VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS OKAN BAYRAK

Definitions A merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business. Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company

Types of Mergers Horizontal Mergers - between competing companies Vertical Mergers - Between buyer-seller relation-ship companies Conglomerate Mergers - Neither competitors nor buyer-seller relationship

History of Mergers and Acquisitions Activity in United States The First Wave After 1883 depression - Horizontal mergers - Create monopolies The Second Wave Oligopolies - The Clayton Act of 1914 The Third Wave Conglomerate Mergers - Booming Economy The Fourth Wave Hostile Takeovers - Mega-mergers Mergers of 1990’s - Strategic mega-mergers

Motives and Determinants of Mergers Synergy Effect - Operating Synergy - Financial Synergy Diversification Economic Motives - Horizontal Integration - Vertical Integration - Tax Motives

FIRM VALUATION IN MERGERS AND ACQUISITIONS Equity Valuation Models - Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the balance sheet. Liquidation Value: the value that would be derived if the firm’s assets were liquidated. Replacement Cost: the replacement cost of its assets less its liabilities.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-2 Dividend Discount Models

FIRM VALUATION IN MERGERS AND ACQUISITIONS-3 The Constant Growth DDM

FIRM VALUATION IN MERGERS AND ACQUISITIONS-4 Price-Earnings Ratio

FIRM VALUATION IN MERGERS AND ACQUISITIONS-5 Cash Flow Valuation Models - The Entity DCF Model : The entity DCF model values the value of a company as the value of a company’s operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity. Value of Operations: The value of operations equals the discounted value of expected future free cash flow.. Value of Debt. Value of Equity

FIRM VALUATION IN MERGERS AND ACQUISITIONS-6 What Drives Cash Flow and Value? - Fundamentally to increase its value a company must do one or more of the following:. Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital).. Increase the return on new capital investment.. Increase its growth rate but only as long as the return on new capital exceeds WACC.. Reduce its cost of capital.

FIRM VALUATION IN MERGERS AND ACQUISITIONS-7 The Economic Profit Model: The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.

STEPS IN VALUATION Analyzing Historical Performance

STEPS IN VALUATION-2 Forecast Performance - Evaluate the company’s strategic position, company’s competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC. - Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance. - Forecast income statement and balance sheet line items based on the scenarios. - Check the forecast for reasonableness.

STEPS IN VALUATION-3 Estimating The Cost Of Capital - Develop Target Market Value Weights - Estimate The Cost of Non-equity Financing - Estimate The Cost Of Equity Financing

STEPS IN VALUATION-4 Estimating The Cost Of Equity Financing - CAPM. Determining the Risk-free Rate (10-year bond rate). Determining The Market Risk premium 5 to 6 percent rate is used for the US companies. Estimating The Beta

STEPS IN VALUATION-5 The Arbitrage Pricing Model (APM)

STEPS IN VALUATION-6 Estimating The Continuing Value - Selecting an Appropriate Technique. Long explicit forecast approach. Growing free cash flow perpetuity formula. Economic profit technique

STEPS IN VALUATION-7 Calculating and Interpreting Results - Calculating And Testing The Results - Interpreting The Results Within The Decision Context

HP-COMPAQ MERGER CASE

HP-COMPAQ MERGER CASE-2 Arguments About The Merger - Supporters. HP-COMPAQ will become the leader in most of the sub-sectors. Ability to offer better solutions to customer’s demands. New strategic position will make it possible to increase R&D efforts and customer research. Decrease in costs and increase in profitability. Financial strength to provide chances to invest in new profitable areas

HP-COMPAQ MERGER CASE-3 Arguments About The Merger - Opponents. A cquiring market share will not mean the leadership. No new significant technology capabilities added to HP. Large stocks will increase the riskiness of the company (Credit rating of the HP is lowered after the merger announcement). Diminishing economies of scale sector which both companies have already a great scale.

HP-COMPAQ MERGER CASE-4 Valuation Process - Relative Historical Stock Price Performance

HP-COMPAQ MERGER CASE-5 Comparable Public Market Valuation Analysis

HP-COMPAQ MERGER CASE-6 Similar Transactions Premium Analysis Salomon Smith Barney's analysis resulted in a range of premiums of: - (8)% to 46% over exchange ratios implied by average prices for the 10 trading days prior to announcement, with a median premium of 23%. - (7)% to 58% over exchange ratios implied by average prices for the 20 trading days prior to announcement, with a median premium of 23%. - (12)% to (29) over exchange ratios implied by average prices for the 1 trading days prior to announcement with a median premium of 15%. Based on its analysis, Salomon Smith Barney determined a range of implied exchange ratios of 0.585x to 0.680x by applying the range of premiums for other transactions to the closing prices of Compaq and HP on August 31, 2001 and the average historical exchange ratio for Compaq and HP for the 10-day period ending on August 31, 2001, as appropriate.

HP-COMPAQ MERGER CASE-7 Contribution Analysis

HP-COMPAQ MERGER CASE-8 Pro Forma Earnings Per Share Impact to Compaq