Chapter 9 Applying Financial Modeling Techniques

To Value, Structure, and Negotiate Mergers and Acquisitions

There are two kinds of forecasters: the ones who don't know and the ones who don't know they don't know.

—John Kenneth Galbraith

Inside M&A: HP buys EDS—the role of financial models in decision making

Personal computer printer behemoth Hewlett-Packard (HP), had just announced its agreement to buy Electronic Data Systems (EDS) on May 9, 2008, for $13.9 billion (including assumed debt of $700 million) in an all-cash deal. The purchase price represented a 33% premium for EDS, a systems integration, consulting, and services firm. Expressing their dismay, investors drove HP's share price down by 11% in a single day following the announcement.

In a meeting arranged to respond to questions about the deal, HP's chief executive Mark Hurd found himself barraged by concerns about how the firm intended to recover the sizeable premium it had paid for EDS. The CEO had been a Wall Street darling since he had assumed his position three years earlier. Under his direction, the firm's profits rose sharply as it successfully cut costs while growing revenue and integrating several acquisitions. Asked how HP expected to generate substantial synergies by combining two very different organizations, Mr. Hurd indicated that the firm and its advisors had done “double-digit thousands of hours” in due diligence and financial modeling and that they were satisfied that the cost synergies were there. In an effort to demonstrate how conservative they had been, the CEO indicated that potential revenue synergies had not even been included in their financial models. However, he was convinced that there were significant upside revenue opportunities.1

Chapter overview

Financial modeling refers to the application of spreadsheet software to define simple arithmetic relationships among variables within the firm's income, balance sheet, and cash-flow statements and to define the interrelationships among the various financial statements. The primary objective in applying financial modeling techniques is to create a computer-based model, which facilitates the acquirer's understanding of the effect that changes in certain operating variables have on the firm's overall performance and valuation. Once in place, these models can be used to simulate alternative plausible valuation scenarios to determine which one enables the acquirer to achieve its financial objectives without violating identifiable constraints. Financial objectives could include earnings per share (EPS) for publicly traded firms, return on total capital for privately held firms, or internal rates of return for leveraged buyout firms. Typical constraints include Wall Street analysts' expectations for the firm's EPS, the acquirer's leverage compared with other firms in the same industry, and loan covenants limiting how the firm uses its available cash flow. Another important constraint is the risk tolerance of the acquiring company's management, which could be measured by the acquirer's target debt-to-equity ratio.

Financial models can be used to answer several sets of questions. The first set pertains to valuation. How much is the target company worth without the effects of synergy? What is the value of expected synergy? What is the maximum price the acquiring company should pay for the target? The second set of questions pertains to financing. Can the proposed purchase price be financed? What combination of potential sources of funds, both internally generated and external sources, provides the lowest cost of funds for the acquirer, subject to known constraints (e.g., existing loan covenants)? The final set of questions pertains to deal structuring. What is the impact on the acquirer's financial performance if the deal is structured as a taxable rather than a nontaxable transaction? What is the impact on financial performance and valuation if the acquirer is willing to assume certain target company liabilities? Deal-structuring considerations are discussed in detail in Chapters 11 and 12.

The purpose of this chapter is to illustrate a process for building a financial model in the context of a merger or acquisition. The process allows the analyst to determine the minimum and maximum prices for a target firm and the initial offer price. The author also provides a simulation model for assessing the impact of various offer prices on postmerger EPS and discusses how this capability can be used in the negotiating process. Finally, the flexibility of these modeling techniques is illustrated by showing how they may be applied to special situations, such as when the acquirer or target is part of a parent firm or when the objective is to value, structure, and negotiate a joint venture or business alliance. The Microsoft Excel spreadsheets and formulas for the models described in this chapter are available in the file folder entitled “Mergers and Acquisitions Valuation and Structuring Model” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858).

A review of this chapter (including practice questions and answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book. The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment, as well as a document discussing how to interpret the financial ratios commonly generated by financial models. See Appendix A for more details on how to use the companion site M&A model,² and see Appendix B for a discussion of common methods of “balancing” financial models.

Limitations of financial data

The output of models is only as good as the accuracy and timeliness of the numbers used to create them and the quality of the assumptions used in making projections. Consequently, analysts must understand on what basis numbers are collected and reported. Consistency and adherence to uniform standards become exceedingly important.

Generally Accepted Accounting Principles and International Standards

U.S. public companies prepare their financial statements in accordance with generally accepted accounting principles (GAAP). GAAP financial statements are those prepared in agreement with guidelines established by the Financial Accounting Standards Board (FASB). GAAP is a rules-based system, giving explicit instructions for every situation that the FASB has anticipated. In contrast, international accounting standards (IAS) are a principles-based system, with more generalized standards to follow. All European Union publicly traded companies had to adopt the IAS system in 2007; according to the International Accounting Standards Board (IASB), more than 150 countries are expected to have adopted IAS by the end of 2011. GAAP and IAS currently exhibit significant differences. However, these differences could narrow in the coming years. The United States is considering whether to utilize international accounting standards for financial reporting purposes for all publicly traded firms.

When and the extent to which GAAP and IAS systems converge are open questions. While it may be possible to establish consistent accounting standards across countries, it is unclear if adherence to such standards can be enforced without a global regulatory authority. It is unclear that individual countries would readily submit to such an authority. Without effective enforcement, firms may largely ignore certain standards without fear of significant consequences. While multinational auditing firms may move to harmonize accounting practices, there are clear limits to their ability and willingness to do so. Multinational auditing firms usually consist of a series of legally independent, country-based partnerships. Consequently, cultural differences may create variation in the way accounting standards are applied.

In the absence of strict enforcement of consistent standards, do the benefits of converging accounting systems outweigh the cost of implementing a new system? By some estimates, the cost of converting to international accounting standards for S&P 500 companies could range from $40 to $60 billion over three years. While theoretically increased consistency and transparency could lower the cost of capital, the lack of a serious enforcement mechanism may limit the extent to which this occurs.³

Few would argue that GAAP ensures that all transactions are accurately recorded. Nonetheless, the scrupulous application of GAAP does ensure consistency in comparing one firm's financial performance to another's. It is customary for purchase agreements in U.S. transactions to require that a target company represent that its financial books are kept in accordance with GAAP. Consequently, the acquiring company at least understands how the financial numbers were assembled. During due diligence, the acquirer can look for discrepancies between the target's reported numbers and GAAP practices. Such discrepancies could indicate potential problems.

Pro Forma Accounting

Pro forma financial statements present financial statements in a way that purports to more accurately describe a firm's current or projected performance. Because there are no accepted standards for pro forma accounting, pro forma statements may deviate substantially from standard GAAP statements. Pro forma statements frequently are used to show what an acquirer's and target's combined financial performance would look like if they were merged.

Although public companies still are required to file their financial statements with the Securities and Exchange Commission in accordance with GAAP, companies often argue that pro forma statements provide investors with a more realistic view of a company's core performance than GAAP reporting. Although pro forma statements provide useful insight into how a proposed combination of businesses might look, such liberal accounting techniques easily can be abused to hide a company's poor performance. Exhibit 9.1 suggests some ways in which an analyst can tell if a firm is engaging in inappropriate accounting practices.⁴

Exhibit 9.1 Accounting Discrepancy Red Flags

1. The source of the revenue is questionable. Beware of revenue generated by selling to an affiliated party, by selling something to a customer in exchange for something other than cash, or the receipt of investment income or cash received from a lender.

2. Income is inflated by nonrecurring gains. Gains on the sale of assets may be inflated by an artificially low book value of the assets sold.

3. Deferred revenue shows an unusually large increase. Deferred revenue increases as a firm collects money from customers in advance of delivering its products. It is reduced as the products are delivered. A jump in this balance sheet item could mean the firm is having trouble delivering its products.

