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S T R I C TL Y

P R I V A T E

AN D

C O N F I D E N T I A L

DECEMBER 2004

M&A:
DCF
AND
MERGER
ANALYSIS

M&A - DCF and M&A analysis

[For any pitchbook or presentation including advisory, equity or debt security or loan product or combinations thereof.
NOT for use in fairness/valuation or Commercial Bank presentations.]

DC F

AN D

M E R G E R

AN ALY SI S

This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including
such clients subsidiaries, the Company) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or
transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes
only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this
presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan.
The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date,
all of which are accordingly subject to change. JPMorgans opinions and estimates constitute JPMorgans judgment and should be regarded as indicative,
preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the
accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was
otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any
other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or
accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account
the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other
effects.
Notwithstanding anything herein to the contrary, the Company and each of its employees, representatives or other agents may disclose to any and all
persons, without limitation of any kind, the U.S. federal and state income tax treatment and the U.S. federal and state income tax structure of the
transactions contemplated hereby and all materials of any kind (including opinions or other tax analyses) that are provided to the Company relating to such
tax treatment and tax structure insofar as such treatment and/or structure relates to a U.S. federal or state income tax strategy provided to the Company
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entities.

M&A:

This presentation does not constitute a commitment by any JPMorgan entity to underwrite, subscribe for or place any securities or to extend or arrange
credit or to provide any other services.

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

M&A - DCF and M&A analysis

Valuation methodologies

Valuation
methodologies

Publicly traded
comparable
companies
analysis
Public Market

Valuation
Value based on

market trading
multiples of
comparable
companies

I N T R O D U C TI O N

Applied using

historical and
prospective
multiples
Does not include a

control premium

Comparable
transactions
analysis
Private Market

Valuation
Value based on

multiples paid for


comparable
companies in sale
transactions
Includes control

premium

Discounted
cash flow
analysis
Intrinsic value

of business
Present value of

projected free
cash flows
Incorporates both

short-term and
long-term
expected
performance
Risk in cash flows

and capital
structure captured
in discount rate

Leveraged
buyout/recap
analysis
Value to a

financial/LBO
buyer
Value based on

debt repayment
and return on
equity investment

Other

Liquidation

analysis
Break-up analysis
Historical trading

performance
Expected IPO

valuation
Discounted future

share price
EPS impact
Dividend discount

model

M&A - DCF and M&A analysis

The valuation process


Determining a final valuation recommendation is a process of triangulation using insight from each
of the relevant valuation methodologies

I N T R O D U C TI O N

(1) Discounted
Cash Flow
Analyzes the
present value of
a company's free
cash flow.

(2) Publicly Traded


Comparable
Companies
Utilizes market
trading multiples
from publicly
traded companies
to derive value.

(3) Comparable
Acquisition
Transactions
Utilizes data from
M&A transactions
involving similar
companies.

(4) Leveraged
Buy Out
Used to determine
range of potential
value for a
company based on
maximum leverage
capacity.

The valuation summary is the most important slide in a


valuation presentation

M&A - DCF and M&A analysis

The science is performing each valuation method correctly, the art is using each
method to develop a valuation recommendation
Price per share

$20.00

$26.75

$15.00
$15.00

Implied
offer =
$8.46

$9.75
$10.00

$10.25

$5.00

$5.00

$5.00

$5.50
$6.00

$4.00

$4.94
$4.00

$3.75

$3.50

$3.00

I N T R O D U C TI O N

$0.00
52-week
high/low

15.0x to 19.0x
2005E EBIT
of $20.6

19.0x to 25.0x
2005E cash
EPS of $0.16

Public trading comparables

15.0x to 20.0x
2006E cash
EPS of $0.25

2.5x to 4.0x
LTM revenue
of $185.7

Transaction
comparables

Mgmt. Case

Street Case

12% to 15%
Discount Rate
EBIT exit mult.
of 15.0x to 20.0x

12% to 15%
Discount Rate
EBIT exit mult.
of 15.0x to 20.0x

DCF analysis

M&A - DCF and M&A analysis

A primer: firm value vs. equity value


Firm value

Market value of all capital invested in a business(1)


(often referred to as enterprise value or firm value or asset value)
The value of the total enterprise: market value of equity + (total debt +
Capitalized Leases - Cash and Cash equivalents) + Minority Interest +
Preferred Equity
Total debt includes all Long term debt, Current portion of Long term
debt, short term debt and overdrafts

Equity value

I N T R O D U C TI O N

Assets

Enterprise
value

Market value of the shareholders equity


(often referred to as offer value)
The market value of a companys equity (shares outstanding x current
stock price)

Liabilities and Shareholders Equity

Enterprise
Value

Net debt, etc.

Equity value
1

The value of debt should be a market value. It may be appropriate to assume book value of debt approximates the market
value as long as the companys credit profile has not changed significantly since the existing debt was issued.
5

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

M&A - DCF and M&A analysis

Discounted cash flow analysis as a valuation methodology

Valuation
methodologies

Publicly traded
comparable
companies
analysis
Valuation
Value based on

Applied using

historical and
prospective
multiples

D I S C O UN T E D

F L OW

market trading
multiples of
comparable
companies

C A S H

AN AL Y SI S

Public Market

Does not include a

control premium

Comparable
transactions
analysis
Private Market

Valuation
Value based on

multiples paid for


comparable
companies in sale
transactions
Includes control

premium

Discounted
cash flow
analysis
Intrinsic value

of business
Present value of

projected free
cash flows
Incorporates both

short-term and
long-term
expected
performance
Risk in cash flows

and capital
structure captured
in discount rate

Leveraged
buyout/recap
analysis
Value to a

financial/LBO
buyer
Value based on

debt repayment
and return on
equity investment

Other

Liquidation

analysis
Break-up analysis
Historical trading

performance
Expected IPO

valuation
Discounted future

share price
EPS impact
Dividend discount

model

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Overview of DCF analysis

WACC
Other topics

Discounted cash flow analysis is based upon the theory that the value of a

business is the sum of its expected future free cash flows, discounted at an
appropriate rate
DCF analysis is one of the most fundamental and commonly-used valuation

techniques
Widely accepted by bankers, corporations and academics

Corporate clients often use DCF analysis internally

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

One of several techniques used in M&A transactions; others include:

Comparable companies analysis


Comparable transaction analysis
Leveraged buyout analysis
Recapitalization analysis, liquidation analysis, etc.

DCF analysis may be the only valuation method utilized, particularly if no

comparable publicly-traded companies or precedent transactions are


available

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Overview of DCF analysis

WACC
Other topics

DCF analysis is a forward-looking valuation approach, based on several key

projections and assumptions


Free cash flows

What is the projected operating and financial performance of the


business?
Terminal value
What will be the value of the business at the end of the projection period?
Discount rate

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

What is the cost of capital (equity and debt) for the business?
Depending on practical requirements and availability of data, DCF analysis can

be simple or extremely elaborate


There is no single correct method of performing DCF analysis, but certain

rules of thumb always apply


Do not simply plug numbers into equations
You must apply judgment in determining each assumption

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

The process of DCF analysis

WACC
Other topics

Project the operating results and free cash flows of the business
Projections/FCF
Projections/FCF

over the forecast period (typically 10 years, but can be 520 years
depending on the profitability horizon)
Estimate the exit multiple and/or growth rate in perpetuity of the

Terminal
Terminal value
value

business at the end of the forecast period

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Estimate the companys weighted-average cost of capital to


Discount
Discount rate
rate

determine the appropriate discount rate range

Determine a range of values for the enterprise by discounting the


Present
Present value
value

projected free cash flows and terminal value to the present

Adjust the resulting valuation for all assets and liabilities not
Adjustments
Adjustments

accounted for in cash flow projections

10

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

DCF theory and its application

WACC
Other topics

DCF theory: The value of a productive asset is equal to the present value of all
expected future cash flows that can be removed without affecting the assets value
(including an estimated terminal value), discounted using an appropriate weightedaverage cost of capital
The cash-flow streams that are discounted include
Unlevered or levered free cash flows over the projection period
Terminal value at the end of the projection period

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

These future free cash flows are discounted to the present at a discount rate

commensurate with their risk


If you are using unlevered free cash flows (our preferred approach), the

appropriate discount rate is the weighted-average cost of capital for debt and
equity capital invested in the enterprise in optimal/targeted proportions
If you are using levered free cash flows, the appropriate discount rate is simply

the cost of equity capital (often referred to as flows to shareholders or dividend


discount model)

11

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

The two basic DCF approaches must not be confused

WACC
Other topics

DCF of unlevered cash flows (the focus of these materials)


Projected income and cash-flow streams are free of the effects of debt, net of

excess cash
Present value obtained is the value of assets, assuming no debt or excess cash

(firm value or enterprise value)


Debt associated with the business is subtracted (and excess cash balances are

added) to determine the present value of the equity (equity value)

DCF of levered cash flows (most common in valuation of financial institutions)


Projected income and cash-flow streams are after interest expense and net of any

interest income
Present value obtained is the value of equity
Cash flows are discounted at the cost of equity

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Cash flows are discounted at the weighted-average cost of capital

12

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Other considerations

WACC
Other topics

Reliability of projections
DCF results are generally more sensitive to cash flows (and terminal value) than to

small changes in the discount rate. Care should be taken that assumptions driving
cash flows are reasonable. Generally, we try to use estimates provided by analysts
from reputable Wall Street firms if the client has not provided projections

Sensitivity analysis
approximate. Use several scenarios to bound the targets value. Generally, the best
variables to sensitize are sales, EBITDA margin, WACC and exit multiples or
perpetuity growth rate

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Remember that DCF valuations are based on assumptions and are therefore

Hence, always present a range for the valuation!

13

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Always remember

WACC
Other topics

Three key drivers


Projections and incremental cash flows (unlevered free cash flow)
Residual value at end of the projection period (terminal value)
Weighted-average cost of capital (discount rate)
Avoid pitfalls
Validate and test projection assumptions
Determine appropriate cash flow stream
Thoughtfully consider terminal value methodology
Carefully consider all variables in calculation of the discount rate
Sensitize appropriately (base projection variables, synergies, discount rates,

terminal values, etc.)


Footnote assumptions in detail
Think about other value enhancers and detractors

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Use appropriate cost of capital approach

Always double-check with a calculator!

14

Overview

The first step in DCF analysis is projection of unlevered


free cash flows

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Calculation of unlevered free cash flow begins with financial projections


Comprehensive projections (i.e., fully-integrated income statement, balance

sheet and statement of cash flows) typically provide all the necessary elements
Quality of DCF analysis is a function of the quality of projections
Often required to fill in the gaps
Confirm and validate key assumptions underlying projections
Sensitize variables that drive projections
Sources of projections include
Acquiring companys management
Research analysts
Bankers

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Target companys management

15

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Projecting financial statements

WACC
Other topics

Ideally projections should go out as far into the future as can reasonably be

estimated to reduce dependence on the terminal value


Most important assumptions
Sales growth: Use divisional, product-line or location-by-location build-up or

simple growth assumptions


Operating margins: Evaluate improvement over time, competitive factors, SG&A

costs
Synergies: Estimate dollars in Year 1 and evaluate margin impact over time

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Depreciation: Should conform with historic and projected capex


Capital expenditures: Consider both maintenance and expansion capex
Changes in net working capital: Should correspond to historical patterns and grow

as the business grows


Should show historical financial performance and sanity check projections against

past results. Be prepared to articulate why projections may or may not be similar to
past results (e.g. reasons behind margin improvements, increased sales growth, etc.)
Analyze projections for consistency
Sales increases usually require working capital increases
CAPEX and depreciation should converge over time

16

Overview

Free cash flow is the cash that remains for creditors and
owners after taxes and reinvestment

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Unlevered free cash flows can be forecast from a firms financial projections, even if

those projections include the effects of debt


To do this, simply start your calculation with EBIT (earnings before interest and

taxes)
EBIT (from the income statement)

Plus: Non-tax-deductible goodwill amortization


Less: Taxes (at the marginal tax rate)
Equals: Tax-effected EBITA
AN AL Y SI S

Plus: Deferred taxes1


Plus: Depreciation and any tax-deductible amortization

F L OW

Less: Capital expenditures


Plus/(less): Decrease/(increase) in net working investment

D I S C O UN T E D

C A S H

Equals: Unlevered free cash flow

Although beyond the scope of our current discussions, you should only include actual cash taxes paid in the DCF. Depending on the firm and industry, you may want to adjust
for the non-cash (or deferred) portion of a firms tax provision. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue
for your analysis

