Mergers, Acquisitions, & Other Restructuring

Activities: Developing Business and Acquisition

Plans
Sessions 7 & 8
Hardeep Singh Mundi
Finance Area
IMT Ghaziabad

Term III, 2022-24

 The Acquisition Process
• Pre-Purchase Decision Activities • Phase 1: Business Plan
• Phase 2: Acquisition Plan
• Phase 3: Search
• Phase 4: Screen
• Phase 5: First Contact
• Post-Purchase Decision Activities • Phase 6: Negotiation
• Phase 7: Integration Plan
• Phase 8: Closing
• Phase 9: Integration
• Phase 10: Evaluation

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 Phase 1: Business Plan
• Industry/market definition (Where have we chosen to compete?)

Example: Automotive industry (a collection of markets)

• Passenger car market by size and by geographic area
• Truck market by size and geographic area
• After-market

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 Hypothetical Amazon.com SWOT Matrix
Opportunity: To be perceived by internet users as Threat: Walmart’s, BestBuy’s, and Costco’s
the preferred online “retail department store” increasing presence on the internet

Relative to the opportunity: Relative to the threat:

Amazon.com’s • Brand recognition • Extensive experience in online
• Convenient online order entry marketing, advertising, and
Strengths system fulfillment
• Information technology
infrastructure
• Fulfillment infrastructure for
selected products (e.g., books)

Relative to the opportunity: Relative to the threat:

Amazon.com’s • Inadequate warehousing and • Substantially smaller retail sales
inventory management systems to volume limits ability to exploit
Weaknesses support quantum sales growth purchase economies
• Limited experience in • Limited financial resources
merchandising non-core retail • Limited name recognition in
products (e.g., electronics) selected markets (e.g., consumer
• Limited financial resources electronics)
• Lack of retail management depth

Solo venture Solo venture

Strategic Options Partner Partner
Acquire Acquire
Exit business

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 Phase 2: Acquisition Plan (How to implement
the acquisition)
• Plan objectives (support the realization of key business plan
objectives)
• How will the acquired firm enable the acquiring firm to better realize its
vision/mission and business plan objectives?

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 Examples of Linkages Between Business and Acquisition Plan Objectives
Business Plan Objective Acquisition Plan Objective
Financial: The firm will Financial returns: The target firm should have
Achieve rates of return that will equal or exceed its cost of A minimum return on assets of x%
equity or capital by 20?? A debt/total capital ratio  y%
Maintain a debt/total capital ratio of x% Unencumbered assets of $z million

Size: The firm will Size: The target firm should be at least $x million in revenue
Be the number one or two market share leader by 20??
Achieve revenue of $x million by 20??

Growth: The firm will achieve through 20?? annual average Growth: The target firm should
Revenue growth of x% Have annual revenue, earnings, and operating cash-flow
Earnings per share growth of y% growth of at least x%, y%, an z%
Operating cash-flow growth of z% Provide new products and entry into new markets resulting
in $z by 20??
Possess excess annual production capacity of x million units

Diversification: The firm will reduce earnings variability Diversification: The target firm’s earnings should be largely
by x%. uncorrelated with the acquirer’s earnings.

Flexibility : Achieve flexibility in manufacturing and design. Flexibility: Target should use flexible manufacturing
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techniques.
 Phase 3: Initiating the Search
• Two step procedure:
• Establish primary selection criteria (e.g., industry and maximum size of
transaction)
• Develop search strategy to identify potential targets using computerized
databases; directory services; legal, banking, and accounting firms; and the
Internet.
• Brokers and finders:
• A broker has a fiduciary responsibility to either the seller or buyer.
• A finder introduces both parties without representing either party.
• Everything is negotiable. Fee structures are normally negotiated and may
include a basic fee, a closing fee, and an “extraordinary” fee (i.e., fees paid if
closing delayed due to obtaining antitrust approval, a hostile takeover, etc.)
• Put everything in writing

