Deck 7: Merger and Acquisition Cash Flow Valuation Basics

Question 1

A beta coefficient is a measure of a firm's diversifiable risk.

Answer 1

False

Question 2

Free cash flow to the firm is also called enterprise cash flow.

Answer 2

True

Question 3

The cost of equity is the minimum financial return required by investors to invest in stocks of comparable risk.

Answer 3

True

Question 4

If an investor anticipates a future cash flow stream of five or ten years,she needs to use either a five- or ten-year Treasury bond rate
as the risk-free rate.

Question 5

Interest payments are tax deductible to firms in the U.S.

Question 6

A risk-free rate of return is one for which the expected return is certain.

Question 7

The estimation of present value using the constant growth model involves the calculation of a terminal value.

Question 8

A firm's beta is affected by the amount of debt a firm maintains relative to its equity.

Question 9

Free cash flow to equity is calculated using operating income.

Question 10

Preferred stock exhibits some of the characteristics of long-term debt in that its dividend is generally constant and preferred
stockholders are paid before common shareholders in the event the firm is liquidated.

Question 11

In calculating the weighted average cost of capital,the weights should be estimated using the market value of the target firm's debt and equity.

Question 12

The size factor used to adjust the capital asset pricing model serves as a proxy for factors such as smaller firms being subject to
higher default risk and generally being less liquid than large capitalization firms.

Question 13

The discounted cash flow method for valuing a firm adjusts for differences in the magnitude and timing of cash flows and for risk.

Question 14

If free cash flow to the firm is expected to remain at $10 million indefinitely and the firm's cost of equity is .10,the present value of the firm is $100 million.

Question 15

Free cash flow to the firm is calculated before debt and taxes.

Question 16

The capital asset pricing model is commonly used to estimate the cost of equity.

Question 17

In the absence of debt,the unlevered beta measures the volatility of the firm's financial return to changes in the general stock market's overall return.

Question 18

The constant growth valuation model is primarily applicable to firms in mature markets.

Question 19

Studies show that it is generally unnecessary to adjust the capital asset pricing model for the size of the firm.

Question 20

It is possible to determine the equity value of the firm if you know the present value of free cash flow to the firm and the book value of the firm's outstanding shares.

Question 21

Free cash flow to the firm is often called enterprise cash flow.

Question 22

The enterprise or free cash flow to the firm approach to valuation discounts the after-tax free cash flow available to the firm from operations at the weighted average cost of capital to obtain the enterprise value.

Question 23

Intuition suggests that the length of the high-growth period when applying the variable growth model should be shorter the greater the current growth rate of the firm's cash flow.

Question 24

The variable growth model would be most appropriate for valuing firms in the growth phase of their product life cycle.

Question 25

According to the capital asset pricing model,risk consists of both diversifiable and non-diversifiable components.

Question 26

Net debt is defined as all of the firm's interest bearing debt less the value of cash and marketable securities.

Question 27

The constant growth model is most applicable to firms in mature markets.

Question 28

The after-tax cost of borrowed funds to the firm is estimated by multiplying the pretax interest rate,i,by (1 - t),where t is the
marginal tax rate for the firm.

Question 29

In the absence of debt, $\beta$ measures the volatility of a firm's financial return to changes in the general market's overall financial
return.

Question 30

When cash flow is temporarily depressed due to strikes,litigation,warranty claims,or other one-time events,it is generally safe to assume that cash flow will recover in the near term.

Question 31

Viewing preferred dividends as paid in perpetuity,the cost of preferred stock can be calculated as dividends per share of preferred
stock divided by the market value of the preferred stock.

Question 32

When the firm increases its debt in direct proportion to the market value of its equity,the level of the debt is perfectly correlated
with the firm's market value.

Question 33

The projected cash flow of firms in highly cyclical industries can be distorted depending on where the firm is in the business cycle.

Question 34

Beta is a measure of non-diversifiable risk.

Question 35

Both public and private firms are subject to non-diversifiable risk.

Question 36

The weighted average cost of capital consists only of debt and equity.

Question 37

The cost of capital formula can be generalized to include hybrid sources of funds available to firms such as convertible preferred
and debt.