17

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Calculating unlevered free cash flows

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
millions
$ millions
Fiscal year ending December 31,
Net sales

AN AL Y SI S

2004P

2005P

2006P

2007P

2008P

$440.0

$484.0

$532.4

$585.6

$644.2

$708.6

$779.5

80.0

88.0

96.8

106.5

117.1

128.8

141.7

155.9

Less: Depreciation

12.0

13.2

14.5

16.0

17.6

19.3

21.3

23.4

EBITA

68.0

74.8

82.3

90.5

99.6

109.5

120.5

132.5

Less: Taxes at marginal rate

27.2

29.9

32.9

36.2

39.8

43.8

48.2

53.0

$40.8

$44.9

$49.4

$54.3

$59.7

$65.7

$72.3

$79.5

16.0

17.6

19.3

21.3

23.4

Less: Capital expenditures

20.0

22.0

24.2

26.6

29.3

Less: Incr./(decr.) in working capital

10.0

8.5

7.0

5.5

4.0

Unlevered free cash flow

40.3

46.8

53.8

61.4

69.6

Adjustment for deal date

(40.3)

$0.0

$46.8

$53.8

$61.4

$69.6

Plus: Deferred taxes

F L OW

2003

$400.0

Plus: Depreciation

C A S H

2002

EBITDA

Tax-effected EBITA

D I S C O UN T E D

2001

Unlevered FCF to acquirer

Key assumptions:
Deal/valuation date = 12/31/04
Marginal tax rate = 40%

18

Overview

Valuing the incremental effects of changes in projected


operating results

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

In performing DCF analysis, we often need to determine the incremental impact on

value of certain events or adjustments to the projections, including:


Synergies achievable through the M&A transaction

Revenue
Cost
Capital expenditures
Expansion plans
Cost reductions
Change in sales growth

These incremental effects can be valued by discounting them independently (net of

taxes) or by adjusting the DCF model and simply measuring the incremental impact

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Margin improvements

19

Overview

Once unlevered free cash flows are calculated, they must


be discounted to the present

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

The standard present value calculation takes into account the cost of capital by attributing

greater value to cash flows generated earlier in the projection period than later cash flows

Present value =

FCF1
(1+r)1

FCF2
(1+r)2

FCF3
(1+r)3

...

FCFn

(1+r)n

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Since most businesses do not generate all of their free cash flows on the last day of the

year, but rather more-or-less continuously during the year, DCF analyses often use the socalled mid-year convention, which takes into account the fact that free cash flows occur
during the year

JPMorgan
JPMorgan
standard
standard

Present value =

FCF1
(1+r)0.5

FCF2
(1+r)1.5

FCF3
(1+r)2.5

...

FCFn
(1+r)n-0.5

This approach moves each cash flow from the end of the applicable period to the middle of

the same period (i.e., cash flows are moved closer to the present)

20

It is important to differentiate between the transaction


date and the mid-year convention

M&A - DCF and M&A analysis

Transaction
Transaction date:
date: 01/01
01/01

Year

0.5

First cash flow,


mid-year 1
CF1

Discounting =

Second cash flow,


mid-year 2
CF2

(1+r)0.5

1.5

CF3

(1+r)1.5

2.5

3.5

3.5

Third cash flow,


mid-year 3
.

(1+r)2.5

Period 1 CF to buyer

Year

D I S C O UN T E D

0.5

0.75

First cash flow,


mid-period 1

C A S H

F L OW

AN AL Y SI S

Transaction
Transaction date:
date: 06/30
06/30

Discounting =

CF1
(0.75-0.5)

(1+r)

1.5

Second cash flow,


mid-year 2
CF2
(1.5-0.5)

(1+r)

2.5

Third cash flow,


mid-year 3
CF3

(2.5-0.5)

(1+r)

21

M&A - DCF and M&A analysis

Practice exercise
Transaction
Transaction date:
date: 09/30
09/30

Period 1 CF
to buyer

Year

0.5

0.75

Discounting =

CF1
(1+r)(0.875-0.75)

2nd cash flow,


mid-year 2
CF2

(1+r)(1.5-0.75)

2.5

3.5

3rd cash flow,


mid-year 3
CF3

(1+r)(2.5-0.75)

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

1st flow,
mid-period 1

1.5

22

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Discounting free cash flows

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
millions
$ millions
Fiscal year ending December 31,
2001

2002

2003

2004P

2005P

2006P

2007P

2008P

$400.0

$440.0

$484.0

$532.4

$585.6

$644.2

$708.6

$779.5

EBITDA

80.0

88.0

96.8

106.5

117.1

128.8

141.7

155.9

Less: Depreciation

12.0

13.2

14.5

16.0

17.6

19.3

21.3

23.4

EBITA

68.0

74.8

82.3

90.5

99.6

109.5

120.5

132.5

Less: Taxes at marginal rate

27.2

29.9

32.9

36.2

39.8

43.8

48.2

53.0

$40.8

$44.9

$49.4

$54.3

$59.7

$65.7

$72.3

$79.5

16.0

17.6

19.3

21.3

23.4

Less: Capital expenditures

20.0

22.0

24.2

26.6

29.3

Less: Incr./(decr.) in working capital

10.0

8.5

7.0

5.5

4.0

Unlevered free cash flow

40.3

46.8

53.8

61.4

69.6

Adjustment for deal date

(40.3)

Unlevered FCF to acquirer

$0.0

$46.8

$53.8

$61.4

$69.6

Memo: Discounting factor

0.0

0.5

1.5

2.5

3.5

$0.0

$44.6

$46.7

$48.4

$49.9

Net sales

Tax-effected EBITA
Plus: Depreciation

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Plus: Deferred taxes

Discounted value of unlevered FCF


Discounted value of FCF 2005P2008P

Formula
Key assumptions:
Deal/valuation date = 12/31/04
Marginal tax rate = 40%
Discount rate = 10%

$189.6 =

189.6

$46.8
(1+.10)0.5

$53.8
(1+.10)1.5

$61.4
(1+.10)2.5

$69.6
(1+.10)3.5

23

Overview

Terminal value can account for a significant portion of


value in a DCF analysis

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Terminal value represents the businesss value at the end of the projection period;

i.e., the portion of the companys total value attributable to cash flows expected
after the projection period
Terminal value is typically based on some measure of the performance of the

business in the terminal year of the projection (which should depict the business
operating in a steady-state/normalized manner)
Terminal (or Exit) multiple method

Assumes that the business is valued/sold at the end of the terminal year at a
multiple of some financial metric (typically EBITDA)
Assumes that the business is held in perpetuity and that free cash flows
continue to grow at an assumed rate
A terminal multiple will have an implied growth rate and vice versa. It is
Once calculated, the terminal value is discounted back to the appropriate date using
Attempt to reduce dependence on the terminal value

D I S C O UN T E D

F L OW

essential to review the implied multiple/growth rate for sanity check purposes

C A S H

AN AL Y SI S

Growth in perpetuity method

the relevant rate

What is appropriate projection time frame?


What percentage of total value comes from the terminal value?

24

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Terminal multiple method

WACC
Other topics

This method assumes that the business will be valued at the end of the last year of

the projected period


The terminal value is generally determined as a multiple of EBIT, EBITDA or

EBITDAR; this value is then discounted to the present, as were the interim free cash
flows
The terminal value should be an asset (firm) value; remember that not all

multiples produce an asset value


Note that in the exit multiple method terminal value is always assumed to be

Should the terminal multiple be an LTM multiple or a forward multiple?


If the terminal value is based on the last year of your projection then the multiple

should be based on an LTM multiple (most common)


There are circumstances where you will project an additional year of EBITDA and

apply a forward multiple

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

calculated at the end of the final projected year, irrespective of whether you are
using the mid-year convention

25

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Most common error: The final year is not normalized

WACC
Other topics

Consider adding a year to the projections which represents a normalized year


A steady-state, long-term industry multiple should be used rather than a current

multiple, which can be distorted by contemporaneous industry or economic factors


Treat the terminal value cash flow as a separate, critical forecast
Growth rate

Consistent with long-term economic assumptions


Net working investment consistent with projected growth
Capital expenditures needed to fuel estimated growth
Depreciation consistent with capital expenditures
Margins

Adjusted to reflect long-term estimated profitability


Normalized tax rate

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Reinvestment rate

26

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Terminal multiple method

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
$ millions
millions
Fiscal year ending December 31,

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Net sales
EBITDA
Less: Depreciation
EBITA
Less: Taxes at marginal rate
Tax-effected EBITA
Plus: Depreciation
Plus: Deferred taxes
Less: Capital expenditures
Less: Incr./(decr.) in working capital
Unlevered free cash flow
Adjustment for deal date
Unlevered FCF to acquirer

2001
$400.0
80.0
12.0
68.0
27.2
$40.8

2001
$440.0
88.0
13.2
74.8
29.9
$44.9

2003
$484.0
96.8
14.5
82.3
32.9
$49.4

Memo: Discounting factor


Discounted value of unlevered FCF
Discounted value of FCF 2005P2008P
EBITDA in 2008P
Exit multiple
Firm value at exit
Discounted terminal value
Total present value to acquirer

Key assumptions:
Deal/valuation date = 12/31/04
Marginal tax rate = 40%
Discount rate = 10%
Exit multiple of EBITDA = 7.0x

2004P
$532.4
106.5
16.0
90.5
36.2
$54.3
16.0

20.0
10.0
40.3
(40.3)
$0.0

2005P
$585.6
117.1
17.6
99.6
39.8
$59.7
17.6

22.0
8.5
46.8

$46.8

2006P
$644.2
128.8
19.3
109.5
43.8
$65.7
19.3

24.2
7.0
53.8

$53.8

2007P
$708.6
141.7
21.3
120.5
48.2
$72.3
21.3

26.6
5.5
61.4

$61.4

2008P
$779.5
155.9
23.4
132.5
53.0
$79.5
23.4

29.3
4.0
69.6

$69.6

0.0

0.5

1.5

2.5

3.5

$0.0
189.6

$44.6

$46.7

$48.4

$49.9

$155.9
7.0x
1,091.3
745.4
$934.9

Formula

($155.9 * 7.0x)
$745.4 =

(1+.10)4
27

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Terminal multiple method (contd)

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
millions,
except
per
share
data
$ millions, except per share data

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Discounted

Discounted terminal value

Firm value

FCF

at 2008P EBITDA multiple of

at 2008P EBITDA multiple of

Discount rate

20052008

6.0x

7.0x

8.0x

6.0x

7.0x

8.0x

8%

$196.8

$687.5

$802.1

$916.7

$884.4

$999.0

$1,113.6

9%

193.1

662.6

773.1

883.5

855.8

966.2

1,076.7

10%

189.6

638.9

745.4

851.8

828.4

934.9

1,041.4

11%

186.1

616.2

718.9

821.6

802.3

904.9

1,007.6

12%

182.7

594.5

693.5

792.6

777.2

876.3

975.3

Net debt
Discount rate

12/31/04

8%

Equity value

Equity value per share1

at 2008P EBITDA multiple of

at 2008P EBITDA multiple of

6.0x

7.0x

8.0x

6.0x

7.0x

8.0x

$100.0

$784.4

$899.0

$1,013.6

$19.17

$21.97

$24.77

9%

100.0

755.8

866.2

976.7

$18.47

$21.17

$23.87

10%

100.0

728.4

834.9

941.4

$17.80

$20.41

$23.01

11%

100.0

702.3

804.9

907.6

$17.16

$19.67

$22.18

12%

100.0

677.2

776.3

875.3

$16.55

$18.97

$21.39

Note: DCF value as of 12/31/01 based on mid-year convention


1 Based on 40.91 million diluted shares outstanding

28

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Growth in perpetuity method

WACC
Other topics

This method assumes that the business will be owned in perpetuity and that the

business will grow at approximately the long-term macroeconomic growth rate


Few businesses can be expected to have cash flows that truly grow forever; be

conservative when estimating growth rates in perpetuity


Take free cash flow in the last year of the projection period, n, and grow it one

more year to n+1;1 this free cash flow is then capitalized at a rate equal to the
discount rate minus the growth rate in perpetuity
To ensure that the terminal year is normalized, JPMorgan models are set up to

JPM
JPM recommended
recommended method
method

Terminal value = (FCFn * (1 + g))/(WACC g)

Terminal value = (FCFn+1)/(WACC g)

