Mergers and Acquisitions

Lecture 1: Introduction
Laurent Bach
ESSEC Business School
Autumn 2018
General info
 Instructor: Laurent Bach
 French, but spent seven years in Stockholm, Sweden
 My research:
 Do family firms face particular governance and financing challenges?
 Is shareholder voting efficient and useful?
 Do rich people invest their money better than you and me?

 Office: A420

 Email: bach@essec.edu

 Office hours: by appointment

 Course objectives
 This course studies corporate merger and acquisition activity from a
financial perspective

 At the end of the course, you should:

1. Understand how valuation plays a central role in decision-making
2. Carry out valuation analysis of complex corporate/financial structures
3. Be familiar with the most common forms of corporate restructuring, as
well as understand their different costs and benefits
4. Analyze the terms of a restructuring deal in a knowledgeable way,
understanding its value implications as well as the incentives and
motivations of the major participants
 Outline
Topic Session
General introduction; DCF Valuation 1
Multiples Valuation; Valuation of Unlisted Assets 2
“Good” and “Bad” Reasons to do an M&A 3
Empirical Evidence on M&A Activity 4
Deal Negotiation Tactics; Takeover Defenses 5
Financial Structuring of a Deal: Financing, Payment 6
Divestitures 7
Leveraged Buyouts 8
Leveraged Buyouts (contd.); Wrap-up 9
Final Exam 10
4
Grading

Sessions 3, 5, 9 (1 hour before the session). Groups of

Cases 5 to 6 students. Grade C is average of three cases.
Formatting details in the course outline on Myessec
Final Exam Session 10

Participation Three possible values for the grade: -1, 0 or 1

Exam grade E plus participation grade P if E+P < 10,

Total grade
and is equal to 0.5*C + 0.5*(E + P) otherwise.
Class policies

■ Do not use cellphones, laptops, tablets, etc.

■ … unless you use them for the course
■ … dismissal may occur if not respected
■ There is a participation grade
■ Do not talk privately. Raise questions publicly.
■ If you miss a class, missed opportunity to participate
 Overview of Class
 Introduction to Mergers and Acquisitions

 Discounted Cash-Flow valuation

1. Estimate cash-flows
2. Estimate the discount rate
3. Estimate the terminal value
4. Sensitivity and scenario analysis
 Some Vocabulary: Mergers & Acquisitions
 Merger = Business combination between two or more firms
 Usually: result of mutually agreed negotiation between management
teams
 … i.e. “friendly”

 Tender offer = Merger in which the buyer makes a direct offer to

the shareholders of the target firm to sell their shares at a pre-
specified price
 The buyer is often called the “bidder” or the “acquirer”
 A bid is “hostile” if the offer is made without the agreement of the
target firm’s board of directors.
 Otherwise, bid is “friendly”
8
 Some Vocabulary: Divestitures
 Divestiture = Sale of one or several business segments by an
existing multi-segment firm (the “parent” firm)
Sold to another firm or private entity:
If industrial buyer Trade sale
If financial investor Buy-Out
Yes
Sold to public in the form of IPO Equity Carve-Out
Cash raised for
Separate class of stock in parent firm Tracking Stock
parent firm?

Distributed pro-rata to shareholders Spin-Off

No Option to exchange shares in parent Exchange Offer
for shares in divested division or Split-Off

9
 Some Vocabulary: Financial Restructurings

 Leveraged Recapitalizations: payment of a dividend to existing

shareholders entirely financed by an increase in debt

 Leveraged Buy-Outs (LBO): leveraged purchase of a division or

the entire division, typically by a financial firm

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 The M&A market: U.S.
Source: Thomson Financial / SDC deals
14,000 2,800
U.S. M&A Activity Deal value 2,590
2,600
USD Bn. (right-hand scale)
12,000 2,400

2,200
2,077

10,000 2,000
1,813
1,800
1,653 1,640
1,583
8,000 1,5171,484 1,600
1,458
1,409 1,393
Number of deals 1,400
1,287
with disclosed value
6,000 (left-hand scale) 1,098 1,200

1,000
859 849
4,000 730 752 800
698
575 565
600
488
427
2,000 318 400
229
171
130 142 200

