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M&As and Corporate Restructuring Tutorial Sessions Instructor: Farooq Ahmad, PhD What we will do? Exercises Part 1 – Distribution of Equity Part 2 – Sharing of Value Part 3 – Valuation of Restaurant Part 4 – M&A Performance Overview of M&A Activity and M&A Waves Motivations for M&A Measuring Shareho...

M&As and Corporate Restructuring Tutorial Sessions Instructor: Farooq Ahmad, PhD What we will do? Exercises Part 1 – Distribution of Equity Part 2 – Sharing of Value Part 3 – Valuation of Restaurant Part 4 – M&A Performance Overview of M&A Activity and M&A Waves Motivations for M&A Measuring Shareholders’ Wealth Creation – Event Study Methodology Valuation of Private Companies What we will do? Session 1: o o o o Exercises – Distribution of Equity Overview of M&A Activity and M&A Waves Motivations for M&A Applied case: Xerox buys ACS Session 2: o Exercises – Sharing of Value o Valuation of Private Companies Session 3: o Exercises – Valuation of Restaurant o Measuring Shareholders’ Wealth Creation – Event Study Methodology o Exercises – M&A Performance Exercises – Part 1 – Distribution of Equity EXERCISE 1 The French company DUPLAT has a registered capital composed of 7,000 shares of 100 € nominal. The shareholders are the members of the family: Parents Duplat: 5,000 shares Son Duplat: 1,000 shares Daughter Duplat: 1,000 shares Parents Son Daughter Total Shares 5,000 1,000 1,000 7,000 % 71.43 14.29 14.29 100.00 Question 1: Comment on the distribution of power within the family. Question 2: The Company has significant development projects that require the use of external equity financing. The family is in negotiation with a PE fund. A SPA (Share Purchase Agreement) has been signed which provides that the fund subscribes to a capital increase of € 700,000. If this operation was carried out, what would be the consequences of the entry of the fund into the capital of the company in terms of assets for the current shareholders, and distribution of powers? Pre-Money and Post-Money Valuation Pre-money valuation is the implied value of the venture prior to new investment Post-money valuation is the total value of the venture after the new investment Pre-Money and Post-Money Valuation Prior to raising capital, a venture has 100,000 existing shares. A new investor will invest $150,000 and get 20,000 shares. What are the pre- and post-money valuations? Implied share price = $150,000 ÷ 20,000 shares = $7.50 Pre-money valuation = 100,000 shares x $7.50 = $750,000 Post-money valuation = $750,000 + $150,000 = $900,000 Exercises – Part 1 – Distribution of Equity EXERCISE 2 Founded in 1965, DUFLOT Inc. is active in the production of regional food specialties. It is owned by the 3 children of the 2nd generation: Alain, the manager; Elise and Max, his sister and brother, who do not work in the company. The capital of the company is composed of 10,000 shares of € 100 nominal. It is distributed as follows: Alain: 7,000 shares / Elise: 1,500 shares / Max: 1,500 shares Facing a strong demand for its products, the company needs to create a new production unit to satisfy its retail customers. An increase in equity is essential. The shareholders of DUFLOT are about to sign a memorandum of understanding with an investment fund which provides for the subscription of the fund to a capital increase of a total amount (nominal + share premium) of 400,000 € giving right to 20% of the capital Question: You will determine the valuation of the company and the price per share of the capital increase that served as the basis for the agreement, and the distribution of capital that would result from the implementation of this protocol and the consequences. Exercises – Part 1 – Distribution of Equity EXERCISE 2 Solution to Question 1: 400,000 € giving right to 20% of the capital → Calculate the number of shares to be purchased in the target company x/(10,000+x) = 0.20 x =2000+0.20x 0.80x =2000 x =2000/0.80=2500 Shares → Implied Share Price = 400,000/2500 = 160 € → Pre-money valuation =10,000 x 160 = 1,600,000 € → Post-money valuation = 1,600,000 + 400,000 = 2,000,000 € Distribution of Capital Alain Elise Max Fund Total Before transaction After transaction Shares % Shares % Value 7,000 70.00 7,000 56.00 1,120,000 1,500 15.00 1,500 12.00 240,000 1,500 15.00 1,500 12.00 240,000 0 0.00 2,500 20.00 400,000 10,000 100.00 12,500 100.00 2,000,000 Exercises – Part 1 – Distribution of Equity EXERCISE 2 Founded in 1965, DUFLOT Inc. is active in the production of regional food specialties. It is owned by the 3 children of the 2nd generation: Alain, the manager; Elise and Max, his sister and brother, who do not work in the company. The capital of the company is composed of 10,000 shares of € 10 nominal. It is distributed as follows: Alain: 7,000 shares / Elise: 1,500 shares / Max: 1,500 shares II - The negotiation finally leads the parties to retain an operation whose characteristics are as follows: The fund invests 450,000 € including 300,000 € in the form of subscription to a capital increase and 150,000 € by repurchase of shares to the shareholders in proportion to their respective percentage in the company. After these transactions, the fund will hold 25% of the company's capital. Questions: 1. What is the valuation that served as the basis for the operation? 