APPLYING FINANCIAL MODELS

To Value, Structure, and Negotiate

Stock and Asset Purchases
 Tact is for people
not witty enough to be sarcastic.
--Anonymous
 Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities

Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Techniques Deal and Liquidation
Corporate Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
 Learning Objectives
• Through “hands on” application of the author’s M&A model,
provide students with a basic understanding of
– How such models work for a stock purchase and an asset
purchase;
– The data input requirements to generate critical model
output
– How to apply such models to address valuation, financing,
and deal structuring questions; and
– How they facilitate the assessment of proposals and
counterproposals that arise during the negotiation
process.
 Financial Models Help Answer Key Valuation,
Financing, and Deal Structuring Questions
• Valuation
– What are the key drivers of firm value?
– 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 acquirer should pay for the target firm?
• Financing
– Can the proposed purchase price be financed?
– What combination of potential sources of funds provides the lowest cost of
funds for the acquirer, subject to existing loan covenants?
• Deal Structuring
– What is the impact on financial performance and valuation if an acquirer is
willing to assume certain target liabilities?
– What is the impact on the acquirer’s earnings per share of alternative forms of
payment?
– What are the implications of a purchase of stock versus a purchase of assets?
– What is the distribution of ownership of the combined businesses between
acquirer and target shareholders following closing?
 Stock Versus Asset Purchase
• Stock purchases:
– Statutory or direct merger: Acquirer and Target combine with one
disappearing. Target shareholders receive cash or Acquirer stock for
their shares. All target assets and liabilities transfer to Acquirer by “rule
of law.”
– Cash-for-stock or stock-for-stock transactions: Acquirer buys Target
stock directly from Target’s shareholders. If unable to buy all Target
shares, Target becomes a partially owned Acquirer subsidiary.
• Asset Purchases
– Cash-for-assets acquisition: Acquirer pays cash for Target’s assets and
may assume responsibility for some or all of Target’s liabilities. If enough
Target assets have been acquired, the target may be liquidated.
– Stock-for-assets transaction, Target shareholders receive Acquirer stock
in exchange for the Target’s assets and assumed liabilities. In a second
stage, Target dissolves leaving its shareholders with Acquirer stock.
 M&A Model Overview

Step 1: Construct historical financials Step 2: Project target’s and acquirer’s

and determine key factors (“value financials and estimate their standalone
drivers) contributing to firm performance values1

M&A Valuation &

Structuring Model
(Summary Table)

Step 3: Estimate value of combined firms Step 4: Determine appropriateness of

(“Newco”), including synergy and deal offer price and Newco’s post-transaction
terms capital structure

1
A standalone business is one which is not part of another firm and whose cash flows reflect revenue at current market prices and costs
include all those required to generate the level of reported revenues.
 M&A Model Value Drivers

• Value drivers are variables which exert the greatest

impact on firm value and include the following:
– Revenue growth rate
– Cost of sales as a percent of sales
– S,G,&A as a percent of sales
– WACC assumed during annual cash flow growth
period (i.e., planning period)
– WACC assumed during terminal period
– Growth rate assumed during terminal period.
 M&A Model
Worksheet Flow Diagram
Valuation, EPS Impact, & Credit Ratios
Deal Payment Terms

Model Summary: Step 2:

Step 1:
Deal terms -- Input forecast
--Input Target and Step 3:
assumptions to Step 4: Determine
Form of Payment Acquirer --Estimate synergy
project Target appropriateness of
Sources/uses of funds historical --Create Newco
and Acquirer offer price and
EPS Impact financial financials
financial Newco
Projected synergy statements --Project financials
statements post-transaction
Key credit ratios --Determine key including synergy
--Estimate capital structure.
Valuation estimates value drivers & deal terms
standalone
values

