Introduction

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Part III covers alternative valuation methods and basic financial modeling techniques, as well as how such models may be applied in the merger and acquisition process. All valuation methods are subject to significant limitations, and a valuation approach reflecting a variety of the alternative methodologies is likely to provide a more accurate estimate of firm value than any single approach.

Chapter 7 provides a primer on how to construct valuation cash flows and the discount rates necessary to convert projected cash flows to a present value. Alternatives to discounted-cash-flow (DCF) methods are discussed in Chapter 8, including relative-valuation, asset-oriented, and replacement-cost techniques. Implicit in the DCF approach to valuation is that management has no flexibility once an investment decision has been made. In practice, management may decide to accelerate, delay, or abandon investments as new information becomes available. The significance of this decision-making flexibility may be reflected in the value of the target firm by adjusting discounted cash flows for the value of so-called real options.

Chapter 9 discusses how to build financial models, which 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.) Finally, Chapter 10 addresses the unique challenges of valuing privately held firms and how to adjust purchase prices for liquidity and minority discounts, as well as for the value of control.