synergies

0.74

1.09

Combined entity pro-forma, including proj. synergies

1.05

1.51

Accretion/(Dilution) to Compaq, excluding proj. synergies

11%

24%

Accretion/(Dilution) to Compaq, including proj. synergies

57%

71%