4. Reserves for bad debt are declining as a percentage of revenue. This implies that the firm may be boosting revenue by not reserving enough to cover probable losses from customer accounts that cannot be collected.

5. Growth in accounts receivable exceeds substantially the increase in revenue or inventory. This may mean that a firm is having difficulty in selling its products (i.e., inventories are accumulating) or that it is having difficulty collecting what it is owed.

6. The growth in net income is significantly different from the growth in cash from operations. Because it is more difficult to “manage” cash flow than net income (which is subject to distortion due to improper revenue recognition), this could indicate that net income is being deliberately misstated. Potential distortion may be particularly evident if the analyst adjusts end-of-period cash balances by deducting cash received from financing activities and adding back cash used for investment purposes. Consequently, changes in the adjusted cash balances should reflect changes in reported net income.

7. An increasing gap between a firm's income reported on its financial statements and its tax income. While it is legitimate for a firm to follow different accounting practices for financial reporting and tax purposes, the relationship between book and tax accounting is likely to remain constant over time, unless there are changes in tax rules or accounting standards.

8. Unexpected large asset write-offs. This may reflect management inertia in incorporating changing business circumstances into its accounting estimates.

9. Extensive use of related party transactions. Such transactions may not be subject to the same discipline and high standards of integrity as unrelated party transactions.

10. Changes in auditing firms that are not well justified. The firm may be seeking a firm that will accept its aggressive accounting positions.

The model-building process

The logic underlying the Excel-based M&A model found on the companion site follows the process discussed in this chapter. This process involves four discrete steps (Table 9.1). First, value the acquiring and target firms as stand-alone businesses. A stand-alone business is one whose financial statements reflect all the costs of running the business and all the revenues generated by the business. Second, value the consolidated acquirer (PV _A ) and target (PV _T ) firms, including the effects of synergy. The appropriate discount rate for the combined firms is generally the target's cost of capital; if the two firms have similar risk profiles and are based in the same country, either firm's cost of capital could be used. It is particularly important to use the target's cost of capital if the acquirer is merging with a higher-risk business, resulting in an increase in the acquirer's cost of capital.

Table 9.1. The Mergers and Acquisitions Model-Building Process

Note: Key assumptions made for each step should be clearly stated.

Third, determine the initial offer price for the target firm. Fourth, determine the acquirer's ability to finance the purchase using an appropriate financial structure. The appropriate financial structure (debt–to–equity ratio) is that which satisfies certain predetermined criteria and which can be determined from a range of scenarios created by making small changes in selected value drivers. Value drivers are factors, such as product volume, selling price, and cost of sales, that have a significant impact on the value of the firm whenever they are altered (see Chapter 7).

Step 1. Value Acquirer and Target Firms as Stand-Alone Businesses

A merger or acquisition makes sense to the acquirer's shareholders only if the combined value of the target and acquiring firms exceeds the sum of their stand-alone (i.e., independent or separate) values. Consequently, in the first step of the model-building process outlined in Table 9.1, it is necessary to determine each firm's stand-alone value. This requires understanding the basis of competition within an industry.

Understand Specific Firm and Industry Competitive Dynamics

The accuracy of any valuation depends heavily on understanding the historical competitive dynamics of the industry, the historical performance of the company within the industry, and the reliability of the data used in the valuation. Competitive dynamics simply refer to the factors within the industry that determine industry profitability and cash flow. A careful examination of historical information can provide insights into key relationships among various operating variables. Examples of relevant historical relationships include seasonal or cyclical movements in the data, the relationship between fixed and variable expenses, and the impact on revenue of changes in product prices and unit sales. If these relationships can reasonably be expected to continue through the forecast period, they can be used to project valuation cash flows.

If the factors affecting sales, profit, and cash flow historically are expected to exert about the same degree of influence in the future, it is reasonable to forecast a firm's financial statements by extrapolating historical growth rates in key variables such as revenue. However, if the dynamics underlying sales growth are expected to change due to such factors as the introduction of new products, total revenue growth may accelerate from its historical trend. In contrast, the emergence of additional competitors may limit revenue growth by eroding the firm's market share and selling prices. Answers to the questions posed in Figure 9.1 provide helpful insights into how financial performance can be projected. (See Chapter 4 and Exhibit 4.2 for a more detailed discussion of the Porter Five Forces Model.)

Figure 9.1 Using the Porter Five Forces Model to project acquirer and target financial performance.

Normalize Historical Data

To ensure that these historical relationships can be accurately defined, it is necessary to normalize the data by cleansing it of nonrecurring changes and questionable accounting practices. For example, cash flow may be adjusted by adding back unusually large increases in reserves or deducting large decreases in reserves from free cash flow to the firm. Similar adjustments can be made for significant nonrecurring gains or losses on the sale of assets or nonrecurring expenses, such as those associated with the settlement of a lawsuit or warranty claim. Monthly revenue may be aggregated into quarterly or even annual data to minimize period-to-period distortions in earnings or cash flow resulting from inappropriate accounting practices. While public companies are required to provide financial data for only the current and two prior years, it is highly desirable to use data spanning at least one business cycle (i.e., about five to seven years).

Common-size financial statements are among the most frequently used tools to uncover data irregularities. These statements may be constructed by calculating the percentage each line item of the income statement, balance sheet, and cash-flow statement is of annual sales for each quarter or year for which historical data are available. Common-size financial statements are useful for comparing businesses of different sizes in the same industry at a specific moment in time. Such analyses are called cross-sectional comparisons. By expressing the target's line-item data as a percentage of sales, it is possible to compare the target company with other companies' line-item data expressed in terms of sales to highlight significant differences. For example, a cross-sectional comparison may indicate that the ratio of capital spending to sales for the target firm is much less than for other firms in the industry.

This discrepancy may simply reflect “catch-up” spending under way at the target's competitors, or it may suggest a more troubling development in which the target is deferring necessary plant and equipment spending. To determine which is true, it is necessary to calculate common-size financial statements for the target firm and its primary competitors over a number of consecutive periods. This type of analysis is called a multiperiod comparison. Comparing companies in this manner helps confirm whether the target simply has completed a large portion of capital spending that others in the industry are undertaking currently or is woefully behind in making necessary expenditures.⁵

Financial ratio analysis is the calculation of performance ratios from data in a company's financial statements to identify the firm's financial strengths and weaknesses. Such analysis helps in identifying potential problem areas that may require further examination during due diligence. Because ratios adjust for firm size, they enable the analyst to compare a firm's ratios with industry averages. A file entitled “A Primer on Applying and Interpreting Financial Ratios” on the companion site lists commonly used formulas for financial ratios, how they are expressed, and how they should be interpreted. These ratios should be compared with industry averages to discover if the company is out of line with others in the industry. A successful competitor's performance ratios may be used if industry average data⁶ are not available.

Project Normalized Cash Flow

Normalized cash flows should be projected for at least five years, and possibly more, until they turn positive or the growth rate slows to what is believed to be a sustainable pace. Projections should reflect the best available information about product demand growth, future pricing, technological changes, new competitors, new product and service offerings from current competitors, potential supply disruptions, raw material and labor cost increases, and possible new product or service substitutes. Projections also should include the revenue and costs associated with known new product introductions and capital expenditures, as well as additional expenses, required to maintain or expand operations by the acquiring and target firms during the forecast period.

A simple model to project cash flow involves the projection of revenue and the various components of cash flow as a percent of projected revenue. For example, cost of sales, depreciation, gross capital spending, and the change in working capital are projected as a percent of projected revenue. What percentage is applied to projected revenue for these components of free cash flow to the firm may be determined by calculating their historical ratio to revenue. In this simple model, revenue drives cash-flow growth. Therefore, special attention must be given to projecting revenue by forecasting unit growth and selling prices, the product of which provides estimated revenue. As suggested in Chapters 4 and 7, the product life cycle concept may be used to project unit growth and prices. Common projection methods include trend extrapolation and scenario analysis.⁷ See this chapter's Appendix B for a discussion of how to force the balance sheet of such models to balance (i.e., total assets equal total liabilities plus shareholders' equity).