Synergy Data Inputs

Capital Structure Inputs
 M&A Model Worksheets
• Model Instructions
• Summary (Includes deal terms, sources/uses of funds, synergy estimates, EPS impact, and
key credit ratios.)
• Step 1: Input historical financial data and determine key value drivers
– Target and Acquirer Assumptions (historical data used to project financial statements)
– Target and Acquirer Income Statement (historical period only)
– Target and Acquirer Balance Sheet Statements (historical period only)
– Target and Acquirer Cash Flow Statements (historical periods only)
• Step 2: Input Target and Acquirer forecast assumptions and estimate standalone values
– Target and Acquirer Assumptions (enables projections of Target and Acquirer financial statements)
– Target and Acquirer IS (Income Statement—selected line item s only)
– Target and Acquirer BS (Balance Sheet—selected line items only)
– Target and Acquirer CF (Cash Flow—selected line items only)
• Step 3: Estimate value of Newco, including synergy & deal terms
– Newco Assumptions (enables projections of combined firms financial statements)
– Newco IS (Income Statement)
– Newco BS (Balance Sheet)
– Newco CF (Cash Flow)
• Step 4: Determine appropriateness of offer price and Newco post-transaction capital
structure
– Debt Repayment (Includes repayment schedule for target debt assumed by the acquirer, the acquirer’s
pre-transaction debt), and new debt issued to finance the deal)
– Options-Convertibles (Estimates number of new target shares that must be acquired due to option conversion
and the conversion of convertible debt and preferred equity.
– Valuation (Includes the valuation of target, acquirer, and Newco enterprise value, equity value and price per
share.)
 Model Balancing Mechanism

• Financial models are in balance when total assets (TA)

equal liabilities (TL) plus shareholders’ equity (SE).
• The model balances automatically:
– If TA > TL + SE (i.e., a cash outflow), the firm borrows
through its revolving loan facility (credit line) to
finance the asset growth
– If TA < TL + SE (i.e., a cash inflow), the firm pays off
any outstanding revolving loan balance with the cash
inflow exceeding the minimum required cash
balances
 Input Versus Formula Model Cells

• Cells containing formulas are in black

• Cells highlighted in yellow are input cells
– Changes to the content of these cells will fill in
all cells containing formulas.
– When replacing pre-existing data, it is helpful
to change the color of those cells for which the
data inputs have been made.
• Red cells at the bottom of the balance sheet
worksheets should be zero indicating the model
is in balance.
 Using the M&A Model

• Step 1: Construct historical financial statements for

Acquirer and Target and determine key value drivers

• Step 2: Project Target and Acquirer financials and

determine their standalone value

• Step 3: Estimate the value of the combined firms

(“Newco), including the effects of synergy & deal terms.

• Step 4: Determine the appropriateness of the offer price

and Newco’s post-transaction capital structure.
Step 1: Construct Historical Financial Statements
and Determine Key Value Drivers

a. Collect/analyze historical financials to identify

key value drivers
b. Normalize/smooth historical data (3-to-5 years if
possible) to identify long-term trends
c. Input actual historical Target and Acquirer data
into historical input cells of income statement,
balance sheet, and cash flow statement
worksheets
 Target Historical Income Statement
Actual
2013 2014 2015
Sales $ 3,588.1 $ 3,775.7 $ 3,958.5
Cost of Goods Sold 1,482.0 1,665.7 1,664.1
Gross Profit 2,106.1 2,110.0 2,294.4
SG&A 1,023.2 1,009.0 1,054.6
Other Operating Expense 470.7 453.2 414.6
Depreciation 123.0 123.6 126.0
Amortization 299.6 313.9 302.9

EBIT 189.6 210.3 396.3

Unusual (Gain) Loss (37.2) - -
(Income) from Affiliates - -
Other Expense (Income) 60.0 10.9 11.9
Interest (Income) (4.3) (3.9) (2.4)
Interest Expense 152.3 162.1 123.9

Earnings before Taxes 18.8 41.2 262.9

Noncontrolling Interest - - -
Taxes 63.7 100.9 101.4

Net Income before Extra Items (44.9) (59.7) 161.5

Extraordinary Items 0.6 0.7 0.4

Net Income after Extra Items $ (44.3) $ (59.0) $ 161.9

 Step 2: Project Acquirer and Target
Financials and Estimate Standalone Values

a. Determine forecast assumptions for each key

input variable
1. Revenue assumption drives cash flow growth
2. Determine using historical extrapolation or
scenario “what if” analysis
b. Input forecast assumptions into the model and
project financials
c. Select appropriate discount rate and terminal
assumptions to estimate standalone values
Applying the 5-Forces Model to Project Acquirer and
Target Firm Financial Performance
• How have the following factors • How will these factors change (if
affected revenue growth and profit at all) to impact future revenue
margins in the acquirer and target growth and profit margins of these
firms’ industry historically? firms?
– Customers (size, number, – Customers (size, number,
price sensitivity) price sensitivity)
– Current competitors (market – Current competitors (market
share, differentiation) share, differentiation)
– Potential entrants (entry – Potential entrants (entry
barriers, relative costs) barriers, relative costs)
– Substitutes (availability, prices, – Substitutes (availability, prices,
switching costs) switching costs)
– Suppliers (size, number, – Suppliers (size, number,
uniqueness) uniqueness)

