Financial Modeling Using Excel

Mergers and Acquisitions

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 M&A

Source: www.ft.com

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 Agenda

Meaning and categories of M&A

Merger motivations

Forms of payment

Hostile Vs Friendly offer

Estimating value

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 Mergers & Acquisitions defined

Mergers & acquisitions

Refer to the aspect of corporate finance dealing with purchase, sale or combination of two
business entities that can add strategic value to a company in a given industry and grow
rapidly without having to grow organically.

Mergers
Refer to the acquirer absorbing the entire target
company.
Involve purchase of controlling stock
Both the acquirer and target lose their respective
identities after merger (e.g., Glaxo Smithkline)
It is generally friendly in nature
Acquisitions
Refer to the acquirer buying only a part of target
company
Involve purchase of assets or a distinct business
segment (e.g., subsidiary)
The acquirer and/or target retain their identity after
merger. (Mahindra Satyam)
It can be a hostile take-over

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 Transaction Structure - Amalgamation into an
Existing Company

S1 Co. 1: Amalgamating Company; Ceases

to Exist
Co. 2: Amalgamated Company
Co. 1 Co. 2 receives all of Co. 1s assets
and liabilities
Issue S1: Shareholders of Co. 1 receive shares
Transfer
shares S2 in Co. 2 and maybe other benefits like
Assets &
debentures, cash
Liabilities
Co. 2 will now have S1 and S2 as its
Co. 2 shareholders
Case in Example Merger of Reliance
Petroleum into Reliance Industries Limited

S1 S2

Co. 2

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 Categories of M&A - Horizontal Integration

Two firms in the same industry combine Industry 1

Typically the competitors

Firm 1 Firm 2
Motivation: To achieve Firm 5
Industry consolidation to exploit economies of Firm 3 Firm 4
scale, size and / or scope
Entry into a new geography
Enhance product / services portfolio

Examples
P&G acquiring Gillette
Acquisition of equity stake in IBP by IOCL
Bharat Forges acquisition of CDP (Germany)
S&Ps stake in CRISIL

Which Industries / Sectors will typically see Horizontal Integration? Why???

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 Categories of M&A - Vertical Integration

goods
Vertical Integration

Customersofof
finishedgoods
Industry 3
Internalization of crucial

Customers
forward or backward activities

finished
Firm 1 Firm 2
Firm 5
Firm 3 Firm 4

Forward Integration Backward Integration

Buying your customer Buying your supplier Industry 2

Manufacturer

Supply Chain
Manufacturer
/ /
Producer
Producer
Firm 1 Firm 2
Firm 5
Two firms across the vertically integrated industries combine
Firm 3 Firm 4

Motivation: To achieve
Control of a forward or backward activity in supply chain Industry 1

Material
RawMaterial
Secure Raw Materials

Supplier
Supplier
Examples Firm 1 Firm 2
Firm 5

Raw
Indian Rayons acquisition of Madura Garments
Firm 3 Firm 4
IBMs acquisition of Daksh

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 Categories of M&A - Conglomerate

Combination of two firms in uncorrelated business

Motivation: To achieve
Diversification by combining uncorrelated assets and income streams
To reduce business risks

Examples
L&Ts attempted acquisition of Satyam

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 Agenda

Meaning and categories of M&A

Merger motivations

Forms of payment

Hostile Vs Friendly offer

Estimating value

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 Merger Motivations

3. Increased
1. Synergy
2. Achieve rapid market power
(Economies of
growth (inorganic) (reduced
scope/scale)
competition)

5. Access to
6. Empire building
4. Diversification unique
by managers
competencies

8. Bootstrapping 9. International
7. Tax benefits
EPS expansion

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 Motivations according to Industry life cycle

Size

Time

Industry
stage Characteristics Motivations Type of M&A
Pioneer Uncertainty of product acceptance Access to larger/mature firms capital Horizontal
High capital requirements, low margins Gain management expertise Conglomerate
Rapid growth High profit margins Access to capital Horizontal
Increasing revenues and profits Capacity expansion Conglomerate
Less competition
Mature growth Increasing competition Operational efficiencies Horizontal
Less scope for supernormal growth Synergies (economies of scale/scope) Vertical
Stabilization Reduced growth potential due to high Economies of scale Horizontal
competition Management efficiency
Capacity constraints
Decline Change in consumer tastes Operational efficiencies Horizontal
Excess capacity/declining margins New growth opportunities Vertical
survival Conglomerate

