1. M&As are financial transactions that involve a change in the control of a company: Control ChangeOperation Changes: - New controlling shareholders - New board of directors - New management - New business strategy M&As are a consequence of changing markets and competitive environments MERGERS AND ACQUISITIONS

2. The buyer or acquiror may be: - An operating company (the most common) - A group of managers - A group of financial investors - A combination of the three The seller side may be: - The board of directors - A controlling shareholder MERGERS AND ACQUISITIONS

3. Financial Justification: The acquisition will increase the per-share value of the acquirer over the long term OR Cash Flows from the transaction > Cost of the Acquisition The seller will be immediately paid for the acquisition’s expected benefits (if made in cash) OR The seller will realize a premium over the trading market stock price (if made for stocks) MERGERS AND ACQUISITIONS

4. Generally Accepted Rules on M&As: 1.Pure conglomerate acquisitions do not necessarily create new shareholder value 2.Counter cyclical acquisitions do not necessarily create value 3.The market does not reward purely acquisition-induced growth MERGERS AND ACQUISITIONS

5. Generally Accepted Rules on M&As: (cont.) 4.Related diversification can be an important means of creating value in acquisitions 5.Acquisitions can be an important means of reaching a critical mass, where size is an important industry factor 6.Acquisitions are a tax-efficient means of investing excess corporate funds MERGERS AND ACQUISITIONS

6. There are three different valuing parties in an acquisition: 1.The BuyerValue = DCF of: - Long-term operating business - Total or partial liquidation of the business - Synergies from the restructuring of both businesses 2.The SellerValue = DCF of the best available alternatives 3. A Potential Competing Buyer MERGERS AND ACQUISITIONS

7. Valuation Techniques: - DCF: The most fundamental method of measuring value (cash) - Acquisition Multiples: Benchmark values based on multiples of earnings, book value, etc. - Premium over Market Trading Value: Percentage premium paid to public shareholders - Liquidation Value: Amount of cash that could be realized if a company sells all of its assets and pays off its liabilities in the near future - Replacement Value: Cost of starting up a similar company from scratch MERGERS AND ACQUISITIONS

8. Valuation Techniques: DCF - Step 1.a Evaluation of historical and projections of operating characteristics of the company, specifically: * Unit growth rate of sales * Rate of price increases * Cost of goods sold as a percentage of sales * Depreciation as a percentage of net fixed assets * Selling, general, and administrative expenses as a percentage of sales * Effective tax rate * Working capital required as a percentage of sales * Net fixed assets required as a percentage of sales MERGERS AND ACQUISITIONS

9. Valuation Techniques: DCF - Step 1.b Definition of specific economic and industry assumptions: * Inflation * Industry size and unit growth rate * Market share changes within the industry - Step 1.c Definition of scenarios by grouping varying sets of the economic assumptions into: * Maturity scenarios * Growth scenarios MERGERS AND ACQUISITIONS

10. Valuation Techniques: DCF - Example: MERGERS AND ACQUISITIONS

11. Valuation Techniques: DCF - Example: MERGERS AND ACQUISITIONS

12. Valuation Techniques: DCF - Step 2. Project Free Cash Flows: Levered FCF = net income after taxes - noncash charges to income (deferred taxes, depreciation, amort. of intangibles, etc.) - capital expenditures - investment in net working capital (excluding cash and short-term debt) Example: MERGERS AND ACQUISITIONS

13. Valuation Techniques: DCF - Step 3. Calculate WACC (k): Optimum Level of Debt = 20% - 50% debt to total capital WACC (weighted average cost of debt and equity) is defined by: k = k E (% equity) + k p (1 - t)(% debt); where: k E = cost of equity kp = cost of debt (pre-tax) t = marginal tax rate %debt = percentage of debt to total capital % equity = percentage of equity to total capital MERGERS AND ACQUISITIONS

14. Valuation Techniques: DCF - Step 3. Calculate WACC (k):(cont.) Cost of Debt ( kp) = medium to long-term borrowing rate Cost of Equity ( k E ) = r f +  (r m - r f ); where r f = long-term risk free rate r m = long-term return on the market  = systematic risk factor of the company and its industry r m - r f = long-term real return on the market (usually estimated between 3% and 8.5%) MERGERS AND ACQUISITIONS

15. Valuation Techniques: DCF - Step 4. DCF Value Calculation V firm (DCF value) = V debt + V equity DCF value= cash flow component + terminal component = PV of unleveraged FCFs for each projection year (discounted at k) + PV of the terminal value of the firm at the end of the projection period (discounted at k) Unleveraged FCF = FCF + (interest expense)(1 - tax rate) MERGERS AND ACQUISITIONS