To illustrate this process, consider the income, balance sheet, and cash-flow statements for Alanco Technologies Inc., a provider of wireless systems for tracking the movement of freight and people. In 2010, Alanco acquired StarTrak Systems, a provider of global positioning satellite tracking and wireless subscription data services to the transportation industry. Alanco believed that the acquisition would help it develop new markets for its products and services for wireless tracking and management of people and assets. With StarTrak less than 10% of the size of Alanco, Alanco believed that most of the synergy would come from cross-selling its products and services to StarTrak's customers rather than from cost savings.

Alanco's management understood that a successful acquisition would be one that would create more shareholder value at an acceptable level of risk than if the firm retained its current “go it alone” strategy. Consequently, Alanco valued its own business on a stand-alone basis (Table 9.2), StarTrak's business as a stand-alone unit (financials not shown), estimated potential synergy (Table 9.3), and combined firms including the effects of potential synergy (Table 9.4). The difference between the combined valuation with synergy and the sum of the two businesses valued as stand-alone operations provided an estimate of the potential incremental value that could be created from the acquisition of StarTrak.

Table 9.2. Step 1: Acquirer (Alanco) 5-Year Forecast and Stand-Alone Valuation

^* In millions of dollars/.

^† As of December 31, 2010

Table 9.3. Step 2: Synergy Estimation^a

^a Note that incremental sales and cost savings are realized gradually due to the time required to implement such plans.

^* In millions of dollars

Table 9.4. Step 2: Consolidated Alanco and StarTrak 5-Year Forecast and Valuation

^* In millions of dollars.

Note that the layout in Table 9.2 is identical to those worksheets provided for the M&A Valuation and Structuring Model on the companion site. The assumptions provided in the top panel drive the forecast of the various line items for the income, balance sheet, and cash-flow statements. The historical financial data provides recent trends. As is typical of discounted cash-flow valuations, the terminal value comprises about three-fourths of the total present value (i.e., $6,342 million/$8,442 million) of Alanco's projected operating cash flows. Nonoperating assets such as the $245 million in excess cash balances are added to the total present value of the firm's operating cash flows.

Step 2. Value Acquirer and Target Firms, Including Synergy

Synergy generally is considered as those factors or sources of value that add to the economic value (i.e., ability to generate future cash flows) of the combined firms. However, factors that destroy value also should be considered in the estimation of the economic value of the combined firms. Net synergy (NS) is the difference between estimated sources of value and destroyers of value. The common approach to estimating the present value of net synergy is to subtract the sum of the present values of the acquirer and target firms on a stand-alone basis from the present value of the consolidated acquirer and target firms, including the estimated effects of synergy.⁸ This approach has the advantage of enabling the analyst to create an interactive model to simulate alternative scenarios including different financing and deal-structuring assumptions.

Sources of Value

Look for quantifiable sources of value while conducting due diligence. The most common include the potential for cost savings resulting from shared overhead, duplicate facilities, and overlapping distribution channels. Synergy related to cost savings that are generally more easily identified seems to have a much better chance of being realized than synergy due to other sources.⁹

Potential sources of value also include assets not recorded on the balance sheet at fair value and off-balance-sheet items. Common examples include land, “obsolete” inventory and equipment, patents, licenses, and copyrights. Underutilized borrowing capacity also can make an acquisition target more attractive. The addition of the acquired company's assets, low level of indebtedness, and strong cash flow from operations could enable the buyer to increase substantially the borrowing levels of the combined companies.¹⁰

Other sources of value could include access to intellectual property (i.e., patents, trade names, and rights to royalty streams), new technologies and processes, and new customer groups. Gaining access to new customers is often given as a justification for mergers and acquisitions. Kmart Holding Corp's acquisition of Sears, Roebuck and Co. in 2004 was in part motivated by the opportunity to sell merchandise with strong brand equity, which had been sold exclusively at Kmart (e.g., Joe Boxer) to a whole new clientele in Sears stores.

Income tax loss carryforwards and carrybacks, as well as tax credits, also may represent an important source of value for an acquirer seeking to reduce its tax liability. Loss carryforwards and carrybacks represent a firm's losses that may be used to reduce future taxable income or recover some portion of previous taxes paid by the firm. See Chapter 12 for a more detailed discussion of tax-related issues.

Destroyers of Value

Factors that can destroy value include poor product quality, wage and benefit levels above comparable industry levels, low productivity, and high employee turnover. A lack of customer contracts or badly written contracts often result in customer disputes about terms and conditions and what amounts actually are owed. Verbal agreements made with customers by the seller's sales representatives also may become obligations for the buyer. These are particularly onerous, because commissioned sales forces frequently make agreements that are not profitable for their employer.

Environmental issues, product liabilities, unresolved lawsuits, and other pending liabilities are also major potential destroyers of value for the buyer. These often serve as ticking time bombs, because the actual liability may not be apparent for years following the acquisition. Moreover, the magnitude of the liability actually may force a company into bankruptcy.¹¹

Implementation Costs

In calculating net synergy, it is important to include the costs associated with recruiting and training, realizing cost savings, achieving productivity improvements, and exploiting revenue opportunities. No matter how much care is taken to minimize employee attrition following closing, some employees will be lost. Often these are the most skilled. Once a merger or acquisition is announced, target company employees start to circulate their resumes. The best employees start to receive job solicitations from competitors or executive search firms. Consequently, the costs associated with replacing employees who leave following closing can escalate sharply. The firm will incur recruitment costs as well as the cost of training the new hires. Moreover, the new hires are not likely to reach the productivity levels of those they are replacing for some time.

Cost savings are likely to be greatest when firms with similar operations are consolidated and redundant, or overlapping positions are eliminated. Many analysts take great pains to estimate savings in terms of wages, salaries, benefits, and associated overhead, such as support staff and travel expenses, without accurately accounting for severance expenses associated with layoffs.¹²

Realizing productivity improvements frequently requires additional spending in new structures and equipment, retraining employees that remain with the combined companies, or redesigning work flow. Similarly, exploiting revenue-raising opportunities may require training the sales force of the combined firms in selling each firm's products or services and additional advertising expenditures to inform current or potential customers of what has taken place. See Table 9.4 for estimated sources of synergy resulting from the combination of Alanco and StarTrak, which presents the consolidated financial statements (including the effects of anticipated synergy) for the two firms. The impact of anticipated synergy is illustrated on the income statement in terms of incremental revenue, as well as savings from cost of sales and selling and general and administrative expense reductions. Note how synergy-related revenue is added to total revenue and synergy-related reductions in cost of sales, selling expenses, and general and administrative expenses are deducted from their respective line items on the income statement.

Step 3. Determine the Magnitude and Composition of the Offer Price for the Target Firm

In practice, many factors affect the amount and form of payment of the initial offer price. Which are most important depends largely on the circumstances surrounding the transaction. In some cases, these factors can be quantified (e.g., synergy), while others are largely subjective (e.g., the degree of acquirer shareholder and management risk aversion). The amount of the initial offer price may also reflect a premium for control. While the actual value of control is difficult to quantify, a bidder may be willing to pay more to gain control if it is believed that this would provide for better decision making and the implementation of a more effective strategy. The value of control and how it may be estimated is discussed in more detail in Chapter 10.

Table 9.5 identifies many of the factors that affect the magnitude and composition of the offer price. The remainder of this section of this chapter addresses how some of these factors can be incorporated into the model-building process.