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 Agenda

Meaning and categories of M&A

Merger motivations

Forms of payment

Hostile Vs Friendly offer

Estimating value

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 Form of acquisition
Metric Stock purchase
Payment to party Made directly to targets
shareholders in exchange for their
shares
Approval Majority shareholder approval
required
Taxes No tax expense incurred by
company, but shareholders pay
capital gains tax
Liabilities of target Acquiring firm assumes targets
liabilities
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Asset purchase
Made directly to the company
Unless asset sale is a substantial
portion, no shareholder approval
necessary
Target company has to pay capital
gains tax
Usually the liabilities are avoided by
acquirer in the transaction.
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 Methods of payment

Metric Stock offering Cash offering

Meaning Targets shareholders receive Acquirer pays an agreed amount of
proportion of acquirers common cash for target company stock
stock in exchange for their targets
holding
Risk in the merged Part of the risk (and reward) is Risk is entirely borne by acquirer
entity borne by targets shareholders. Higher confidence in synergies
Lower confidence in synergies
by acquirer.
Relative valuations Stock offer is a signal that
acquirers shares may be
overvalued
Capital structure Decreases leverage as issuance of Increases leverage, especially if
impact new stock dilutes ownership for acquirer borrows money to pay targets
existing shareholders shareholders.

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 Agenda

Meaning and categories of M&A

Merger motivations

Forms of payment

Hostile Vs Friendly offer

Estimating value

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 Friendly Vs Hostile offer

Friendly offer:
Refer to the acquisition of a target company that is willing to be taken over.
Usually, the target will accommodate overtures and provide access to confidential information to facilitate the scoping
and due diligence processes.
Normally the process is started voluntarily by target company, but can be initiated by friendly overture by acquirer
seeking better information to value target.

Friendly Acquisition

Information Main due

memorandum Confidentiality
agreement diligence Ratified

Approach Sign letter Final sale

target of intent agreement

Both parties have opportunity to structure deal to their mutual satisfaction:

Taxation Issues (stock offer instead of cash offer)
Asset purchase rather than stock purchase
Earn outs

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 Friendly Vs Hostile Offer (Cont)

Hostile offer:
A takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide
any confidential information.
The acquirer usually has already accumulated an interest in the target (25% of the outstanding shares) and this
preemptive investment indicates the strength of resolve of the acquirer.

Hostile Acquisition

Beachhead: slowly acquire

Acquire 25% stock through open
toehold by open market
market purchase over longer
purchase of targets shares
period

File statement with SEBI Make a tender offer to bring

without attracting attention ownership percentage to the
desired level.

Acquirers tactics:
Bear hug: acquirer submits merger proposal directly to targets board of directors
Tender offer: acquirer offers to buy shares directly from targets shareholders
Proxy battle: acquirer seeks control over target by having targets shareholders approve a new board of directors
chosen by acquirer. If successful, the new board may then replace targets management and execute a
friendly merger.

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Understanding M&A Process - Typical Steps & Timelines
Fortnights
1 2 3 4 5 6 7 8 9 10 11
Preliminary Preparation and
Shortlisting of Buyers

Signing of Non Disclosure Agreement

Dispatch of Info Pack to selected Buyers

Management Meetings, discussion on Info Pack and Business Model

Receipt of Preliminary Bid

Shortlist 2-3 Potential Buyers

Buyer Due Diligence,

Data room

Receipt of Final Bid

Shortlist Final Buyer and

provide exclusivity

Activity
Confirmatory due diligence
and Final Negotiations
Key external point

Finalize transaction
Key decision point documents

Closure

Phase I Phase II Phase III

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 Understanding M&A Process - Typical Terms

Teaser
Confidentiality Agreement / Non Disclosure Agreement
Information Memorandum
Business Model, Valuation - Methodology
Synergies
Building synergies into the model
Preliminary bid Non Binding Offer
Due Diligence
Term Sheet
Final Bid Binding Offer
Negotiations: How do valuations change?
Deal Closure