0 0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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 The M&A market: Western Europe
Source: Thomson Financial / SDC deals
5,000 2,200
Western Europe M&A
4,500 Deal value in USD Bn. 2,000
(right-hand scale)
1,800
4,000

1,600
3,500
1,383
1,400
3,000
1,157 1,127 1,200
1,097
2,500 Number of deals 1,036
with disclosed value 1,000
894 880
(left-hand scale)
2,000
752 759 800
690 692
644
1,500 587 610
524 600
485
440 445
1,000 412 426
400
297
257
500 177 153 168 182 162 200

0 0
12 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
 M&A Forms of payment
 Stock, cash, debt or some combination of the three
 cash merger: target shareholders receive a fixed payment per share
 stock-for-stock merger: target shareholders receive a fixed
number of acquirer shares in exchange for each target share
 This number is called the exchange ratio

 The implicit value of the offer in a stock-for-stock merger depends

on the acquirer’s share price and will therefore fluctuate until the
offer is completed.

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 M&A Forms of payment
Source: Mergermarket

14
 Further M&A Features from the U.S.
Source: Thomson Financial/SDC Deals

U.S. M&A activity features

% Premium to % of deals with

% of related Number of bids % of all-cash
Period stock price 4 at least one
deals per deal offers
weeks prior* hostile bid

1981-1984 n.a. 7.3% 31.9% 1.2 18.2%

1985-1989 39.1% 16.8% 32.8% 1.4 52.1%
1990-1994 37.2% 7.6% 48.7% 1.2 30.2%
1995-1999 34.7% 6.9% 53.6% 1.1 35.9%
2000-2004 37.6% 6.6% 49.1% 1.1 44.3%
2005-2008 27.0% 7.1% 53.7% 1.1 61.8%
Includes deals for listed U.S. targets where the percentage sought is higher than 25%.
*Median.
Related
Source: deal: acquisition
Thomson ofDeals.
Financial / SDC a business sharing similar market and technology

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 The M&A Cast of Characters
ACQUIROR FIRM TARGET FIRM

FIRM ASSETS
Employees
Business relationships

16
 ACQUIROR FIRM TARGET FIRM

MANAGEMENT

FIRM ASSETS
17 Employees
Business relationships
 ACQUIROR FIRM TARGET FIRM

MANAGEMENT
Board of directors

CEO and senior officers

FIRM ASSETS
18 Employees
Business relationships
 ACQUIROR FIRM TARGET FIRM

MANAGEMENT
Board of directors

CEO and senior officers

FIRM ASSETS
19 Employees
Business relationships
 MERGER PROFESSIONALS
M&A Advisory: Investment bank boutiques
Financial Advisory: Investment bankers
Legal advisory: Lawyers
Due Diligence: Auditors
Tax advisory: Accountants
Other: Insurance, Environmental,…

ACQUIROR FIRM TARGET FIRM

MANAGEMENT
Board of directors

CEO and senior officers

FIRM ASSETS
20 Employees
Business relationships
 MERGER PROFESSIONALS
M&A Advisory: Investment bank boutiques
Financial Advisory: Investment bankers
Legal advisory: Lawyers
Due Diligence: Auditors
Tax advisory: Accountants
Other: Insurance, Environmental,…

ACQUIROR FIRM TARGET FIRM

MANAGEMENT
Board of directors

SHAREHOLDERS
SHAREHOLDERS
CEO and senior officers

FIRM ASSETS
21 Employees
Business relationships
 Any Other Third
Parties Involved?

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24
25
 “SOCIETY”
Unions
NGOs
26 Politicians
 Financial Advisors on US market (2016)

Source: Factset
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 Are mergers beneficial to the economy?

Michael C. Jensen
Harvard University

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 Are mergers beneficial to the economy?