Table 9.5. Determinants of Magnitude and Composition of Initial Offer Price

Factors Affecting	Magnitude	Composition
Acquirer's Perspective	• Estimated net synergy • Perceived contribution of target to net synergy • Willingness to share net synergy with target shareholders • Relative attractiveness of alternative investment opportunities • Number of potential bidders • Effectiveness of target's defenses • Public disclosure requirements (may result in preemptive bid) • Degree of management's risk aversion • Perceived value of control	• Current borrowing capacity • After-tax cost of debt versus cost of equity • Size and duration of potential EPS dilution (impacts attractiveness of share exchange) • Size of transaction (may make borrowing impractical) • Desire for risk sharing (may result in contingent or deferred payments) • Extent to which acquirer shares are overvalued (makes an all-equity transaction more attractive)
Target's Perspective	• Number of potential bidders • Perceived contribution of target to net synergy • Perception of bidder as friendly or hostile • Effectiveness of defenses • Size of potential tax liability (may require an increase in the purchase price) • Stand-alone valuation • Availability of recent comparable transactions • Relative attractiveness of alternative investment opportunities	• Perceived attractiveness of acquirer stock • Shareholder preference for cash versus stock • Size of potential tax liability (may make share exchange most attractive option) • Perceived upside potential of target (may result in contingent payout)

Estimating the Minimum and Maximum Offer Price Range (Stock and Asset Purchases)

For transactions in which there is potential synergy between the acquirer and the target firms, the initial offer price for the target firm lies between the minimum and maximum offer prices. In a purchase of stock transaction, the minimum offer price may be defined as the target's stand-alone or present value (PV _T ) or its current market value (MV _T ) (i.e., the target's current stock price times its shares outstanding). The maximum price is the sum of the minimum price plus the present value of net synergy (PV_NS).¹³ The initial offer price (PV_IOP) is the sum of both the minimum purchase price and some percentage between 0 and 1 of the PV of net synergy (see Exhibit 9.2).

The percentage of net synergy (i.e., α) that is to be shared with the target firm's shareholders may be determined by considering premiums paid on recent similar transactions, the portion of net synergy that is provided by the target, and the target firm's negotiating leverage. In addition, acquirers might make so-called preemptive bids, which represent proposals so attractive that the target firm's board would have considerable difficulty in explaining to shareholders their reasons for rejecting the offer. The acquirer's hope is that such bids will discourage other potential bidders. Finally, an acquirer may be very reluctant to share more than a small fraction of the anticipated net synergy with target shareholders, recognizing that actually realizing the synergy on a timely basis is highly problematic.

The stand-alone value is applicable for privately held firms. In an efficient market in which both buyer and seller have access to the same information, the stand-alone value would be the price the rational seller expects to receive. In practice, markets for small, privately owned businesses are often inefficient. Either the buyer or seller may not have access to all relevant information about the economic value of the target, perhaps due to the absence of recent comparable transactions. Consequently, the buyer may attempt to purchase the target firm at a discount from what it believes is the actual economic or fair market value.

In an asset purchase, the target's net assets (i.e., total assets less total liabilities) have to be adjusted to reflect the fair market value of the target assets and liabilities that are retained by the target. Consequently, the target's adjusted net assets represent assets included in the transaction less liabilities assumed by the buyer and equal the PV of the cash flows generated by the target's adjusted net assets. Therefore, the minimum purchase price would be the liquidation value of the target's adjusted net assets; the maximum purchase price would equal the minimum price plus 100% of net synergy, and the initial offer price would equal the PV of adjusted net assets plus some portion of net synergy.

Exhibit 9.2 Determining the Offer Price (PV_OP)—Purchase of Stock

a. PV_MIN = PV _T or MV _T , whichever is greater. MV _T is the target firm's current share price times the number of shares outstanding

b. PV_MAX = PV_MIN + PV_NS, where PV_NS = PV (sources of value) – PV (destroyers of value)

c. PV_OP = PV_MIN + α PV_NS, where 0 ≤ α ≤ 1

d. Offer price range for the target firm = (PV _T or MV _T ) < PV_OP < (PV _T or MV _T ) + PV_NS

Determining the Distribution of Synergy between the Acquirer and the Target

In determining the initial offer price, the acquiring company must decide how much of the anticipated synergy it is willing to share with the target firm's shareholders. This is often determined by the portion of anticipated synergy contributed by the target firm. For example, if following due diligence, it is determined that the target would contribute 30% of the synergy resulting from combining the acquirer and target firms, the acquirer may choose to share up to 30% of the estimated net synergy with the target firm's shareholders. The actual amount of synergy shared with the target firm shareholders will reflect the relative bargaining power of the acquirer and target firms and recent comparable firm transaction prices.

It is logical that the offer price should fall between the minimum and maximum prices for three reasons. First, it is unlikely that the target company can be purchased at the minimum price, because the acquiring company normally has to pay a premium over the current market value to induce target shareholders to transfer control to another firm. In an asset purchase, the rational seller would not sell at a price below the liquidation value of the net assets being acquired, since this represents what the seller could obtain by liquidating rather than selling the assets and using a portion of the proceeds to pay off liabilities that would have been assumed by the buyer. Second, at the maximum end of the range, the acquiring company would be ceding all of the net synergy value created by the combination of the two companies to the target company's shareholders. Third, it is prudent to pay significantly less than the maximum price, because the amount of synergy actually realized often tends to be less than the amount anticipated.

Determining the Appropriate Composition of the Offer Price

The purchase price offered to the target company could consist of the acquirer's stock, debt, cash, or some combination of all three. The actual composition of the purchase price depends on what is acceptable to the target and acquiring companies and what the financial structure of the combined companies can support. Consequently, the acquirer needs to determine the appropriate financing or capital structure of the combined companies, including debt, common equity, and preferred equity. In this chapter, the initial offer price is the market value or economic value (i.e., present value of the target firm defined as a stand-alone business) plus some portion of projected net synergy. In Chapter 5, the offer or purchase price was defined in a different context, as total consideration, total purchase price or enterprise value, and net purchase price. These definitions were provided with the implicit assumption that the acquiring company had determined the economic value of the firm on a stand-alone basis and the value of net synergy. Economic value is determined before any consideration is given to how the transaction will be financed.

Share-exchange ratios

For public companies, the exchange of the acquirer's shares for the target's shares requires the calculation of the appropriate exchange ratio. The share-exchange ratio (SER) can be negotiated as a fixed number of shares of the acquirer's stock to be exchanged for each share of the target's stock. Alternatively, SER can be defined in terms of the dollar value of the negotiated offer price per share of target stock (P_OP) to the dollar value of the acquirer's share price (P_A). The SER is calculated by the following equation:

The SER, defined in this manner, can be less than, equal to, or greater than 1, depending on the value of the acquirer's shares relative to the offer price on the date set during the negotiation for valuing the transaction. For example, in a share-for-share exchange in which the offer price per target share and acquirer's share prices are $25.50 and $37.25, respectively, the target firm's shareholders would receive 0.6846 shares (i.e., $25.50 ÷ $37.25) of acquirer stock for each share of target stock they tender. Furthermore, if the number of acquirer and target shares outstanding is 10 million and 2 million, respectively, the acquirer would have to issue 1,369,200 new shares (i.e., .6846 × 2,000,000) to purchase all of the target shares. Since the target shares are canceled, the total number of shares outstanding for the combined firms is 11,369,200 (i.e., 10,000,000 + 1,369,200). The shareholders of the acquiring company would own 88% (i.e., 10,000,000 ÷ 11,369,200) of the combined firms and the target shareholders the remaining 12%.