16. Valuation Techniques: Acquisition Multiples - Earnings Multiples: Use unleveraged acquisition multiples = gross acquisition price / operating earnings; Gross acquisition price= price paid for equity + market value of total debt owed by acquired company Operating Earnings= earnings before interest and taxes (EBIT) = pretax earnings + interest expense Possible Distortions: * Non-comparable accounting principles underlying earnings * Amount of debt associated with an acquired company * Cyclicality of earnings MERGERS AND ACQUISITIONS

17. Valuation Techniques: Acquisition Multiples - Earnings Multiples: (cont.) Example: MERGERS AND ACQUISITIONS

18. Valuation Techniques: Acquisition Multiples - Book Value Multiples: Useful ONLY for industries where a company’s book value plays a role in determining future profitability. Examples: * In rate-of-return regulated industries, such as telephone, electric, and gas utilities, where the company’s future earnings are limited to a defined return on the company’s equity * In financial institutions such as banks, insurance companies, and security firms, where the balance sheet values of most assets and liabilities are reasonably close to market values MERGERS AND ACQUISITIONS

19. Valuation Techniques: Acquisition Multiples - Cash Flow Multiples: Useful in industries where the cash flow from operations (net income plus noncash charges) is close to the free cash flow of the DCF analysis. Example: * Industries that undertake project-type investments: Real estate and oil and gas industries MERGERS AND ACQUISITIONS

20. Valuation Techniques: Premium over Market Trading Value - When an acquisition candidate is publicly traded, the buyer must pay a premium to market. The amount of the premium will depend on the attitude of the company’s management (friendly or hostile to the acquiror) and the regulatory climate - Market trading values are also useful as a benchmark in calculating the value of a privately held company or division MERGERS AND ACQUISITIONS

21. Valuation Techniques: Liquidation and Replacement Values - Liquidation Value: amount of proceeds that could be realized by a stockholder if a company ceased operations, if all assets were sold at prevailing market prices, and if all liabilities and tax obligations were satisfied - Replacement Value: cost that would be incurred if one tried to replicate all of the assets and liabilities of a company by building them or purchasing them on the market Liquidation ValueMinimum value for a company Replacement ValueMaximum value for a company MERGERS AND ACQUISITIONS

22. Valuation Techniques: Excess Assets and Liabilities - If there are excess assets or liabilities of a company that play no part in determining the earnings or cash flows on which the basic valuation is made, such assets and liabilities must be separately added to (or substracted from) the basic value estimate MERGERS AND ACQUISITIONS

23. Financing an Acquisition - Most acquisitions are made in cash - Non cash payments are allowed when an alternative form of consideration can achieve a superior result for both parties - The driving factors for non cash payments are: * Tax Deferrals * Accounting * Regulatory Requirements * Contingent Payments * Financing Ability MERGERS AND ACQUISITIONS

24. Financing an Acquisition: Income Tax Aspects - The IRC provides that an acquisition can be accomplished without triggering income tax liability on the part of the selling shareholder, ONLY in the following cases: * Reorganization through Merger * Reorganization through Stock Purchase * Reorganization through Asset Purchase * Reorganization through Forward Triangular Merger * Reorganization through Reverse Triangular Merger MERGERS AND ACQUISITIONS

25. Financing an Acquisition: Obtaining Tax Deferrals 1. Reorganization (merger): Y merges into X to form XY AND at least 40-50% of the consideration paid for Y consists of equity securities of X 2. Reorganization (stock purchase): X purchases at least 80% of the voting stock of Y, using only voting stock of X in payment MERGERS AND ACQUISITIONS

26. Financing an Acquisition: Obtaining Tax Deferrals (cont.) 3. Reorganization (asset purchase): Y transfers all of its assets (with or without liabilities) to X in exchange for voting stock of X 4. Reorganization (forward triangular merger): Y merges in to S (a subsidiary of X) and X retains 100% ownership of S. Y’s former shareholders receive 40 to 50% equity securities of X to satisfy the continuity-of-interest test MERGERS AND ACQUISITIONS

27. Financing an Acquisition: Obtaining Tax Deferrals (cont.) 5. Reorganization (reverse triangular merger): S merges in to Y (a subsidiary of X) and X receives all of the voting securities of Y. Y’s former shareholders receive solely voting stock in X - The most commonly used structures for tax-free acquisitions are (4) and (5), the triangular mergers MERGERS AND ACQUISITIONS

28. (s)he may have dividend treatment on the cash portion Financing an Acquisition: Obtaining Tax Deferrals (cont.) What happens to the selling shareholders in a tax free reorganization? - If shareholders receive equity securities from the acquiror he maintains a carry over basis in the new security - Recognition of gain or loss by shareholders will have no impact on the target company MERGERS AND ACQUISITIONS (s)he owes a capital gains tax on his gain If shareholders receive cash or debt If shareholders receive a mixture