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 Agenda

Meaning and categories of M&A

Merger motivations

Forms of payment

Hostile Vs Friendly offer

Estimating value

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 Estimating Value
Types of
valuation DCF
Advantages Easy to make
modifications in cash flow
forecasts
Based on forecasts of
future conditions than on
current data
Easy to customize
Disadvantages Difficult to apply during
negative cash flows
Heavy reliance on
assumptions like discount
rate, and on terminal cash
flow
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Comparable
companies Comparable transactions
Data of comparable No takeover premium
firms readily available necessary since actual
Relies on market data valuations are considered
than on assumptions of Estimates are based on
variables recent prices
Avoid any potential lawsuit
for mispricing deal
Implicitly assumes Implicitly assumes accurate
comparables are valuation for comparables
accurately valued Lack of sufficient number of
Difficult to incorporate comparable transactions
synergies into analysis Does not incorporate merger
Estimation of takeover synergies in analysis
premium may not be
accurate
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 Evaluating a merger bid

Post merger valuation for an acquirer: VAT=Value post merger

VA=Value of acquirer
VAT VA VT S C

VT= Value of target
S=synergies
C=Costs

Gains accrued to Target:

PT=price paid by acquirer
GainT PT VT (includes premium)

Gains accrued to acquirer:

GainA S ( PT VT ) N=number of shares

In case of stock offer,

PT ( N PAT )

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 M&A Case

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Agenda
Valuing Target Company in Mergers and Acquisition
DFC, Comparable Company, and Transaction Analysis

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Mergers and Acquisitions - Recap
Merger and acquisition (M&A) refer to the act of two business combining, in some way or the
other.

Company which is getting acquired is called target, and the company acquiring is called acquirer

Merger is when controlling stake in target is acquired by the acquirer

Merger: Example- Arcelor- Mittal

Acquisition is when a part of the target is acquired

Acquisition: Example- Tata Motors taking over JLR

In Mergers and Acquisition target company is valued using any of the following valuation methods
Discounted Cashflow Analysis
Comparable Company Analysis
Comparable Transaction Analysis
We will use each of the method using a case.

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Case:

Core Industries is considering acquiring Duo Systems through a hostile takeover. Their plan is to
make a tender offer directly to the shareholders of Duo Systems. Eva Fox, a financial analyst
with Core, has been asked to estimate a fair acquisition price for the offer. Fox has considered
using three different valuation methods to estimate the acquisition price and has gathered the
required financial data for this purpose.

Pro Forma Income Statement and Other Financial Data for Duo Systems are as follows

Income Statement (in $ 000) FY 01 FY 02 FY 03 FY 04 FY 05

Revenue 10,000 11,000 12,500 14,000 16,500
COGS 5,500 6,500 7,500 8,500 9,500
Gross Profit 4,500 4,500 5,000 5,500 7,000
SG&A 1,300 1,550 1,700 1,800 2,000
Depreciation 450 490 530 570 610
EBIT 2,750 2,460 2,770 3,130 4,390

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Cont.

Net Interest Expense 700 660 600 550 500

EBT 2,050 1,800 2,170 2,580 3,890
Income Tax 855 768 1,041 1,149 1,257
Net Income 1,195 1,032 1,129 1,431 2,633

Other Financial Data (in $ 000)

Change in Working capital 384 415 452 493 537
Change in deferred Taxes 17 19 22 25 27
Capital Expenditures 1,104 1,192 1,300 1,417 1,544

Duo Systems has 1 million shares outstanding. From sixth year onwards, Fox expects Duos free
cash flows to grow at a constant rate of 7% per year. She also determines that Duos weighted
average cost of capital of 9.5% is the appropriate discount rate to use for the analysis. The
market value of Duo's debt is $7,44,000.

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Cont.

Fox did some research and found three companies from the same industry as Duo, and with a
similar capital structureMouse Corporation, Pad Inc., and Wire Dynamics. In addition, Fox
could gather data for three takeover transactions with characteristics similar to DuoPage
Corporation, Cover Industries, and Wrap Corp. Data gathered by Fox are shown in the
following figure.