Key questions:
1. How might changes in the bargaining power of customers and suppliers
relative to the acquirer and target firms impact product pricing, costs, and
profit margins?
2. How might substitutes and new entrants affect product pricing and profit
margins?
 Target Assumptions Worksheet
Projections for the Period Ending
Actual December 31,

2013 2014 2015 2016 2017 2018 2019 2020

Income Statement

Sales Growth NA 18.1% 27.7% 27.0% 27.0% 27.0% 27.0% 27.0%

COGS as a % of Sales 51.3% 52.1% 46.9% 51.2% 51.2% 51.2% 51.2% 51.2%
SG&A % annual increase
(decrease) NA 16.3% 27.0% 20.0% 20.0% 20.0% 20.0% 20.0%

Other Operating Expense as

a % of Sales 8.1% 8.4% 8.8% 8.7% 8.7% 8.7% 8.7% 8.7%

EBITDA Growth NA 10.8% 90.5% 5.6% 42.8% 40.2% 38.3% 36.8%

EBITDA Margin 10.6% 9.9% 14.8% 12.3% 13.9% 15.3% 16.7% 18.0%

Key Point: Make small changes to assumptions one at a time to assess their
impact on financial statements.
 Practice Exercise 1
• Using the M&A Valuation & Deal Structuring Model
accompanying this text:
– On the Valuation worksheet, identify the enterprise and
equity value of Target and Newco.
– On the worksheet named Target Assumptions, increase
the sales growth rate by 1% (i.e., to 6.5%). What is the
impact on the Target’s and Newco’s enterprise and equity
values? (Hint: See Valuation and Summary worksheets)
– Click undo command to eliminate increase in sales growth
rate or close model but do not save results1 from Practice
Exercise 1
Key Point: Impact of assumption changes on value
observable on the Valuation and Summary Worksheets
1
This allows the model results to revert back to the “base” case and enables the model to be used in additional practice exercises.
 Practice Exercise 2
• Using the M&A Valuation & Deal Structuring Model
accompanying this text:
– On the Valuation worksheet, identify the enterprise and
equity values of Target and Newco?
– On the worksheet named Target Assumptions, increase
COGS (cost of goods sold) as a percent of sales by one
percentage point (i.e., .43 to .44). What is the impact on the
Target’s and Newco’s enterprise and equity values? (Hint:
See Valuation and Summary worksheets)
– Click undo command to eliminate increase in cost of sales
or close Model but do not save results from Practice
Exercise 2
Key Point: Changes to key driver assumptions should be small
and made one at a time to determine their impact on firm value.
Step 3: Estimate the Value of Newco,
Including Synergy

a. Estimate synergy and investment required to

realize synergy
b. Project Newco financials including effects of
synergy and deal terms
c. Select appropriate discount rate1 and terminal
period assumptions

1
The appropriate discount rate for the combined firm’s cash flows should be that associated with the Target if the
Target is large relative to the Acquirer and its cash flows are viewed as riskier than those of the Acquirer.
 Quick Quiz

Which of the following is generally not considered a source

of value to the acquiring firm?

a. Duplicate facilities
b. Patents
c. Land on the balance sheet at below market value
d. Warranty claims
e. Copyrights
 Summary Worksheet: Deal Terms
Acquirer Transaction Summary
($Millions, except per share data)

Transaction Value Form of Payment Sources & Uses

Price Per Share $ 115.0 % Stock 50.0% Excess Cash $ 2,500.0

Target Shares Common Shares Issued to

Outstanding 51.3 % Cash 50.0% Target Shareholders 3,093.8

Dilutive Effect of New Common Shares

Stock Options 2.5 Issued -
Equity Target Preannouncement Convertible Preferred
Consideration $ 6,187.7 Share Price $ 91.14 Equity 5.00% -
Implied Purchase Price Revolving Credit
Premium 26.2% Facility 4.00% -

Less: Cash $ 203.9 Shares % Senior Debt 4.50% 593.8

Less: Equity in Current Shares
Affiliates - Outstanding 475.5 77.3% Subordinated Debt 10.00% -
New Common Shares
Plus: Total Debt 9.1 Issued 139.4 22.7% Total Sources $ 6,187.7
Plus: Noncontrolling Convertible Preferred
Interests - Shares - -
Less Other
Adjustments - Convertible Debt - - Equity Consideration $ 6,187.7