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 Phase 4: The Screening Process
• As a refinement of the search process, screening involves increasing the number
of selection criteria to reduce the list of potential candidates.
• In addition to the industry and maximum size of transaction used in the search
process, additional criteria could include:
• Targeted market segment
• Product line
• Profitability
• Degree of leverage
• Market share
• Cultural compatibility (e.g., AOL/Time Warner)

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 Phase 5: First Contact
• The appropriate approach strategy depends on
• Size of target
• Whether target is publicly or privately held
• Acquirer’s timeframe for completing transaction
• Trust and relationship building when time is not critical
• Discussing value
• Preliminary legal documents:
• Confidentiality agreements
• Term sheets (price range/formula, form of acquisition, extent of due diligence, no-
shop provision))
• Letter of intent (price range/formula, form of acquisition, form of payment, non-
competes, employee contracts, no-shop provision)

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 Phase 6: Viewing Negotiation as a Process
If No,
Walk
Away1
Perform Due Diligence
Profiling
Target First
Market & Contact
Firm Structuring the Deal
Form of Acquisition
Form of Payment Develop Decision:
If Yes, Refine Financing Proceed to
Tax Considerations
Initiate Initial Plan/ Closing or
Accounting Considerations
Negotiations Valuation Structure Walk Away
Acquisition Vehicle
Post-Closing Organization
Legal Form of Selling Entity

Negotiation Process

1Alternatively, the potential buyer could adopt a more hostile approach

12-02-2023 PGDMsuch as III,
Term initiating
2023 a tender offer to achieve a majority stake in the target firm. 10
Determining the Purchase Price for the Target Firm
• Total consideration (TC):
PVTC = C+ PVS+ PVND
Where C = cash; PVS = market value of acquirer stock; and PVND = market value of acquirer
debt issued to seller, respectively.
Composition of purchase/offer price
• Total purchase price (TPP) or enterprise value (EV):
PVTPP = PVTC+ PVAD
Where PVTPP = PV of total purchase price; PVTC = PV of total consideration; PVAD = PV of
assumed Target debt, respectively.
Purchase/offer price plus long-term assumed liabilities
• Net purchase price (NPP):
PVNPP = PVTPP+ PVOAL- PVDA
= (C+ PVS+ PVND+ PVAD) + PVOAL- PVDA
Where PVOAL = other assumed Target liabilities and PVDA = PV of discretionary (non-critical)
assets,1 respectively.
Actual cash cost of acquisition
1Assets not critical to the ongoing operation of the combined businesses can be sold to finance the purchase price.

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 Phase 7: Viewing Negotiation as a Process
• Use due diligence to determine post-closing sequencing of events necessary to realize
potential savings and revenue enhancements
• Resolve contract-related transition issues in purchase agreement
• Employee payroll and benefit claims processing
• Seller reimbursement for products shipped before closing for which payment not
received
• Buyer reimbursement for vendor supplies/services received before closing for which
payment had not yet been made
• Ensure contract closing conditions include those necessary to facilitate integration (e.g.,
employee contracts, agreements not to compete)
• Develop post-merger integration organization consisting of both target and acquirer
managers to
• Build a master schedule of what should be done, by whom and by what date
• Establish work teams to determine how each function and business unit will be
combined
• Establish post-closing communication
12-02-2023 strategy
PGDM Term III, 2023 for all stakeholders 12
 Phase 8: Closing
• Obtain all necessary consents:
• Shareholder
• Regulatory (e.g., state and federal)
• Third party (e.g., customer, lender, and vendor)
• Complete definitive agreement
• Purchase price
• Allocation of purchase price
• Assumption of liabilities
• Representations and warranties (“reps” and “warranties”)
• Covenants
• Closing conditions
• Indemnification (reimbursement for actions of the other party)
• Loan documents
• Etc.
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 Phase 9: Implementing Post-Closing
Integration
• Communication plans (e.g., consistent and continuous)
• Employee retention (e.g., retention bonuses)
• Employing best practices (e.g., competitor or similar business)
• Cultural issues (e.g. joint work teams, co-location of acquirer and
target employees)

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 Phase 10: Conducting Post-Closing Evaluation
• Don’t change performance benchmarks

• Ask the difficult questions

• Learn from mistakes

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 Primer on Cash Flow Valuation