F L OW

where FCFn = FCF in final projected period


g = growth rate in perpetuity
WACC = weighted-avg. cost of capital

where

PV of terminal value = terminal value/(1+WACC)n-0.5

PV of terminal value = terminal value/(1+WACC)n-0.5

D I S C O UN T E D

Academic
Academic formula
formula

C A S H

AN AL Y SI S

project one year past the projection year and allow for normalizing adjustments;
this FCFn+1 is then discounted by the perpetuity formula

FCFn+1
g
WACC

= FCF in year after projections


= growth rate in perpetuity
= weighted-avg. cost of capital

This step is taken because the perpetuity growth formula is based on the principle that the terminal value of a business is the value of its next cash flow, divided by the
difference between the discount rate and a perpetual growth rate

29

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Growth in perpetuity method (contd)

WACC
Other topics

Note that when using the mid-year convention, terminal value is discounted as if

cash flows occur in the middle of the final projection period


Here the growth-in-perpetuity method differs from the exit-multiple method
Typical adjustments to normalize free cash flow in Year n include revising the

relationship between revenues, EBIT and capital spending, which in turn affects
CAPEX and depreciation
Working capital may also need to be adjusted

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Often CAPEX and depreciation are assumed to be equal

30

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Growth in perpetuity method

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
millions
$ millions
Fiscal year ending December 31,
2001

2002

2003

2004P

2005P

2006P

2007P

2008P

$400.0

$440.0

$484.0

$532.4

$585.6

$644.2

$708.6

$779.5

EBITDA

80.0

88.0

96.8

106.5

117.1

128.8

141.7

155.9

Less: Depreciation

12.0

13.2

14.5

16.0

17.6

19.3

21.3

23.4

EBITA

68.0

74.8

82.3

90.5

99.6

109.5

120.5

132.5

Less: Taxes at marginal rate

27.2

29.9

32.9

36.2

39.8

43.8

48.2

53.0

$40.8

$44.9

$49.4

$54.3

$59.7

$65.7

$72.3

$79.5

16.0

17.6

19.3

21.3

23.4

Less: Capital expenditures

20.0

22.0

24.2

26.6

29.3

Less: Incr./(decr.) in working capital

10.0

8.5

7.0

5.5

4.0

Unlevered free cash flow

40.3

46.8

53.8

61.4

69.6

Adjustment for deal date

(40.3)

Unlevered FCF to acquirer

$0.0

$46.8

$53.8

$61.4

$69.6

Memo: Discounting factor

0.0

0.5

1.5

2.5

3.5

$0.0

$44.6

$46.7

$48.4

$49.9

Net sales

Tax-effected EBITA
Plus: Depreciation

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Plus: Deferred taxes

Discounted value of unlevered FCF


Discounted value of FCF 2005P2008P

189.6

PV of Terminal Value

733.7

Total present value to acquirer


Key assumptions:
Deal/valuation date = 12/31/04
Marginal tax rate = 40%
Discount rate = 10%
Perpetuity growth rate = 3%

$923.3

Formula

$69.6 * (1 + .03)
$733.6 =
(.10 - .03)*(1+.10)3.5
31

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Example: Growth in perpetuity method (contd)

WACC
Other topics

Stand-alone
Stand-alone DCF
DCF analysis
analysis of
of Company
Company X
X
$
$ millions,
millions, except
except per
per share
share data
data
A

Discount rate
8%
9%
10%
11%
12%

Firm value

FCF

at perpetuity growth rate of

at perpetuity growth rate of

2.5%
$991.0
811.9
681.5
582.6
505.1

3.0%
$1,095.4
883.8
733.7
622.0
535.8

3.5%
$1,223.0
968.9
794.0
666.7
570.1

12/31/04
$100.0
100.0
100.0
100.0
100.0

2.5%
$1,187.8
1,005.0
871.1
768.7
687.9

3.0%
$1,292.2
1,077.0
923.3
808.1
718.5

3.5%
$1,419.8
1,162.0
983.6
852.8
752.8

E
Equity value

Equity value per share1

at perpetuity growth rate of

at perpetuity growth rate of

2.5%
$1,087.8
905.0
771.1
668.7
587.9

3.0%
$1,192.2
977.0
823.3
708.1
618.5

3.5%
$1,319.8
1,062.0
883.6
752.8
652.8

2.5%
$26.59
$22.12
$18.84
$16.34
$14.37

3.0%
$29.14
$23.88
$20.12
$17.31
$15.12

3.5%
$32.26
$25.96
$21.59
$18.40
$15.95

D I S C O UN T E D

C A S H

F L OW

Discounted terminal value

Net debt
Discount rate
8%
9%
10%
11%
12%

Discounted
20052008
$196.8
193.1
189.6
186.1
182.7

AN AL Y SI S

Note: DCF value as of 12/31/04 based on mid-year convention


1

Based on 40.91 million diluted shares outstanding

32

Overview

Terminal multiples and perpetuity growth rates are often


considered side-by-side

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Assumptions regarding exit multiples are often checked for reasonableness by calculating the

growth rates in perpetuity that they imply (and vice versa)


To go from the exit-multiple approach to an implied perpetuity growth rate:

g = [(WACC*terminal value) / (1+WACC)0.5 - FCFn] / [FCFn + (terminal value / (1 + WACC)0.5)]


To go from the growth-in-perpetuity approach to an implied exit multiple:

multiple = [FCFn * (1 + g)(1 + WACC)0.5] / [EBITDAn * (WACC - g)]


the mid-year convention

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

These formulas adjust for the different approaches to discounting terminal value when using

33

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Terminal multiple method and implied growth rates

WACC
Other topics

Standalone
Standalone Company
Company X
X DCF
DCF analysis
analysis
$
$ millions
millions
A
Discounted
FCF
20052008
$196.8
193.1
189.6
186.1
182.7

Discount
rate
8%
9%
10%
11%
12%

AN AL Y SI S

D
Net debt
12/31/04
$100.0
100.0
100.0
100.0
100.0

D I S C O UN T E D

Discounted terminal value


at 2008P EBITDA multiple of
6.0x
7.0x
8.0x
$687.5
$802.1
$916.7
662.6
773.1
883.5
638.9
745.4
851.8
616.2
718.9
821.6
594.5
693.5
792.6

C
Firm value
at 2008P EBITDA multiple of
6.0x
7.0x
8.0x
$884.4
$999.0 $1,113.6
855.8
966.2
1,076.7
828.4
934.9
1,041.4
802.3
904.9
1,007.6
777.2
876.3
975.3

Terminal value as percent


of total firm value
6.0x
7.0x
8.0x
78%
80%
82%
77%
80%
82%
77%
80%
82%
77%
79%
82%
76%
79%
81%

Equity value per share1


at 2008P EBITDA multiple of
6.0x
7.0x
8.0x
$19.17
$21.97
$24.77
$18.47
$21.17
$23.87
$17.80
$20.41
$23.01
$17.16
$19.67
$22.18
$16.55
$18.97
$21.39

Implied perpetuity growth rate


at 2008P EBITDA multiple of

E
Equity value
at 2008P EBITDA multiple of
6.0x
7.0x
8.0x
$784.4
$899.0 $1,013.6
755.8
866.2
976.7
728.4
834.9
941.4
702.3
804.9
907.6
677.2
776.3
875.3

C A S H

F L OW

Discount
rate
8%
9%
10%
11%
12%

6.0x
0.2%
1.1%
2.0%
2.9%
3.8%

7.0x
1.3%
2.2%
3.1%
4.0%
4.9%

8.0x
2.1%
3.0%
3.9%
4.8%
5.8%

At a 9% discount rate and an 8.0x exit multiple the price


is $23.87 and the implied terminal growth rate is 3.0%
Note: DCF value as of 12/31/04 based on mid-year convention
1

Based on 40.91 million diluted shares outstanding

34

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Perpetuity growth rate and implied terminal multiples

WACC
Other topics

Standalone
Standalone Company
Company X
X DCF
DCF analysis
analysis
$
$ millions
millions
A
Discounted
FCF
20052008
$196.8
193.1
189.6
186.1
182.7

Discount
rate
8%
9%
10%
11%
12%

D
Net debt
12/31/04
$100.0
100.0
100.0
100.0
100.0

D I S C O UN T E D

Discounted terminal value


at perpetuity growth rate of

Firm value
at perpetuity growth rate of

2.5%
3.0%
3.5%
$991.0 $1,095.4 $1,223.0
811.9
883.8
968.9
681.5
733.7
794.0
582.6
622.0
666.7
505.1
535.8
570.1

2.5%
3.0%
3.5%
$1,187.8 $1,292.2 $1,419.8
1,005.0
1,077.0
1,162.0
871.1
923.3
983.6
768.7
808.1
852.8
687.9
718.5
752.8

Terminal value as percent


of total firm value
2.5%
83%
81%
78%
76%
73%

3.0%
85%
82%
79%
77%
75%

3.5%
86%
83%
81%
78%
76%

E
Equity value
at perpetuity growth rate of
2.5%
3.0%
3.5%
$1,087.8 $1,192.2 $1,319.8
905.0
977.0 1,062.0
771.1
823.3
883.6
668.7
708.1
752.8
587.9
618.5
652.8

C A S H

F L OW

AN AL Y SI S

Discount
rate
8%
9%
10%
11%
12%

Equity value per share1


at perpetuity growth rate of
2.5%
$26.59
$22.12
$18.84
$16.34
$14.37

3.0%
$29.14
$23.88
$20.12
$17.31
$15.12

3.5%
$32.26
$25.96
$21.59
$18.40
$15.95

Implied EBITDA exit multiple


at perpetuity growth rate of
2.5%
8.6x
7.4
6.4
5.7
5.1

3.0%
9.6x
8.0
6.9
6.1
5.4

3.5%
10.7x
8.8
7.5
6.5
5.8

At a 9% discount rate and a terminal growth rate of 3.0%,


the price is $23.88 and the implied exit multiple is 8.0x
Note: DCF value as of 12/31/04 based on mid-year convention
1 Based on 40.91 million diluted shares outstanding

35

Overview

Choosing the discount rate is a critical step in


DCF analysis

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

The discount rate represents the required rate of return given the risks inherent in

the business, its industry, and thus the uncertainty regarding its future cash flows, as
well as its optimal capital structure
Typically the weighted average cost of capital (WACC) will be used as a foundation

for setting the discount rate


The WACC is always forward-looking and is predicted based on the expectations of

an investment's future performance; an investor contributes capital with the


expectation that the riskiness of cash flows will be offset by an appropriate return
The WACC is typically estimated by studying capital costs for existing investment
AN AL Y SI S

opportunities that are similar in nature and risk to the one being analyzed
The WACC is related to the risk of the investment, not the risk or creditworthiness of

D I S C O UN T E D

C A S H

F L OW

the investor

In valuing a company, always use the riskiness of its cash flows or comparable companies in estimating a weighted average cost of capital. Never use the acquirers cost
capital unless, by some chance, it is engaged in an extremely similar line of business. However, if a business is small relative to an acquirors, sometimes ti may be
appropriate to consider the use of the acquirors WACC in performing the valuation. The additional value created by using the acquirors WACC can be viewed as a synergy to
the acquiror in the context of the transaction.