2. What is the position of the family shareholders after this operation? Comment. Exercises – Part 1 – Distribution of Equity EXERCISE 2 Solution to Question 1: Fund investment = 450,000 € (25% share of total capital) Capital increase = 300,000 € Share repurchases = 150,000 € After these transactions, the fund will hold 25% of the company's capital. → Post-money valuation = 450,000 / 0.25 = 1,800,000 → Pre-money valuation = 1,800,000 -300,000 = 1,500,000 → Implied share price =1,500,000/10,000= 150 € → Number of new shares purchased =300,000 /150 = 2,000 → Number of existing shares purchased =150,000 /150 = 1,000 EXERCISE 2 Solution to Question 2: Before transaction After share capital increase Shares % Value Shares Alain 7,000 70.00 1050000 Elise 1,500 15.00 Max 1,500 Fund 0 Total 10,000 % After share capital increase and repurchase Value Shares % Value 7,000 58.33 1,050,000 6,300 52.50 945,000 225000 1,500 12.50 225,000 1,350 11.25 202,500 15.00 225000 1,500 12.50 225,000 1,350 11.25 202,500 0.00 0 2,000 16.67 300,000 3,000 25.00 450,000 100.00 1,500,000 12,000 100.00 1,800,000 12,000 100.00 1,800,000 EXERCISE 2 Question 3 (optional): In case of selling the company 4 years later at a price of 6M€, then how much will they receive each? and what is the Internal Rate of Return of the Investment fund? Solution to Question 3: Re-sale 6 000 000 Shares % Value Shares Case 1 Without repurchases Case 2 With repurchases -350,000 -300000 -450000 0 0 0 0 0 0 1,000,000 1500000 35.12% 35.12% Re-sale 6 000 000 % Value Difference Alain 7,000 58.33 3,500,000 6,300 52.50 3,150,000 Elise 1,500 12.50 750,000 1,350 11.25 675,000 -75,000 Max 1,500 12.50 750,000 1,350 11.25 675,000 -75,000 Fund 2,000 16.67 1,000,000 3,000 25.00 1,500,000 500,000 Total 12,000 100.00 6,000,000 12,000 100.00 6,000,000 M&A Activity around world M&A Activity around world M&A Activity around world All cross-border Mergers Causes and Significance of M&A Waves Factors contributing to increasing M&A activity: o Shocks (e.g., technological change, deregulation, etc) o Ample liquidity and low cost of capital o Overvaluation of acquirer share prices relative to target share prices Why it is important to anticipate M&A waves: o Financial markets reward firms pursuing promising (often undervalued) opportunities early on and penalize those that follow later in the cycle. o Acquisitions made early in the wave often earn substantially higher financial returns than those made later in the cycle. Who buys whom in cross-border mergers Who buys whom in cross-border mergers Who buys whom in cross-border mergers Who buys whom in cross-border mergers Merger Network (1989) Merger Network (2002) Merger Network (2016) Top 10 largest M&A Transactions Date Date Announced Effective Transaction Acquirer Name ($mil) Acquiror Nation Target Name Target Nation 11/14/1999 6/19/2000 202.74 Vodafone AirTouch PLC United Kingdom Mannesmann AG Germany 01/10/2000 01/12/2001 164.75 America Online Inc United States Time Warner Inc United States 09/02/2013 2/21/2014 130.30 Verizon Communications Inc United States Verizon Wireless Inc United States 09/16/2015 10/04/2016 101.49 Anheuser-Busch Inbev Belgium SABMiller PLC United Kingdom 04/25/2007 11/02/2007 98.17 RFS Holdings BV Netherlands ABN-AMRO Holding NV Netherlands 11/04/1999 6/19/2000 89.56 Pfizer Inc United States Warner-Lambert Co United States 06/09/2019 04/03/2020 86.83 United Technologies Corp United States Raytheon Co United States 12/14/2017 3/20/2019 84.20 Walt Disney Co United States 21st Century Fox Inc United States 10/22/2016 6/14/2018 79.41 AT&T Inc United States Time Warner Inc United States 01/03/2019 11/20/2019 79.38 Bristol-Myers Squibb Co United States Celgene Corp United States Top 10 largest French M&A Transactions Date Transaction Date Effective Acquirer Name Announced ($mil) Acquiror Nation Target Name Target Nation 2/25/2006 7/22/2008 60.83 Gaz de France SA France Suez SA France 01/26/2004 8/20/2004 60.25 Sanofi-Synthelabo SA France Aventis SA France 07/05/1999 3/27/2000 50.06 Total Fina SA France Elf Aquitaine France 05/30/2000 8/22/2000 46.47 France Telecom SA France Orange PLC United Kingdom 06/20/2000 12/08/2000 40.45 Vivendi SA France Seagram Co Ltd Canada 08/29/2010 04/08/2011 23.90 Sanofi-Aventis SA France Genzyme Corp United States 10/30/2019 1/16/2021 22.12 Peugeot SA France Fiat Chrysler Automobiles NV United Kingdom 05/17/1999 12/15/1999 21.89 Rhone-Poulenc SA France Hoechst AG Germany 03/11/2014 11/27/2014 21.03 Numericable Group SA France Societe Francaise du Radiotelephone SA France 01/19/2016 08/03/2016 20.05 SACAM Mutualisation France Credit Agricole SA-Regional Banks France M&As as a Form of Corporate Restructuring Corporate restructuring refers broad array of activities intended to expand or contract a firm’s basic operations or fundamentally change its asset or financial structure. Restructuring Activity Corporate Restructuring Balance Sheet