Warren Buffett
CEO, Berkshire Hathaway

Robert Reich
29 Harvard University
 An Overview of Valuation

 Just as for any acquisition, eventually it’s all about the price

 Hence, valuation is the key to a “successful” M&A deal

 Keep in mind though that:

 “Success” will mean different things to different people!
 There is no such thing as a true value, only imperfect estimates
 Valuation is therefore also a key bargaining tool

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 An Overview of Valuation
Base case Worst case

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 Reorganizing Accounting Data
This where you start from…

Income Statement Balance Sheet

+ Revenues Long-term assets Equity

– Cost of goods sold + Gross assets + Capital stock
– Accumulated + Retained earnings
– Selling, gen. & admin costs
depreciation
= EBITDA Long-term debt
– Depreciation
Short-term assets
= EBIT
+ Interest income + Inventories Short-term debt
– Interest expense + Accounts + Accounts payable
= Earnings before taxes receivable
– Taxes + Operating cash + Operating ST debt
= Net income + Excess cash + Non-operat. ST debt

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Reorganizing Accounting Data
This is what financial analysts care about…

Financial Balance Sheet

Long-term Equity
Operating Assets + Capital stock
+ Retained earnings
Total
Invested
Capital Financial Debt
Operating + Long-term debt
Working Capital** + Non-operating ST debt

Excess cash

*** Inventories + Acc. Receivable + Operating cash

– Accounts payable – Operating ST debt
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Reorganizing Accounting Data
This is what financial analysts care about…

Free Cash Flow Calculation

+ Revenues + Decreases in financial debt
– CGS – Increases in financial debt
– SGA
= EBITDA + Interest expense (after tax)
– Depreciation
= EBIT + Decreases in LT Liabilities
– Taxes on EBIT – Increases in LT Liabilities
+ Depreciation
= Operating CF (A)
+ Sales of LT Assets + Dividend Payments
– Acquisitions of LT Assets + Capital Stock Repurchases
= CF from Capital Spending (B) – Capital Stock Issues
+ Decreases in NWC – Decreases in marketable securities
– Increases in NWC + Increases in marketable securities
= CF from Changes in NWC (C)
Free Cash Flow = (A) + (B) + (C) = Financial Flow
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 Steps in calculating cash-flow
Step 1: Distinguish operating vs. non-operating (i.e. financing) items (Cash Fl.)

 Interest income and expense?

 Financing-related items not counted as CF generated by the business.

 Taxes?
= Operating CF: amount of taxes paid if the business did not have
financing debt (i.e. had only operating debt)
= Financing CF: amount of taxes saved thanks to the existence of tax-
deductible interest on the financing debt.

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 Steps in calculating cash-flow
Step 1: Distinguish operating vs. non-operating (i.e. financing) items (Bal. Sh.)

 Cash?
= Operating cash: if necessary to make payments related to the business
= Non-operating (or excess) cash: if the CFO could use it to pay
back debt or pay a dividend or to make an acquisition soon without
affecting current operations

 Operating working capital (“Net working capital”)?

= Difference between short-term operating assets and short-term
operating liabilities
 An interest-bearing debt is usually a financing liability; non-interest-
bearing debt usually an operating liability
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 Additional steps in calculating cash-flow
 Step 2: Distinguish between “true” cash and non-cash items.
 Depreciation? Accounting movement that only serves to save tax
 Add it back after calculating the tax saving.

 Step 3: Apply the recipe

FCF = OCF + CF from Capex + CF from Changes in NWC

1. CF from Capex is negative since most of the times is composed of new

expenditures
2. CF from Changes in NWC is equal to the negative of Changes in NWC.
 So we can write: FCF = OCF – Capex – Δ NWC

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 A few remarks on cash-flow
1. You have two equivalent ways of calculating OCF:

OCF = EBIT x ( 1 – tc) + Dep. = EBITDA x ( 1 – tc) + tc x Dep.

2. You can also write:

FCF = EBIT x ( 1 – tc) + Dep. – Capex – Δ NWC
= EBIT x ( 1 – tc) – (Capex – Dep.)– Δ NWC
= EBIT x ( 1 – tc) – (Capex – Dep. + Δ NWC)

3. Fixation with EBITDA (“EBEETDAH”) is explainable because

Capex, Dep, NWC can be seen as a function of EBITDA.
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Using this accounting data, estimate the FCF for Disney in 2017 (USD mil.)
Walt Disney Co.
Key Financials
In millions of reported currency except per share data
Fiscal Year FY2012 FY2013 FY2014 FY2015 FY2016 FY2017
Fiscal period length 12 months 12 months 12 months 12 months 12 months 12 months
Fiscal year end Sep-29-2012 Sep-28-2013 Sep-27-2014 Oct-3-2015 Oct-1-2016 Sep-30-2017
Currency USD USD USD USD USD USD