Comparable Company Mouse

Statistics Duo Systems Corporation Pad Inc. Wire Dynamics

Current stock price ($) 33.00 55.00 38.00 110.00

Earnings per share (EPS) ($) 1.80 2.75 2.15 3.70

Book value per share ($) 10.20 16.95 12.20 35.60

Sales per share ($) 30.10 51.80 37.65 109.15

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Cont.

Comparable Transaction
Statistics Page Corporation Cover Industries Wrap Corp
Stock price pre-takeover ($) 18.20 26.95 42.80
Acquisition stock price - Deal
Price ($) 21.80 33.80 53.15
Earnings per share (EPS) ($) 1.10 1.70 2.50
Book value per share ($) 6.25 10.15 14.00
Sales per share ($) 17.50 27.10 39.95

Calculate the appropriate valuation metrics and using the mean of those metrics, and estimate
the price that Core Industries should pay for the Duo System using DFC, comparable company
and comparable transaction analysis.

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Valuing a Company : DCF
Step 1 : List down all assumptions to be used in estimating future cash flows

Step 2 : Make pro-forma financial estimates

Step 3: Calculate free cash flow to firm using the formula and deduct the market value of debt to get
value of equity

FCF = EBIT(1-T) + Depreciation and Amortization +/- Change in working capital Capex

Working capital = current assets (excl. cash etc.) current liabilities (excl. short term debt)

Step 4: Calculate discount rate

Step 5: Calculate terminal value

Terminal value = FCF(t)(1+g)/(r-g) assuming that the company grows at constant rate g

OR

Terminal value = FCF(t)* (P/FCF) assuming a market multiple of projected price / FCF

Step 6: Discount everything and find NPV

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Valuation using DCF:

Pro-forma financial estimates,

calculate FCFF and discount it
with the appropriate rate to arrive
at the target vale.

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Pros and Cons: DCF
Pros
Easily customizable
Based on future forecasts, and is fundamental valuation
Easy to model or incorporate changes due to synergies etc.
Cons
Subject to error, as everything is forecasted
Terminal value forms a major chunk of the value and can change drastically with minor changes in
assumptions
Any small error in the estimation of discount rate can cause big errors in the value, moreover discount
rate changes over time
Special cases where it is difficult to segregate cash flows like in Banks etc.
Companies which have seen just negative cash flows till date are difficult to value, they although may just be
having tremendous growth.

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Valuing a company : Comparable companies
Step 1

List down a set of comparable firms

Step 2

Define comparative value metric like P/E, P/CF. The exact metric used is decided after taking into
account many subjective parameters. A combination of these ratios can also be used.

Step 3

Calculate statistically one value metric to reflect all. This number is used to value the company.

Step 4

Estimate the takeover premium, add it up to value to get the takeover price

Deal price per share - Target' s stock price

Takeover premium =
Target' s stock price

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Valuation using Comparable Company Analysis:

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Pros and Cons: Comparable companies
Pros
Data is easily available
Incorporates market view in the value of the company
Cons
Assumes market valuation is accurate
Synergies must be calculated separately and added to the value arrived by this method
Changing capital structures are difficult to model
Based on historical data, may not be a good indication of future

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Valuing a Company : Comparable Transactions
Step 1

List down all recent comparable transactions (within the same industry, possibly also of a similar size
of the transaction being done etc.)

Step 2

Define comparable value metric like P/E, P/CF. The exact metric used is decided after taking into
account many subjective parameters. A combination of these ratios can also be used.

Step 3

Calculate statistically one value of the metric to reflect all. This number is used to value the company

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Valuation using Comparable Transaction Analysis:

Since we used deal prices from actual transactions as the basis for our analysis, there is no need
to calculate a separate transaction premium because it is already incorporated into the price.

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Pros and Cons: Comparable Transactions
Pros
Takes data from similar transactions, so every price is built right in (like takeover premium)
Easily comparable price with respect to recent similar transaction, makes investor confident
about the pricing of the deal
Cons
Assume that the market valued previous transactions correctly
Synergies from the previous transactions have to be separated for a good pricing.
Synergies must be calculated separately and added to the value arrived by this method.
Enough data must be available to compare with
Synergies must be calculated separately and added to the value arrived by this method

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