Assets Only Potential Strategy Redeploy Assets Mergers, Spin-Offs,etc Acquisitions, divestitures, etc. Financial Restructuring Increase leverage to lower cost of capital or as a takeover defense; share repurchases Operational Restructuring Divestitures, widespread employee reduction, or reorganization Ways of Increasing Shareholder Value Solo venture (AKA “going it alone” or “organic growth”) Partnering (Marketing/distribution alliances, JVs, licensing, franchising, and equity investments) Mergers and acquisitions Minority investments in other firms Financial restructuring Operational restructuring Motivations for M&A Operating synergy Economies of Scale Economies of Scope Complementary technical assets and skills Illustrating Economies of Scale Period 1: Firm A (Pre-merger) Period 2: Firm A (Post-merger) Assumptions: Assumptions: Price = $4 per unit of output sold Variable costs = $2.75 per unit of output Firm A acquires Firm B which is producing 500,000 units of the same product per year Fixed costs = $1,000,000 Firm A closes Firm B’s plant and transfers production to Firm A’s plant Firm A is producing 1,000,000 units of output per year Price = $4 per unit of output sold Firm A is producing at 50% of plant capacity Variable costs = $2.75 per unit of output Fixed costs = $1,000,000 Profit = price x quantity – variable costs – fixed costs Profit = price x quantity – variable costs – fixed costs = $4 x 1,000,000 - $2.75 x 1,000,000 - $1,000,000 = $4 x 1,500,000 - $2.75 x 1,500,000 - $1,000,000 = $250,000 = $6,000,000 - $4,125,000 - $1,000,000 = $875,000 Profit margin (%)1 = $250,000 / $4,000,000 = 6.25% Fixed costs per unit = $1,000,000/1,000,000 = $1 Profit margin (%)2 = $875,000 / $6,000,000 = 14.58% Fixed costs per unit = $1,000,000/1.500,000 = $.67 Key Point: Profit margin improvement is due to spreading fixed costs over more units of output. 1Margin per 2Margin per unit sold = $4.00 - $2.75 - $1.00 = $.25 units sold = $4.00 - $2.75 - $.67 = $.58 Illustrating Economies of Scope Pre-Merger: Post-Merger: Firm A’s data processing center supports 5 manufacturing facilities Firm A’s and Firm B’s data processing centers are combined into a single operation to support all 8 manufacturing facilities Firm B’s data processing center supports 3 manufacturing facilities By combining the centers, Firm A is able to achieve the following annual pre-tax savings: Direct labor costs = $840,000. Telecommunication expenses = $275,000 Leased space expenses = $675,000 General & administrative expenses = $230,000 Motivations for M&A Operating synergy Economies of Scale Economies of Scope Complementary technical assets and skills Financial Synergy Diversification/ (Related/Unrelated) Current Products/New Markets New Products/Current Markets New Product/New Markets Strategic realignment Technological change Deregulation Motivations for M&A Hubris – the “Winner’s Curse” Buying Undervalued Assets: The Q-Ratio Managerialism (Agency Problems) Tax Credits Market Power Mis-valuation Empirical Findings Abnormal (or excess) financial returns are those earned by acquirer and target shareholders above or below what would have been earned without a takeover. Around transaction announcement date, abnormal returns1: For target shareholders averaged 25.1% during the 2000s as compared to 18.5% during the 1990s For acquirer shareholders generally positive averaging about 1-1.5% However, zero to slightly negative for acquirer shareholders for deals involving large public firms and those using stock to pay for the deal Positive abnormal returns to acquirer shareholders often are situational and include the following: Target is a private firm or a subsidiary of another firm The acquirer is relatively small (large firm management may be more prone to hubris) The target is small relative to the acquirer Cash rather than equity is used to finance the transaction Transaction occurs early in the M&A cycle No evidence that alternative strategies (e.g., solo ventures, alliances) to M&As are likely to be more successful 1These conclusions are based on recent studies using large samples over lengthy time periods involving U.S., foreign, and cross-border deals (including public and private firms). See J. Netter, M. Stegemoller, and M. Wintoki, 2011 Implications of Data Screens on Merger and Acquisition Analysis: A Large Sample Study of Mergers and Acquisitions, Review of Financial Studies 24 2316-2357 and J. Ellis, S. B. Moeller, F.P. Schlingemann, and R.M. Stulz, 2011 Globalization, Governance, and the Returns to Cross-Border Acquisitions, NBER Working Paper No. 16676. Primary Reasons Some M&As Fail to Meet Expectations Overpayment due to over-estimating synergy Slow pace of integration Poor strategy Application: Xerox Buys ACS In 2010, Xerox, a slower growing, cyclical an office equipment manufacturer, acquired Affiliated Computer Systems (ACS) for $6.4 billion. With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing and claims processing for governments and private companies. With about one-fourth of ACS’ revenue derived from the healthcare and government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets which should benefit from the 2009 government stimulus spending and 2010 healthcare legislation. There is little customer overlap between the two firms. The sale of services tends to be more stable and offers higher margins than product companies. Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into services achieved limited success due largely to poor management execution. While some progress in shifting away from the firm’s dependence on printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate transitioning from a product driven company to one whose revenues were more dependent on the delivery of business services. More than two-thirds of ACS’ revenue comes from the operation of client back office operations such as accounting, human resources, claims management, and other outsourcing services, with the rest coming from providing technology consulting services. ACS would also triple Xerox’s service revenues to $10 billion. Xerox chose to run ACS as a separate standalone business. Discussion Questions: 1. What alternatives to buying ACS do you think Xerox could have considered? 2. Why do you think they chose a merger strategy? (Hint: Consider the advantages and disadvantages of alternative implementation strategies.) 3. Speculate as to Xerox’s primary motivations for acquiring ACS? 4. How might the decision to manage ACS as a separate business affect realizing the full value of the transaction? What other factors could limit the realization of synergy? Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager At the end of 2011, the Medpart holding company acquired the entire capital of Ganivet for a price of € 1,000,000. Medpart, the LBO holding company created for this transaction, financed this acquisition as follows: Capital: 400,000 € Convertible Bonds: € 100,000 Senior debt: € 500,000 over 5 years, constant amortization. MEDPART 2011 Ganivett Shares 1,000,000Equity 400,000 Conv. Bonds 100,000 Senior Debt 500,000 Total 1,000,000Total 1,000,000 The capital of Medpart was then composed of 4,000 shares held at 90% by the investment fund named « Industry Value », and 10% by the manager of Ganivet. Convertible Bonds were wholly owned by Industry Value. Shares Perct. Question 1: At the end of each financial year, the Industry Value (IV) teams evaluate the investments in their portfolio, to transmit the estimated value of the fund to their investors. At the end of 2014, a reasonable valuation of Ganivet amounted to 1,500,000 €. A. What was the valuation of the stake held by Industry Value in Medpart at the end of 2014, knowing that the assumption is made that the Convertible Bonds would not be converted? B. What was the potential « capital gain » on Medpart shares held by Industry Value at the end of 2014? IV Manager Total 3,600 400 4,000 90.00% 10.00% 100.00% As at 31/12/2014, Medpart's balance sheet was as follows: Before valuation → MEDPART 2014 (€) ASSETS LIABILITIES Ganivet shares 1 000 000 Equity Conv. Bonds Senior Debt Total 1 000 000 Total 700 000 100 000 200 000 1 000 000 Exercises – Part 2 – Sharing of Value Shares 3,600 400 4,000 IV Manager Total EXERCISE 1 – Sharing of Value between Investment Fund and Manager Perct. 90.00% 10.00% 100.00% Solution to Question 1 – Part A: After valuation - MEDPART 2014 (€) Before valuation- MEDPART 2014 (€) ASSETS Ganivet shares Total ASSETS LIABILITIE 1 000 000 Equity 700 000 Ganivet shares LIABILITIES 1,500,000 Equity 1,200,000 Conv. Bonds 100 000 Conv. Bonds 100,000 Senior Debt 200 000 Senior Debt 200,000 1 000 000 Total 1 000 000 Total Solution to Question 1 – Part B: Capital Gain of IV = Equity Capital of IV2014 – Equity Capital of IV2011 Capital Gain of IV = 0.90 x 1,200,000 – 0.90 x 400,000 Capital Gain of IV = 1,080,000 – 360,000 Capital Gain of IV = 720,000 1,500,000 Total 1,500,000 Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager Question 2: At the end of 2016, all Medpart shares were sold to other investors on the basis of a valuation of 100% of the capital of Ganivet equal to € 1,600,000 (stock value). A. At what unit price Medpart shares were sold knowing that at the time of the transaction, all of the senior debt had been repaid and that the Convertible Bonds had been converted in full by Industry Value? Face Value of Bond: 100 € Coupon Rate: 5% Conversion parity: 1 Medpart share for 1 Convertible Bond. B. In the Medpart shareholders' agreement, it was expected that Industry Value would give back 20% of its total capital gain to the Ganivet manager. What was 1) the total amount of cash received by the manager after the deal is completed, and 2) what would have been cash received by the IV Fund? C. Draw up all the annual financial flows of Industry Value related to this operation, knowing that Medpart did not pay any dividends and that the characteristics of the Medpart Convertible Bonds were as follows: Face Value of Bond: 100 € Coupon Rate: 5% D. What would be the Internal Rate of Return for the Investment fund? Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager Solution to Question 2 – Part A: MEDPART 2016 (€) ASSETS Ganivet shares Total LIABILITIES 1,600,000 Equity 1,600,000 Conv. Bonds 0 Senior Debt 0 1,600,000 Total 1,600,000 Number of shares acquired by IV after converting bonds: 100,000/100 = 1000 shares Shares Perct. IV 4,600 92.00% Manager 400 8.00% Total 5,000 100.00% Share Price = 1,600,000/5,000 = 320 Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager Solution to Question 2 – Part B: IV Manager Total Value received by managers: Shares 4,600 400 5,000 Perct. 92.00% 8.00% 100.00% (1) Shares in equity2016 = 400 x 320 = 128,000 (2) Compensation by IV20% of capital gain = 20% (Shares in Equity2016 – (Initial Investment2011 + Bonds Conversion Value)) = 20% (4,600 x 320 – ((400,000 x 0.90) + (100,000)) = 20% (1,472,000 – (360,000 + 100,000)) = 20% ( 1,012,000) = 202,400 Total value received by manager = 128,000 + 202,400 = 330,400 Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager Solution to Question 2 – Part B: Value received by IV Funds: Shares in equity2016 = 4,600 x 320 = 1,472,000 Net value received= 1,472,000 - 202,400 = 1,269,600 IV Manager Total Shares 4,600 400 5,000 Perct. 92.00% 8.00% 100.00% Exercises – Part 2 – Sharing of Value EXERCISE 1 – Sharing of Value between Investment Fund and Manager Solution to Question 2 – Part C and D: Years Shares 2011 2012 2013 2014 2015 2016 IRR -360,000 0 0 0 0 1,152,000 Convertible Bonds -100,000 5,000 5,000 5,000 5,000 325,000 Total – before sharing value -460,000 5,000 5,000 5,000 5,000 1,274,600 23.27% Analyzing Privately Held Companies What is a Private Firm? A firm whose securities are not registered with state or federal authorities Their shares cannot be traded in the public securities markets. Share ownership usually heavily concentrated (i.e., firms “closely held”) Key Characteristics of Privately Held U.S. Firms There are more than 28 million firms in the U.S. Of these, 7.4 million have employees, with the rest largely self-employed, unincorporated businesses M&A market in U.S concentrated among smaller, family-owned firms ✓ Firms with 99 or fewer employees account for 98% of all firms with employees M&As Around the World Source: Thomson Reuters (Between 1985 and 2021) Challenges of Analyzing and Valuing Privately Held Firms Lack of externally generated information Lack of internal controls and rigorous reporting systems Lack of adequate documentation of key intangible assets such as software, chemical formulae, recipes, etc. Firm specific problems Narrow product offering Lack of management depth Lack of leverage with customers and vendors Limited ability to finance future growth Common forms of manipulating reported income Revenue may be understated and expenses overstated to minimize tax liabilities The opposite may be true if the firm is for sale Steps Involved in Valuing Privately Held Businesses 1. Adjust target firm data to reflect true current profitability and cash flow 2. Determine appropriate valuation methodology (e.g., DCF, Relative Valuation) 3. Estimate appropriate discount (capitalization) rate 4. Adjust firm value for liquidity risk, value of control, or minority risk if applicable Step 1: Adjusting the Income Statement Owner/officer’s salaries Benefits Travel and entertainment Auto expenses and personal life insurance Family members Rent or lease payments in excess of fair market value Professional service fees (e.g., legal or consulting) Depreciation expense (e.g., accelerated makes economic sense when equipment obsolescence rapid) Reserves (e.g., for doubtful accounts, pending litigation, future retirement or healthcare obligations) Step 1: Adjusting the Income Statement Areas Commonly Understated When a business is being sold, the following expense categories are often understated by the seller: The marketing and advertising expenditures required to support an aggressive revenue growth forecast Training sales forces to market new products Environmental clean-up Employee safety Step 1: Adjusting the Income Statement Areas Commonly Overlooked When a business is being sold, the following asset categories are often overlooked by the buyer as potential sources of value: Customer lists (e.g., cross-selling opportunities) Intellectual property (e.g., unused patents) Licenses (e.g., unused licenses) Distributorship agreements (e.g., alternative marketing channels for acquirer products) Leases (e.g., at less than fair market value) Regulatory approvals (e.g., permits sale of acquirer products) Employment contracts (e.g., employee retention) Non-compete agreements (e.g., limits competition) Step 1: Adjusting the Income Statement Target’s Statements Revenue 8000 Cost of Sales 5000 Depreciation Net Adjustments Adjusted Statements Comments 8000 Check for premature booking of revenue & adequacy of reserves1 (400) 4600 Convert LIFO to FIFO 100 (40) 60 Convert accelerated to straight line Selling: Salaries/Benefits 1000 (100) 900 Eliminate family member Selling: Rent 200 (100) 100 Eliminate sales offices Selling: Insurance 20 (5) 15 Reduce premiums Selling: Advertising 20 10 30 Increase advertising Selling: Travel & Enter 250 50 300 Increase travel Admin.: Salaries/Benefits 600 (100) 500 Reduce owner’s pay Admin: Rent 150 (30) 120 Reduce office space Admin: Directors’/Prof. Fees 280 (40) 240 Reduce fees Total Expenses 7620 (755) 6865 EBIT 380 1135 Discussion Questions 1. Why is it often more difficult to value privately owned companies than publicly traded firms? Give specific examples. 