Enterprise Value $ 5,992.9 New Warrants Issued - - Transaction Expenses 5 yrs. -

Total Shares 614.9 100.0% Total Uses $ 6,187.7

 Newco Assumptions Worksheet
Actual Projections

2013 2014 2015 2016 2017 2018 2019 2020

Income Statement

Sales Growth NA (0.3%) 0.3% 7.7% 3.9% 3.6% 4.0% 4.6%

COGS as a % of Sales 53.3% 53.7% 54.3% 56.1% 54.7% 53.5% 53.4% 53.4%
Integration Related Expenses
($M) 500.0 250.0

SG&A % annual increase NA 2.9% 5.8% 5.4% 5.0% 5.0% 5.1% 5.3%
Other Operating Expense as a %
of Sales - - - 0.6% 0.7% 0.9% 1.1% 1.3%

EBITDA Growth NA (10.2%) (18.6%) (12.2%) 8.4% 10.1% (1.5%) 0.1%

EBITDA Margin 14.4% 13.0% 10.6% 8.6% 9.0% 9.6% 9.1% 8.7%

Balance Sheet

Receivable Days 53.3 49.0 54.3 52.2 52.0 51.9 51.7 51.4

Inventory Days 84.6 76.5 71.0 86.9 88.3 89.9 91.8 93.9

Oth Cur Assets % of Sales 2.5% 2.4% 3.0% 2.6% 2.6% 2.5% 2.5% 2.5%

Days in Accounts Payable 33.4 37.7 45.4 41.8 42.0 42.3 42.7 43.1
 Summary Worksheet:
Newco Synergy Inputs
SG&A Synergies Gross Margin Improvement Incremental Sales Synergy

$'s % $'s Margin $'s

2016 $20.0 2016 0.12% $25.0 2016 43.9% 100.0

2017 25.0 2017 0.23% 50.0 2017 45.3% 250.0

2018 25.0 2018 0.23% 50.0 2018 46.5% 250.0

2019 25.0 2019 0.22% 50.0 2019 46.6% 250.0

2020 25.0 2020 0.21% 50.0 2020 46.6% 250.0

 Newco Income Statement Worksheet
Pro
Actual Projected 2016 Trans Forma Projections
2015 Acquirer Target Adj 2016 2017 2018 2019 2020

Sales $19,062.0 $19,347.9 $1,389.3 $100.0 $20,837.2 $21,652.5 $22,423.4 $23,327.4 $24,399.3

Integration Expenses 500.0 500.0 250.0

Cost of Goods Sold 10,354.0 10,447.9 711.3 31.1 11,690.3 11,844.7 11,994.7 12,465.7 13,022.8

Gross Profit 8,708.0 8,900.0 678.0 9,146.9 9,807.8 10,428.8 10,861.7 11,376.4

SG&A 6,693.0 6,960.7 385.7 (10.0) 7,336.4 7,702.0 8,084.1 8,496.3 8,942.8
Other Operating
Expense - - 120.9 120.9 153.5 194.9 247.6 314.4

Depreciation 342.0 309.6 41.7 351.2 367.1 386.1 409.1 437.0

Amortization 85.0 - - - - 112.0 112.0 112.0 112.0

EBIT 1,588.0 1,629.8 129.7 1,338.4 1,473.2 1,651.6 1,596.7 1,570.2

 Practice Exercise 3
• Using the M&A Valuation & Deal Structuring Model
accompanying this text:
– On the Valuation worksheet, identify the enterprise and
equity values for Newco.
– On the Summary worksheet under Incremental Sales
Synergy, increase incremental revenue to $200 million in
the first year, $250 million in the second year and $350 in
the third year. What is the impact on Newco’s enterprise
and equity values? (Hint: See Valuation worksheet)
– Click undo command to eliminate increases in incremental
sales revenue or close model but do not save results from
Practice Exercise 3
Key Point: Synergy is generally realized gradually and
requires some investment to realize full potential.
 Step 4: Determine Appropriateness of Offer
Price & Post-Transaction Capital Structure
a. Is the offer price appropriate?:
--Compare offer price with estimated maximum price
and the offer price multiple with recent comparable deals
--Determine if the deal will allow Newco to meet or
exceed required returns (i.e., NPV ≥ 0)1
b. Is the post-transaction capital structure sustainable?:
--Compare projected Newco credit ratios and industry average
credit ratios
--Determine impact of deal on Newco EPS and current Newco
loan covenants
1
NPV = PVNewco (including synergy) – Offer Price (including transaction expenses) ≥ 0
 Determining the Offer Price

PVMIN = PVT or MVT, whichever is greater. MVT is Target’s current share price
times the number of shares outstanding