29. Financing an Acquisition: Obtaining Tax Deferrals (cont.) Subsidiary Divestitures: - Section 355 of the IRC allows a company to distribute a subsidiary to its stockholders in 2 ways: 1. Spin-off: the shares in the subsidiary are distributed as a pro-rata dividend to the company’s common stockholders 2. Split-off: one or more stockholders of the company exchange their shares for shares in the subsidiary, on a non-pro rata basis MERGERS AND ACQUISITIONS

30. Financing an Acquisition: Obtaining Tax Deferrals (cont.) Subsidiary Divestitures: - Section 355 restrictions: * Both, distributing company and subsidiary must have conducted an active trade or business for 5 years preceding the date of the transaction, and not have been acquired during that period * The distribution transaction must transfer at least 80% control of the subsidiary from the company to its stockholders * The transaction must be supported by a non tax corporate business purpose MERGERS AND ACQUISITIONS

31. Financing an Acquisition: Obtaining Tax Deferrals (cont.) Subsidiary Divestitures: - Section 355 conditions to be used as a tax saving device for divestitures: * The divesting company cannot arrange to sell the subsidiary to a third party * The distributing company receives no cash consideration for its equity in the subsidiary and is effectively shrinking its capitalization MERGERS AND ACQUISITIONS

32. Financing an Acquisition: Accounting Aspects - There are two principal methods of accounting for acquisitions of control of a company: * Pooling Method Accounting: which applies exclusively to acquisitions using the acquiror’s common stocks * Purchase Method: which applies to all other forms of acquisitions MERGERS AND ACQUISITIONS

33. Financing an Acquisition: Obtaining Pooling Accounting Pooling of Interest Method of Accounting: - Benefit: Favorable effects on the reported earnings per share (EPS) of an acquiror when the target is being acquired for a high multiple of its earnings - Requirements : * The merger must be for common stocks of the acquiror * No subsidiaries * Mutual independence *Timely completion MERGERS AND ACQUISITIONS

34. Financing an Acquisition: Obtaining Pooling Accounting Pooling of Interest Method of Accounting: - Requirements (cont.): * 90% rule * No equity changes * Repurchases * No voting realignments or restrictions * No contingent earnouts * No plan to dispose of significant assets * No other financial arrangements MERGERS AND ACQUISITIONS

35. Financing an Acquisition: Obtaining Pooling Accounting Pooling of Interest Method of Accounting: - Balance Sheet treatment: B/Ss are simply added together, line by line, eliminating any inter-company investments which are treated as treasury stocks Example: MERGERS AND ACQUISITIONS

36. Financing an Acquisition: Obtaining Pooling Accounting Pooling of Interest Method of Accounting: - Income Statement treatment: All items, down to net income, are simply added together - Key Statistics for Merger Analysis: * Pro-forma EPS: Earnings are additive and the number of shares outstanding after the merger depends on the exchange ratio of the merger. Analyze forecasted EPS dilution to see when it disappears and the opposite emerges * Credit Statistics: Debt ratio and interest coverage must be examined. As a general rule, poolings create the least concern for the credit position of the acquiror MERGERS AND ACQUISITIONS

37. Pooling of Interest Accounting. Example: MERGERS AND ACQUISITIONS

38. Financing an Acquisition: Obtaining Purchase Accounting Pooling of Interest Method of Accounting: - Basis: The investment has taken place on the part of an acquiror, and it must be recorded at the acquiror’s full cost - The cost of an investment must be allocated among the assets acquired as follows: * Adjust each acquiree B/S account to its fair value * Any excess of purchase price over net fair value is recorded as goodwill *If the purchase price is bellow net fair value, non current assets should be reduced proportionatelyNegative goodwill is ordinarily not recorded MERGERS AND ACQUISITIONS

39. Financing an Acquisition: Obtaining Purchase Accounting Pooling of Interest Method of Accounting: - Implication for the earnings of the combined companies: * Revaluations must be amortized against future earnings according to the remaining life of the asset * Goodwill must be amortized against future earnings over a period not to exceed 40 years * Revaluations of liabilities (bond discount or premium) must also be amortized into earnings over an appropriate period * In each case, it is important to ascertain the tax effect of the particular adjustment to earnings MERGERS AND ACQUISITIONS

40. Purchase Method of Accounting. B/S Example: MERGERS AND ACQUISITIONS

41. Purchase Method of Accounting. B/S Example: Notes on B/S: - a Since B is on LIFO, B’s B/S understates the value of B’s inventory by $10 - b B’s fixed assets are worth 50% more as a result of long-term inflation effects - c Goodwill incurred by B in its own past acquisitions has no identifiable value and therefore is eliminated - d B’s outstanding fixed-rate debt is worth less today because of general interest rate rises. It therefore must be revalued at a discount - e B’s unfunded vested pension liability is added - f B’s deferred tax liabilities are increased by the tax effect on timing differences arising from valuation adjustments a, b, c and e. The net valuation adjustment is a debit of $65, which creates an additional deferred tax provision of $25 (at a 38% tax rate) MERGERS AND ACQUISITIONS