2. Why is it important to restate financial statements provided to the acquirer by the target firm? Be specific. 3. How could an analyst determine if the target firm’s cost and revenues are understated or overstated? Give specific examples. Step 2: Determine Appropriate Valuation Methodology Discounted cash flow approach Relative or market-based approach Other valuation approaches Capitalization Multiples Perpetuity (zero growth) or constant growth methods commonly used in valuing small, privately owned firms for simplicity and due to data limitations FCFF/WACC = (1/WACC) x FCFF, where (1/WACC) is the capitalization (valuation) multiple FCFF(1+g)/(WACC – g) = [(1+g)/(WACC – g)] x FCFF, where g is the growth rate [(1+g)/(WACC-g)] is the capitalization (valuation) multiple Assume discount rate is 8% and firm’s current cash flow is $1.5 million. Multiples in brackets. If cash flow expected to remain level in perpetuity, the implied valuation is [1/.08] x $1.5 = 12.5 x $1.5 = $18.75 million If cash flow expected to grow 4 percent annually in perpetuity, the implied valuation is [(1.04) / (.08.04)] x $1.5 = 26 x $1.5 = $39.0 million Step 3: Select Appropriate Discount (Capitalization) Rates Capital asset pricing model (CAPM) Estimate firm’s beta based on comparable publicly listed firms Cost of capital Cost of debt based on what public firms of comparable risk are paying Step 3: Select Appropriate Discount (Capitalization) Rates Alternative Ways to Estimate Discount Rates: The Build-Up Method Represents the sum of risks associated with a particular firm by adding to the CAPM’s estimate of the firm’s cost of equity (for which the firm’s market beta is assumed to be one)1 an estimate of firm size, industry risk, and firm specific risk. The build-up method could be displayed as follows: ke = Rf + ERP + FSP + IND + CSR where ke = cost of equity Rf = risk free return ERP = Equity risk premium FSP = firm size premium IND = Industry risk premium CSR = Firm specific risk premium (e.g., excessive dependence of a single customer, narrow product focus, limited access to capital)2 1Assumes factors causing the firm’s beta to deviate from one are captured by firm size, industry and firm specific risk adjustments. for firm size and industry risk premiums available from Morningstar’s Ibbotson Stocks, Bonds, Bills & Inflation and Duff & Phelps Risk Premium Report. Firm specific risk often obtained through management interviews and firm site visits. 2Data Step 4: Adjust Firm Value for Liquidity Risk, Value of Control, or Minority Risk Discount Applied to Firm Value Liquidity risk: Reflects potential loss in value when an asset is sold in an illiquid market Minority risk: Reflects lack of control associated with minority ownership. Risk varies with size of ownership position Premium Applied to Firm Value Value of control: Ability to direct activities of the firm (e.g., make key decisions, declare a dividend, hire or fire key employees, direct sales to or purchases from preferred customers or suppliers at prices different from market levels) Liquidity Discount A liquidity discount is a reduction in the offer price for the target firm by an amount equal to the potential loss of value when sold due to the lack of liquidity in the market. Recent studies suggest a median liquidity discount of approximately 20% in the U.S. The size of the liquidity discount will vary with profitability, growth rate and degree of risk (e.g., beta or leverage) of the firm. Premium Purchase price premium represents amount a buyer pays seller in excess of the seller’s current share price and includes both a synergy and control premium Control and synergy premiums are distinctly different Value of synergy represents revenue increases and cost savings resulting from combining two firms, usually in the same line of business Value of control provides right to direct the activities of the target firm (e.g., change business strategy, declare dividends, and extract private benefits) Country comparisons indicate huge variation in median control premiums from 2-5% in countries with relatively effective investor protections (e.g., U.S. and U.K.) to as much as 60-65% in countries with poor governance practices (e.g., Brazil and Czech Republic). Median estimates across countries are 10 to 12 percent. Minority Discount Minority discounts reflect loss of influence due to the power of controlling block shareholder. Investors pay a higher price for control of a company and a lesser amount for a minority stake. Large control premiums indicate high perceived value accruing to the controlling shareholders and significant loss of influence for minority shareholders Increasing control premiums associated with increasing minority discounts Implied Median Minority Discount = 1 – [1/(1 + median control premium paid)] Control Premium (%) Minority Discount (%) 10 9.1 15 13.0 20 16.7 25 20.0 Interaction