Download - JP Morgan M&a DCF and Merger Analysis
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D E C E M B E R 2 0 0 4
M & A : D C F A N D M E R G E R A N A L Y S I S
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M&A - DCF and M&A analysis
[For any pitchbook or presentation including advisory, equity or debt security or loan product or combinations thereof. NOT for use in fairness/valuation or Commercial Bank presentations.]
This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including such clients subsidiaries, the Company) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan.
The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. JPMorgans opinions and estimates constitute JPMorgans judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects.
Notwithstanding anything herein to the contrary, the Company and each of its employees, representatives or other agents may disclose to any and all persons, without limitation of any kind, the U.S. federal and state income tax treatment and the U.S. federal and state income tax structure of the transactions contemplated hereby and all materials of any kind (including opinions or other tax analyses) that are provided to the Company relating to such tax treatment and tax structure insofar as such treatment and/or structure relates to a U.S. federal or state income tax strategy provided to the Company by JPMorgan.
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This presentation does not constitute a commitment by any JPMorgan entity to underwrite, subscribe for or place any securities or to extend or arrange credit or to provide any other services.
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Agenda
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M&A - DCF and M&A analysis
Merger consequences
Relative value analysis
Discounted cash flow analysis
Introduction 1
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Valuation methodologies
Publicly tradedcomparablecompanies
analysis
Comparable transactions
analysis
Discountedcash flowanalysis
Leveragedbuyout/recap
analysisOther
Public Market Valuation
Value based on market trading multiples of comparable companies
Applied using historical and prospective multiples
Does not include a control premium
Private Market Valuation
Value based on multiples paid for comparable companies in sale transactions
Includes control premium
Intrinsic value of business
Present value of projected free cash flows
Incorporates both short-term and long-term expected performance
Risk in cash flows and capital structure captured in discount rate
Value to a financial/LBO buyer
Value based on debt repayment and return on equity investment
Liquidation analysis
Break-up analysis
Historical trading performance
Expected IPO valuation
Discounted future share price
EPS impact
Dividend discount model
Valuationmethodologies
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M&A - DCF and M&A analysis
The valuation process
Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies
(3) Comparable Acquisition TransactionsUtilizes data from M&A transactions involving similar companies.
(2) Publicly Traded Comparable CompaniesUtilizes market trading multiples from publicly traded companies to derive value.
(4) LeveragedBuy OutUsed to determine range of potential value for a company based on maximum leverage capacity.
(1) DiscountedCash FlowAnalyzes the present value of a company's free cash flow.
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$15.00
$9.75
$5.50
$26.75
$5.00
$4.00$5.00
$3.50$4.94
$3.00$4.00
$10.25
$6.00
$3.75
$0.00
$5.00
$10.00
$15.00
$20.00
Price per share
Implied offer = $8.46
Public trading comparablesTransaction comparables
DCF analysis
52-weekhigh/low
19.0x to 25.0x2005E cash
EPS of $0.16
15.0x to 19.0x2005E EBITof $20.6
2.5x to 4.0xLTM revenue
of $185.7 12% to 15% Discount RateEBIT exit mult.
of 15.0x to 20.0x
15.0x to 20.0x2006E cash
EPS of $0.25
Mgmt. Case Street Case
12% to 15% Discount RateEBIT exit mult.
of 15.0x to 20.0x
The valuation summary is the most important slide in a valuation presentation
The science is performing each valuation method correctly, the art is using each method to develop a valuation recommendation
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A primer: firm value vs. equity value
Firm value = Market value of all capital invested in a business(1) (often referred to as enterprise value or firm value or asset value) The value of the total enterprise: market value of equity + (total debt + Capitalized Leases - Cash and Cash equivalents) + Minority Interest + Preferred Equity
Total debt includes all Long term debt, Current portion of Long term debt, short term debt and overdrafts
Equity value = Market value of the shareholders equity (often referred to as offer value) The market value of a companys equity (shares outstanding x current stock price)
Liabilities and Shareholders EquityAssets
Enterprisevalue
Net debt, etc.
Equity value
EnterpriseValue
1 The value of debt should be a market value. It may be appropriate to assume book value of debt approximates the market value as long as the companys credit profile has not changed significantly since the existing debt was issued.