Question 38

The constant growth model may be used to estimate the risk premium component of the cost of equity as an alternative to relying on historical information as is done in the capital asset pricing model.

Question 39

The weights used to calculate the weighted average cost of capital for a firm with common equity and debt only represent the book
value of equity and debt.

Question 40

Growth rates can be calculated based on the historical experience of the firm or industry.

Question 41

When the firm increases its debt in direct proportion to the market value of its equity,the level of the debt is perfectly correlated with the firm's market value.Consequently,the risk associated with the tax shield (resulting from interest paid on outstanding debt)is the same as that associated with the firm.

Question 42

A three-month Treasury bill rate is not free of risk for a five- or ten-year period,since interest and principal received at maturity must be reinvested at three month intervals.

Question 43

The reduction in the firm's tax liability due to the tax deductibility of interest is often referred as a tax shield.

Question 44

Investors require a minimum rate of return on an investment to compensate them for the level of perceived risk associated with that investment.

Question 45

The cost of equity can also be viewed as an opportunity cost.

Question 46

A firm's credit rating is a poor measure of a firm's default risk.

Question 47

Betas do not vary over time and are quite insensitive to the time period and methodology employed in their estimation.

Question 48

Discounted cash flow and the asset-oriented valuation methods necessarily provide identical results.

Question 49

For firms whose market value is less than $50 million,the adjustment to the CAPM in estimating the cost of equity can be as large as 2 percentage points.

Question 50

Which one of the following factors is not considered in calculating the firm's cost of equity?

A) risk free rate of return
B) beta
C) interest rate on corporate debt
D) expected return on equities
E) difference between expected return on stocks and the risk free rate of return

Question 51

For a return to be considered risk-free over some future time period it must be free of default risk and there must not be any uncertainty about the reinvestment rate (i.e.,the rate of return that can be earned at the end of the investor's holding period).

Question 52

Whether an analyst should use a short or long-term interest rate for the risk free rate in calculating the CAPM depends on when
the investor receives their future cash flows.

Question 53

Preferred dividends are tax deductible to U.S.corporations.

Question 54

Assume a firm has a market value of less than $50 million and a $\beta$ of 1.75.Also,assume the risk-free rates of return and equity premium are 5.0 and 5.5 percent,respectively.The firm's cost of equity using the CAPM method adjusted for firm size is 23.8%.

Question 55

Studies show that the market risk premium is unstable,lower during periods of prosperity and higher during periods of economic slowdowns.

Question 56

The effective tax rate is calculated from actual taxes paid based on accounting statements prepared for tax reporting purposes.

Question 57

The market risk or equity premium refers to the additional rate of return in excess of the weighted average cost of capital that investors require to purchase a firm's equity.

Question 58

The weighted average cost of capital (WACC)is the broadest measure of the firm's cost of funds and represents the return that a firm must earn to induce investors to buy its common stock.

Question 59

For non-rated firms,the analyst may estimate the pretax cost of debt for an individual firm by comparing debt-to-equity or total capital ratios,interest coverage ratios,and operating margins with those of similar rated firms.

Question 60

The relationship between the overall market and a specific firm's beta may change significantly if a large sector of stocks that make up the overall index increase or decrease substantially.

Question 61

Additional Problems/Case Studies
The Importance of Distinguishing Between Operating and Nonoperating Assets
In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon's management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI's cash in excess of what was required to meet its normal operating cash requirements.
To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI's stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion.
In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon's shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise.
The Hunt for Elusive Synergy-@Home Acquires Excite
Background Information
Prior to @Home Network's merger with Excite for $6.7 billion, Excite's market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home's agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm's market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Subscribers paid $39.95 per month for the service.
Assumptions
• Excite is properly valued immediately prior to announcement of the transaction.
• Annual customer service costs equal $50 per customer.
• Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services.
• None of the current Excite user households are current @Home customers.
• New @Home customers acquired through Excite remain @Home customers in perpetuity.
• @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households.
• @Home's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent.
• Capital spending equals depreciation; current assets equal current liabilities.
• FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent.
• The maximum purchase price @Home should pay for Excite equals Excite's current market price plus the synergy that results from the merger of the two businesses.
Discussion Questions
1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite.
2. What other assumptions might you consider in addition to those identified in the case study?
3. What are the limitations of the discounted cash flow method employed in this case?
What are the limitations of the valuation methodology employed in this case?