42. Purchase Method of Accounting. B/S Example: Notes on B/S: (cont.) - g This is a balancing adjustment reflecting the net effect on the fair value of B’s common equity - h Transaction price of $200 is financed by $100 in excess cash and $100 in new long-term debt - i Goodwill incurred is aggregate price paid ($200) less fair value of net assets acquired ($70) MERGERS AND ACQUISITIONS

43. Purchase Method of Accounting. Income Stat. Example: MERGERS AND ACQUISITIONS

44. Purchase Method of Accounting. B/S Example: Notes on Income Statement: - a Interest Income forgone on $100 of excess cash (at 10%) - b Increased depreciation on B’s fixed assets’ $50 increase, amortized over remaining life of six years - c Net change in B’s goodwill amortization, assumes prior amortization of $1.7 per year and 40-year life for amortization of new goodwill ($130) - d Increased expense: $100 new debt, financed at 10%. In addition, amortization of debt discount will generate another $1 of interest expense - e Income tax effect of all purchase accounting adjustments other than goodwill at 40% MERGERS AND ACQUISITIONS

45. Financing an Acquisition: Legal and Regulatory Aspects Mergers and Consolidations: - The most basic form of combination. In a merger, 2 corporations, A and B, combine as follows: * The directors of corporations A and B approve an agreement of merger, specifying: - Terms and conditions, - Designation of one corporation as the survivor, - Number of shares or other consideration as a result of the merger, - Timing and means by which the merger is to be carried out MERGERS AND ACQUISITIONS

46. Financing an Acquisition: Legal and Regulatory Aspects Mergers and Consolidations: (cont.) * The % of each corporation’s outstanding shares that must approve the merger is 50% plus one vote, unless otherwise specified * The surviving corporation files a certificate of merger with the secretary of state of Delaware * As a result of filing, the target corporation ceases to exist and each share of the target Corp. becomes a right to receive the consideration provided in the agreement of merger * All assets and liabilities of the target Corp. becomes assets and liabilities of the survivor MERGERS AND ACQUISITIONS

47. Financing an Acquisition: Legal and Regulatory Aspects Tender Offers: - Solicitation made broadly to shareholders of a target company requesting tenders of shares for purchase by the bidder. The consideration is cash or an exchange offer (less frequent) * Tender offers are regulated by the SEC under Williams Act. The most important regulations are referred to: - Prorationing - Withdrawal - Minimum offer period - Amendments - Purchases outside the offer MERGERS AND ACQUISITIONS

48. Financing an Acquisition: Legal and Regulatory Aspects Asset Sales: - The buyer agrees to buy specified assets and to assume specified liabilities of the seller. The only assets and liabilities transferred are those specifically agreed to in the purchase and sale agreement * The steps involved in a typical asset sale are: - Buyer and seller reach agreement with respect to the sale of a division, specifying: the price to be paid, terms and conditions, general principal for determination of assets and liabilities to be transferred - Buyer and seller negotiate and execute purchase and sale agreement. Boards of both sides approve it. MERGERS AND ACQUISITIONS

49. Financing an Acquisition: Legal and Regulatory Aspects Asset Sales: (cont.) - Buyer and seller file for antitrust clearance - Third party waivers and consents are obtained (if necessary) - Asset and liabilities transferred to buyer and buyer makes payment at closing date - Buyer and seller negotiate and execute purchase and sale agreement. Boards of both sides approve it. - Buyer and seller file for antitrust clearance - Third party waivers and consents are obtained (if necessary) - Asset and liabilities transferred to buyer and buyer makes payment at closing date MERGERS AND ACQUISITIONS

50. Financing an Acquisition: Legal and Regulatory Aspects Antitrust Review: - The Department of Justice (DOJ) and the Federal Trade Commission (FTC) provide public guidelines to determine possible violations of the antitrust laws. Specifically: * Vertical Mergers: The DOJ generally will not challenge vertical mergers unless it creates barriers to entry, facilitates collusion, or is designed to evade rate regulation MERGERS AND ACQUISITIONS

51. Financing an Acquisition: Legal and Regulatory Aspects Antitrust Review: (Cont.) * Conglomerate Mergers: They will ordinarily be challenged only ifthey involve the elimination of a potential entrant and: a. the industry HHI* exceeds 1,800; b. entry is difficult; c. there are fewer than 3 other potential entrants; and d. the market share of the acquired firm exceeds 5% *Herfindahl-Hirschman Index (HHI) is used to measure industry concentration MERGERS AND ACQUISITIONS