36

Overview

JPMorgan estimates the cost of equity using the capital


asset pricing model

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

The Capital Asset Pricing Model (CAPM) classifies risk as systematic and

unsystematic. Systematic risk is unavoidable. Unsystematic risk is that portion of


risk that can be diversified away, and thus will not be paid for by investors
The CAPM concludes that the assumption of systematic risk is rewarded with a risk

premium, which is an expected return above and beyond the risk-free rate. The size
of the risk premium is linearly proportional to the amount of risk taken. Therefore,
the CAPM defines the cost of equity as equaling the risk-free rate plus the amount of
systematic risk an investor assumes

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

The CAPM formula follows:

Cost of equity = Risk-free rate + (beta * market risk premium)


re = rf + * (rm - rf)
Where
re =
rf =
rm =
=

the required market return on the equity of the company


the risk-free rate
the return on the market
the companys projected (leveraged) beta

There is also an error term in the CAPM formula, but this is usually omitted

37

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

The cost of equity is the major component of the WACC

WACC
Other topics

The cost of equity reflects the long-term return expected by the market (dividend

yield plus share appreciation)


Risk-free rate based on the 10 year bond yield
Incorporates the undiversifiable risk of an investment (beta)
Equity risk premium reflects expectations of todays market
The market risk premium (rm - rf; i.e., the spread of market return over the risk-free

Cost of equity

D I S C O UN T E D

Risk free rate

Beta

Equity risk premium

Adjustment for
correlation to
stock market
returns

Appropriate extra
return above risk free
x
rate

Long-term return on
equity investment in
=
todays market

Long-term risk-free
rate of return
(beta=0)

10-year bond yield


(annual average)

Predicted betas

Estimated using
various techniques

4.97%

1.00

5.00%

9.97%

C A S H

F L OW

AN AL Y SI S

rate) is periodically estimated by M&A research based on analysis of historical data

For market average

38

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

JPMorgan estimates the equity risk premium at 5.0%

WACC
Other topics

Equity risk premiums is estimated based on expected returns and recent historical returns
Equity
Equity premiums
premiums
Rolling
Rolling average
average over
over 10-year
10-year bond
bond
14%

Rolling 30 years

Rolling 40 years

Equity
Equity returns
returns less
less 10-year
10-year bond
bond yield
yield
Arithmetic
average
Arithmetic average
Rolling 50 years

12%

Equity risk premium (%)

1994

2.7

1995

3.4

1996

4.4

1997

4.7

1998

5.2

1999

6.2

2000

5.8

2001

5.0

8%

6%

4%

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

10%

30 years ending

2%
1955 1959 1963 1968 1972 1976 1980 1984 1988 1993 1997 2001

39

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Beta

WACC
Other topics

Beta provides a method to estimate an asset's systematic (non-diversifiable) risk


Beta equals the covariance between expected returns on the asset and on the stock

market, divided by the variance of expected returns on the stock market


A company whose equity has a beta of 1.0 is as risky as the overall stock market

and should therefore be expected to provide returns to investors that rise and fall as
fast as the stock market; a company with an equity beta of 2.0 should see returns on
its equity rise twice as fast or drop twice as fast as the overall market
Returning to our CAPM formula, the beta determines how much of the market risk
Since the cost of capital is an expected value, the beta value should be an expected

value as well
Although the CAPM analysis, including the use of beta, is the overwhelming favorite

for DCF analysis, other capital asset pricing models exist, such as multi-factor
models like the Arbitrage Pricing Theory

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

premium will be added to or subtracted from the risk-free rate

40

Overview

JPMorgan uses predicted betas to calculate the cost of


equity

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Predicted betas are constructed to adjust for many risk factors, incorporating firms earnings

volatility, size, industry exposure, and leverage


Predicted betas are more consistent and less volatile than historical betas
Historical betas only measure the past relationship between a firms return and market returns

and are often distorted


Projected betas can be obtained from Barra or an online database (e.g., IDD)
Barra predicted betas can be found through the Investment Bank Home Web page1
Note that Bloomberg betas are based on historic prices and are therefore not forward-looking

D I S C O UN T E D

C A S H

Distribution
Distribution of
of predicted
predicted and
and historical
historical betas
betas for
for 5,600
5,600 publicly-traded
publicly-traded companies
companies
800

Historical Beta

Predicted Beta

800

600

# of companies

# of companies

F L OW

AN AL Y SI S

Impute unlevered beta for private company from public comparables

400
200
0
(1.5) (1.0) (0.5) 0.0

Supermarkets
0.78

Predicted betas

600
400
200

Cellular
1.62

Food
0.52

Internet
2.09

Utilities
0.43

0
0.5

1.0

1.5
Beta

2.0

2.5

3.0

3.5

4.0

(0.5)

0.2

1.0
Beta

1.9

2.6

41

M&A - DCF and M&A analysis

Delevering and relevering beta


Recalling our previous discussion regarding the difference between asset values and

equity values, a similar argument exists for betas. The predicted equity beta, i.e.,
the observed beta, included the effects of leverage. In the course of performing a
variance analysis, which looks at different target capitalizations, the equity beta
must be delevered to get an asset, or unlevered, beta. This asset beta is then
used in the CAPM formula to determine the appropriate cost of capital for various
debt levels
The formula follows:

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

U= L/[1 = ((1 T) * (Debt/Equity))]

Where:
U = unlevered (asset) beta

BL = leveraged beta
T = marginal tax rate
To relever the beta at a target capital structure:

L= U*[1 + ((1 T) * (Debt/Equity))]

42

M&A - DCF and M&A analysis

Delevering and relevering beta (contd)


Note that JPMorgan M&A sometimes uses a factor, tau, in place of the marginal tax

rate, T
Tau, currently equal to 0.26, represents the average blended benefit a

shareholder gets from a company borrowing (reflects many factors)


The value of Tau is derived by researchers using complicated statistical analyses
Although the delevering/relevering methodology is standard for WACC analyses, the

formula does not produce a highly accurate result


Remember the fundamentals: the market charges more for equity of companies that
Exercise
1. Levered Beta = 1.25, T = 40%, D/E= 0.75; What is the Beta Unlevered?
2. Find the levered Beta at a D/E = 1.0

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

are financially risky

43

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

The cost of a firms equity should be adjusted for size

WACC
Other topics

Size
Size premium
premium by
by market
market cap
cap
Based
on
historical
Based on historical returns
returns analysis
analysis

Investors typically expect higher returns

when investing in smaller companies

Market cap ($mm)

5.2%

Increased risk

3.1%

Lower liquidity

2.5%

1.9%

1.7%

1.4%

1.1%

Betas vary very little by size


Historical equity returns suggest higher

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

return required by investors in smaller


companies
P/E growth ratios (PEG) tend to decline with

size

0.8%
0.0%

$0
100

$100
250

$250
500

$500
700

$7001,000

$1,000 $1,500 $2,500


$5,000+
1,500
2,500
5,000

Size
Size premium
premium by
by market
market cap
cap
Based
on
PE/growth
Based on PE/growth (PEG)
(PEG)
Market cap ($mm)

2.2%
1.6%

Empirical data combined with judgement

1.1%

should be applied when estimating the cost


of equity for smaller firms

0.8%
0.0%
$100500

$5001,000

$1,0002,500

$2,5005,000

$5,000+

44

Overview

JPMorgan uses the long-term cost of debt in


estimating WACC

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

The long-term cost of debt is used because the cost of capital is normally applied to

long-term cash flows


Using the long-term cost of debt removes any refinancing costs/risks from the

valuation analysis
To the extent a company can fund its investments at a lower cost of debt (with

the same risk), this value should be attributed to the finance staff

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

JPMorgan uses the companys normalized cash tax rate

45

Overview

The cost of equity and debt are blended together based


on a target capital structure

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

The target capital structure reflects the companys rating objective


Firms generally try to minimize the cost of capital through the appropriate use of leverage
The percentage weighting of debt and equity is usually based on the market value of a firms equity and debt

position
Most firms are at their target capital structure
Adjustments should be made for seasonal or cyclical swings, as well as for firms moving toward a target
Using a weighted average cost of capital assumes that all investments are funded with the same mix of equity

and debt as the target capital structure


WACC
WACC formula
formula
AN AL Y SI S

WACC = rd *

Where:

T = Marginal tax rate

E = Market value of equity


D = Market value of debt

re = Return on equity
rd = Return on debt

Illustrative
Illustrative SYSCO
SYSCO weighted
weighted average
average cost
cost of
of capital
capital calculation
calculation

F L OW

Cost of equity

Cost of debt

Cost of capital
10-year T-bond (Avg)

C A S H
D I S C O UN T E D

[D *(1-T)] + re * E
D+E
D+E

4.97%

Market risk premium


(x) Beta (current predicted)
Adjusted market premium
Cost of equity

5.00%
0.62
3.10%
=

Target capital structure


(Assumes current = optimal)

Cost of debt

6.25%

(-) Tax shield1

2.19%

After-tax cost of debt

4.06%

Debt/total capital2 = 6.1%

8.07%

Nominal WACC = 7. 82%


1
2

Assumes 35% marginal tax rate


Total capital = debt + market value of equity

46

Example: Calculating WACC based on


comparable companies

M&A - DCF and M&A analysis

Target
Target WACC
WACC analysis
analysis as
as of
of 1/1/01
1/1/01
Macroeconomic
Macroeconomic assumptions
assumptions
Risk free rate1

5.40%

Estimated market equity risk premium

Projected Target marginal tax rate

40.0%

4.0%

Industry
Industry beta
beta analysis
analysis

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Comparable
company

Projected
levered beta3

Net
debt/mkt.
cap

Total
debt/mkt.
equity

Tax rate

Unlevered
beta4

Cost of
levered
equity

Cost of
unlevered
equity

Company A

1.06

17.2%

22.5%

0.40

0.93

9.6%

9.1%

Company B

0.90

18.0

22.2

0.40

0.79

9.0

8.6

Company C

0.90

40.3

78.4

0.40

0.61

9.0

7.8

Company D

0.89

8.6

10.1

0.40

0.84

9.0

8.8

Average

0.94

21.0%

33.3%

0.40

0.79

9.1%

8.6%

Levered beta
assuming
unlevered
beta of 0.79

Cost of
levered
equity

Target
nominal
WACC

Target
Target WACC
WACC calculation
calculation
Optimal
debt/market
capitalization

Optimal debt/equity

Spread to
10-yr
treasuries
(bp)

Country risk
premium

Pre-tax long
term cost of
debt

30.0%

42.9%

175.0

0.00%

7.1%

1.00

9.4%

7.9%

40.0

66.7

200.0

0.00

7.4

1.11

9.8

7.7

50.0

100.0

300.0

0.00

8.4

1.27

10.5

7.8

60.0

150.0

400.0

0.00

9.4

1.51

11.4

8.0

70.0

233.3

500.0

0.00

10.4

1.91

13.0

8.3

1 Risk-free rate=yield-to-maturity of 10-year U.S. Treasury bond as of 1/1/01 (Source: Bloomberg)


2 Source: JPMorgan M&A research
3 Source: Barra predicted betas
4 Unlevered beta=Levered beta/(1 + (total debt/market value of equity)*(1-tax rate)). Assumes beta of debt equals zero

47

Overview

The appropriate cost of capital will depend on the entity


which is being valued

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

For
For illustrative
illustrative purposes
purposes

Risk
premium

Unlevered
beta

Optimal
debt/equity

Re-levered
beta

Cost of
equity

Cost of
financing

WACC

5.0%

0.70

20%

0.80

9.0%

6.25%

8.2%

$1BN target

5.0%-6.5%

0.70

20%

0.80

9.0%10.3%

6.25%7.50%

8.3%9.3%

$500mm target

5.0%-7.0%

0.70

20%

0.80

9.0%10.6%

6.25%8.00%

8.4%9.7%

$200mm target

5.0%-7.5%

0.70

20%

0.80

9.0%11.0%

6.25%8.50%

8.4%10.1%

SYSCO

SYSCO
SYSCO WACC
WACC sensitivity
sensitivity

$1bn target
target WACC
WACC sensitivity
sensitivity
$1bn

10%

20%

30%

40%

0.65 7.8%

7.5%

7.3%

7.0%

0.70 8.1%

7.7%

7.5%

7.2%

0.75 8.3%

7.9%

7.7%

7.4%

0.80 8.5%

8.2%

7.8%

7.6%

0.85 8.8%

8.4%

8.0%

7.8%

Levered beta

Levered beta

Debt/equity

Debt/equity

10%

20%

30%

40%

0.70

9.1%

8.7%

8.4%

8.2%

0.75

9.4%

9.0%

8.7%

8.4%

0.80

9.7%

9.3%

8.9%

8.7%

0.85

10.0%

9.6%

9.2%

8.9%

0.90

10.3%

9.8%

9.4%

9.1%

10%

20%

30%

40%

0.70

9.8%

9.4%

9.1%

8.9%

0.75

10.1%

9.8%

9.4%

9.1%

0.80

10.5%

10.1%

9.7%

9.4%

0.85

10.8%

10.4%

10.0%

9.7%

0.90

11.2%

10.7%

10.3% 10.0%

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Debt/equity

$200mm target
target WACC
WACC sensitivity
sensitivity
$200mm

Levered beta

Company

Note: Assumes 35% marginal tax rate


1 Assuming an equity risk premium of 6.5%
2 Assuming an equity risk premium of 7.5%

48

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

DCF in-class exercise

WACC
Other topics

The Forecasted EBITDA and FCF for the next three years (2005, 2006, 2007) are
EBITDA (US $mm): 450, 500, 550
FCF (US $mm): 250, 261, 277
Other assumptions:
Perpetuity growth rate of 3.0%
Terminal exit multiple of 7.5x
Unlevered beta of 0.80
Risk free rate= 4.6%
Cost of debt: 6.2%
Marginal tax rate: 35%
Market value of equity=US $4,541mm
Net debt= US $2,524mm

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Market risk premium= 6%

49

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

DCF in-class exercise (contd)

WACC
Other topics

Calculate
The cost of equity
WACC
PV of FCF
NPV of company Perpetual growth method
PV of Exit multiple method
What if we use end period discounting in:

Perpetual growth method


Exit multiple method
Use Exit/Perpetual growth methods using mid year conventions
Use Exit/Perpetual growth methods using end year conventions

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

What is the valuation if we need to value the company as on March 31, 2005?