Question 62

The zero growth model is a special case of what valuation model?

A) Variable growth model
B) Constant growth model
C) Delta growth model
D) Perpetuity valuation model
E) None of the above

Question 63

Which of the following is not true about the variable growth valuation model?

A) Assumes a high growth period followed by a stable growth period.
B) Assumes that the discount rate during the high and stable growth periods is the same.
C) Is used primarily to evaluate firms in high growth industries.
D) Involves the calculation of a terminal value.
E) The terminal value often comprises a substantial percentage of the total present value of the firm.

Question 64

The calculation of free cash flow to the firm includes all of the following except for

A) Net income
B) Marginal tax rate
C) Change in working capital
D) Gross plant and equipment spending
E) Depreciation

Question 65

A firm's leveraged beta reflects all of the following except for

A) unleveraged beta
B) the firm's debt
C) marginal tax rate
D) the firm's cost of equity
E) the firm's equity

Question 66

For a firm having common and preferred equity as well as debt,common equity value can be estimated in which of the following ways?

A) By subtracting the book value of debt and preferred equity from the enterprise value of the firm
B) By subtracting the market value of debt from the enterprise value of the firm
C) By subtracting the market value of debt and the market value of preferred equity from the enterprise value of the firm
D) By adding the market value of debt and preferred equity to the enterprise value of the firm
E) By adding the market value of debt and book value of preferred equity to the enterprise value of the firm

Question 67

When evaluating an acquisition,you should do which of the following:

A) Ignore market values of assets and focus on book value
B) Ignore the timing of when the cash flows will be received
C) Ignore acquisition fees and transaction costs
D) Apply the discount rate that is relevant to the incremental cash flows
E) Ignore potential losses of management talent

Question 68

Which of the following is not true about the constant growth valuation model?

A) The firm's free cash flow is assumed to be unchanged in perpetuity
B) The firm's free cash flow is assumed to grow at a constant rate in perpetuity
C) Free cash flow is discounted by the difference between the appropriate discount rate and the expected growth rate of cash flow.
D) The constant growth model is sometimes referred to as the Gordon Growth Model.
E) If the analyst were using free cash flow to the firm, cash flow would be discounted by the firm's cost of capital less the expected growth rate in cash flow.

Question 69

The calculation of free cash flow to equity includes all of the following except for

A) Operating income
B) Preferred dividends
C) Change in working capital
D) Gross plant and equipment spending
E) Principal repayments

Question 70

The incremental cash flows of a merger can relate to which of the following:

A) Working capital
B) Profits
C) Capital spending
D) Income taxes
E) All of the above

Question 71

Case Study Short Essay Examination Questions
Creating a Global Luxury Hotel Chain
Fairmont Hotels & Resorts Inc. announced on January 30, 2006, that it had agreed to be acquired by Kingdom Hotels and Colony Capital in an all-cash transaction valued at $45 per share. The transaction is valued at $3.9 billion, including assumed debt. The purchase price represents a 28% premium over Fairmont's closing price on November 4, 2005, the last day of trading when Kingdom and Colony expressed interest in Fairmont. The combination of Fairmont and Kingdom will create a luxury global hotel chain with 120 hotels in 24 countries. Discounted cash-flow analyses, including estimated synergies and terminal value, value the firm at $43.10 per share. The net asset value of Fairmont's real estate is believed to be $46.70 per share.
1. Is it reasonable to assume that the acquirer could actually be getting the operation for "free," since the value of the real estate per share is worth more than the purchase price per share? Explain your answer.
2. Assume the acquirer divests all of Fairmont's hotels and real estate properties but continues to manage the hotels and properties under long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the acquirer? Explain your answer.
Is it reasonable to assume that the acquirer could actually be getting the operation for "free," since the value of the real estate per share is worth more than the purchase price per share? Explain your answer.

Question 72

Which of the following is true about the variable growth model?

A) Present value equals the discounted sum of the annual forecasts of cash flow
B) Present value equals the discounted sum of the annual forecasts of cash flow plus the discounted value of the terminal value
C) Present value equals the discounted value of the next year's cash flow grown at a constant rate in perpetuity
D) Present value equals the current year's free cash flow discounted in perpetuity
E) None of the above

Question 73

Which of the following is true of the equity valuation model?