Total Revenue 42,278 45,041 48,813 52,465 55,632 55,137

Growth Over Prior Year 3.4% 6.5% 8.4% 7.5% 6.0% (0.9%)
EBITDA 10,971 11,642 13,828 15,578 16,987 16,770
Margin % 25.9% 25.8% 28.3% 29.7% 30.5% 30.4%
Depreciation & Amort., Total 1,784 1,957 2,064 2,132 2,320 2,586
EBIT 8,984 9,450 11,540 13,224 14,460 13,988
Margin % 21.2% 21.0% 23.6% 25.2% 26.0% 25.4%
Net Income 5,682 6,136 7,501 8,382 9,391 8,980
Margin % 13.4% 13.6% 15.4% 16.0% 16.9% 16.3%
Effective Tax Rate 33.3% 31.0% 34.6% 36.2% 34.2% 32.1%

+Total Current Assets 13,709 14,109 15,169 16,758 16,966 15,889

- Cash And Equivalents 3,387 3,931 3,421 4,269 4,610 4,017
= Operating Current Assets 10,322 10,178 11,748 12,489 12,356 11,872
+ Total Current Liabilities 12,813 11,704 13,292 16,334 16,842 19,595
- Short-term Borrowings 2,050 0 50 2,430 1,521 2,772
- Curr. Port. of LT Debt 1,564 1,606 2,114 2,133 2,166 3,400
= Operating Current Liabilities 9,199 10,098 11,128 11,771 13,155 13,423
Net (operating) Working Capital 1,123 80 620 718 -799 -1,551
Change in Net Working Capital -416 -1,043 540 98 -1,517 -752

Capital Expenditure -3,784 -2,796 -3,311 -4,265 -4,773 -3,623

Cash Acquisitions -488 -2,443 -402 0 0 -417
45 Divestitures 0 0 0 0 0 0
 Disney’s FCF
Data FY2017
Sales = 55,137 $M
EBITDA = 16,770 $M
EBIT = 13,988 $M
Tax rate = 32.1%
Operating taxes = 4,486 $M
Capital spending = 4,040 $M
Depreciation = 2,586 $M
Increase in Non-cash WC = -752 $M

FCF = EBIT*(1-tax rate) 9,502 = 13,988 * 67.9%

− Net Capex 1,454 = 4,040 - 2,586
− Change in WC -752
Free Cashflow = 8,800

Net Reinvestment = 702 = 2,187 + -752

Net Reinvestment Rate = 7.4% = 702 / 9,502

Net Capex excl. Acq. / Div. 2,187 = 4,773 + 2,586

Net Reinvestment excl. Acq. / Div. = 1,435 = 2,187 + -752
46 Net Reinv. Rate excl. Acq./ Div. = 15.1% = 1,435 / 9,502
 Disney’s Investment Policy
Disney Historical Cash-Flow Calculation

In millions of reported currency except per share data

Fiscal Year FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Average
Fiscal period length 12 months 12 months 12 months 12 months 12 months 12 months
Fiscal year end Sep-29-2012 Sep-28-2013 Sep-27-2014 Oct-3-2015 Oct-1-2016 Sep-30-2017
Currency USD USD USD USD USD USD

Total Revenue 42,278 45,041 48,813 52,465 55,632 55,137

Growth Over Prior Year 3.4% 6.5% 8.4% 7.5% 6.0% (0.9%) 5.2%
EBITDA 10,971 11,642 13,828 15,578 16,987 16,770
Margin % 25.9% 25.8% 28.3% 29.7% 30.5% 30.4% 28.5%

Historical Cash-flow
= EBIT 8,984 9,450 11,540 13,224 14,460 13,988
Margin % 21.2% 21.0% 23.6% 25.2% 26.0% 25.4% 23.7%
- Operating taxes 2,995 2,931 3,997 4,783 4,939 4,486
Effective tax rate 33.3% 31.0% 34.6% 36.2% 34.2% 32.1% 33.6%
'= EBIT After Operating Taxes 5,989 6,519 7,543 8,441 9,521 9,502
+ Depreciation and Amortization 1,784 1,957 2,064 2,132 2,320 2,586
=Operating Cash-flow 7,773 8,476 9,607 10,573 11,841 12,088