Fully diluted shares outstanding

When the target firm has outstanding management stock options and convertible securities, it is necessary to adjust the offer price to reflect the extent to which options and convertible securities will be exchanged for new common shares. If the acquirer is intent on buying all the target's outstanding shares, these new shares also have to be purchased. Convertible securities commonly include preferred stock and debentures. Information on the number of options outstanding and their associated exercise prices, as well as convertible securities, generally are available in the footnotes to the financial statements of the target firm.¹⁴ With respect to convertible securities, it is reasonable to assume that such securities will be converted to common equity if the conversion price is less than the offer price for each common share. Such securities are said to be “in the money.” Table 9.6 illustrates the calculation of the target firm's fully diluted shares outstanding and the impact on the equity value of the target firm.

Table 9.6. Calculating the Target's Fully Diluted Shares Outstanding and Equity Value (Using If-Converted Method)

Assumptions about Target		Comment
Basic Shares Outstanding	2,000,000 shares
In-the-Money Options^a	150,000 shares	Exercise price = $15/share
Convertible Securities
Convertible Debt (Face value = $1,000; convertible into 50 shares of common stock)	$10,000,000	Implied conversion price = $20 (i.e., $1,000/50)
Preferred Stock (Par value = $20; convertible into one share of common at $24 per share)	$5,000,000	Preferred shares outstanding = $5,000,000/$20 = 250,000
Offer Price per Share	$30	Purchase price offered for each target share outstanding
Total Shares Outstanding^b = 2,000,000 + 150,000 + ($10,000,000/$1,000) × 50 + 250,000 = 2,000,000 + 150,000 + 500,000 + 250,000 = 2,900,000
Target Equity Value^c = 2,900,000 × $30 – 150,000 × $15 = $87,000,000 – $2,250,000 = $84,750,000

^a An option whose exercise price is below the market value of the firm's share price.

^b Total shares outstanding = Issued shares + Shares from “in-the-money” options and convertible securities.

^c Purchase price adjusted for new acquirer shares issued for convertible shares or debt less cash received from “in-the-money” option holders.

Table 9.7 summarizes the steps involved in determining the offer price. Please pay special attention to the addendum to this exhibit because it contains formulas for estimating each row of the section entitled “Model Output.”

Table 9.7. Step 3: Offer Price Determination

^* In millions of dollars.

Addendum:

Ownership distribution:

Acquirer shareholders = acquirer shares outstanding/total shares outstanding for the combined firms = 426/450 = 0.947 × 100 = 94.7%.

Target shareholders = 1 – 0.947 = 0.053 × 100 = 5.3%.

Step 4. Determine the Combined Firms' Ability to Finance the Transaction

The consolidated target and acquiring firms' financial statements, adjusted to reflect the net effects of synergy, are run through a series of scenarios to determine the impact on such variables as earnings, leverage, covenants, and borrowing costs. For example, each scenario could represent different amounts of leverage as measured by the firm's debt-to-equity ratio.

In theory, the optimal capital or financing structure is the one that maximizes the firm's share price. When borrowed funds are reinvested at a return above the firm's cost of capital, firm value is increased. Also, higher interest expense will result in increased tax savings due to the tax deductibility of interest. However, higher debt levels relative to equity increase the risk of default and the firm's cost of equity by raising its levered beta, which works to lower the firm's share price. Since many factors affect share price, it is difficult to determine the exact capital structure that maximizes the firm's share price.

In practice, financial managers attempt to forecast how changes in debt will affect those ratios that have an impact on a firm's creditworthiness. Such factors include the interest-coverage ratio, debt-to-equity ratio, times-interest-earned ratio, current ratio, and the like. They subsequently discuss their projected pro forma financial statements with lenders and bond rating agencies, which may make adjustments to the firm's projected financial statements. The lenders and rating agencies then compare the firm's credit ratios with those of other firms in the same industry to assess the likelihood that the borrower will be able to repay the borrowed funds (with interest) on schedule. Ultimately, interaction among the borrower, lenders, and rating agencies is what determines the amount and composition of combined firms' capital structure.

For purposes of model building, the appropriate financing structure can be estimated by selecting that structure which satisfies certain predetermined selection criteria. These selection criteria should be determined as part of the process of developing the acquisition plan (see Chapter 4). For a public company, the appropriate capital structure could be that scenario whose debt-to-equity ratio results in the highest net present value for cash flows generated by the combined businesses, the least near-term EPS dilution, no violation of loan covenants, and no significant increase in borrowing costs. Excluding EPS considerations, private companies could determine the appropriate capital structure in the same manner.

Table 9.8 displays the consolidated financial statements for Alanco and StarTrak, including the effects of synergy and financing. The addendum provides selected loan covenants and the projected performance of the combined firms with respect to these covenants and in terms of earnings per share. The pro formas suggest that the acquisition can be financed without any deterioration in earnings per share, violation of existing loan covenants, deterioration in liquidity, or increase in interest expense.

Table 9.8. Combined Firms' Financing Capacity

^* In millions of dollars.

Addendum:

Selected Loan Covenants.

Long-Term Debt / Equity ≤ 0.75.

Interest Coverage Ratio (EBIT/Interest Expense) ≥ 2.5.

Current Ratio (Current Assets / Current Liabilities) ≥ 1.25.

Using financial models in support of M&A negotiations

The acquirer's initial offer generally is at the lowest point in the range between the minimum and maximum prices consistent with the acquirer's perception of what constitutes an acceptable price to the target firm. If the target's financial performance is remarkable, the target firm will command a high premium and the final purchase price will be close to the maximum price. Moreover, the acquirer may make a bid close to the maximum price to preempt other potential acquirers from having sufficient time to submit competing offers. However, in practice, hubris on the part of the acquirer's management or an auction environment may push the final negotiated purchase price to or even above the maximum economic value of the firm. Under any circumstance, increasing the offer price involves trade-offs.

The value of the offer price simulation model is that it enables the acquirer to see trade-offs between changes in the offer price and postacquisition EPS. EPS is widely used by acquirers whose shares are publicly traded as a measure of the acceptability of an acquisition. Even a short-term reduction in EPS may dissuade some CEOs from pursuing a target firm.15

The acquiring firm may vary the offer price by changing the amount of net synergy shared with the target firm's shareholders. Increases in the offer price affect the postacquisition EPS for a given set of assumptions about the deal's terms and conditions and firm-specific data. Terms and conditions include the cash and stock portion of the purchase price. Firm-specific data include the preacquisition share prices, the number of common shares outstanding for the acquirer and target firms, and the present value of anticipated net synergy, as well as the postacquisition projected net income available for common equity of the combined firms. Note that alternative performance measures, such as cash flow per share, can be used in place of EPS.

Table 9.9 illustrates alternative scenarios for postacquisition earnings per share generated by varying the amount of synergy shared with the target firm's shareholders based on a 75% equity/25% cash offer price. The composition reflects what the acquirer believes will best meet both the target's and its own objectives. The table shows the trade-off between increasing the offer price for a given postacquisition projection of net income and EPS. The relatively small reduction in EPS in each year as the offer price increases reflects the relatively small number of new shares the acquirer has to issue to acquire the target's shares. The data in the table reflects the resulting minimum, maximum, and initial offer price, assuming that the acquirer is willing to give up 30% of projected synergy. At that level of synergy sharing, the equity of the new firm will be 95% owned by the acquirer's current shareholders, with the remainder owned by the target firm's shareholders.

Table 9.9. Offer Price Simulation Model

Note: This model is available on the companion site in an Excel worksheet entitled “Offer Price Simulation Model.”

^* In millions of dollars.

See Case Study 9.1 for an application of the offer price simulation model to Cleveland Cliffs' 2008 takeover attempt of Alpha Natural Resources Corporation. Readers are encouraged to examine the formulas underlying the Excel-Based Offer-Price Simulation Model on the companion site and to apply the model to an actual or potential transaction of their choosing. Note that the offer price simulation model in Table 9.9 is embedded in Step 3 of the worksheets entitled “Excel-Based Merger and Acquisition Valuation and Structuring Model” on the companion site.