50

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Most common errors in calculating WACC

WACC
Other topics

Cost of equity
Equity risk premium based on very long time frame (post 1926: Ibbotson data)
Substitute hurdle rate (goal) for cost of capital
Use of historical (or predicted) betas that are clearly wrong
Investment specific risk not fully incorporated (e.g., country risk premiums)
Incorrect releveraging of the cost of equity

Target capital structure


The actual, not target, capital structure is used
WACC calculated based on book weights

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Cost of equity based on book returns, not market expectations

51

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Valuing synergies

WACC
Other topics

When two businesses are combined, the term synergies refers to the changes in

their aggregate operating and/or financial results attributable to their being


operated as a combined enterprise. Synergies can take many forms
Revenue enhancements
Cost savings

Raw material discounts/purchasing power


Sales and marketing overlap, Corporate overhead reductions
Distribution cost reductions, Facilities consolidation
Tax savings

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Merger related expenses (restructuring, additional CAPEX, integration expenses)


The value of achievable synergies is often a key element in whether to proceed with

a proposed transaction
Calculate synergies for both the acquiring company and the target
Remember incremental cash flow
Synergies are generally valued by toggling pre-tax changes to various financial

statement line items into a DCF model of the combined enterprise and simply
measuring the incremental impact

52

Overview
M&Aflow
- DCF and M&A analysis
Free cash

Terminal value

Valuing synergies

WACC
Other topics

Sources of synergy projections


Management
Research
Estimates from comparable transaction (% of sales, increase in EBITDA

margin etc.)
DCF with synergies
Valued separately from standalone DCF
Run sensitivity on synergy valuations

Timeline for achieving synergies


Run as sensitivity various cases of realization e.g., 25%, 50%, 75%, 100% realization
Tax impact
Costs incurred to achieve synergies

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Other considerations

53

Overview

Sensitivity analysis is vital when presenting the results of


DCF analysis

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

Recall that DCF valuation is highly sensitive to projections and assumptions


So-called sensitivity tables chart the output based on ranges of input variables
It is common to use a 3x3 table (i.e., showing three different values for each of

two input variables) to enable the reader to triangulate to the appropriate


inferences
Since DCF results are by their nature approximate, depicting sensitivity tables

enables users of DCF output to assess the degree of fuzziness in the results
growth rates generally show sensitivities for the method used to calculate terminal
value and a range of discount rates
Sensitivities can be shown for any variable in the model (including financial

projections)
Judge which sensitivities would be useful to decision makers

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

As shown in our previous examples, DCF analyses using exit multiples and perpetuity

54

Overview

Companies with multiple businesses are often valued on a


sum-of-the-parts basis

M&Aflow
- DCF and M&A analysis
Free cash

Terminal value
WACC
Other topics

This approach is sometimes referred-to as a break-up valuation


Particularly common when the company is believed to be undervalued by

the public
Better accounts for discrepancies in market conditions facing the businesses
The methodology requires estimating financial results for each business (EBIT,

EBITDA and/or net income), which can then be used with appropriate
multiples or growth rates in order to arrive at a firm value for each part
before the results are summed

D I S C O UN T E D

C A S H

F L OW

AN AL Y SI S

Completing a sum-of-the-parts valuation can be more challenging than a

straightforward (single-business/consolidated) DCF analysis


Typically less detailed financial data is publicly-available for segments
Often assumptions must be made about how to allocate expenses,

especially those that are clearly shared across businesses (like corporatelevel SG&A)
Need to consider different characteristics of each business segment

(discount rate, terminal value assumptions, etc.)

55

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

56

M&A - DCF and M&A analysis

Introduction to relative valuation


Relative valuation is utilized to illustrate how the value of one company compares to

another company
Typically, relative valuation analysis is utilized in the context of stock-for-stock

exchanges to determine the appropriate exchange ratio offered to shareholders in a


transaction
The exchange ratio reflects the number of acquiror shares offered for each target

share
So if you are a target shareholder and you are offered an exchange ratio of

0.500x, you are being offer 1/2 of an acquiror share for each share of the target
you own
Several relative valuation approaches exist
Contribution analysis
Relative multiple and discounted cash flow analysis
Valuation of synergies

R E L A T I V E

V A L U E

AN A L Y S I S

Historical trading and exchange ratio analysis

57

M&A - DCF and M&A analysis

Historical trading and exchange ratio analysis


Historical exchange ratio analysis Illustrates the relative movement in stock prices

(and implied exchange ratios, aka natural exchange ratios) looking back over a
certain timeframe
Calculated simply as the target share price on a given date divided by the acquiror

share price on the same date


Does not include any premium to the target
Provides a historical benchmark to justify the contemplated exchange ratio
Issues to consider when analyzing data include
Liquidity of shares / trading volume (small vs. large cap)
Relative market attention / analyst coverage
Multiple expansion of one of the companys peer group versus the other over the

R E L A T I V E

V A L U E

AN A L Y S I S

selected time horizon

58

M&A - DCF and M&A analysis

Illustrative historical trading and exchange ratio analysis

Acquiror shares per Target share


Implied Target share price

$12.00 ratio as a premium


Implied Target pro forma ownership

Ratio at
$12.00

Current1

0.347x

0.194x

Last
month1
0.184x

Last 3
months1

Last 6
months1

Last 12
months1

0.203x

0.236x

0.270x

$12.00

$6.70

$6.38

$7.02

$8.15

$9.33

0%

79.1%

88.2%

71.0%

47.3%

28.7%

38.7%

24.6%

23.6%

25.6%

28.9%

32.2%

Historical
Historical exchange
exchange ratio
ratio
Current stock price2

# of acquiror shares per target share


0.45x

Current market capitalization2

Acquiror

Target

Acquiror

Target

$34.60

$6.70

$274.8

$89.7

0.40x

More
favorable
to Target

At $12 per share = 0.347x

0.35x
0.30x

R E L A T I V E

V A L U E

AN A L Y S I S

0.25x
0.20x

Less
favorable
to Target
Source:

Current = 0.194x

0.15x
0.10x
0.05x
0.00x
Jun-00

1
2
3

Sep-00

Dec-00

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Represents average exchange ratio over the trailing period ended June 27, 2002
Closing prices as of June 27, 2002
Assumes acquirors current price of $34.60 per share

59

M&A - DCF and M&A analysis

Contribution analysis
Compares the relative equity valuation of two parties to their respective

contribution to a combined companys financial performance


Typical firm value metrics would include
Revenues
EBITDA
EBIT
Unlevered free cash flow measures
Industry-specific (i.e. customers, reserves, etc.)
Typical equity value metrics would include
Net income

Cautionary note: contribution analysis does not measure the growth and risk profile

of the two companies financial performance and differing multiples may be


justifiablie when assessing relative value

R E L A T I V E

V A L U E

AN A L Y S I S

Levered free cash flow measures

60

M&A - DCF and M&A analysis

Relative contribution analysis


$
$ millions
millions
Implied equity value
Market value
% contribution
Firm value
% contribution

Implied

Acquiror

Target

Total

Acquiror

Target

exchange ratio

$18,150

$7,653

$25,803

$18,150

$7,653

0.4340x

70.3%

29.7%

70.3%

29.7%

$38,450

$19,592

$18,150

$7,653

66.2%

33.8%

70.3%

29.7%

$5,275

$3,528

$14,482

$11,322

59.9%

40.1%

56.1%

43.9%

$5,320

$3,253

$15,716

$10,087

62.1%

37.9%

60.9%

39.1%

$1,790

$1,210

$15,397

$10,406

59.7%

40.3%

59.7%

40.3%

$2,018

$1,380

$15,326

$10,477

59.4%

40.6%

59.4%

40.6%

$58,042

0.4340x

EBITDA
2004E
% contribution
2005E
% contribution

$8,803
$8,573

0.8046x
0.6606x

Net income
2004E
% contribution

R E L A T I V E

V A L U E

AN A L Y S I S

2005E
% contribution

$3,000
$3,398

0.6956x
0.7036x

As of 2/6/02; net debt for ACQUIROR as of 12/31/01 (per press release) and for TARGET as of 9/30/01 (per 10-Q); pro forma for acquisitions
2001A for ACQUIROR; based on company press release; other estimates based on JPMorgan Equity Research
3 Based on I/B/E/S consensus estimates; ACQUIROR 2002E EPS based on company guidance; TARGET EPS estimates based on I/B/E/S consensus estimates post 1/29/02
1
2

61

M&A - DCF and M&A analysis

Sample contribution analysis

Target

$25,308

$58,042

$8,803

56.1%
70.3%

70.3%

Relative owner ship

Acquiror

Exchange r atio

0.5385x

Tar get

35.0%

Acquir or

65.0%

$8,573

$3,000

$3,398

60.9%

59.7%

59.4%

R E L A T I V E

V A L U E

AN A L Y S I S

Offer =
35.0%
43.9%
29.7%

29.7%

Market value

Firm value

.4340x

Implied
ER
.4340x

39.1%

40.3%

40.6%

2002E EBITDA

2003E EBITDA

2002E Net Income

2003E Net Income

.8046x

.6606x

.6956x

.7036x

62

M&A - DCF and M&A analysis

Calculating the implied exchange ratio


Company statistics
statistics
Company

Implied
Implied exchange
exchange ratio
ratio (equity
(equity value
value metrics)
metrics)

Acquiror
Current share price

$34.22

% of net income contributed by acquiror

59.7%

Fully-diluted share count

531

Fully-diluted market cap

18,150

Fully-diluted acquiror shares

530

Net debt

20,300

888

EBITDA

5,320

Pro forma shares outstanding to yield


59.7% ownership

Net income

1,790

Implied shares issued to target

358

Current target shares outstanding

515

Target
Current share price

$14.85

Fully-diluted share count

515

Fully-diluted market cap

7,653

Net debt

11,939
3,253

Net income

1,210

0.6956x

Natural exchange ratio based on current


share prices ($14.85 / $34.22)

0.4340x

R E L A T I V E

V A L U E

AN A L Y S I S

EBITDA

Implied exchange ratio based on net


income (358 / 515)

63

M&A - DCF and M&A analysis

Calculating the implied exchange ratio (contd)


Company
Company statistics
statistics

Implied
Implied exchange
exchange ratio
ratio (firm
(firm value
value metrics)
metrics)

Acquiror
Current share price

$34.22

Fully-diluted share count

531

Fully-diluted market cap

18,150

Net debt

20,300

EBITDA
Net income

Combined firm value

58,042

Combined equity value

25,803

% EBITDA contributed by acquiror

62.1%

5,320

Firm value based on EBITDA contribution

36,044

1,790

Implied equity value

15,744

As a % of total equity value

60.9%

Target
Fully-diluted acquiror share count

531

Pro forma shares outstanding to yield 61.0% acquiror


ownership

871

11,939

Implied shares issued to target

340

EBITDA

3,253

Fully-diluted target share count

515

Net income

1,210

Current share price


Fully-diluted share count

515

Fully-diluted market cap

7,653

Net debt

Implied exchange ratio based on EBITDA (338 / 515)

0.66x

Natural exchange ratio based on current share prices


($14.85 / $34.22)

0.43x

R E L A T I V E

V A L U E

AN A L Y S I S

$14.85

64

M&A - DCF and M&A analysis

Class exercise
Company
Company statistics
statistics

Calculate the % contribution based on

Acquiror
Current share price

$12.1

Fully-diluted share count (mm)

110.3

Net debt

450

EBITDA

172

Net income

the EBITDA and the Net income


What is the implied exchange ratio?

