Using Financial Modeling Techniques to Value and Structure Mergers & Acquisitions

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Part IV: Deal Structuring and Financing Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities Part IV: Deal Structuring and Financing Part II: M&A Process Part I: M&A Environment Ch. 11: Payment and Legal Considerations Ch. 7: Discounted Cash Flow Valuation Ch. 9: Financial Modeling Techniques Ch. 6: M&A Postclosing Integration Ch. 4: Business and Acquisition Plans Ch. 5: Search through Closing Activities Part V: Alternative Business and Restructuring Strategies Ch. 12: Accounting & Tax Considerations Ch. 15: Business Alliances Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs Ch. 17: Bankruptcy and Liquidation Ch. 2: Regulatory Considerations Ch. 1: Motivations for M&A Part III: M&A Valuation and Modeling Ch. 3: Takeover Tactics, Defenses, and Corporate Governance Ch. 13: Financing the Deal Ch. 8: Relative Valuation Methodologies Ch. 18: Cross-Border Transactions Ch. 14: Valuing Highly Leveraged Transactions Ch. 10: Private Company Valuation

Learning Objectives Primary learning objective: Provide students with a basic understanding of how to use financial models to value and structure M&As Secondary learning objectives: Provide students with a knowledge of How to estimate the value of synergy; Commonly used relationships in building M&A valuation models; and How to use models to estimate the purchase price range, initial offer price (and other key deal characteristics)1 for a target firm, and to evaluate the feasibility of financing the proposed offer price. 1Other key deal characteristics include form of payment, form of acquisition, and tax considerations.

Financial Models Help Answer Key Valuation, Financing, and Deal Structuring Questions 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, both internally generated and external sources, provides the lowest cost of funds for the acquirer, subject to existing loan covenants? 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 liabilities?

M&A Model Building Process Step 1: Value acquirer and target as standalone firms Step 2: Value acquirer and target firms including synergy Step 3: Determine initial offer price for target firm Step 4: Determine the combined firms’ ability to finance the transaction

Step 1: Value Acquirer & Target as Standalone Firms Use the 5-forces model to understand determinants of profits and cash flow, i.e., bargaining strength of Customers (size, number, price sensitivity) Current competitors (market share, differentiation) Potential entrants (entry barriers, relative costs) Substitutes (availability, prices, switching costs) Suppliers, incl. labor, lenders, etc. (size, number, uniqueness) relative to industry participants. Normalize 3-5 years of historical financial information Project normalized cash flow based on expected market growth and changes in profits/cash flow determinants.

Applying the 5-Forces Model to Project Acquirer and Target Firm Financial Performance How have the following factors affected revenue growth and profit margins in the acquirer and target firms’ industry historically? Customers (size, number, price sensitivity) Current competitors (market share, differentiation) Potential entrants (entry barriers, relative costs) Substitutes (availability, prices, switching costs) Suppliers (size, number, uniqueness) How will these factors change (if at all) to impact future revenue growth and profit margins of these firms? Customers (size, number, price sensitivity) Current competitors (market share, differentiation) Potential entrants (entry barriers, relative costs) Substitutes (availability, prices, switching costs) Suppliers (size, number, uniqueness) Key questions: 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? How might substitutes and new entrants affect product pricing and profit margins?

Step 2: Value Acquirer & Target Firms Including Synergy Estimate Sources and destroyers of value Implementation costs incurred to realize synergy Consolidate acquirer and target projected financials including the effects of synergy Estimate net synergy (consolidated firms less values of target and acquirer) Under what circumstances would the acquisition make sense?

Anticipated Cost Savings Adjusting Combined Acquirer/Target Company Projections For Estimated Synergy Year 1 Year 2 Year 3 Year 4 Year 5 Net Sales1 $200 $220 $242 $266 $293 Cost of sales2 $160 $176 $194 $213 $234 Anticipated Cost Savings Direct labor $(2) $(4) $(6) $(8) Indirect labor (overhead) $(1) Purchased materials $(3) $(5) Selling expenses Total $(12) $(20) $(22) Implementation costs $3 $2 $1 Cost of sales (incl. synergy) $157 $166 $175 $191 $212 Cost of sales/Net sales 78.5% 75.5% 72.3% 71.8% 72.4% 1Combined company net sales projected to grow 10% annually during forecast period. 2Cost of sales before synergy assumed to be 80% of net sales during forecast period.

Discussion Questions 1. How would you adjust the combined firm’s income statement for cost savings due to improved worker productivity? (Hint: Determine the line item most directly affected by the improvement in productivity.) How would you adjust the combined firm’s income statement for additional revenue generated from cross-selling (i.e., Acquirer selling its products to the target’s customers and vice versa)? How would you reflect the expenses incurred in implementing the worker productivity improvement and cross-selling programs on the combined firm’s income statement?