Alternative applications of M&A financial models

The modeling process outlined in this chapter can also be applied when the acquirer or the target is part of a larger organization or to value the assets contributed to a joint venture or business alliance.

When the Acquirer or the Target Is Part of a Larger Legal Entity

The acquirer or the target may be a wholly-owned subsidiary, an operating division, a business segment, or product line of a parent corporation. When this is the case, it should be treated as a stand-alone business (i.e., one whose financial statements reflect all the costs of running the business and all the revenues generated by the business). This is the methodology suggested for Step 1 in the modeling process outlined in this chapter (refer to Exhibit 9.1).

Wholly-owned subsidiaries differ from operating divisions, business segments, and product lines in that they are units whose stock is entirely owned by the parent firm. Operating divisions, business segments, or product lines may or may not have detailed income, balance sheet, and cash-flow statements for financial reporting purposes. The parent's management may simply collect data sufficient for tracking the unit's performance. For example, such operations may be viewed as “cost centers,” responsible for controlling their own costs. Consequently, detailed costs may be reported, with little detail for assets and liabilities associated with the operation. This is especially true for product lines, which often share resources (e.g., manufacturing plants, shipping facilities, accounting and human resource departments) with other product lines and businesses. The solution is to allocate a portion of the cost associated with each resource shared by the business to the business' income statement and estimate the percentage of each asset and liability associated with the business to create a balance sheet.

As an operating unit within a larger company, administrative costs such as legal, tax, audit, benefits, and treasury may be heavily subsidized or even provided without charge to the subsidiary. Alternatively, these services may be charged to the subsidiary as part of an allocation equal to a specific percentage of the subsidiary's sales or cost of sales. If these expenses are accounted for as part of an allocation methodology, they may substantially overstate the actual cost of purchasing these services from outside parties. Such allocations are often ways for the parent to account for expenses incurred at the level of the corporate headquarters but have little to do with the actual operation of the subsidiary. Such activities may include the expense associated with maintaining the corporation's headquarters building and airplanes.

If the cost of administrative support services is provided for free or heavily subsidized by the parent, the subsidiary's reported profits should be reduced by the actual cost of providing these services. If the cost of such services is measured using some largely arbitrary allocation methodology, the subsidiary's reported profits may be increased by the difference between the allocated expense and the actual cost of providing the services.

When the target is an operating unit of another firm, it is common for its reported revenue to reflect sales to other operating units of the parent firm. Unless the parent firm contractually commits as part of the divestiture process to continue to buy from the divested operation, such revenue may evaporate as the parent firm satisfies its requirements from other suppliers. Moreover, intercompany revenue may be overstated because the prices paid for the target's output reflect artificially high internal transfer prices (i.e., the price products are sold by one business to another in the same corporation) rather than market prices. The parent firm may not be willing to continue to pay the inflated transfer prices following the divestiture.

If the unit, whose financials have been adjusted, is viewed by the parent firm as the acquirer, use its financials (not the parent's) as the acquirer in the computer model. Then proceed with Steps 1 through 4 of the model-building process described earlier in this chapter. You may wish to eliminate the earnings per share lines in the model. Similar adjustments are made for targets that are part of larger organizations.

Joint Ventures and Business Alliances

For alliances and joint ventures, the process is very much the same. The businesses or assets contributed by the partners to a joint venture (JV) should be valued on a stand-alone basis. For consistency with the model presented in this chapter, one of the partners may be viewed as the acquirer and the other as the target. Their financials are adjusted so that they are viewed on a stand-alone basis. Steps 1 and 2 enable the determination of the combined value of the JV and Step 4 incorporates the financing requirements for the combined operations. Step 3 is superfluous, as actual ownership of the partnership or JV depends on the agreed-on (by the partners) relative value of the assets or businesses contributed by each partner and the extent to which these assets and businesses contribute to creating synergy.

Some things to remember

Financial modeling in the context of M&As facilitates the process of valuation, deal structuring, and selecting the appropriate financial structure. The methodology developed in this chapter also may be applied to operating subsidiaries and product lines of larger organizations as well as joint ventures and partnerships. The process outlined in this chapter entails a four-step procedure.

1. Value the acquirer and target firms as stand-alone businesses. All costs and revenues associated with each business should be included in the valuation. Multiple valuation methods should be used and the results averaged to increase confidence in the accuracy of the estimated value.

2. Value the combined financial statements of the acquirer and target companies including the effects of anticipated synergy. Ensure that all costs likely to be incurred in realizing synergy are included in the calculation of net synergy.

3. Determine the initial offer price for the target firm. For stock purchases, define the minimum and maximum offer price range where the potential for synergy exists as follows:

where PV _T and MV _T are the economic value of the target as a stand-alone company and the market value of the target, respectively. PV_NS is the present value of net synergy, and P_OP is the initial offer price for the target. For asset purchases, the minimum price is the liquidation value of acquired net assets (i.e., acquired assets – acquired/assumed liabilities).

4. Determine the combined companies' ability to finance the transaction. The appropriate capital structure of the combined businesses is that which enables the acquirer to meet or exceed its required financial returns, satisfies the seller's price expectations, does not significantly raise borrowing costs, and does not violate significant financial constraints (e.g., loan covenants and prevailing industry average debt service ratios).

Discussion Questions

9.1 Why are financial modeling techniques used in analyzing M&As?

9.2 Give examples of the limitations of financial data used in the valuation process.

9.3 Why is it important to analyze historical data on the target company as part of the valuation process?

9.4 Explain the process of normalizing historical data and why it should be done before the valuation process is undertaken.

9.5 What are common-size financial statements, and how are they used to analyze a target firm?

9.6 Why should a target company be valued as a stand-alone business? Give examples of the types of adjustments that might have to be made if the target is part of a larger company.

9.7 Define the minimum and maximum purchase price range for a target company.

9.8 What are the differences between the final negotiated price, total consideration, total purchase price, and net purchase price?

9.9 Can the offer price ever exceed the maximum purchase price? If yes, why? If no, why not?

9.10 Why is it important to clearly state assumptions underlying a valuation?

9.11 Assume two firms have little geographic overlap in terms of sales and facilities. If they were to merge, how might this affect the potential for synergy?

9.12 Dow Chemical, a leading manufacturer of chemicals, announced in 2008 that it had an agreement to acquire competitor Rhom and Haas. Dow expected to broaden its current product offering by offering the higher-margin Rohm and Haas products. What would you identify as possible synergies between these two businesses? In what ways could the combination of these two firms erode combined cash flows?

9.13 Dow Chemical's acquisition of Rhom and Haas included a 74% premium over the firm's preannouncement share price. What is the probable process Dow employed in determining the stunning magnitude of this premium?

9.14 For most transactions, the full impact of net synergy will not be realized for many months. Why? What factors could account for the delay?

9.15 How does the presence of management options and convertible securities affect the calculation of the offer price for the target firm?

Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.

Practice Problems and Answers

9.16 Acquiring Company is considering the acquisition of Target Company in a share-for-share transaction in which Target Company would receive $50.00 for each share of its common stock. Acquiring Company does not expect any change in its P/E multiple after the merger.