65

Target
Current share price
Fully-diluted share count
Net debt

$14.1
30.4
295
81

Net income

25

R E L A T I V E

V A L U E

AN A L Y S I S

EBITDA

65

M&A - DCF and M&A analysis

Relative multiple and discounted cash flow valuation


Compares the ranges suggested by stand-alone valuations of two companies on a

multiples or discounted cash flow basis


Step 1: Valuation the acquiror and the target separately
Step 2: Create a relative value summary
Need to consider which ends of the range it is appropriate to compare when

determining an appropriate exchange ratio / ownership percentage


High/Low and Low/High

R E L A T I V E

V A L U E

AN A L Y S I S

High/High and Low/Low

66

M&A - DCF and M&A analysis

Sample relative value football field: Target valuation


Price
Price per
per share
share

$20.00

$26.75

$15.00

$15.00

$9.75

$10.00

$5.00

R E L A T I V E

V A L U E

AN A L Y S I S

Highest public
comp price

$0.00

$5.00
$4.94

$5.00
$4.00

$4.00

$10.25

Implied offer1 = $8.46

$5.50
$6.00

$3.75

$3.50

$3.00

Lowest public
comp price

52-week
high/low

Street case DCF

15.0x to 19.0x
2001E EBIT
of $20.6

19.0x to 25.0x
2001E cash
EPS of $0.16

Public trading comparables

15.0x to 20.0x
2002E cash
EPS of $0.25

2.5x to 4.0x
LTM revenue
of $185.7

Transaction
comparables2

Mgmt. Case

Street Case3

12% to 15%
Discount Rate
EBIT exit mult.
of 15.0x to 20.0x

12% to 15%
Discount Rate
EBIT exit mult.
of 15.0x to 20.0x

DCF analysis
Based on the offer exchange ratio of 0.311x and Pedros closing price $27.19 as of 7/12/01
Certain of the multiples implied by precedent transactions have been adjusted by indexing them to the movement in an index of stock prices of companies comparable to
Pablo
3 Based on IBES EPS growth estimate and average margin estimates of brokerage reports
1
2

67

M&A - DCF and M&A analysis

Sample relative value football field: Acquiror valuation


Price
Price per
per share
share

$50.00

DCF
$40.00

Highest public
comp price

$43.25

$33.00
$28.00

$30.00

$29.25

$29.50
$30.75

$26.50
$20.00

$21.28

Lowest public
comp price

$21.00

$22.50

$20.50

Current = $27.19

AN A L Y S I S

$10.00

$0.00

R E L A T I V E

V A L U E

52-week
high/low

10.0x to 12.0x
2001E EBITDA
of $346

12.0x to 15.0x
2001E EBIT
of $239

19.0x to 25.0x
2001E EPS
of $1.18

Comparable diversified company analysis


1
2

Sum-of-the-parts

Discount rate 9% to 13%


EBITDA with exit multiple
of 11.0x to 13.0x

Public company analysis

DCF analysis2

Comparable diversified company analysis and public company analysis are based on brokerage report estimates
Based on management projections

68

M&A - DCF and M&A analysis

Relative valuation summary


Less
favorable to
Acquiror

Exchange ratio1
1.000x

0.750x

High/Low
Low/High
$5.00/$20.50 $3.00/$33.00
High/Low
Low/High
$5.50/$30.75 $3.50/$43.25
0.488x
0.476x

0.500x

0.441x

0.313x

Offer: 0.311x
0.311x

0.244x
0.250x
0.179x
0.219x

0.162x

0.237x

R E L A T I V E

V A L U E

AN A L Y S I S

0.182x

Natural exchange
ratio

More
favorable to
Acquiror

0.081x

0.091x

0.000x

Public
comparables to
Public
comparables
(Sum of Parts &
Diversified)

Transaction
comparables to
Public
comparables
(Sum of Parts &
Diversified)

0.217x

0.074x

Street case/Mgmt. Street case/Mgmt. Mgmt. case/Mgmt. Mgmt. case/Mgmt.


case
case w ith $40 mm
case
case w ith $40 mm
of synergies
of synergies

0.073x
Contribution
analysis

Discounted Cash Flow Analysis

Exchange ratio ranges computed by taking the high/low equity value per share of Target using various valuation methodologies over the low/high valuation of
the acquiror using various valuation methodologies

69

M&A - DCF and M&A analysis

Merger of Equals transactionsexample


$
$ in
in millions
millions
Acquiror
Transaction

Acquiror/

NewCo

pro forma

target

Chairman

CEO

ownership

Board Split

Accounting
regime

date

Target

Acquiror

value

Premium1

3/19/01

Billiton PLC

BHP Ltd

$11,511

20.9%

Acquiror

Acquiror

58.0%

9/9

United Kingdom

6/20/00

Seagram

Vivendi

40,428

22.8%

Acquiror

Acquiror

59.0%

14/6

France

5/17/00

Compass Group PLC

Granada group PLC

8,089

3.4%

Acquiror

Joint

66.3%

8/8

United Kingdom

5/16/00

Lycos Inc.

Terra Networks (Telefonica SA)

6,188

58.3%

Acquiror

Target

63.0%

11/3

Spain

2/21/00

Norwich Union PLC

CGU PLC

11,858

(12.2%)

Acquiror

Target

58.5%

9/8

United Kingdom

1/17/00

SmithKline Beecham

Glaxo Wellcome

75,961

(2.3%)

Acquiror

Target

58.8%

8/8

United Kingdom

12/21/99

Pharmacia & Upjohn

Monsanto

26,486

(7.1%)

Acquiror

Target

51.0%

9/9

United States

9/27/99

VIAG AG

VEBA AG

13,153

6.8%

Acquiror

Joint

67.0%

7/3

United States

6/30/99

Banca Commerciale Italiana SpA

Banca Intesa Spa

15,940

8.5%

Acquiror

Joint

57.0%

NA

Italy

5/17/99

Hoechst

Rhone Poulenc

21,918

(9.9%)

Target

Target

47.0%

5/5

France

1/5/99

AirTouch Communications

Vodafone group PLC

60,287

40.6%

Target

Acquiror

50.0%

7/7

United Kingdom

1/15/99

Banco Central Hispanoamericano

Banco de Santander SA

11,320

(3.6%)

Joint

Target

63.8%

13/12/2

Spain

12/9/98

Astra AB

Zeneca Group plc

32,199

9.8%

Target

Acquiror

53.5%

7/7

United Kingdom
France

12/2/98

Synthelabo SA

Sanofi SA

11,234

5.7%

Acquiror

Joint

64.1%

4/3/5

8/11/98

Amoco

British Petroleum

55,040

22.7%

Joint

Acquiror

60.0%

13/9

United Kingdom

5/7/98

Chrysler Corp

Daimler-Benz AG

40,467

38.0%

Joint

Joint

58.0%

6/6

United States
United Kingdom

2/25/98

General Accident

Commercial Union

11,152

(4.2%)

Acquiror

Target

53.6%

7/7

12/8/97

Swiss Bank

Union Bank of Switzerland

22,765

0.3%

Acquiror

Target

60.0%

4/4/1

IAS

5/12/97

Guinness PLC

Grand Metropolitan

15,970

1.3%

Joint

Acquiror

52.8%

5/5

United Kingdom

3/7/96

Ciba-Geigy AG

Sandoz AG

29,000

9.5%

Target

Acquiror

55.0%

8/8

IAS

Premium to target share price one day prior to announcement


Source: Press releases, SEC filings, SDC

R E L A T I V E

V A L U E

AN A L Y S I S

Ann.

70

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

Accretion/(dilution) review
Pro forma balance sheet analysis review

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

71

M&A - DCF and M&A analysis

Introduction
Pro forma analysis provides both acquirers and targets insight into the

income statement and balance sheet impact of a transaction


Revenue, EBITDA or earnings impact
Capitalization, leverage and credit capacity impact
Valuable tool for both acquirer and target
Indicates buyers ability to pay
Suggests most appropriate form of consideration to offer
Allows buyer to predict or manage market reaction to announcement
Demonstrates landscape of competing buyers
Balance sheet and income statement impact go hand-in-hand

M E R G E R

C O N S E Q U EN C E S

Both driven by form and amount of consideration

72

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

Accretion/(dilution) review
Pro forma balance sheet analysis review

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

73

M&A - DCF and M&A analysis

Overview of accretion/(dilution) analysis


Accretion/(dilution) primarily measures the impact of a merger or acquisition on the

income statement of a potential buyer


Accretion/(dilution) analysis can be based on revenue, EBITDA, earnings, after-tax

cash flow, and dividends per share


EPS is most commonly used form of accretion/(dilution) analysis
Industry will typically dictate which are the most relevant metrics (e.g. wireless

telecom companies may prefer to show EBITDA)


Two methods exist for calculating accretion/(dilution)
Top down: integrated merger model
Bottom up: transaction-adjusted, estimate-based model
Key measures for accretion/(dilution)
Dollar and percent change of acquirer earnings per share

M E R G E R

C O N S E Q U EN C E S

Pre-tax synergies required for break-even impact to EPS


Pro forma ownership when stock is used as an acquisition currency
Pro forma leverage/capitalization

Note that capitalization will change when stock is used and net debt leverage levels will change when cash is used

74

M&A - DCF and M&A analysis

Purpose of accretion/(dilution) analysis


Accretion/(dilution) analysis can be used to determine
The capacity of the acquirer (or potential acquirers) to pay a premium for a

target
Optimal form of consideration (cash, stock, other securities, combination)
Used by both buyers and sellers
Buyers identify highest price they can afford to pay and what currency to offer
Buyers evaluate how much competing bidders can afford to pay
Sellers evaluate what price potential buyers can afford to pay and in what

currency
In the context of a divestiture, sellers also evaluate their break-even sale price

and required currency

M E R G E R

C O N S E Q U EN C E S

Typically, JPMorgan performs sensitivity analyses to find break-even points where

the offer price for a target results in no incremental earnings or losses to acquirers
earnings per share

75

Two primary methods exist to compute


accretion/(dilution)

Description
Description

Benefits
Benefits

M&A - DCF and M&A analysis

Top down

Bottom up

Integrated merger model with projected balance


sheet and cash flow statement for target, acquirer
and the combined company

EPS estimate-based analysis that combines acquirer


and target projections, adjusting for impact of
incremental transaction-related expenses and
income

Provides most accurate picture of combined


companies

Quick and intuitive demonstration of accretive or


dilutive impact

Reflects impact of debt pay-down and other


cash flow implications to net interest expense
and net income

Flexible analysis that can incorporate multiple


buyers or targets

Clearly and accurately shows balance sheet


impact in pro forma statistics

M E R G E R

C O N S E Q U EN C E S

Considerations
Considerations

Difficult to efficiently incorporate multiple


acquirers and targets for competitive analysis

Risks over-simplifying pro forma analysis and overor under-stating impact to acquirer

Relies on estimates which, although more


robust, are also subject to uncertainty or
questionable assumptions

May be inappropriate for a deal where the


acquirers credit rating is impacted by the
transaction
Must be customized for asset deals, joint ventures
and other transactions

76

M&A - DCF and M&A analysis

Sample transaction assumptions


Transaction
Transaction description
description

Acquirer buying target with the following

Target
Target

transaction assumptions:

Current share price


Shares outstanding

$12.25
41.500

Transaction closes 12/31/04

Market capitalization

$508.4

Advisory fees of 0.25% of transaction value

Net debt (6/30/04)

500.0

Firm value
Earnings per share:
2004E
2005E
2006E

$1,008.4

Financing fees of 1.0% on debt issued (amortized

as deferred financing fees over 7 years)


Interest rates assumptions
Tranche I ($300mm maximum senior debt):

7.0%
Tranche II (subordinated debt): 12.5%

Dividend per share (annual):


Implied gross dividends paid (annual, $mm):

$1.20
0.95
1.45
$0.48
$19.2

Interest rate earned on existing cash: 3.0%


Tax rate on incremental earnings and expenses

Acquirer
Acquirer

(including net interest expense): 35%


Dividend policy of acquirer remains unchanged

M E R G E R

C O N S E Q U EN C E S

50% of excess purchase price allocated to

goodwill (approximately $70 million)


Remaining 50% of excess purchase price
allocated to asset write-up and depreciated
over 20 years
Target's existing debt not refinanced

Current share price


Shares outstanding
Market capitalization

$20.03
58.669
$1,175.1

Net debt (6/30/04)


Firm value
Earnings per share:
2004E
2005E
2006E
Dividend per share (annual):
Implied gross dividends paid (annual, $mm):

750.0
$1,925.1
$1.56
1.68
1.80
$0.85
$44.6

77

M&A - DCF and M&A analysis

Key adjustments to pro forma income statement


The
The applicability
applicability of
of most
most income
income statement
statement adjustments
adjustments depends
depends on
on the
the consideration
consideration issued
issued to
to the
the seller
seller and
and the
the way
way the
the
acquiror
funds
an
acquisition
acquiror funds an acquisition

Consideration
Adjustment

Stock

After-tax financing fee amortization

Cash

Mix

Non-deductible advisory fee amortization


After-tax incremental DD&A from asset write-up

M E R G E R

C O N S E Q U EN C E S

After-tax interest on transaction debt


After-tax interest deduction from cash used

After-tax interest (loss) gain on dividend shortfall

After-tax synergies

Transaction goodwill impairment

Change in pro forma fully diluted shares

78

M&A - DCF and M&A analysis

What is in a consensus estimate?