Between Liquidity Discounts, Control Premiums, and Minority Discounts When markets are liquid, investors place a lower value on control since investors dissatisfied with controlling shareholder decisions can easily sell their shares. When markets are illiquid, investors place a higher value on control since shareholders can only sell their shares at a substantial discount. Minority shareholder stakes are illiquid in part because Minority shareholders cannot force the sale of the business. This implies that the size of liquidity discounts and control premiums are positively correlated. Adjusting Target Firm Value Where PV = Present value of projected target firm free cash flows FCFF = Free cash flow to the firm WACC = Weighted average cost of capital TV = Terminal value Adjust PV for Liquidity Discount (LD%): PVadj = PV(1 – LD%) Adjust PV for Liquidity Discount and Control Premium (CP%): PVadj = PV(1 – LD%)(1+CP%) Adjust PV for Liquidity Discount and Minority Discount (MD%): PVadj = PV(1-LD%)(1-MD%) Generalizing Adjustments to Target Firm Value PVMAX = (PVMIN + PVNS)(1 + CP%)(1 – LD%) Where PVMAX = Maximum purchase price PVMIN = Minimum firm value PVNS = Net synergy LD% = Liquidity discount (%) CP% = Control premium or minority discount (%) Incorporating Liquidity Risk, Control Premiums, and Minority Discounts in Valuing a Private Business LGI wants to acquire a controlling interest in Acuity Lighting, whose estimated standalone equity value equals $18,699,493. LGI believes that the present value of synergies is $2,250,000 due to cost savings. LGI believes that the value of Acuity, including synergy, can be increased by at least 10 percent by applying professional management methods. To achieve these efficiencies, LGI must gain control of Acuity. LGI is willing to pay a control premium of as much as 10 percent. LGI reduces the median 20% liquidity discount by 4% to reflect Acuity’s high financial returns and cash flow growth rate. What is the maximum purchase price LGI should pay for a 50.1 percent controlling interest in the business? For a minority 20 percent interest in the business? To adjust for presumed liquidity risk of the target firm due to lack of a liquid market, LGI discounts the amount it is willing to offer to purchase 50.1 percent of the firm’s equity by 16 percent. PVMAX = ($18,699,493 + $2,250,000)(1 - 0.16)(1 + 0.10)) x 0.501 = $20,949,493 x 0.924 x0.501 = $9,698,023 If LGI were to acquire only a 20 percent stake in Acuity, it is unlikely that there would be any synergy, because LGL would lack the authority to implement potential cost saving measures without the approval of the controlling shareholders. Because it is a minority investment, there is no control premium, but a minority discount for lack of control should be estimated. The minority discount is estimated using Equation 1 – [1/(1 + median control premium paid)] (i.e., 1 – (1/(1 +.10)) = 9.1). PVMAX = ($18,699,493 x (1- 0.16)(1 -0.091)) x 0.20 = $2,855,637 Discusson Questions 1. What is a liquidity risk premium? Why is it important to adjust projected cash flows for this risk? 2. How might the size of a firm affect its level of risk? Be specific. 3. Does beta in the capital asset pricing model have meaning for a firm that is not publicly traded? Explain your answer. Practice Problem An investor believes that she can improve the operating income of a target firm by 30 percent by introducing modern management and marketing techniques. A review of the target’s financial statements reveals that it’s operating profit in the current year is $150,000. Recent transactions, resulting in a controlling interest in similar businesses, were valued at six times operating income. The investor also believes that the liquidity discount for businesses similar to the target firm is 20 percent. What is the most she should be willing to pay for a 50.1 percent stake in the target firm? Practice Problem - Solution PVMAX = (PVMIN + PVNS)(1 – LD%)(DOP%) Where PVMAX = Maximum purchase price PVMIN = Minimum firm value (i.e., standalone value) PVNS = Net synergy or value added LD% = Liquidity discount (%) DOP% = Desired ownership percentage Maximum Purchase Price = ((6 x $150,000) + 0.3 x (6 x $150,000)) x (1 - 0.2) x.501 = ($900,000 + $270,000) x 0.8 x 0.501 = $ 468,936 A short case You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $300,000. Income has grown 4% annually during the last 5 years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $20,000, and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating-income growth rate can be increased to 6% beyond the second year and sustained at that rate into the foreseeable future. The 10-year Treasury bond rate is 5%, the equity-risk premium is 5.5%, and the marginal federal, state, and local tax rate is 40%. The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The business’s target debt-toequity ratio is one, and its pretax cost of borrowing, based on its recent borrowing activities, is 7%. The business-specific-risk premium for firms of this size is estimated to be 6%. The liquidity-risk premium is believed to be 15%, relatively low for firms