PVMAX = PVMIN + PVNS, PVNS (net synergy) = PV (sources of value) –

PV (destroyers of value)

PVOP (offer price) = PVMIN + α1 PVNS, where 0 ≤ α ≤ 1

Offer price range for Target = (PVT or MVT) < PVOP < (PVT or MVT) + PVNS

Key Point: Offer price lies between the minimum and maximum prices

1
Alpha (α) is that portion of the PV of net synergy paid to Target shareholders.
Determining the Offer Price, Premium, and
Purchase Price Multiple: An Example
Assumptions:
Target’s pre-deal price per share = $18
Target shares outstanding = 5 million
Target’s current earnings per share = $2.20
Target’s minimum (standalone or market) value = $100 million
PV of net synergy = $20 million
Alpha (α) = 50%

Offer Price, Premium, and Purchase Price Multiple:

Offer price per share = (Target’s minimum value + α x PVnetsynergy) /
Target shares outstanding
= ($100 million + .5 x $20 million) / 5 million = $22
Offer (purchase) price premium = $22/$18 = 22.2%
Offer (purchase) price multiple = $22 / $2.20 = 101
1
Offer price multiple, in this instance measured as a P/E ratio, can be compared to P/E ratios for recent
comparable transactions to determine the reasonableness of the premium.
 Summary Worksheet (Performance Metrics):
Newco EPS, Valuation & Key Credit Ratios
Earnings per Cash
Share Acquirer Newco Cash EPS Acquirer Newco Accretion / (Dilution) EPS EPS

2016P $ 2.42 $ 1.39 2016P $ 2.65 $ 5.64 2005P (42.5%) 112.9%

2017P $ 2.19 $ 1.74 2017P $ 2.97 $ 2.34 2017P (20.2%) (21.2%)

2018P $ 1.94 $ 1.96 2018P $ 2.73 $ 2.60 2018P 1.2% (4.8%)

2019P $ 1.67 $ 1.90 2019P $ 2.47 $ 2.70 2019P 13.6% 8.9%

2020P $ 1.39 $ 1.87 2020P $ 2.20 $ 2.71 2020P 34.5% 23.1%

Newco Interest Coverage (EBITDA to

Valuation Present Value $'s Newco Total Debt to Total Capital Interest Expense)

Target $ 5,590.7 2016P 5.7% 2016P 44.6x

Acquirer 36,330.3 2017P 5.0% 2017P 56.5x

Newco 48,110.8 2018P 4.2% 2018P 68.9x

Synergies 6,189.8 2019P 3.6% 2019P 76.0x

Newco Terminal
Value/Enterprise Value 77.0% 2020P 3.0% 2020P 86.4x
 Summary Worksheet: Deal Financing
Acquirer Transaction Summary
($Millions, except per share data)

Transaction Value Form of Payment Sources & Uses

Price Per Share $ 115.0 % Stock 50.0% Excess Cash $ 2,500.0

Target Shares Common Shares Issued to

Outstanding 51.3 % Cash 50.0% Target Shareholders 3,093.8

Dilutive Effect of New Common Shares

Stock Options 2.5 Issued -
Equity Target Preannouncement Convertible Preferred
Consideration $ 6,187.7 Share Price $ 91.14 Equity 5.00% -
Implied Purchase Price Revolving Credit
Premium 26.2% Facility 4.00% -

Less: Cash $ 203.9 Shares % Term Debt 4.50% 593.8

Less: Equity in Current Shares
Affiliates - Outstanding 475.5 77.3% Subordinated Debt 10.00% -
New Common Shares
Plus: Total Debt 9.1 Issued 139.4 22.7% Total Sources $ 6,187.7
Plus: Noncontrolling Convertible Preferred
Interests - Shares - -
Less Other
Adjustments - Convertible Debt - - Equity Consideration $ 6,187.7