While
While First
First Call
Call or
or I/B/E/S
I/B/E/S estimates
estimates may
may provide
provide a
a perceived
perceived Street
Street consensus,
consensus, they
they introduce
introduce some
some degree
degree of
of uncertainty
uncertainty

First Call and I/B/E/S consensus estimates are based on an aggregation of research analysts

estimates, with little discretion applied to mean and median calculations


Quality of estimates and analysts varies dramatically across consensus samples
Modeling conventions are often not explained or apparent
Analysts may be assuming different projected share counts, rather than net income
Some estimates included in consensus numbers are out-dated
May not reflect updated company guidance or recent financial results
May not reflect abrupt changes to underlying industry economics
May not reflect recent M&A transactions or securities offerings
Items embedded in consensus estimates are not always clearly explained or uniform

M E R G E R

C O N S E Q U EN C E S

across samples
Fully diluted share assumptions and treatment of options and convertibles may vary
Interest expense
Tax rates
Accounting policies
Stock-based compensation and amortization of intangibles other than goodwill

79

Transaction assumptions are the foundation of all


sound analysis

M&A - DCF and M&A analysis

Always
Always clearly
clearly describe
describe transaction
transaction assumptions
assumptions

Choose an appropriate closing date reflecting available information and transaction structure
Timing of process requirements for closing (share registration, shareholder votes, etc.)
Timing of regulatory requirements for closing (HSR review, etc.)
Seasonality of industry economics and impact on estimates or calendarization
Capital structures should best reflect current circumstances
Equity currency should be reviewed in context of recent share price and larger equity market

performance
Cash deals should reflect reasonable interest rates and lending market capacity
Pro forma leverage and interest coverage levels should be consistent with acquirers desired credit

rating
Both advisory and financing fees have a meaningful impact on pro forma financials

M E R G E R

C O N S E Q U EN C E S

Although equity analysts tend to look through some extraordinary charges, advisory and other one-

time fees will impact the cash balance used in the transaction and subsequent annual interest
expense
Amortization of financing fees will impact EPS over the immediate future of the combined entity
Tax rate on incremental earnings and expenses should reflect acquirors and targets combined tax

efficiencies and adjustments should be made to post-transaction tax expenses for potential NOLs
assumed by an acquirer

80

M&A - DCF and M&A analysis

Sample transaction100% stock consideration


Assumptions
Assumptions

Earnings
Earnings impact
impact ($
($ millions,
millions, except
except per
per share
share data)
data)

Acquirer share price:


2003 P/E
2004 P/E

$20.03
12.0x
11.1

Acquirer shares outstanding

58.669

Target share price:


2003 P/E
2004 P/E

$12.25
12.9x
8.4

Transaction assuming 25% premium


Offer price (assuming 25% premium)
Shares acquired
Implied exchange ratio (T/A)
Shares issued

$15.31
42.468
0.764x
32.466

2003

2004

Acquirer EPS
Acquirer net income

$1.68
98.3

$1.80
105.7

Target EPS
Target net income

$0.95
39.4

$1.45
60.2

Adjustments

M E R G E R

C O N S E Q U EN C E S

Tax rate on incremental expenses:

35.0%

After-tax financing fee amortization


Non-deductible advisory fee amortization
After-tax DD&A from asset write-up
After-tax interest on transaction debt
After-tax interest deduction from cash used
After-tax interest (loss) gain on dividend shortfall
After-tax synergies
Transaction goodwill amortization (or impairment)
Other reductions
Total adjustments to net income
Pro forma net income
Pro forma shares outstanding

($0.0)
0.0
(2.3)
(0.0)
(0.1)
(0.2)
0.0
0.0
0.0
(2.5)
$135.2
91.135

Pro forma EPS


Accretion/(dilution) ($)
Accretion/(dilution) (%)

$1.48
($0.19)
(11.5%)

Pre-tax synergies to break-even

$26.9

($0.0)
0.0
(2.3)
(0.0)
(0.1)
(0.3)
0.0
0.0
0.0
(2.7)
$163.2
91.135
$1.79
($0.01)
(0.6%)
$1.5

1 Should be calculated using the offer price not current target price
Used to fund transaction expenses and advisory fees of $2.9 million

81

M&A - DCF and M&A analysis

Considerations for a stock transaction


P/Es and relative valuations play a meaningful role in accretion/(dilution) analysis
High P/E of an acquirer may imply stock may be cheap acquisition currency,

relative to lower P/E stock or the implied debt P/E


A number of issues will play an important role in the optics, attitudes and receptivity

of principals and investors in a transaction


Exchange ratios should not be grossly inconsistent with historical relative trading

performance of acquirer and target


Purchase price and pro forma ownership should take into account contribution

analysis
Flow back and sell-off of acquirer stock could meaningfully affect acquirers share

prices on announcement/closing
Cross-shareholder analysis

M E R G E R

C O N S E Q U EN C E S

Whether acquirer and target are included in the same indexes, if any
Fund limitations on owning international stocks and/or stocks not listed on local

exchanges
Dividend policy implications of receiving acquirer stock

82

M&A - DCF and M&A analysis

Sample transaction100% cash consideration


Earnings
Earnings impact
impact
Assumptions
Assumptions

Earnings
Earnings impact
impact
Figures in millions, except per share data

Target share price:


Offer price (assuming 25% premium)
Shares acquired

$12.25
15.31
42.468

Acquirer EPS
Acquirer net income
Target EPS
Target net income

2003

2004

$1.68

$1.80

98.3

105.7

$0.95

$1.45

39.4

60.2

($0.6)

($0.6)

Debt issued to fund acquisition:


Equity purchased with cash
Transaction fees
Financing fees
Cash balance used in transaction
Total debt raised

$650.3
2.9

After-tax financing fee amortization

6.6

Non-deductible advisory fee amortization

(0.0)
$659.8

Debt allocation:
Tranche I

$300.0

Tranche II

359.8

Interest Rates:

C O N S E Q U EN C E S
M E R G E R

Adjustments

After-tax DD&A from asset write-up


After-tax interest on transaction debt

7.0%

Tranche II

12.5%

(42.9)

(44.8)

0.0

0.0

After-tax interest (loss) gain on dividend shortfall

0.4

0.8

After-tax synergies

0.0

0.0

Transaction goodwill amortization (or impairment)

0.0

0.0

Other reductions

0.0

0.0

(45.4)

(47.0)

$92.4

$118.9

58.669

58.669

$1.57

$2.03

Pro forma net income


Pro forma shares outstanding

Interest rate on foregone cash balance

3.0%

Pro forma EPS


Tax rate on incremental earnings

35.0%

Accretion/(dilution) ($)

($0.10)

$0.23

Accretion/(dilution) (%)

(6.1%)

12.5%

$9.1

NM

Pre-tax synergies to break-even


1

0.0
(2.3)

After-tax interest deduction from cash used

Total adjustments to net income

Tranche I

0.0
(2.3)

Should be calculated using the offer price not current target price

83

M&A - DCF and M&A analysis

Considerations for a cash transaction


Use multiple tranches of debt where appropriate
Reflects capital structure and market capacity limitations for larger deals
Varying interest rate on debt tranches will impact interest expense on offer price increases or

decreases
Note that depending on debt mix, stock may be more or less appropriate as an acquisition

currency
Financing assumptions should reflect both acquirers stand-alone and combined debt capacity and

ratings circumstances
Debt coverage and capitalization statistics should be included to highlight potential ratings issues

and support interest rate assumptions


Current and recent ratings history of acquirer should be reviewed to confirm ability to issue debt

securities
Covenants of existing acquirer debt should be considered
Review transaction and pro forma financials with ratings advisory and DCM teams to determine

M E R G E R

C O N S E Q U EN C E S

appropriate rates
Use existing acquirer cash sparingly, if at all
Existing cash is likely used to meet working capital funding requirements
Minimum cash balance may be required for debt covenants
Opportunity cost of using cash on hand should always be contemplated and reflected in interest

expense
Restricted cash considerations

84

M&A - DCF and M&A analysis

Sample transaction50% cash/50% stock consideration


Earnings
Earnings impact
impact
Mixed
Mixed consideration
consideration assumptions
assumptions

Earnings impact
impact
Earnings
Figures in millions, except per share data

Target share price:


Offer price (assuming 25% premium)
Shares acquired

$12.25
15.31
42.468

Acquirer EPS
Acquirer net income
Target EPS
Target net income

Shares issued

2003

2004

$1.68

$1.80

98.3

105.7

$0.95

$1.45

39.4

60.2

($0.3)

($0.3)

16.233

Adjustments
After-tax financing fee amortization

Debt issued to fund acquisition:


Equity purchased with cash
Transaction fees

0.0

0.0

After-tax DD&A from asset write-up

(2.3)

(2.3)

(16.2)

(16.9)

0.0

0.0

After-tax interest (loss) gain on dividend shortfall

0.1

0.2

After-tax synergies

0.0

0.0

Debt allocation:

Transaction goodwill amortization (or impairment)

0.0

0.0

Tranche I

$300.0

Other reductions

Tranche II

31.3

Cash balance used in transaction


Total debt raised

C O N S E Q U EN C E S

Non-deductible advisory/ other fee

2.9

After-tax interest deduction from cash used

Financing fees

M E R G E R

$325.1
3.3
(0.0)
$331.3

After-tax interest on transaction debt

0.0

0.0

(18.7)

(19.3)

$119.1

$146.6

74.902

74.902

$1.59

$1.96

Accretion/(dilution) ($)

($0.09)

$0.16

Accretion/(dilution) (%)

(5.1%)

8.6%

$9.9

NM

Total adjustments to net income


Pro forma net income

Interest Rates:
Tranche I

7.0%

Tranche II

12.5%

Pro forma shares outstanding


Pro forma EPS

Interest rate foregone on cash balance


Tax rate on incremental earnings

3.0%
35.0%

Pre-tax synergies to break-even

85

M&A - DCF and M&A analysis

The role of P/E valuations in accretion/(dilution)


For stock-for-stock deals, accretion or dilution potential will usually be evident by simply

comparing the P/E multiples of the acquirer and the target


If the acquirer has a higher P/E than the target, the deal will be accretive because the acquirer

is buying more EPS than the target shareholders are accepting as consideration
If the acquirer has a lower P/E than the target, the deal will be dilutive because the acquirer is

buying less EPS than the target shareholders are accepting as consideration
Remember to take the premium into account when calculating the targets P/E
Utility of comparison will also depend on transaction assumptions regarding goodwill impairment

or other asset amortization


For 100% cash transactions, the cost of debt (interest payments) and cost of acquiring the targets

earnings will determine the accretive or dilutive impact of a transaction


Where the inverse cost of debt (1/(after-tax cost of debt)) is greater than the P/E of the target,

the deal will be accretive

M E R G E R

C O N S E Q U EN C E S

Where the inverse cost of debt is lower than the P/E of the target, the deal will be dilutive

86

M&A - DCF and M&A analysis

Presenting accretion/(dilution) with sensitivities


Sensitivities provide the total picture of a transactions potential impact; relevant

sensitivities to demonstrate may include


Premium (discount)
Consideration offered (% of stock/% of cash)

y Acquirers stock price


y Earnings per share
y Synergies
Interest rate(s) on debt issued
Sensitivities should reflect consideration specifics
Purchase price and ownership (stock)
2003
2003 accretion/(dilution)(%
accretion/(dilution)(% per
per share)
share)

2003
2003 synergies
synergies to
to break-even($mm)
break-even($mm)
Stock consideration

Stock consideration

M E R G E R

62.5%

75.0%

87.5%

100.0%

50.0%

62.5%

75.0%

87.5%

100.0%

10.0%

1.0%

(1.1%)

(3.0%)

(4.8%)

(6.4%)

10.0%

NM

$2.2

$6.3

$10.4

$14.4

20.0%

(3.0%)

(4.6%)

(6.5%)

(8.3%)

(9.8%)

20.0%

5.8

9.3

13.8

18.3

22.8

30.0%

(7.7%)

(8.4%)

(10.2%)

(11.9%)

(13.4%)

30.0%

15.0

17.3

22.3

27.2

32.1

40.0%

(14.1%)

(13.5%)

(15.2%)

(16.8%)

(18.1%)