Step 3: Determine Initial Offer Price for Target Firm Estimate minimum and maximum purchase price range Determine amount of synergy willing to share with target shareholders Determine appropriate composition of offer price

Calculating Initial Offer Price (PVIOP) PVMIN = PVT or PVMV, whichever is greater for a stock purchase (liquidation value of net acquired assets for an asset purchase) PVMAX = PVMIN + PVNS, where PVNS = PVSOV – PVDOV PVIOP = PVMIN + αPVNS, where 0 ≤ α ≤ 1 Offer price range = (PVT or MVT) < PVIOP < (PVT or MVT) + PVNS Where PVMIN = PV minimum purchase price PVT = PV standalone value of target firm PVMV = Market value target firm PVMAX = PV maximum purchase price PVNS = PV of net synergy PVSOV = PV of sources of value PVDOV = PV of destroyers of value α = Portion of net synergy shared with target company shareholders Offer price per share = PVIOP / Target’s fully diluted shares outstanding1 How is “α” determined? 1Fully diluted shares outstanding includes basic shares plus shares resulting from exercising “in the money” options and conversion of convertible debt and preferred stock.

Calculating Initial Offer Price--Example A potential bidder estimates the following information for a target firm: PVMIN $650 million (i.e., standalone value) PVNS 50 million PVMAX $700 million α = 30% Therefore, PVIOP = $650 million + .3 x $50 million = $665 million Offer Price Range = $650 million < $665 million < $700 million Note: The offer price, expressed as a multiple of earnings, cash flow, sales, book value, and so on, should be compared to similar multiples paid for recent comparable transactions to determine if the offer price is excessive.

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 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 1When 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).

Assumptions about Target 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 = $1000; convertible into 50 shares of common stock; implied conversion price = $20 (i.e. $1000/50)) Preferred Stock (Par value = $60; convertible into 3 common shares; implied conversion price = $20 (i.e., $60/3)) $10,000,000 $5,000,000 Debentures outstanding = $10,000,000/$1,000 = 10,000 If fully converted = 10,000 x 50 = 500,000 common shares Preferred shares outstanding = $5,000,000 / $60 = 83,333 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 aAn option whose exercise price is below the market value of the firm’s share price. cTotal shares Outstanding = Issued Shares + Shares from “in the money” options and convertible securities. dPurchase price adjusted for new acquirer shares issued for convertible shares or debt less cash received from “in the money” option holders. Prof. Notes: “In-the-money” options provide a cash inflow equal to the number of such options times the exercise price and reduce the adjusted target equity value. “Out of the money” options may also be convertible in change of control situations for some target firms. Convertible securities such as convertible debt and preferred stock do not provide cash inflows since when converted the original investment simply changes form from debt to common stock. Key Point: Actual purchase price is $84.8 million rather than $60 million.

Step 4: Determine Combined Firms’ Ability to Finance Transaction Estimate impact of alternative financing structures (e.g., debt/equity ratios) Select financing structure that Meets acquirer’s required financial returns and desired financial structure; Meets target’s primary financial and non-financial needs (e.g., nontaxable); Does not raise borrowing costs or violate existing loan covenants; and Is supportable by the combined firms’ operating cash flows.

Determining Dilution/Accretion by Calculating Post-Merger Earnings Per Share (EPS) Will the transaction be transaction be dilutive or accretive to the acquirer’s EPS? Acquirer is considering the acquisition of Target in which Target would receive $84.30 for each share of its common stock. Acquirer wishes to assess the impact of alternative forms of payment on post-merger EPS. Acquirer believes that any synergies in the first year following closing would be fully offset by costs incurred in combining the two businesses. Selected data are presented as follows: 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 Post-Merger EPS in a Share for Share Exchange1 1. Share exchange ratio = Price per share offered for Target / Price per share for Acquirer = $84.30 / $56.25 = 1.5 2. New shares issued by Acquirer = 18,750,000 (shares of Target) x 1.5 (share exchange ratio) = 28,125,000 Total shares outstanding of the combined firms = 112,000,000 + 28,125,000 = 140,125,000 Post-merger EPS of the combined firms = ($281,500,000 + $62,500,000) / 140,125,000 = $2.46 (versus $2.51 for Acquirer prior to the merger) Implication: EPS for the combined firms is diluted $.05 during the first full year following closing. 1Target has no convertible preferred stock or debt outstanding, and its employees have no “in the money” options..

Calculating Post-Merger EPS in an All Cash Transaction Purchase price = $84.30 x 18,750,000 = $1,580,625,000 Assume Acquirer borrowed the entire purchase price at 8% interest with the principal repaid in 10 years Annual interest expense = .08 x $1,580,625,000 = $126,450,000 Post merger EPS of the combined firms = ($281,500,000 + $62,500,000 - $126,450,000 (1 - .4)) / 112,000,000 = $2.39 (versus $2.51 for Acquirer before the merger) Implication: EPS of the combined firms is diluted by $.12 during the first full year following closing due to the annual interest expense. This dilution is $.07 higher than an all stock transaction. 1Assumes the firm’s marginal tax rate is 40 percent.