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M&A - DCF and M&A analysis
Merger consequences
Relative value analysis
Discounted cash flow analysis
Introduction 1
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Discounted cash flow analysis as a valuation methodology
Publicly tradedcomparablecompanies
analysis
Comparable transactions
analysis
Discountedcash flowanalysis
Leveragedbuyout/recap
analysisOther
Public Market Valuation
Value based on market trading multiples of comparable companies
Applied using historical and prospective multiples
Does not include a control premium
Private Market Valuation
Value based on multiples paid for comparable companies in sale transactions
Includes control premium
Intrinsic value of business
Present value of projected free cash flows
Incorporates both short-term and long-term expected performance
Risk in cash flows and capital structure captured in discount rate
Value to a financial/LBO buyer
Value based on debt repayment and return on equity investment
Liquidation analysis
Break-up analysis
Historical trading performance
Expected IPO valuation
Discounted future share price
EPS impact
Dividend discount model
Valuationmethodologies
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Overview of DCF analysis
Discounted cash flow analysis is based upon the theory that the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate
DCF analysis is one of the most fundamental and commonly-used valuation techniques
Widely accepted by bankers, corporations and academics Corporate clients often use DCF analysis internally
One of several techniques used in M&A transactions; others include: Comparable companies analysis Comparable transaction analysis Leveraged buyout analysis Recapitalization analysis, liquidation analysis, etc.
DCF analysis may be the only valuation method utilized, particularly if no comparable publicly-traded companies or precedent transactions are available
Overview
Free cash flow
Terminal value
WACC
Other topics
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Overview of DCF analysis
DCF analysis is a forward-looking valuation approach, based on several key projections and assumptions
Free cash flows What is the projected operating and financial performance of the
business?
Terminal value
What will be the value of the business at the end of the projection period? Discount rate
What is the cost of capital (equity and debt) for the business?
Depending on practical requirements and availability of data, DCF analysis can be simple or extremely elaborate
There is no single correct method of performing DCF analysis, but certain rules of thumb always apply
Do not simply plug numbers into equations You must apply judgment in determining each assumption
Overview
Free cash flow
Terminal value
WACC
Other topics
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The process of DCF analysis
Project the operating results and free cash flows of the business over the forecast period (typically 10 years, but can be 520 years depending on the profitability horizon)
Estimate the exit multiple and/or growth rate in perpetuity of the business at the end of the forecast period
Estimate the companys weighted-average cost of capital to determine the appropriate discount rate range
Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present
Adjust the resulting valuation for all assets and liabilities not accounted for in cash flow projections
Overview
Free cash flow
Terminal value
WACC
Other topics
Projections/FCFProjections/FCF
Terminal valueTerminal value
Discount rateDiscount rate
Present valuePresent value
AdjustmentsAdjustments
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DCF theory and its application
Overview
Free cash flow
Terminal value
WACC
Other topics
DCF theory: The value of a productive asset is equal to the present value of all expected future cash flows that can be removed without affecting the assets value (including an estimated terminal value), discounted using an appropriate weighted-average cost of capital
The cash-flow streams that are discounted include Unlevered or levered free cash flows over the projection period Terminal value at the end of the projection period
These future free cash flows are discounted to the present at a discount rate commensurate with their risk
If you are using unlevered free cash flows (our preferred approach), the appropriate discount rate is the weighted-average cost of capital for debt and equity capital invested in the enterprise in optimal/targeted proportions
If you are using levered free cash flows, the appropriate discount rate is simply the cost of equity capital (often referred to as flows to shareholders or dividend discount model)
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The two basic DCF approaches must not be confused
Overview
Free cash flow
Terminal value
WACC
Other topics
DCF of unlevered cash flows (the focus of these materials) Projected income and cash-flow streams are free of the effects of debt, net of
excess cash
Present value obtained is the value of assets, assuming no debt or excess cash (firm value or enterprise value)
Debt associated with the business is subtracted (and excess cash balances are added) to determine the present value of the equity (equity value)
Cash flows are discounted at the weighted-average cost of capital
DCF of levered cash flows (most common in valuation of financial institutions) Projected income and cash-flow streams are after interest expense and net of any
interest income
Present value obtained is the value of equity Cash flows are discounted at the cost of equity
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Other considerations
Overview
Free cash flow
Terminal value
WACC
Other topics
Reliability of projections
DCF results are generally more sensitive to cash flows (and terminal value) than to small changes in the discount rate. Care should be taken that assumptions driving cash flows are reasonable. Generally, we try to use estimates provided by analysts from reputable Wall Street firms if the client has not provided projections
Sensitivity analysis
Remember that DCF valuations are based on assumptions and are therefore approximate. Use several scenarios to bound the targets value. Generally, the best variables to sensitize are sales, EBITDA margin, WACC and exit multiples or perpetuity growth rate
Hence, always present a range for the valuation!