- Capital Expenditure -3,784 -2,796 -3,311 -4,265 -4,773 -3,623

- Cash Acquisitions -488 -2,443 -402 0 0 -417
+ Divestitures 0 0 0 0 0 0
= CF from Capital Spending -4,272 -5,239 -3,713 -4,265 -4,773 -4,040

- Change in Net Working Capital 416 1,043 -540 -98 1,517 752

Free Cash-Flow 3,917 4,280 5,354 6,210 8,585 8,800

Net reinvestment* 2,072 2,239 2,189 2,231 936 702

Net reinvestment rate** 34.6% 34.3% 29.0% 26.4% 9.8% 7.4% 23.6%
* Equal to CF from Cap. Sp. - D&A + Chg. In NWC
** Net reinvestment / EBIT After Operating Taxes

Net reinv., excl Acq. & Divest. 1,584 -204 1,787 2,231 936 285
47 Net reinv.rate, excl Acq. & Divest. 26.4% -3.1% 23.7% 26.4% 9.8% 3.0% 14.4%
 Disney’s Investment Policy
Disney Historical Cash-Flow Calculation

In millions of reported currency except per share data

Fiscal Year FY2012 FY2013 FY2014 FY2015 FY2016 FY2017 Average
Fiscal period length 12 months 12 months 12 months 12 months 12 months 12 months
Fiscal year end Sep-29-2012 Sep-28-2013 Sep-27-2014 Oct-3-2015 Oct-1-2016 Sep-30-2017
Currency USD USD USD USD USD USD

Total Revenue 42,278 45,041 48,813 52,465 55,632 55,137

Growth Over Prior Year 3.4% 6.5% 8.4% 7.5% 6.0% (0.9%) 5.2%
EBITDA 10,971 11,642 13,828 15,578 16,987 16,770
Margin % 25.9% 25.8% 28.3% 29.7% 30.5% 30.4% 28.5%

Historical Cash-flow
= EBIT 8,984 9,450 11,540 13,224 14,460 13,988
Margin % 21.2% 21.0% 23.6% 25.2% 26.0% 25.4% 23.7%
- Operating taxes 2,995 2,931 3,997 4,783 4,939 4,486
Effective tax rate 33.3% 31.0% 34.6% 36.2% 34.2% 32.1% 33.6%
'= EBIT After Operating Taxes 5,989 6,519 7,543 8,441 9,521 9,502
+ Depreciation and Amortization 1,784 1,957 2,064 2,132 2,320 2,586
=Operating Cash-flow 7,773 8,476 9,607 10,573 11,841 12,088

- Capital Expenditure -3,784 -2,796 -3,311 -4,265 -4,773 -3,623

- Cash Acquisitions -488 -2,443 -402 0 0 -417
+ Divestitures 0 0 0 0 0 0
= CF from Capital Spending -4,272 -5,239 -3,713 -4,265 -4,773 -4,040

- Change in Net Working Capital 416 1,043 -540 -98 1,517 752

Free Cash-Flow 3,917 4,280 5,354 6,210 8,585 8,800

Net reinvestment* 2,072 2,239 2,189 2,231 936 702

Net reinvestment rate** 34.6% 34.3% 29.0% 26.4% 9.8% 7.4% 23.6%
* Equal to CF from Cap. Sp. - D&A + Chg. In NWC
** Net reinvestment / EBIT After Operating Taxes

Net reinv., excl Acq. & Divest. 1,584 -204 1,787 2,231 936 285
48 Net reinv.rate, excl Acq. & Divest. 26.4% -3.1% 23.7% 26.4% 9.8% 3.0% 14.4%
 Discounting Methods: Weighted Average
Cost of Capital (WACC)
 In the absence of specific costs/benefits of debt, all methods lead to
exact same result
 Methods diverge only if debt has an impact on funding cost
 With the WACC, he impact of debt financing occurs via the discount
rate:
𝐹𝐶𝐹𝑡
𝑉𝑊𝐴𝐶𝐶 = ෍
(1 + 𝑟𝑊𝐴𝐶𝐶 )𝑡
𝑡