Enterprise Value $ 5,992.9 New Warrants Issued - - Transaction Expenses 5 yrs. -

Total Shares 614.9 100.0% Total Uses $ 6,187.7

 Newco Balance Sheet Worksheet
Actual 2015 Pre-Trans Trans Pro Forma Projections

Acquirer Target Adj Adj 2015 2016 2017

Cash $ 4,938.0 $ 203.9 $ (2,500.0) $ 2,641.9 $ 5,236.2 $ 5,704.6
Accounts Receivable 2,838.0 102.0 2,940.0 2,979.5 3,087.7
Inventory 2,015.0 215.4 - 2,230.4 138.6 138.4
Other 563.0 19.3 582.3 533.4 552.3
Current Assets 10,354.0 540.6 8,394.6 8,887.7 9,482.9
Property, Plant, & Equipment 4,906.0 162.9 - 5,068.9 5,504.4 5,953.8
Accumulated Depreciation (2,791.0) (86.8) - (2,877.8) (3,229.0) (3,596.2)
Net Property, Plant, & Equipment 2,115.0 76.1 2,191.1 2,275.3 2,357.6
Goodwill 205.0 - - 5,690.7 5,895.7 5,883.7 5,871.7
Intangible Assets 487.0 3.9 490.9 390.9 290.9
Deferred Taxes 1,184.0 36.6 1,220.6 1,275.6 1,330.6
Other 53.0 18.2 71.2 71.2 71.2
Total Assets $ 14,398.0 $ 675.4 $ 18,264.1 $ 18,784.4 $ 19,404.9
Accounts Payable 1,289.0 84.7 1,373.7 1,339.2 1,364.5
Other 2,069.0 64.4 2,133.4 2,279.2 2,295.5
Current Liabilities 3,358.0 149.1 3,507.1 3,618.4 3,660.0
Senior Debt 276.0 9.1 593.8 878.9 804.7 730.5
Subordinated Debt - - - - - -
Total 276.0 9.1 878.9 804.7 730.5
Deferred Taxes 910.0 - 910.0 944.0 978.0
Other 11.0 20.2 31.2 31.2 31.2
Total Liabilities 4,555.0 178.4 5,327.2 5,398.3 5,399.7
Common Stock 3,947.0 225.0 2,868.8 7,040.8 7,040.8 7,040.8
Retained Earnings 5,801.0 270.0 (270.0) 5,801.0 6,250.2 6,869.4
Other Adjustments 95.0 2.0 (2.0) 95.0 95.0 95.0
Total Stockholders Equity 9,843.0 497.0 12,936.8 # 13,386.1 14,005.2
Total Liabilities and Equity $ 14,398.0 $ 675.4 $ 18,264.1 $ 18,784.4 $ 19,404.9
 Practice Exercise 4
• Using the M&A Valuation & Deal Structuring Model accompanying this
text:
– On the Summary worksheet under the Sources and Uses heading,
note how the purchase price is financed.
– Under the heading Form of Payment, change the composition of the
purchase price to 100% cash. Assume the purchase price is partially
financed by reducing Acquirer excess cash by $1 billion and by raising
$4 billion by issuing new Acquirer equity to the public. Under the
Sources and Uses heading, how is the remainder of the purchase
price financed?
– Change the composition of the purchase price to 100% equity, what is
the impact on how the purchase price is financed?
– Click undo command to eliminate changes to base case model or
close model but do not save the results from Practice Exercise 4
Key Point: How a deal is financed reflects: form of payment (share exchange
requires new Acquirer shares), that combination of sources of funds resulting
in the lowest average cost of funds, and the impact on Newco EPS and
current loan covenants,
 Practice Exercise 5
Using the M&A Deal Structuring Model accompanying this text:
On the Summary worksheet under the Valuation heading (lower left
hand corner of worksheet), note the net present value of Newco
including synergy (last row of worksheet).

On the Valuation worksheet, increase Newco’s terminal value

growth rate by one percentage point and reduce the discount rate
by one percentage point (lower left hand corner) and enter the new
values. How do these changes in the Newco terminal value
assumptions affect Newco’s net present value including synergy on
the Summary worksheet?

Click undo command to eliminate changes to the base case model

or close model but do not save the results from Practice Exercise 5

Key Point: Small changes in terminal value assumptions result in

disproportionately large changes in firm value.
Calculating Offer Price Per Share and Target’s Equity
Value Under Alternative Payment Scenarios
All Stock Transaction:
Offer Price Per Share = Share Exchange Ratio1 x Acquirer’s Share Price
= Offer Price Per Share x Acquirer’s Share Price
Acquirer’s Share Price
Equity Value = Offer Price Per Share x Target’s Fully Diluted Shares Outstanding 2

All Cash Transaction:

Offer Price Per Share = Cash Offer Per Target Share
Equity Value = Cash Offer Per Target Share x Target’s Fully Diluted Shares
Outstanding

Cash and Stock Transaction:

Offer Price Per Share = Cash Offer Per Share + (Share Exchange Ratio x Acquirer’s
Share Price)
Equity Value = [Cash Offer Per Share + (Share Exchange Ratio x Acquirer’s Share
Price)] x Target’s Fully Diluted Shares Outstanding