of this type due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain when the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 10% premium to reflect the value of control. a) What is free cash flow to the firm in year 1? b) What is free cash flow to the firm in year 2? c) What is the firm’s cost of equity? d) What is the firm’s after-tax cost of debt? e) What is the firm’s target debt-to-total capital ratio? f) What is the weighted average cost of capital? g) What is the business worth? A short case - Answer a) What is free cash flow to the firm in year 1? Free cash flow to the firm in year 1 = $300,000 x 1.04 x (1 -.4) - $20,000 x 1.04 - $15,000 x 1.04 = $187,200 – $20,800 – $15,600 = $150,800 b) What is free cash flow to the firm in year 1? Free cash flow to the firm in year 2 = ($300,000 x 1.042) x (1-.4) - $20,000 x 1.042 - $15,000 x 1.042 = $194,688 – $21,632 – $16,224 = $156,832 c) What is the firm’s cost of equity? Industry’s unleveraged beta = 2 / (1 +.6 x 1.5) = 1.05 → βasset = [βequity / (1+((1−𝑡) 𝐷/𝐸 ))] Restaurant’s leveraged beta = 1.05 (1 +.6 x 1.0) = 1.68 → βequity = βasset [1+((1−𝑡) 𝐷/𝐸 )] Cost of Equity =.05 + 1.68 (.055) +.06 =.2024 d) What is the firm’s after-tax cost of debt? After-tax cost of debt =.07 x (1-.4) =.042 e) What is the firm’s target debt-to-total capital ratio? Restaurant’s target debt-to-total capital ratio = target D/E / (1 + target D/E) = 1 / 2 =.5 short f) What is the weighted average cost of capital? Weighted average cost of capital =.5 x.2024 +.5 x.042 =.1012 +.0210 =.1222 f) What is the business worth? PV = $150,800 + $156,832 + ($156,832 x 1.06)/(.1222 -.06) (1.1222) (1.1222)2 (1.1222)2 = $134,379 + $124,536 + $2,122,313 = $2,381,228 PV (after the liquidity discount & control premium) = $2,381,228 x (1 -.15) x (1 +.10) = $2,226,448 Event Studies Event Studies Since Fama, Fisher, Jensen and Roll (1969) the accepted method for isolating the impact of a particular event on market valuations is the event study. Event studies examine the behavior of firms’ stock prices around corporate events Widely used empirical method in accounting and finance “[…]there was little evidence on the central issues of corporate finance. Now we are overwhelmed with results, mostly from event studies.” (Fama, 1991, p. 1600) Event Studies Application in Finance and Accounting: Mergers and Acquisitions, Earnings Announcements, Issues of new debt or equity, and announcements of macroeconomic variables such as the trade deficit. Application in the field of law and Economics: to measure the impact on the value of a firm of a change in the regulatory environment (see G. William Schwert 1981) and in legal liability cases event studies are used to assess damages (see Mark Mitchell and Jeffry Netter 1994). Event Studies Price-based event studies originally designed to test the efficient market hypothesis (EMH) Efficient market = market in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security Informational efficiency: The speed and accuracy with which prices reflect new information. Event Studies The Different Types of Efficiency: Weak Form Security prices reflect all information found in past prices and volume. Semi-Strong Form Security prices reflect all publicly available information. Strong Form Security prices reflect all information—public and private. Event Studies The goal is to measure the effect of an economic event on firm value abnormal return = event-driven return − normal return event-driven return = return observed on the event day normal return = return that would have been observed in the absence of the event Event Studies Steps Identification of the events (nature, announcement date, …) Identification of the estimation and event windows Estimation of the normal return model parameters Computation of the abnormal returns over the event window ARt = Rt - E(Rt) CAR(K,L) = Cumulated abnormal return between day K (event window 1st day) and day L (event window last day) Event Studies Event Studies Event Studies – An Illustration Case: Danone and The WhiteWave Foods (WWF) – Acquisition ✓ Announcement Date: July 7, 2016 (day 0) ✓ Normal Return Generating Process: Market Model ✓ Estimation Window: 200 Days (from day -235 to day -36) ✓ Event Window: 11-day centered on the announcement date (-5, +5) ✓ Market Value (in Billions) on June 01, 2016 ✓ AR: Abnormal return ✓ CAR: Cumulated abnormal return ✓ VW CAR: Value Weighted CAR Event Studies – An Illustration Danone and The WhiteWave Foods (WWF) Acquisition of ‘The WhiteWave Foods’ by ‘Danone’ The biggest deal to date in the natural and organic foods industry Transaction Value: $10.356 Billion Deal Announced: 07.07.2016 Deal Completed: 12.04.2017 Market Value of Danone (on 07.06.2016): $41.538 Billion Market Value of WWF (on 07.06.2016): $8.179 Billion Event Studies – An Illustration Exercise for Students Merger between Total SA and Saft Deal Announced: 9th May 2016 Deal Completed: 12th August 2016 Deal Value: $1.031 Billion Market Value Total SA (9th April 2016): 98.626 Billion Market Value Saft (9th April 2016): 0.674 Billion Data: 20/05/2015 to 20/05/2016 (See excel file on K2)