A) Discounts free cash flow to the firm by the weighted average cost of capital
B) Discounts free cash flow to equity by the cost of equity
C) Discounts free cash flow the firm by the cost of equity
D) Discounts free cash flow to equity by the weighted average cost of capital
E) None of the above

Question 74

The cost of capital reflects all of the following except for

A) Cost of equity
B) The firm's beta
C) The book value of the firm's debt
D) The after-tax cost of interest paid by the firm
E) The risk free rate of return

Question 75

All of the following are true about the marginal tax rate for the firm except for

A) The marginal tax rate in the U.S. is usually about 40%.
B) The effective tax rate is usually less than the marginal tax rate.
C) Once tax credits have been used and the ability to further defer taxes exhausted, the effective rate can exceed the marginal rate at some point in the future.
D) It is critical to use the effective tax rate in calculating after-tax operating income in perpetuity.
E) It is critical to use the marginal rate in calculating after-tax operating income in perpetuity.

Question 76

Which of the following factors is excluded from the calculation of free cash flow to the firm?

A) Principal repayments
B) Operating income
C) Depreciation
D) The change in working capital
E) Gross plant and equipment spending

Question 77

Which of the following is true of the enterprise valuation model?

A) Discounts free cash flow to the firm by the cost of equity
B) Discounts free cash flow to the firm by the weighted average cost of capital
C) Discounts free cash flow to equity by the cost of equity
D) Discounts free cash flow to equity by the weighted average cost of capital
E) None of the above

Question 78

Additional Problems/Case Studies
The Importance of Distinguishing Between Operating and Nonoperating Assets
In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon's management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI's cash in excess of what was required to meet its normal operating cash requirements.
To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI's stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion.
In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon's shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise.
The Hunt for Elusive Synergy-@Home Acquires Excite
Background Information
Prior to @Home Network's merger with Excite for $6.7 billion, Excite's market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home's agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm's market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Subscribers paid $39.95 per month for the service.
Assumptions
• Excite is properly valued immediately prior to announcement of the transaction.
• Annual customer service costs equal $50 per customer.
• Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services.
• None of the current Excite user households are current @Home customers.
• New @Home customers acquired through Excite remain @Home customers in perpetuity.
• @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households.
• @Home's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent.
• Capital spending equals depreciation; current assets equal current liabilities.
• FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent.
• The maximum purchase price @Home should pay for Excite equals Excite's current market price plus the synergy that results from the merger of the two businesses.
Discussion Questions
1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite.
2. What other assumptions might you consider in addition to those identified in the case study?
3. What are the limitations of the discounted cash flow method employed in this case?
What other assumptions might you consider?

Question 79

Additional Problems/Case Studies
The Importance of Distinguishing Between Operating and Nonoperating Assets
In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon's management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI's cash in excess of what was required to meet its normal operating cash requirements.
To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI's stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion.
In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon's shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise.
The Hunt for Elusive Synergy-@Home Acquires Excite
Background Information
Prior to @Home Network's merger with Excite for $6.7 billion, Excite's market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home's agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm's market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Subscribers paid $39.95 per month for the service.
Assumptions
• Excite is properly valued immediately prior to announcement of the transaction.
• Annual customer service costs equal $50 per customer.
• Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services.
• None of the current Excite user households are current @Home customers.
• New @Home customers acquired through Excite remain @Home customers in perpetuity.
• @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households.
• @Home's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent.
• Capital spending equals depreciation; current assets equal current liabilities.
• FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent.
• The maximum purchase price @Home should pay for Excite equals Excite's current market price plus the synergy that results from the merger of the two businesses.
Discussion Questions
1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite.
2. What other assumptions might you consider in addition to those identified in the case study?
3. What are the limitations of the discounted cash flow method employed in this case?
Did @Home overpay for Excite?

Question 80

Which one of the following factors is not considered in calculating the firm's cost of capital?

A) cost of equity
B) interest rate on debt
C) the firm's marginal tax rate
D) book value of debt and equity
E) the firm's target debt to equity ratio