1
When share exchange ratios (SERs) are fixed, the value of the transaction can change due to fluctuations in the acquirer’s share price. Assume the SER
is 2 and the acquirer’s share price is $50, the offer price per share is $100. However, if the acquirer’s share price falls to $40 or increases to $60
before closing, the offer price is $80 and $120, respectively. Under a floating SER, the dollar value of the offer price per share is fixed and the
number of shares exchanged varies with the value of the acquirer’s share price. Acquirer share price changes require re-estimating the SER. For
example, if the acquirer’s share price falls to $40, the number of new acquirer shares issued per target share to preserve the $100 offer price is 2.5
(i.e., $100/$40); if the acquirer’s share price rises to $60, the new SER would be 1.6667 (i.e., $100/$60). Fixed SERS are most common because
the risk of changes in the offer price is shared equally by the acquirer (i.e., if acquirer’s share price rises) and the target (i.e., if the acquirer’s share
price falls).
2
Fully diluted shares represent the total number of Target shares outstanding if all options, convertible preferred and debt outstanding were converted into
Target common shares.
 Calculating Post-Merger EPS
in a Cash & Stock Transaction: Practice Exercise 6

Assume the offer or purchase price determined through negotiation is $84.30

for each Target share and consists of 1 share of Acquirer stock (i.e.,
$56.25) and $28.05 (i.e., $84.30 offer price - $56.25) in cash. Furthermore,
assume that the cash portion of the purchase price is financed by the
acquirer at an 8% annual interest rate with the principal due in 10 years.
The firm’s marginal tax rate is 40%. What is the earnings per share of the
combined businesses after closing?

Pre-Merger Data Acquirer Target

Net Earnings $281,500,000 $62,500,000
Shares Outstanding 112,000,000 18,750,000
EPS $2.51 $3.33
Market Price Per Share $56.25 $62.50
 Calculating the Target’s Fully Diluted Shares Outstanding
and Adjusting Equity Value (If Converted Method)
Assumptions about Target Comment
Basic Shares Outstanding 2,000,000
In-the-Money Optionsa 150,000 Exercise Price = $15/share
Convertible Debentures (Face value = $10,000,000 Number of Debentures outstanding =
$1000; convertible into 50 shares of $10,000,000/$1,000 = 10,000
common stock; implied conversion price = If fully converted = 10,000 x 50 =
$20 (i.e. $1000/50)) 500,000 common shares

Preferred Stock (Par value = $60; $5,000,000 Preferred shares outstanding = $5,000,000 / $60
convertible into 3 common shares; implied = 83,333
conversion price = $20 (i.e., $60/3)) If fully converted = 83,333 x 3 =250,000 common
shares
Offer Price Per Share $30 Purchase price offered for each target share
outstanding

Total Shares Outstandingb = 2,000,000 + 150,000 + 500,000 + 250,000

= 2,900,000
Adjusted Target Equity Valuec = 2,900,000 x $30 -150,000 x $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.
c
Total shares Outstanding = Issued Shares + Shares from “in the money” options and convertible securities.
d
Purchase price adjusted for new acquirer shares issued for convertible shares or debt less cash received from “in the money” option holders.

Key Point: Actual purchase price is $84.8 million rather than $60 million.
 Calculating Fully Diluted Shares
Outstanding: Options
Options Outstanding Strike Price In the Money Number Likely to be
(Mil. of Shares) Converted

4.045 $37.46 Yes 4.045

Assumptions:
Current Target Share Price = Offer Price = $82/share
Proceeds from Option Holders used to repurchase Target shares at current Target share price
New Target Shares from Option Conversion:
What firm has to pay to repurchase new Target shares: $82 x 4.045 = $331.69
What firm receives from converting option holders: $37.46 x 4.045 = $151.53
Difference = $180.16

New Target shares issued = [Cost to Repurchase All Shares Converted – Proceeds from
Converting Option Holders] / Current Target Share Price = $180.16 / $82 = 2.1971
 Calculating Fully Diluted Shares
Outstanding: Convertible Debt
Principal Par Value Conversion Conversion Likely to New Shares
(Millions) Ratio Price Convert
$.44 $1000 20 $50 Yes .0088

Assumptions:
Current Target share price = offer price = $82/share
New Target Shares Issued:
Conversion Ratio (CV) = Number of target common shares when debt converted at par
value = 20
CV Price = Par Value / CV Ratio = $1000/20 = $50
New Target Shares = ($.44 / $1000) x 20 = .0088 (i.e., 88,000 shares)