More debt usually means lower cost of

capital and therefore higher value

49
 Discounting Methods: Adjusted Present
Value (APV)
 In the APV, the value of debt financing is calculated explicitly:

𝐹𝐶𝐹𝑡 𝐷𝑒𝑏𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑𝑠𝑡

𝑉𝐴𝑃𝑉 =෍ 𝑡
+෍
(1 + 𝑟𝑈 ) (1 + 𝑟𝐷 )𝑡
𝑡 𝑡

More debt means tax savings from debt

because interest is tax-deductible

50
 Discounting Methods: WACC vs. APV

51
 Where does the WACC come from?
𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 × (𝑟𝑚 -𝑟𝑓 )

Cost of levered equity = Risk-free rate + Beta of levered equity*Market risk premium

Capital structure weights

using market values

𝐷 𝐸
𝑟𝑊𝐴𝐶𝐶 = × 𝑟𝐷 × (1 − 𝑡𝑐 ) + × 𝑟𝐸
𝐷+𝐸 𝐷+𝐸

Required rate of return on debt Marginal corporate tax rate

52
 WACC weights: How do you compute them?

 You are typically using WACC to compute the value of equity…

 … but you need to know E if you want to compute D/E !

 Only way out: infer from the case what is the desired level of leverage
 Looking at leverage in comparable traded companies helps

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 WACC weights: Gross debt or net debt?
 Net debt = total financial debt minus excess cash
 Very often used in the WACC formula above instead of gross debt

 Assumption: cash can be used to instantly reimburse debt  excess cash

is effectively negative debt.

 The discount rate obtained from the WACC will be different, but
usually the difference will be small.

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 WACC weights: Gross debt or net debt?
 In practice there are many difficult issues involved in using net debt:

1. Cash is not (necessarily) remunerated at the same rate! rD ≠ rC

2. Trapped cash: how much is operating cash, how much is excess?
3. Cash as a strategic weapon: more value inside the firm than outside
4. Beta of cash? Implicitly equal to beta of debt (i.e. zero)
 Correct equity beta observed?
 Correct leveraging / re-leveraging?

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Please estimate the cost of capital for Disney in 2014, using gross and
net debt.

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59
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 Leveraging and re-leveraging
 What would happen to the WACC of Disney if the firm decided to
implement a debt ratio of 40% (using gross debt to simplify)?

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 Leveraging and re-leveraging

Tax rate t 33.6%

A rating spread 1.00%
BBB rating spread 1.80%
Risk-free rate 2.5%
Market risk premium 6.00%

Current leverage

D / (D+E) 14%
D/E 16%
Rating A
Spread 1.00%
Cost of debt RD 3.45%
Implicit debt beta* 0.1667
Levered equity beta 1.390
Cost of equity RE 10.79%
RWACC 9.64%

Deleveraging using MM II

Cost of unlevered equity RU** 8.42%

Unlevered beta*** 0.9954

New leverage

D / (D+E) 40%
D/E 67%
Rating BBB
Spread 1.80%
Cost of debt RD 4.25%
Implicit debt beta 0.3000
Levered equity beta 1.303
Cost of equity RE**** 10.27%
63 RWACC† 7.29%
Unlevering and Relevering Betas:
 Remember Modigliani & Miller Proposition:
𝐷
 𝛽𝐸 = 𝛽𝑈 + 𝛽𝑈 − 𝛽𝐷
𝐸
 In the presence of corporate taxes, this formula must be adjusted
 If the firm currently has debt level D:
𝐷
 𝛽𝐸 = 𝛽𝑈 + (1 − 𝜏) 𝛽𝑈 − 𝛽𝐷
𝐸

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 Computing the APV discount rate
𝑟𝑈 = 𝑟𝑓 + 𝛽𝑈 × (𝑟𝑚 -𝑟𝑓 )

Cost of unlevered eq. = Risk-free rate + Beta of unlevered eq.*Market risk premium