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Always remember
Three key drivers Projections and incremental cash flows (unlevered free cash flow) Residual value at end of the projection period (terminal value) Weighted-average cost of capital (discount rate)
Avoid pitfalls Validate and test projection assumptions Determine appropriate cash flow stream Thoughtfully consider terminal value methodology Use appropriate cost of capital approach Carefully consider all variables in calculation of the discount rate Sensitize appropriately (base projection variables, synergies, discount rates,
terminal values, etc.)
Footnote assumptions in detail Think about other value enhancers and detractors
Overview
Free cash flow
Terminal value
WACC
Other topics
Always double-check with a calculator!
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M&A - DCF and M&A analysisThe first step in DCF analysis is projection of unlevered free cash flows
Overview
Free cash flow
Terminal value
WACC
Other topics
Calculation of unlevered free cash flow begins with financial projections Comprehensive projections (i.e., fully-integrated income statement, balance
sheet and statement of cash flows) typically provide all the necessary elements
Quality of DCF analysis is a function of the quality of projections Often required to fill in the gaps Confirm and validate key assumptions underlying projections Sensitize variables that drive projections
Sources of projections include Target companys management Acquiring companys management Research analysts Bankers
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Projecting financial statements
Overview
Free cash flow
Terminal value
WACC
Other topics
Ideally projections should go out as far into the future as can reasonably be estimated to reduce dependence on the terminal value
Most important assumptions Sales growth: Use divisional, product-line or location-by-location build-up or
simple growth assumptions
Operating margins: Evaluate improvement over time, competitive factors, SG&A costs
Synergies: Estimate dollars in Year 1 and evaluate margin impact over time Depreciation: Should conform with historic and projected capex Capital expenditures: Consider both maintenance and expansion capex Changes in net working capital: Should correspond to historical patterns and grow
as the business grows
Should show historical financial performance and sanity check projections against past results. Be prepared to articulate why projections may or may not be similar to past results (e.g. reasons behind margin improvements, increased sales growth, etc.)
Analyze projections for consistency Sales increases usually require working capital increases CAPEX and depreciation should converge over time
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M&A - DCF and M&A analysisFree cash flow is the cash that remains for creditors and owners after taxes and reinvestment
Overview
Free cash flow
Terminal value
WACC
Other topics
1 Although beyond the scope of our current discussions, you should only include actual cash taxes paid in the DCF. Depending on the firm and industry, you may want to adjust for the non-cash (or deferred) portion of a firms tax provision. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue for your analysis
Unlevered free cash flows can be forecast from a firms financial projections, even if those projections include the effects of debt
To do this, simply start your calculation with EBIT (earnings before interest and taxes)
EBIT (from the income statement)Plus: Non-tax-deductible goodwill amortizationLess: Taxes (at the marginal tax rate)
Equals: Tax-effected EBITAPlus: Deferred taxes1
Plus: Depreciation and any tax-deductible amortization
Less: Capital expendituresPlus/(less): Decrease/(increase) in net working investment
Equals: Unlevered free cash flow
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AdministratorThe tax shield effect of debt is not reflected in this formula, by which I mean I*(1-t)
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Fiscal year ending December 31,
2001 2002 2003 2004P 2005P 2006P 2007P 2008P
Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5
EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9
Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4
EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5
Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0
Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5
Plus: Depreciation 16.0 17.6 19.3 21.3 23.4
Plus: Deferred taxes
Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3
Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0
Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6
Adjustment for deal date (40.3)
Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6
Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%
Example: Calculating unlevered free cash flows
Overview
Free cash flow
Terminal value
WACC
Other topics
Stand-alone DCF analysis of Company X$ millions
Stand-alone DCF analysis of Company X$ millions
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M&A - DCF and M&A analysisValuing the incremental effects of changes in projected operating results
In performing DCF analysis, we often need to determine the incremental impact on value of certain events or adjustments to the projections, including:
Synergies achievable through the M&A transaction Revenue Cost Capital expenditures
Expansion plans Cost reductions Change in sales growth Margin improvements
These incremental effects can be valued by discounting them independently (net of taxes) or by adjusting the DCF model and simply measuring the incremental impact
Overview
Free cash flow
Terminal value
WACC
Other topics
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The standard present value calculation takes into account the cost of capital by attributing greater value to cash flows generated earlier in the projection period than later cash flows
Since most businesses do not generate all of their free cash flows on the last day of the year, but rather more-or-less continuously during the year, DCF analyses often use the so-called mid-year convention, which takes into account the fact that free cash flows occur during the year
This approach moves each cash flow from the end of the applicable period to the middle of the same period (i.e., cash flows are moved closer to the present)
FCF1 FCF2 FCF3 FCFn Present value =
(1+r)1 +
(1+r)2 +
(1+r)3 +
. . . +
(1+r)n
FCF1 FCF2 FCF3 FCFn Present value =
(1+r)0.5 +
(1+r)1.5 +
(1+r)2.5 +
. . . +
(1+r)n-0.5
Once unlevered free cash flows are calculated, they must be discounted to the present
Overview
Free cash flow
Terminal value
WACC
Other topics
JPMorgan standard
JPMorgan standard
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M&A - DCF and M&A analysisIt is important to differentiate between the transaction date and the mid-year convention
Year 0 1 2 30.5 1.5 2.5 3.5
First cash flow,mid-year 1
Second cash flow,mid-year 2
Third cash flow,mid-year 3
Discounting =CF1
(1+r)0.5+
CF2
(1+r)1.5+
CF3
(1+r)2.5+ .