Key Point: Add new shares issued to Target’s basic shares outstanding.
 Calculating Fully Diluted Shares
Outstanding: Convertible Preferred
Balance Par Value CV Ratio CV Price Likely to New
Convert Shares
$3.40 $100 1.7 $57.14 Yes .0595

Assumptions:
Current Target share price = offer price = $82/share
New Shares Issued:
Conversion Ratio (CV) = number of new Target shares when converted at par
value = 1.75
CV Price = $100 / 1.75 = $57.14
New Target Shares Issues = )$3.40 / $100) x 1.75 = .0595 (i.e., 59,500 shares)

Key Point: Add new shares issued to Target’s basic shares outstanding
 Modeling An Asset Purchase
• As with a stock purchase model, asset purchases begin with the
estimation of Target’s enterprise value.1
• Enterprise value is then adjusted by subtracting Target assets excluded
from the deal (Aexcl) and Target liabilities included in the deal (Linc). The
end result is referred to as net acquired assets.

Net Acquired Assets = TA – Aexcl – Linc = Aincl – Linc

where Aincl equals Target assets included in the deal.

• The purchase price is what Acquirer pays for net acquired assets and is
often expressed as a multiple of net book assets (i.e., book assets less
book liabilities).
1
Recall that enterprise value can be viewed from either the asset side (total assets) or the liability side (total liabilities plus equity) of the
balance sheet. In the context of an asset purchase, enterprise value equals total Target assets. TA = Aexcl + Aincl = Lexcl + Lincl + EQ and Aincl
– Lincl = Lexcl – Aexcl + EQ, where EQ = Target shareholders’ equity and Ainc – Lincl = Net acquired assets by Acquirer.
 Asset Purchase Illustration

• Assume that Acquirer pays $90 million to purchase $75 million in net
acquired assets, consisting of $100 million of Target net property,
plant and equipment (i.e., Net PP&E) less assumed Target current
liabilities of $25 million and that the book values of Target assets
and liabilities are equal to their fair market value.
• The purchase is financed by using $20 million in Acquirer
pre-transaction cash balances and by borrowing $70 million in
long-term debt.
• Synergies in the first year include a reduction in cost of sales of $5
million. First year integration expenses are $15 million.
• The implied purchase price multiple is 1.2 times net acquired assets
(i.e., $90 million/$75 million).
 Asset Purchase: Acquirer
Income Statement Adjustments
 Asset Purchase: Acquirer
Balance Sheet Adjustments
Table 9.12 Acquirer Balance Sheet: Asset Purchase

Actual Trans Pro Forma

2015 Adj. 2016

Acquirer Pre-Deal Adj. Acquirer Post-Deal

Cash $125.00 ($20.00) $105.00
Current Assets (Excl.
Cash) 550.00 550.00
Net Property, Plant &
Equipment 1,250.00 100.00 1,350.00
Goodwill 15.00 15.00
Other Long-Term
Assets 450.00 450.00
Total Assets $2,375.00 $2,470.00
Current Liabilities 550.00 25.00 575.00
Long-Term Debt 450.00 70.00 520.00
Other Long-Term
Liabilities 375.00 375.00
Total Liabilities 1,375.00 1,470.00
Common Stock 500.00 500.00
Preferred Equity 50.00 50.00
Retained Earnings 400.00 400.00
Other Adjustments 50.00 50.00
Total Shareholders‘
Equity 1,000.00 1,000.00
Total Liabilities and
Equity $2,375.00 $2,470.00
 Asset Purchase: Acquirer
Cash Flow Statement Adjustments
2015 Ending Cash $125.00
Cash used to finance PP&E
Purchase (20.00)
2016 Beginning Cash Balance $105.00
Cash from Operations
Net Income (1.20)
Depreciation 0.00
(Gain)/Loss (10.00)
Current Assets 0.00
Current Liabilities 25.00
Net cash flow from Operations 13.80
Cash from Investing
PP&E Acquisition (90.00)
Net cash flow from Investing (90.00)
Cash from Financing
Increase in Debt 70.00
Net Cash Flow from Financing 70.00
Net Cash Flow (6.20)
Ending Cash Balance $98.80
 Things to Remember…
• Financial modeling facilitates the process of valuation,
deal structuring, and selection of the appropriate
financing plan.
• The process entails the following four steps:
– Step 1: Construct historical financial statements for
Acquirer and Target and determine key value
drivers
– Step 2: Project Target and Acquirer financials and
determine their standalone value
– Step 3: Estimate the value of the combined firms
(“Newco), including the effects of synergy & deal
terms.
– Step 4: Determine the appropriateness of the offer
price and Newco’s post-transaction capital
structure.