40.0%

28.2

28.8

34.3

39.9

45.3

50.0%

(20.2%)

(19.0%)

(19.9%)

(21.3%)

(22.5%)

50.0%

41.7

41.9

46.6

52.8

58.9

Premium

Premium

C O N S E Q U EN C E S

50.0%

87

M&A - DCF and M&A analysis

Relevant sample transaction sensitivities


Stock
Stock deals
deals
2003
2003 accretion/(dilution)(%
accretion/(dilution)(% per
per share)
share)

2003
2003 accretion/(dilution)(%
accretion/(dilution)(% per
per share)
share)

Acquirer stock price


$20.03

$21.00

$22.00

$23.00

$5.0

$10.0

$15.0

$20.0

$25.0

10.0%

(8.1%)

(6.4%)

(5.0%)

(3.5%)

(2.2%)

10.0%

(4.2%)

(2.0%)

0.2%

2.5%

4.7%

20.0%

(11.6%)

(9.8%)

(8.3%)

(6.8%)

(5.5%)

20.0%

(7.7%)

(5.5%)

(3.3%)

(1.2%)

1.0%

30.0%

(15.2%)

(13.4%)

(11.8%)

(10.3%)

(8.9%)

30.0%

(11.3%)

(9.2%)

(7.1%)

(5.0%)

(2.9%)

40.0%

(20.0%)

(18.1%)

(16.5%)

(15.0%)

(13.5%)

40.0%

(16.1%)

(14.1%)

(12.1%)

(10.1%)

(8.1%)

50.0%

(24.4%)

(22.5%)

(20.9%)

(19.3%)

(17.8%)

50.0%

(20.6%)

(18.7%)

(16.8%)

(14.9%)

(13.0%)

Premium

Premium

$19.00

Pre-tax synergies realized 2003

Cash
Cash deals
deals
2003
2003 accretion/(dilution)(%
accretion/(dilution)(% per
per share)
share)

2003
2003 accretion/(dilution)(%
accretion/(dilution)(% per
per share)
share)

M E R G E R

Blended interest rate (%)

6.5%

7.0%

7.5%

8.0%

8.5%

10.0%

3.1%

2.1%

1.1%

0.1%

(0.9%)

20.0%

(2.4%)

(3.4%)

(4.3%)

(5.3%)

(6.3%)

30.0%

(8.4%)

(9.4%)

(10.4%)

(11.4%)

(12.4%)

40.0%

(17.1%)

(18.1%)

(19.1%)

(20.1%)

(21.1%)

50.0%

(25.9%)

(26.9%)

(27.9%)

(28.9%)

(29.9%)

Premium

Premium

C O N S E Q U EN C E S

Interest rate on senior debt (Tranche 1)


11.0%

10.5%

10.0%

9.5%

9.0%

10.0%

(2.3%)

(0.1%)

2.1%

4.2%

6.4%

20.0%

(7.7%)

(5.5%)

(3.4%)

(1.2%)

1.0%

30.0%

(13.8%)

(11.6%)

(9.4%)

(7.2%)

(5.1%)

40.0%

(22.5%)

(20.3%)

(18.1%)

(15.9%)

(13.7%)

50.0%

(31.3%)

(29.1%)

(26.9%)

(24.7%)

(22.6%)

88

M&A - DCF and M&A analysis

Synergies and transaction related costs


Synergies
For top-down modeling simplicity, assume synergies come from cost-savings unless told

otherwise
Revenue synergies

Incremental revenues may have costs associated with them that need to be reflected
in any synergy calculations (e.g variable margins on incremental revenues)
Equity markets heavily discount or, in many cases, disregard revenue synergies, as
they are typically difficult to quantify and accurately project
Synergies are typically realized gradually over time and should be phased in accordingly
It may be prudent to risk-adjust any expected synergies to account for ability to

realize them and/or for negative synergies (i.e., integration costs)


Consider the cash flow impact of synergies
One-time charges and expenses

M E R G E R

C O N S E Q U EN C E S

Acquiring companies will incur one-time merger-related costs due to reorganization,

severance packages
One-time charges are disclosed in SEC filings
From a valuation perspective, the Street looks through one-time charges
Include the net interest impact of cash changes

89

M&A - DCF and M&A analysis

Additional items to consider


Tax benefits
In assuming additional options are exercised under premium scenarios a tax shield will be generated

based on the implied deductible compensation expense generated from the vesting / exercise of
options at a discount to the acquisition price
Asset write-ups have tax implications1
Acquirers may be forced to pay interest on interest
In using cash and thereby raising debt, an acquirer will incur future interest and amortization

payments that may require additional borrowing


AccretionOne calculation method
Asset write-ups and additional depreciation expenses
While asset write-ups will reduce goodwill generated in a transaction, they will increase annual

depreciation expenses based on the incremental increase in depreciable assets


Limiting asset write-ups will reduce negative impact of increased depreciation expenses

M E R G E R

C O N S E Q U EN C E S

In some cases, asset write-downs may impact EPS accretion / dilution


Impact of dividends paid by acquirer
Additional cash will be necessary to fund new dividends paid and should be reflected in incremental

expenses
Dividend accretion/(dilution) analysis may be relevant to determine appropriate premium

Write-ups create a deferred tax liability (equal to the write-up multiplied by the tax rate)

90

Summary considerations for EPS accretion/(dilution)


analysis

M&A - DCF and M&A analysis

EPS-based accretion/(dilution) is only a back-of-the-envelope exercise and is not a

substitute for an integrated merger model


Does not necessarily reflect cash flow implications and debt pay-down capabilities of

combined company
EPS estimates should be used with caution
First Call and I/B/E/S estimates are consensus numbers that do not always reflect

consistent underlying assumptions


Small differences in EPS figures can have dramatic impact on net income ($0.05 per

share on 200 million shares reflects a $10 million variance in net income)
Share count of target must be a dynamic number
Share count should increase (decrease) with offer price to reflect additional (reduced)

shares underlying in-the-money options

M E R G E R

C O N S E Q U EN C E S

Negative net income targets CANNOT create meaningful accretion


Accretion/(dilution) should always be sanity-checked
Relative P/Es
Acquirers cost of debt vs. cost of targets earnings
Accretion/(dilution) should always be checked with your calculator

91

M&A - DCF and M&A analysis

Agenda

Introduction

Discounted cash flow analysis

Relative value analysis

56

Merger consequences

71

Accretion/(dilution) review
Pro forma balance sheet analysis review

M&A:

DC F

AN D

M E R G E R

AN ALY SI S

Page

92

M&A - DCF and M&A analysis

Overview of pro forma balance sheet analysis


Pro forma balance sheet analysis provides a means of assessing the impact of a

potential transaction on an acquirers cost of borrowing, market access, and


financial flexibility
Two methods exist for demonstrating balance sheet impact:
Top down: integrated merger model with income statement, balance sheet and

cash flow statement (preferred)


Bottom up: transaction-adjusted, LTM-based model
Pro forma balance sheet analysis relies primarily upon a comparison of an acquirers

pre- and post-acquisition credit metrics


Key credit metrics include:
Pretax interest coverage
EBITDA interest coverage

M E R G E R

C O N S E Q U EN C E S

Funds from operations to interest


Funds from operations to debt
Debt to EBITDA
Debt to book capitalization

93

M&A - DCF and M&A analysis

Significance of pro forma balance sheet analysis


Pro forma balance sheet analysis is critical in determining
The debt-financed acquisition capacity of an acquirer (or competing bidders)
Required equity component of an offer to ensure a particular rating outcome
Financing implications of a particular transaction structure (cost of capital and

market access)
In a divestiture, the pro forma credit rating of the seller and the minimum level of

cash consideration needed


Used by both buyers and sellers
Buyers identify highest price they can afford to pay and how much cash can be

offered
Buyers evaluate how much other competitive bidders can afford to pay
Sellers evaluate how much potential buyers can afford to pay and how much cash

M E R G E R

C O N S E Q U EN C E S

to demand
Typically, JPMorgan performs sensitivity analyses to address relevant inflection

points where the offer price for a target results in meaningful changes to a combined
capital structure

94

M&A - DCF and M&A analysis

Credit ratings as a key financing decision driver


A companys corporate credit rating determines its
Cost of borrowing
Breadth and depth of access to the capital markets
Financial flexibility (liquidity/covenant constraints)
Pro forma balance sheet analysis allows potential acquirers to assess

leverage breakpoints and their associated ratings outcomes in order to


develop a comprehensive financing plan
Significant debt-financed transactions can erode credit profile and can

lead to a ratings downgrade


The determination of potential financing structures is often bound by the

M E R G E R

C O N S E Q U EN C E S

trade-offs between maximizing EPS subject to limiting ratings pressure

95

M&A - DCF and M&A analysis

Sample transaction 100% cash consideration

Acquirer

Target

Adjustments

Pro forma

Balance sheet:
Total debt
Shareholders equity value
Minority interest

$800.0
950.0
0.0

$575.0
525.0
0.0

$659.8
(525.0)
0.0

$2,034.8
950.0
0.0

Income statement:
LTM EBITDA
LTM EBIT
LTM interest expense

$226.0
176.0
55.0

$119.0
94.0
40.0

42.6

$345.0
270.0
137.6

84.2%
45.7%

109.5%
52.3%

214.2%
68.2%

3.5x
4.5
4.1
3.2

4.8x
6.1
3.0
2.4

5.9x
7.5
2.5
2.0

M E R G E R

C O N S E Q U EN C E S

Capitalization:
Debt/equity
Debt/total capitalization1
Coverage ratios:
Debt/LTM EBITDA
Debt/LTM EBIT
LTM EBITDA/interest
LTM EBIT/interest

Note: excludes lease-related leverage and hybrid securities


1 Includes minority interest

96

M&A - DCF and M&A analysis

Sample transaction100% stock consideration

Acquirer

Target

Adjustments

Pro forma

Balance sheet:
Total debt
Shareholders equity value
Minority interest

$800.0
950.0
0.0

$575.0
525.0
0.0

$0.0
125.3
0.0

$1,375.0
1,600.3
0.0

Income statement:
LTM EBITDA
LTM EBIT
LTM interest expense

$226.0
176.0
55.0

$119.0
94.0
40.0

0.0

$345.0
270.0
95.0

84.2%
45.7%

109.5%
52.3%

85.9%
46.2%

3.5x
4.5
4.1
3.2

4.8x
6.1
3.0
2.4

4.0x
5.1
3.6
2.8

M E R G E R

C O N S E Q U EN C E S

Capitalization:
Debt/equity
Debt/total capitalization1
Coverage ratios:
Debt/LTM EBITDA
Debt/LTM EBIT
LTM EBITDA/interest
LTM EBIT/interest

Note: excludes lease-related leverage and hybrid securities


1 Includes minority interest

97

M&A - DCF and M&A analysis

Pro forma balance sheet sensitivities


Debt/total
Debt/total capitalization
capitalization
Stock consideration

Similar to EPS analysis, sensitivities provide


Sensitivities should demonstrate the impact

of changes to relevant metrics


Consideration (stock vs. cash)

Premium

the whole picture

Estimates (EBITDA)

0.0%

25.0%

50.0%

75.0%

100.0%

10.0%

67.3%

62.4%

57.4%

52.5%

47.5%

20.0%

67.9%

62.6%

57.3%

52.0%

46.6%

30.0%

68.5%

62.8%

57.2%

51.5%

45.7%

40.0%

69.4%

63.2%

57.0%

50.7%

44.4%

50.0%

70.3%

63.5%

56.8%

50.0%

43.2%

Assumptions (premium, interest rates,

etc.)

Debt/EBITDA
Debt/EBITDA

EBITDA/interest
EBITDA/interest

M E R G E R

Stock consideration

0.0%

25.0%

50.0%

75.0%

100.0%

10.0%

5.66x

5.24x

4.83x

4.41x

3.99x

20.0%

5.82

5.36

4.91

4.45

3.99

30.0%

6.00

5.49

4.99

4.49

3.99

40.0%

6.25

5.68

5.12

4.56

3.99

50.0%

6.50

5.88

5.25

4.62

3.99

Premium

Premium

C O N S E Q U EN C E S

Stock consideration
0.0%

25.0%

50.0%

75.0%

100.0%

10.0%

2.63x

2.89x

3.19x

3.39x

3.63x

20.0%

2.54

2.81

3.13

3.37

3.63

30.0%

2.45

2.73

3.06

3.35

3.63

40.0%

2.34

2.62

2.97

3.32

3.63

50.0%

2.23

2.51

2.88

3.29

3.63

98