Year 0 1 2 30.75 1.5 2.5 3.5
First cash flow,mid-period 1
Second cash flow,mid-year 2
Third cash flow,mid-year 3
Discounting =CF1
(1+r)(0.75-0.5)+ +
CF3
(1+r)(2.5-0.5)+ .
0.5
Period 1 CF to buyer
CF2
(1+r)(1.5-0.5)
Transaction date: 01/01Transaction date: 01/01
Transaction date: 06/30Transaction date: 06/30
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1st flow,mid-period 1
2nd cash flow,mid-year 2
3rd cash flow,mid-year 3
Discounting =CF1
(1+r)(0.875-0.75)+ +
CF3
(1+r)(2.5-0.75)+ .
Period 1 CF to buyer
CF2
(1+r)(1.5-0.75)
Practice exercise
Year 0 1 2 30.75 1.5 2.5 3.50.5
Transaction date: 09/30Transaction date: 09/30
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Stand-alone DCF analysis of Company X$ millions
Stand-alone DCF analysis of Company X$ millions
Example: Discounting free cash flows
Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%
$189.6 = $46.8
(1+.10)0.5$53.8
(1+.10)1.5$61.4
(1+.10)2.5$69.6
(1+.10)3.5+ + +Formula
Overview
Free cash flow
Terminal value
WACC
Other topics
Fiscal year ending December 31,
2001 2002 2003 2004P 2005P 2006P 2007P 2008P
Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5
EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9
Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4
EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5
Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0
Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5
Plus: Depreciation 16.0 17.6 19.3 21.3 23.4
Plus: Deferred taxes
Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3
Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0
Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6
Adjustment for deal date (40.3)
Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6
Memo: Discounting factor 0.0 0.5 1.5 2.5 3.5
Discounted value of unlevered FCF $0.0 $44.6 $46.7 $48.4 $49.9
Discounted value of FCF 2005P2008P 189.6
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M&A - DCF and M&A analysisTerminal value can account for a significant portion of value in a DCF analysis
Terminal value represents the businesss value at the end of the projection period; i.e., the portion of the companys total value attributable to cash flows expected after the projection period
Terminal value is typically based on some measure of the performance of the business in the terminal year of the projection (which should depict the business operating in a steady-state/normalized manner)
Terminal (or Exit) multiple method Assumes that the business is valued/sold at the end of the terminal year at a
multiple of some financial metric (typically EBITDA)
Growth in perpetuity method Assumes that the business is held in perpetuity and that free cash flows
continue to grow at an assumed rate
A terminal multiple will have an implied growth rate and vice versa. It is essential to review the implied multiple/growth rate for sanity check purposes
Once calculated, the terminal value is discounted back to the appropriate date using the relevant rate
Attempt to reduce dependence on the terminal value What is appropriate projection time frame? What percentage of total value comes from the terminal value?