	Acquiring Co.	Target Co.
Earnings available for common stock	$150,000	$30,000
Number of shares of common stock outstanding	60,000	20,000
Market price per share	$60.00	$40.00

Using the preceding information about these two firms and showing your work, calculate the following:

9.17 Acquiring Company is considering buying Target Company. Target Company is a small biotechnology firm that develops products licensed to the major pharmaceutical firms. Development costs are expected to generate negative cash flows during the first two years of the forecast period of $(10) million and $(5) million, respectively. Licensing fees are expected to generate positive cash flows during years 3 through 5 of the forecast period of $5 million, $10 million, and $15 million, respectively. Because of the emergence of competitive products, cash flow is expected to grow at a modest 5% annually after the fifth year. The discount rate for the first five years is estimated to be 20% and then to drop to the industry average rate of 10% beyond the fifth year. Also, the present value of the estimated net synergy by combining Acquiring and Target companies is $30 million. Calculate the minimum and maximum purchase prices for Target Company. Show your work.Answer: Minimum price: $128.5 million; maximum price: $158.5 million.

9.18 Using the Excel-Based Offer Price Simulation Model (see Table 9.9) on the companion site, what would the initial offer price be if the amount of synergy shared with the target firm's 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?

Answers to these Practice Problems are available in the Online Instructor's Manual for instructors using this book.

Chapter business cases

Case Study 9.1

Cleveland Cliffs Fails to Complete Takeover of Alpha Natural Resources in a Commodity Play

In an effort to exploit the long-term upward trend in commodity prices, Cleveland Cliffs, an iron ore mining company, failed in its attempt to acquire Alpha Natural Resources, a metallurgical coal mining firm, in late 2008 for a combination of cash and stock. In a joint press release on November 19, 2008, the firms announced that their merger agreement had been terminated due to adverse “macroeconomic conditions” at that time. Nevertheless, the transaction illustrates how a simple simulation model can be used to investigate the impact of alternative offer prices on postacquisition earnings per share.

When first announced in mid-2008, the deal was valued at about $10 billion. Alpha shareholders would receive total consideration of $131.42 per share, an approximate 46% premium over the firm's preannouncement share price. The new firm was to be renamed Cliffs Natural Resources and would have become one of the largest U.S. diversified mining and natural resources firms. The additional scale of operations, purchasing economies, and elimination of redundant overhead were expected to generate about $290 million in cost savings annually. The cash and equity portions of the offer price were 17.4% and 82.6%, respectively. See Table 9.10. The present value of anticipated synergy discounted in perpetuity at Cliff's estimated cost of capital of 11% was about $2.65 billion. Posttransaction net income projections were derived from Wall Street estimates.

Table 9.10. Cleveland-Cliffs' Attempted Acquisition of Alpha Natural Resources: Offer Price Simulation Model

^* In millions of dollars.

Discussion Questions

1. Purchase price premiums contain a synergy premium and a control premium. The control premium represents the amount an acquirer is willing to pay for the right to direct the operations of the target firm. Assume that Cliffs would not have been justified in paying a control premium for acquiring Alpha. Consequently, the Cliffs's offer price should have reflected only a premium for synergy. According to Table 9.10, did Cliffs overpay for Alpha? Explain your answer.

2. Based on the information in Table 9.10 and the initial offer price of $10 billion, did this transaction implicitly include a control premium? How much? In what way could the implied control premium have simply reflected Cliffs potentially overpaying for the business? Explain your answer.

3. The difference in postacquisition EPS between an offer price in which Cliffs shared 100% of synergy and one in which it would share only 10% of synergy is about 22% (i.e., $3.72 ÷ $3.04 in 2008). To what do you attribute this substantial difference?

Answers to these questions are found in the Online Instructor's Manual Available to instructors using this book.

Case Study 9.2

Mars Buys Wrigley in One Sweet Deal

Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley Corporation, a U.S. based leader in gum and confectionery products, faced increasing competition from Cadbury Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation.

On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23 billion in cash. Under the terms of the agreement, which were unanimously approved by the boards of the two firms, shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding, a 28% premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would have a 14.4% share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees worldwide. The merger of the two firms that were family controlled represents a strategic blow to competitor Cadbury Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate business. Prior to the announcement, Cadbury had a 10% worldwide market share.

As of the September 28, 2008 closing date, Wrigley became a separate stand-alone subsidiary of Mars, with $5.4 billion in sales. The deal is expected to help Wrigley augment its sales, marketing, and distribution capabilities. To provide more focus to Mars's brands in an effort to stimulate growth, Mars would in time transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley Jr., who controls 37% of the firm's outstanding shares, remained the executive chairman of Wrigley. The Wrigley management team also remained in place after the closing.

The combined companies would have substantial brand recognition and product diversity in six growth categories: chocolate, not chocolate confectionary, gum, food, drinks, and pet care products. While there is little product overlap between the two firms, there is considerable geographic overlap. Mars is located in 100 countries, while Wrigley relies heavily on independent distributors in its growing international distribution network. Furthermore, the two firms have extensive sales forces, often covering the same set of customers.

While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of transactions of this type. Almost 90% of the purchase price would be financed through borrowed funds, with the remainder financed largely by a third-party equity investor. Mars's upfront costs would consist of paying for closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors, such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing $2.1 billion in equity financing for a 9.1% ownership stake in Wrigley.

Appendix A

Utilizing the M&A Model on the Companion Site to This Book

The spreadsheet model on the companion site follows the four-step model-building process discussed in this chapter. Each worksheet is identified by a self-explanatory title and an acronym or “short name” used in developing the worksheet linkages. Appendices A and B at the end of the Excel spreadsheets include the projected timeline, milestones, and individual(s) responsible for each activity required to complete the transaction. See Table 9.11 for a brief description of the purpose of each worksheet.

Table 9.11. Model Structure

Step	Worksheet Title	Objective (Tab Short Name)
1	Determine Acquirer and Target Stand-Alone Valuation	Identify assumptions and estimate preacquisition value of stand-alone strategies
1	Acquirer 5-Year Forecast and Stand-Alone Valuation	Provides stand-alone valuation (BP_App_B1)
1	Acquirer Historical Data and Financial Ratios	Provides consistency check between projected and historical data (BP_App_B2)
1	Acquirer Debt Repayment Schedules	Estimate firm's preacquisition debt (BP_App_B3)
1	Acquirer Cost of Equity and Capital Calculation	Displays assumptions (BP_App_B4)
1	Target 5-Year Forecast and Stand-Alone Valuation	See above (AP_App_B1)
1	Target Historical Data and Financial Ratios	See above (AP_App_B2)
1	Target Debt Repayment Schedules	See above (AP_App_B3)
1	Target Cost of Equity and Capital Calculation	See above (AP_App_B4)
2	Value Combined Acquirer and Target Including Synergy	Identify assumptions and estimate postacquisition value
2	Combined Firm's 5-Year Forecast and Valuation	Provides valuation (AP_App_C)
2	Synergy Estimation	Displays assumptions underlying estimates (AP_App_D)
3	Determine Initial Offer Price for Target Firm	Estimate negotiating price range
3	Offer Price Determination	Estimate minimum and maximum offer prices (AP_App_E)
3	Alternative Valuation Summaries	Displays alternative valuation methodologies employed (AP_App_F)
4	Determine Combined Firm's Ability to Finance Transaction	Reality check (AP_App_G)
Appendix A: Acquisition Timeline	Provides key activities schedule (AP_App_A1)
Appendix B: Summary Milestones and Responsible Individuals	Benchmarks performance to timeline (AP_App_A2)

Each worksheet follows the same layout: the assumptions listed in the top panel, historical data in the lower left panel, and forecast period data in the lower right panel. In place of existing historical data, fill in the data for the firm you wish to analyze in cells not containing formulas. Do not delete existing formulas in the sections marked “historical period” or “forecast period” unless you wish to customize the model. To replace existing data in the forecast period panel, change the forecast assumptions at the top of the spreadsheet.