𝐹𝐶𝐹𝑡
𝑉𝐴𝑃𝑉 =෍
(1 + 𝑟𝑈 )𝑡
𝑡
𝑀𝑖𝑛[𝑃𝑟𝑒 − 𝑑𝑒𝑏𝑡 𝑡𝑎𝑥𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 × 𝑡𝑐 ; 𝐷𝑒𝑏𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 × 𝑡𝑐 ]𝑡
+෍
(1 + 𝑟𝐷 )𝑡
𝑡
[𝐼𝑠𝑠𝑢𝑎𝑛𝑐𝑒\𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠]𝑡
+෍
(1 + 𝑟𝐷 )𝑡
𝑡
+ PV of additional benefits of debt
- PV of costs of financial distress

65
 Discounting Methods: WACC vs. APV
 WACC is simpler to compute and interpret
 APV takes a bit more efforts of interpretation but is more flexible
 Allows for a more complex computation of debt tax shields: what if the
firm is currently making losses? If it has a lot of past losses to carry
forward?
 To be considered when a target has made or is making a lot of losses
 Works even when leverage is not going to remain constant but will
gradually increase/decline
 Very often the case with financial restructurings
 WACC can work with changes in leverage but tedious (one WACC per period)
 Allows for potential costs of leverage, such as expected costs of financial
distress, and additional benefits of debt
 Very important in highly-levered transactions
 APV does not have a circularity problem because it focuses on debt
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amounts, not ratios
 Terminal Value (or Continuing Value)
 Difficult to forecast FCF beyond a certain number of years…
 The precise number depending on industry characteristics
 The last year of forecast is the terminal date

 …but business continues after the terminal date

 Need to make simplifying assumptions to value FCFs generated

beyond that date:

Total Present Present value of FCF Present value of FCF

Value of FCF = during forecast period + after forecast period
t = 1,2,…,T t = T +1, T +2,...

Terminal value

67
 Terminal Value can be very large

68
 Calculating Terminal Value

69
 Calculating Terminal Value
For most businesses in
steady-state growth, Capex
FCFT  1  EBITT  1  1  tc   Dep. and ΔNWC are negative.
Let’s sum them up, subtract
 CapexT  1 depreciation and call it Net
 NWCT  1 Investment

 Assume Net Investment is a

fraction of after-tax EBIT in
FCFT 1  EBITT 1  1 - t c  steady state. Call this
fraction Net Investment
 Net InvestmentT 1 Rate (IR)


It can be shown that IR
FCFT 1  EBITT 1  1  tc   1  IR  equals the growth rate of
g after-tax EBIT divided by
IR   g  IR  RONIC the Return on New Invested
RONIC Capital (RONIC)

1 EBIT  1  tc   1  g RONIC
Terminal Value  
RWACC ,T 1  g
 1  R 
T

WACC ,t
t 1

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 Estimating TV Parameters
 Steady-state after-tax EBIT? Level of after-tax operating earnings
normalized to the mid-point of the business cycle
 Revenues and costs should be based on long-term trends and on
sustainable margin levels
 Taxes should be based on long-term levels
 WACC reflecting steady-state capital structure? Should be
based on a sustainable target capital structure consistent with:
 Industry competitive conditions
 Capital market demands
 Remark: You can use the WACC terminal value formula in an APV
valuation, if after the forecast period the capital structure stabilizes
around a given target value
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 Estimating TV Parameters
 Steady-state growth rate of FCF g? You may pick:
 Long-term consumption nominal growth rate for industry’s
products
 Economy-wide (GDP) nominal growth rate
 Inflation rate [assumes zero real growth]

 Steady-state return on new invested capital RONIC?

 Advice: set it as equal to WACC. Why?
 Competitive pressures and erosion of competitive advantage make it
difficult for the firm to sustain abnormal returns in the long-run
 Remember that RONIC refers to future investment, so it will
probably be different from historical or recent ROIC.
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 Putting it all together: calculate share value
1. Add PV of the FCFs during the forecast period to the TV
 You may adjust for mid-year discounting (see next slide)

2. Add any non-operating assets that were excluded from the

calculation of FCF
 Cash and marketable securities, investments in unrelated subsidiaries

3. Subtract the value of all interest-bearing non-operating debt, as well

as quasi-debt items like leases and pension-related liabilities.