Calculating Post-Merger EPS in a Cash & Stock Transaction: Practice Problem Assume the purchase price equals 1 share of Acquirer stock (i.e., $56.25) and $28.05 (i.e., $84.30 offer price - $56.25) in cash and 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

Model Worksheet Layout1 Assumptions Section Historical Period Forecast Period 1Refers to the model template contained on the companion website accompanying the textbook.

Using M&A Model Template1 Model worksheet layout: Assumptions (top panel); historical period data (lower left panel); forecast period data (lower right panel). Displaying Microsoft Excel formula results on a worksheet: On Tools menu, click Options, and then click the View Tab. To display formulas in cells, select the formulas check box; to display the formula’s results, clear the check box. In place of existing historical data, fill in the data in cells not containing formulas. Do not delete existing formulas in “historical period” unless you wish to customize the model. Do not delete or change formulas in the “forecast period” cells unless you wish to customize the model. To replace existing data, change the forecast assumptions at the top of the spreadsheet. 1Refers to the model template found on the student online website accompanying the textbook.

Model Balance Sheet Adjustment Mechanism Methodology Separate current assets into operating and non-operating assets. Operating assets include minimum operating cash balances1 and other operating assets (e.g., receivables, inventories, and assets such as prepaid items). Current non-operating assets are investments (i.e., cash generated in excess of minimum operating balances invested in short-term marketable securities). The firm issues new debt whenever cash outflows exceed cash inflows. The firm’s investments increase whenever cash outflows are less than cash inflows. 1Minimum cash balances determined by analyzing the firm’s cash conversion cycle, by computing the average ratio of cash and marketable securities to net revenue over some prior period times the firm’s current net revenue, or by applying the industry average ratio of cash and marketable securities to net revenue times the firm’s current net revenue. To illustrate the latter, assume the average ratio of cash and marketable securities in an industry is 10% and that the a target firm has annual revenue of $100 million and cash and marketable securities of $15 million. Excess cash balances are equal to $15 million - .1 x $100 = $5 million.

Model Balance Sheet Adjustment Mechanism Illustration Assets Liabilities Current Operating Assets Cash Needed for Operations (C) Other Current Assets (OCA) Total Current Operating Assets (TCOA) Short-Term (Non-Oper.) Investments (I) Net Fixed Assets (NFA) Other Assets (OA) Total Assets (TA) Current Liabilities (CL) Other Liabilities (OL) Long-Term Debt (LTD) Existing Debt (ED) New Debt (ND) Total Liabilities (TL) Shareholders’ Equity (SE) Cash Outflows Exceed Cash Inflows: If (TA – I)>(TL – ND) + SE, ΔND > 0 (i.e., the firm must borrow), otherwise ΔND = 0 Cash Outflows Less Than Cash Inflows: If (TA – I) < (TL – ND) + SE, ΔI > 0 (i.e., the firm’s non-operating cash increases), otherwise ΔI = 0 Cash Outflows Equal Cash Inflows: If (TA – I) = (TL – ND) + SE = 0, ΔND=ΔI= 0

Estimating Interest Expense IEXP = ((DEOY + DBOY)/2) x i, where DEOY = DBOY - DPRP where DEOY = End of year debt balance DBOY = Beginning of year debt balance DPRP = Annual principal repayment IEXP = Dollar value of annual interest expense i = Weighted average interest rate

Debt Repayment Schedule Total Debt 12/31/12 2013 2014 Maturity Schedule Maturing Amount Interest Rate Long-Term Debt $690,710 $190,710 5.5% Medium Term $540,500 $30,500 7.5% $30,000 Mortgage Debt $42,380 $694 10.15% $767 Total $1,273,590 $31,194 7.559% $221,477 5.787% Remaining Balance 1/1/13 Ending Balance $500,000 $510,000 $480,000 $41,686 10.150% $40,919 $1,242,396 6.477% $1,020,919 6.627%

Hints on Using Financial Models Ensure Excel’s Iteration Command is “on” to accommodate “circular references” inherent in financial models. For example, To turn on the iteration command, On the menu bar, click on Tools >>> Options >>> Calculations Select Automatic and Iteration Set maximum number of iterations to 100 and the maximum amount of change to .01. Cash & Investments x Interest Rate Affects Net Income Net income Affects Cash & Investments

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: Valuing the acquirer and target firms as standalone businesses using multiple valuation methods Valuing consolidated acquirer and target firms including the effects of net synergy Determining the initial offer price for the target firm from within the price range defined by the minimum and maximum purchase prices Determining the combined firms’ ability to finance initial offer price