Exam 14: Applying Financial Modeling

Target is a wholly owned subsidiary of MegaCorp Inc. MegaCorp supplies a number of services to target. Target sells some of its products to other MegaCorp subsidiaries. Target also buys products from other MegaCorp subsidiaries that are used as inputs in producing Target's products. Which of the following adjustments should the acquirer make to Target's financial statements before valuing the firm?

Why should a target company be valued as a standalone business? Give examples of the types of adjustments that might have to be made if the target company is part of a larger company?

The appropriate financial structure can be determined from a range of different scenarios created by making small changes in selected value drivers.

Assume Firm A's acquisition of Firm B results in a reduction in the combined firms' debt-to-total capital ratio to .25. If the same ratio for the industry is .5, the combined firm may be able to increase its borrowing to the industry average, assuming no extenuating circumstances. However, this should not be viewed as a source of value to the acquiring firm.

Using the M&A Valuation & Deal Structuring Model accompanying this text: a. Under the heading Form of Payment, change the composition of the purchase price to 100% cash. Assume the purchase price is partially financed by reducing Acquirer excess cash by $1 billion and by raising $4 billion by issuing new Acquirer equity. Under the Sources and Uses heading, how is the remainder of the purchase price financed? b. Change the composition of the purchase price to 100% equity, what is the impact on how the purchase price is financed? Close model but do not save the results.

Post merger earnings per share are affected by all of the following factors, except for

When one company acquires another, year over year historical earnings comparisons for the acquiring firm are unaffected.

Thermo Fisher designed a capital structure for financing the deal that would retain its investment grade credit rating. To do so, it targeted a debt to total capital and interest coverage ratio consistent with the industry average for these credit ratios. What is the potential impact on Thermo Fisher's ability to retain an investment grade credit rating if it had financed the takeover using 100% senior debt? (Hint: In the Sources and Uses section of the Transaction Summary Worksheet, set excess cash, new common shares issued, and convertible preferred shares to zero. Senior debt will automatically increase to 100% of the equity consideration plus transaction expenses.) Explain your answer.

The share exchange ratio is defined as

Acquiring Corp agrees to buy 100% of the outstanding shares of Target Corp in a share for share exchange. How would Acquiring Corp determine how many new share of its stock it would have to issue?

The share exchange ratio indicates the number of acquirer shares to be exchanged for each share of target stock based on the target firm's current share price.

Which of the following is not true about common size financial statements?

Which of the following statements is true for M&A financial models?

Ford Acquires Volvo’s Passenger Car Operations This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only— they include revenue and costs for all of the firm’s product lines. For purposes of exposition, we shall assume that Ford’s acquisition strategy with respect to Volvo was to acquire all of Volvo’s operations and later to divest all but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the standalone values for the Ford and Volvo passenger car operations from their combined value including the effects of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations. Background By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain market share in this highly competitive environment. By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution channels, entering new markets, reducing development and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford’s Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its size. Historical and Projected Data The initial review of Volvo’s historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo’s cash flow is steadily trending downward from its high in 1997. Table 9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast period. Ford’s acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration. Determining the Initial Offer Price Volvo’s estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the entire company and Volvo’s urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo’s total common shares outstanding of 442 million. Determining the Appropriate Financing Structure Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford’s cost of capital, which is estimated to be 11.5%—about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo’s pretax earnings. Epilogue Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was acquiring only Volvo’s passenger-car operations. Ford acquired Volvo’s passenger car operations on March 29, 1999, for $6.45 billion. At $16,000 per production unit, Ford’s offer price was considered generous when compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo in the case was estimated to be $15 billion. This included Volvo’s trucking operations.) -What is the purpose of the common-size financial statements developed for Volvo (see Table 8-8 in the textbook)? What insights does this table provide about the historical trend in Volvo's historical performance? Based on past performance, how realistic do you think the projections are for 2000-2004?

M&A modeling facilitates deal valuation and structuring but not financing decisions.

In calculating synergy, it is important to include the costs associated with recruiting and training employees, achieving productivity improvements, layoffs, and exploiting revenue opportunities.