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 Required Returns: Cost of Equity (ke)
Capital Asset Pricing Model (adjusted for firm size):
ke = Rf + ß(Rm – Rf) + FSP

Where Rf = risk free rate of return

ß = beta (systematic/non-diversifiable risk)
Rm = expected rate of return on equities
Rm – Rf = 5.5% (i.e., equity risk premium historical average since
1963)
FSP = firm size premium

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 Estimates of Size Premium
Market Value (000,000) Percentage Points Added to
CAPM Estimate

>$21,589 0.0
$7,150 to $21,589 1.3
2.4
$2,933 to $7,150 3.3
$1,556 to $2,933 4.4
$687 to $1,556 5.2
$111 to $687 7.2

<$111

Source: Adapted from estimates provided by Duff & Phelps, LLC.

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 Analyzing Risk
• Risk consists of a non-systematic/diversifiable and systematic/non-diversifiable
component
• Beta (ß) is a measure of non-diversifiable risk
• Beta quantifies a stock’s volatility relative to the overall market
• Beta is impacted by the following factors:
• Degree of industry cyclicality
• Operating leverage refers to the composition of a firm’s cost structure (fixed plus
variable costs)
• Financial leverage refers to the composition of a firm’s capital structure (debt +
equity)
• Firms with high ratios of fixed to total costs and debt to total capital tend to display high
volatility and betas
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 Impact of Operating Leverage1 on Pretax Profits
Revenue – Fixed Costs – Variable Costs = Pretax Profits2 Comment
$250 $50 $125 $75 25% Revenue Increase Results in 50% Pretax
Profit Rise
$200 $50 $100 $50 33% Revenue Increase Doubles Pretax Profit

$150 $50 $75 $25

$100 $50 $50 $0 Breakeven

$50 $50 $25 $(25) Continue Operation

$0 $50 $0 $(50) Shutdown Operations

Key Points: 1. Once revenue exceeds fixed costs, increases in revenue result in more than proportional increases in profits
2. A firm should operate at a loss as long as revenue ≥ variable costs.

1Ameasure of the impact on profit once revenue exceeds fixed costs.

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2Assumes variable costs equal one-half of revenue.
 How Operating Leverage Affects Financial Returns1
Case 1 Case 2: Revenue Increases by Case 3: Revenue Decreases by
25% 25%

Revenue 100 125 75

Fixed 48 48 48
Variable2 32 40 24
Total Cost of Sales 80 88 72

Earnings Before Taxes3 20 37 3

Tax Liability @ 40% 8 14.8 1.2
After-Tax Earnings 12 22.2 1.8
Firm Equity 100 100 100

Return on Equity (%) 12 22.2 1.8

1Allfigures are in millions of dollars unless otherwise noted.
2In Case 1, variable costs represent 32% of revenue. Assuming this relationship is maintained, variable costs in Cases 2 and 3 are

estimated by multiplying total revenue by .32.

3Note that (1-.32)% or 68% of the change in revenue between Case 1 and Case 2 and Case 3, respectively, directly impacts earnings

before taxes.
Key Point: High fixed to total cost ratios magnify fluctuations in financial returns. Why?
12-02-2023 Because of the large percentage of revenue PGDM
inTerm III, 2023of fixed costs that flows to pretax profits.
excess 21
 How Financial Leverage Affects Financial Returns1
Case 1: No Debt Case 2: 25% Debt to Case 3: 50% Debt to
Total Capital Total Capital
Equity 100 75 50
Debt 0 25 50
Total Capital 100 100 100
Earnings before Interest and Taxes 20 20 20