A number of the worksheets use Excel's “iteration” calculation option. This option may have to be turned on for the worksheets to operate correctly, particularly due to the inherent circularity in these models. For example, the change in cash and investments affects interest income, which in turn, affects net income and the change in cash and investments. If the program gives you a “circular reference” warning, please go to Tools, Options, and Calculation and turn on the iteration feature. One hundred iterations usually are enough to solve any “circular reference,” but the number may vary with different versions of Excel.

Individual simulations may be made most efficiently by making relatively small incremental changes to a few key assumptions underlying the model. Key variables include sales growth rates, the cost of sales as a percent of sales, cash-flow growth rates during the terminal period, and the discount rate applied during the annual forecast period and the terminal period. Changes should be made to only one variable at a time.

Appendix B

M&A Model Balance Sheet Adjustment Mechanism

Projecting each line item of the balance sheet as a percent of sales does not ensure that the projected balance sheet will balance. Financial analysts commonly “plug” into financial models an adjustment equal to the difference between assets and liabilities plus shareholders' equity. While this may make sense for one-year budget forecasting, it becomes very cumbersome in multiyear projections. Moreover, it becomes very time consuming to run multiple scenarios based on different sets of assumptions. By forcing the model to automatically balance, these problems can be eliminated. While practical, this automatic adjustment mechanism rests on the simplistic notion that a firm will borrow if cash flow is negative and add to cash balances if cash flow is positive. This assumption ignores other options available to the firm, such as using excess cash flow to reduceoutstanding debt, repurchase stock, or pay dividends.

The balance-sheet adjustment methodology illustrated in Table 9.12 requires that the analyst separate the current assets into operating and nonoperating assets. Operating assets include minimum operating cash balances and other operating assets (e.g., receivables, inventories, and assets such as prepaid items). Current nonoperating assets are investments (i.e., cash generated in excess of minimum operating balances invested in short-term marketable securities). The firm issues new debt whenever cash outflows exceed cash inflows. Investments increase whenever cash outflows are less than cash inflows. For example, if net fixed assets (NFA) were the only balance sheet item that grew from one period to the next, new debt issued (ND) would increase by an amount equal tothe increase in net fixed assets. In contrast, if current liabilities were the only balance sheet entry to rise from one period to the next, nonoperating investments (I) would increase by an amount equal to the increase in current liabilities. In either example, the balance sheet will automatically balance.

Table 9.12. Model Balance Sheet Adjustment Mechanism

Assets	Liabilities
Current Operating Assets Cash Needed for Operations (C) Other Current Assets (OCA) Total Current Operating Assets (TCOA)	Current Liabilities (CL) Other Liabilities (OL)
Short-Term (Nonoperating) Investments (I)	Long-Term Debt (LTD) Existing Debt (ED) New Debt (ND)
Net Fixed Assets (NFA) Other Assets (OA) Total Assets (TA)	Total Liabilities (TL) Shareholders' Equity (SE)

Cash Outflows Exceed Cash Inflows:

– If (TA – I) > (TL – ND) + SE, the firm must borrow.

Cash Outflows Are Less Than Cash Inflows:

– If (TA – I) < (TL − ND) + SE, the firm's nonoperating investments increase.

Cash Outflows Equal Cash Inflows:

– If (TA – I) = (TL – ND) + SE, there is no change in borrowing or nonoperating investments.

The Microsoft Excel formulae that underlie the model's adjustment mechanism correspond to conditional or “if, then” instructions. If in a given year, the firm is borrowing (i.e., new debt is positive), the investment row in the model's Step 1 worksheet is zero for that year. The amount of new debt would equal the difference between total assets less short-term nonoperating investments and total liabilities less new debt plus shareholders' equity. If in a given year, the firm is not borrowing (i.e., new debt is zero), the investment row in the model's Step 1 worksheet is positive. The amount of short-term nonoperating investment would be equal to the difference between total liabilities less new debt plus shareholders' equity and total assets less short-term nonoperating investment. The same logic applies to the balancing mechanism for the Step 2 and Step 4 worksheets.

¹ Richtel, 2008

² For more advanced discussions on financial modeling, see Mun (2006).

³ Reilly, David, “Convergence Flaws,” Presentation to the American Accounting Association, Tampa, Florida, January 29, 2011.

⁴ For a more detailed discussion of these issues, see Sherman and Young (2001).

⁵ Even if it is not possible to collect sufficient data to undertake cross-sectional and multiperiod comparisons of both the target firm and its direct competitors, constructing common-size statements for the target firm only provides useful insights. Abnormally large increases or decreases in these ratios from one period to the next highlight the need for further examination to explain why these fluctuations occurred. If it is determined that they are one-time events, these fluctuations may be eliminated by averaging the data immediately preceding and following the period in which these anomalies occurred. The anomalous data then are replaced by the data created through this averaging process. Alternatively, anomalous data can be completely excluded from the analysis. In general, nonrecurring events affecting more than 10 percent of the net income or cash flow for a specific period should be discarded from the data to allow for a clearer picture of trends and relationships in the firm's historical financial data.

⁶ Industry average data commonly is found in such publications as The Almanac of Business and Industrial Financial Ratios (Prentice Hall), Annual Statement Studies (Robert Morris Associates), Dun's Review (Dun and Bradstreet), Industry Norms and Key Business Ratios (Dun and Bradstreet), and Value Line Investment Survey for Company and Industry Ratios (Value Line).

⁷ Revenue projections are commonly based on trend extrapolation, which entails extending present trends into the future using historical growth rates or multiple regression techniques. Another common forecasting method is to use scenario analysis. Cash flows under multiple scenarios are projected, with each differing in terms of key variables (e.g., growth in gross domestic product, industry sales growth, fluctuations in exchange rates) or issues (e.g., competitive new product introductions, new technologies, and new regulations).

⁸ Alternatively, the present value of net synergy can be estimated by calculating the present value of the difference between the cash flows from sources and destroyers of value.

⁹ Christofferson, McNish, and Sias, 2004

¹⁰ The incremental borrowing capacity can be approximated by comparing the combined firms' current debt-to-total capital ratio with the industry average. For example, assume Firm A's acquisition of Firm B results in a reduction in the combined firms' debt-to-total capital ratio to 0.25 (e.g., debt represents $250 million of the new firm's total capital of $1 billion). If the same ratio for the industry is 0.5, the new firm may be able to increase its borrowing by $250 million to raise its debt-to-total capital ratio to the industry average. Such incremental borrowing often is used to finance a portion of the purchase price paid for the target firm. See Chapter 13 for a more rigorous discussion of how to estimate incremental borrowing capacity.

¹¹ In the 1980s, a major producer of asbestos, Johns Manville Corporation, was forced into bankruptcy because of the discovery that certain types of asbestos, which had been used for decades for insulating buildings, could be toxic. When China's Lenovo Group acquired IBM's PC business in 2005, it disclosed that high warranty costs attributable to a single problem component contributed significantly to the IBM PC business net losses in 2002 and 2003 of $171 million and $258 million, respectively.

¹² How a company treats its employees during layoffs has a significant impact on the morale of those who remain. Furthermore, if it is widely perceived that if a firm treats laid-off employees fairly, it will be able to recruit new employees more easily in the future. Consequently, severance packages should be as equitable as possible.

¹³ Note that the maximum price may be overstated if the current market value of the target firm reflects investor expectations of an impending takeover. As such, the current market value may already reflect some portion of future synergies. Consequently, simply adding the present value of net synergy to the current market value of the target firm can result in double-counting some portion of future synergy.

¹⁴ Note that “out-of-the-money” options (i.e., those whose exercise or conversion price exceeds the firm's current shares price) often are exercisable if the firm faces a change of control.

¹⁵ As noted in Chapter 8, studies suggest that cash flows and earnings are highly positively correlated with stock returns over long periods such as five-year intervals. However, for shorter time periods, earnings show a stronger correlation with stock returns than cash flows.