4. Subtract quasi-equity items: preferred stock, minority interests.

5. Divide the resulting value by the number of shares outstanding

 Advisable to do it on a fully diluted basis (as if all outstanding stock options
73
are exercised)
 An example of mid-year discounting
 You’re valuing a company on September 30, 2017.
 Suppose that the first yearly cash-flow of your spreadsheet refers
to 2017 and the accounting year ends on December 31st.
 You may want to assume:
 Remaining cash flows from October 1st to December 31st are a
fourth of annual cash flows; but you may adjust if highly seasonal
 Cash flows are received at the middle of each considered period
 Here: remaining cash flows are distributed on November 15th
 Discount them by (1+r) at the power of (1.5/12)
 Alternatively, you may assume cash flows are received at the end
 Discount remaining CF in 2017 by (1+r) at the power of (3/12)

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 Putting it all together: calculate share value

75
 Disney DCF Valuation summary
USD millions
Valuation date: Jan-01-2017

Cash-flow projections 2018 2019 2020 2021 2022

Fiscal year end Sep-30-2018 Sep-30-2019 Sep-30-2020 Sep-30-2021 Sep-30-2022
+ Net sales 57,979 60,967 64,109 67,414 70,888
Sales nominal growth rate 5.2% 5.2% 5.2% 5.2% 5.2%
= EBITDA 16,502 17,352 18,246 19,187 20,176
EBITDA margin 28.5% 28.5% 28.5% 28.5% 28.5%
= EBIT 13,764 14,474 15,219 16,004 16,829
EBIT margin 23.7% 23.7% 23.7% 23.7% 23.7%
- Operating taxes 4,620 4,858 5,108 5,372 5,649
Cash tax rate 33.6% 33.6% 33.6% 33.6% 33.6%
- Net reinvestment* 2,158 2,269 2,386 2,509 2,639
Net reinvestment rate 23.6% 23.6% 23.6% 23.6% 23.6%
Free Cash-Flow 6,986 7,346 7,725 8,123 8,541
*Capex - Depreciation +Chg. In NWC

EBITDA
RONIC
multiple at
perpetual
end of
growth model
forecast
WACC 9.84% 11.0x EBITDA multiple
Return on new invested capital (RONIC) 9.84% 20,176 EBITDA @ horizon
Steady state growth rate 2.30%
Implied Net Reinvestment Rate 23.38%
EBIT after tax at T+1 11437.3 TEV/EBITDA
+ Value during forecast horizon 29,200.9 29,200.9 multiple in 2017
+ Terminal value 72,704.3 138,937.4
= Enterprise value 101,905.1 168,138.2
EV incl. mid-year discounting adjustment 95,021.6 156,780.9
+ Excess marketable securities 4,610.0 4,610.0
= Total asset value 99,631.6 161,390.9
- Value of outstanding debt 25,291.0 25,291.0
- Preferred Equity 0.0 0.0
- Minority Interests 4,837.0 4,837.0
= Equity value 69,503.6 131,262.9

Shares outstanding (millions) 1,591.5 1,591.5

Share price 43.7 82.5
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 Scenario analysis
 Develop self-contained firm- or industry-specific scenarios for the
main operating line items
 E.g., “price war”, “business as usual”, “market share consolidation”
 Interact these scenarios with sensitivity analysis on values of economic
and financial parameters
 Inflation, economic growth, interest rates, beta estimates, etc.
 Objectives
1. Identify critical assumptions / value drivers for a given valuation level
2. Make sure forecasted company performance (market share, product
mix, cost margins) is consistent with the industry economics
3. Establish the underlying probabilities of each scenario and use them in
strategic decision-making (if possible…)

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 Why DCF Matters
 Advantages
 Forces collective brainstorming to produce forecasts
 Generates lots of information
 WACC is analogous to calculation of an internal rate of return
 Very good for performing sensitivity / scenario analysis
 Often produced to justify a price
 Obtain IRR for investors (PE deals)

 Disadvantages
 Time consuming
 Requires careful analysis of underlying assumptions
 Industry knowledge is very important
 Dependent on accounting data
 Special care needed when calculating terminal value
 Best results if done with inside knowledge about the firm
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 Why DCF Matters
 Biggest advantage of DCF methods: force the analyst to think WHY
the company creates value
 This advantage far surpasses all its disadvantages

79