Interest @ 10% 0 2.5 5

Income before Taxes 20 17.5 15
Less income Taxes @ 40% 8 7 6
Net Income 12 10.5 9
After-Tax Return on Equity (%) 12 14 18
1All figures are in millions of dollars unless otherwise noted.
Key Point: High debt to total capital ratios magnify fluctuations in financial returns. Why?
Because equity’s share of total capital declines faster than net income as debt’s share of total capital
increases.
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 Leveraged versus Unleveraged Betas
• In the absence of debt, the ß is called the unleveraged ßu, which is impacted by the firm’s
operating leverage and the cyclicality of the industry in which the firm competes
• In the presence of debt, the ß is called the leveraged ßl, which is impacted by the firm’s operating
leverage, industry cyclicality, and financial leverage
• If a firm’s shareholders bear all the risk of operating and financial leverage and interest is tax
deductible, leveraged and unleveraged betas can be calculated as follows:
ßl = ßu (1 + (1-t) (D/E)) and ßu = ßl / (1 + (1-t) (D/E))
where t, D, and E are the tax rate, debt and equity, respectively.

Implications:
--Increasing D/E raises firm’s breakeven and increases shareholder risk that firm will be unable to
generate future cash flows sufficient to pay their minimum required returns.
--Tax deductibility of interest reduces shareholder risk by increasing after-tax cash available for
shareholders.
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 Estimating a Firm’s Beta
• Regression approach: Regress percent change in firm’s share price plus dividends against percent change in a
broadly defined stock index plus dividends for last 3-5 years.
• However, this assumes the historical relationship between risk and return will hold in the future
• If we have reason to believe this is not true, the “bottoms-up” approach may be appropriate.
• “Bottoms-up” approach: Use a sample of similar firms:1
• Step 1: Select sample of firms with similar size, cyclicality, and operating leverage (i.e., usually in the same
industry).
• Step 2: Calculate average unlevered beta for firms in the sample to eliminate the effects of their current
capital structures on their betas.
ßu = ßl / (1 + (1-t) (D/E))
• Step 3: Relever average unlevered beta using the (D/E)* ratio and marginal tax rate t*of the firm whose
levered beta (ßl*) you are trying to estimate (i.e., target firm)
ßl* = ßu (1 + (1-t*) (D/E)*)

1This assumes the firm’s future risk/reward relationship is more likely to mirror that of the average firm in the industry adjusted for
financial leverage. The “bottoms-up” approach involves the estimation of the comparable firm unlevered beta to estimate the levered
beta for the target firm.

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 Estimating Brocade Communications Systems’ Levered Beta Using the
“Bottoms-Up” Approach
Brocade’s beta estimated using historical data is .88 and its current debt-to-equity ratio is .256.
What is the firm’s estimated levered beta using the “bottoms-up” methodology?
Step 1: Select sample of firms having similar cyclicality and Step 2: Compute average Step 3: Relever average
operating leverage of firms’ unlevered betas unlevered beta using
Brocade’s debt/equity ratio

Firm Levered Beta1 Debt / Equity1 Unlevered Beta2 Brocade’s

Relevered Beta3
EMC 1.62 .301 1.37 NA
Sandisk 1.44 .285 1.23 NA
Western Digital 1.51 .273 1.30 NA
NetApp Inc. 1.83 .254 1.59 NA
Terredata 1.12 .149 1.03 NA
Average = 1.30 1.50
1Yahoo Finance (3/14/2014). Beta estimates are based on historical relationship between the firm’s share price and a broadly defined stock
index.
2ß = ßl / (1 + (1-t) (D/E)), where ßu and ßl are unlevered and levered betas; marginal tax rate is .4. For example, EMC (ßu ) = 1.62 / (1 + (1 -
u
.4).301)) = 1.37
3ß
l= ßu (1 + (1-t) (D/E)) using Brocade’s debt/equity ratio of .256 and marginal tax rate of .4, Brocade’s relevered beta = 1.30 (1 + (1 - .4).256))
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= 1.50 PGDM Term III, 2023 25
 Valuation Cash Flow
• Valuation cash flows represent actual cash flows available to reward both
shareholders and lenders
• Cash flow statements include cash inflows and outflows from:
operating,
investing, and
financing activities
• The cash flows are adjusted for non-cash inflows and outflows to calculate
valuation cash flow. Examples include the following:
• Adding depreciation back to net income
• Deducting gains from and adding losses to net income resulting from asset
sales
• Valuation cash flows include free cash flows to equity investors or equity cash
flow and free cash flows to the firm or enterprise cash flow

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