Overview
Free cash flow
Terminal value
WACC
Other topics
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M&A - DCF and M&A analysis
Terminal multiple method
This method assumes that the business will be valued at the end of the last year of the projected period
The terminal value is generally determined as a multiple of EBIT, EBITDA or EBITDAR; this value is then discounted to the present, as were the interim free cash flows
The terminal value should be an asset (firm) value; remember that not all multiples produce an asset value
Note that in the exit multiple method terminal value is always assumed to be calculated at the end of the final projected year, irrespective of whether you are using the mid-year convention
Should the terminal multiple be an LTM multiple or a forward multiple? If the terminal value is based on the last year of your projection then the multiple
should be based on an LTM multiple (most common)
There are circumstances where you will project an additional year of EBITDA and apply a forward multiple
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Free cash flow
Terminal value
WACC
Other topics
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Most common error: The final year is not normalized
Consider adding a year to the projections which represents a normalized year
A steady-state, long-term industry multiple should be used rather than a current multiple, which can be distorted by contemporaneous industry or economic factors
Treat the terminal value cash flow as a separate, critical forecast Growth rate
Consistent with long-term economic assumptions
Reinvestment rate Net working investment consistent with projected growth Capital expenditures needed to fuel estimated growth Depreciation consistent with capital expenditures
Margins Adjusted to reflect long-term estimated profitability
Normalized tax rate
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Free cash flow
Terminal value
WACC
Other topics
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Example: Terminal multiple method
Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%Exit multiple of EBITDA = 7.0x
$745.4 =($155.9 * 7.0x)
(1+.10)4Formula
Overview
Free cash flow
Terminal value
WACC
Other topics
Fiscal year ending December 31,
2001 2001 2003 2004P 2005P 2006P 2007P 2008P Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5 EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9 Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4 EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5 Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0 Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5 Plus: Depreciation 16.0 17.6 19.3 21.3 23.4 Plus: Deferred taxes Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3 Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0 Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6 Adjustment for deal date (40.3) Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6
Memo: Discounting factor 0.0 0.5 1.5 2.5 3.5 Discounted value of unlevered FCF $0.0 $44.6 $46.7 $48.4 $49.9 Discounted value of FCF 2005P2008P 189.6 EBITDA in 2008P $155.9 Exit multiple 7.0x Firm value at exit 1,091.3 Discounted terminal value 745.4 Total present value to acquirer $934.9
Stand-alone DCF analysis of Company X$ millions
Stand-alone DCF analysis of Company X$ millions
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Example: Terminal multiple method (contd)
A + B = C
Discounted Discounted terminal value Firm value
FCF at 2008P EBITDA multiple of at 2008P EBITDA multiple of
Discount rate 20052008 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x
8% $196.8 $687.5 $802.1 $916.7 $884.4 $999.0 $1,113.6 9% 193.1 662.6 773.1 883.5 855.8 966.2 1,076.7
10% 189.6 638.9 745.4 851.8 828.4 934.9 1,041.4 11% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.6 12% 182.7 594.5 693.5 792.6 777.2 876.3 975.3
D = E
Equity value Equity value per share1
Net debt at 2008P EBITDA multiple of at 2008P EBITDA multiple of
Discount rate 12/31/04 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x
8% $100.0 $784.4 $899.0 $1,013.6 $19.17 $21.97 $24.77 9% 100.0 755.8 866.2 976.7 $18.47 $21.17 $23.87
10% 100.0 728.4 834.9 941.4 $17.80 $20.41 $23.01 11% 100.0 702.3 804.9 907.6 $17.16 $19.67 $22.18 12% 100.0 677.2 776.3 875.3 $16.55 $18.97 $21.39
Overview
Free cash flow
Terminal value
WACC
Other topics
Stand-alone DCF analysis of Company X$ millions, except per share data
Stand-alone DCF analysis of Company X$ millions, except per share data
Note: DCF value as of 12/31/01 based on mid-year convention1 Based on 40.91 million diluted shares outstanding
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Growth in perpetuity method
This method assumes that the business will be owned in perpetuity and that the business will grow at approximately the long-term macroeconomic growth rate
Few businesses can be expected to have cash flows that truly grow forever; be conservative when estimating growth rates in perpetuity
Take free cash flow in the last year of the projection period, n, and grow it one more year to n+1;1 this free cash flow is then capitalized at a rate equal to thediscount rate minus the growth rate in perpetuity
To ensure that the terminal year is normalized, JPMorgan models are set up to project one year past the projection year and allow for normalizing adjustments; this FCFn+1 is then discounted by the perpetuity formula
Overview
Free cash flow
Terminal value
WACC
Other topics
JPM recommended methodJPM recommended methodAcademic formulaAcademic formula
Terminal value = (FCFn * (1 + g))/(WACC g)
where FCFn = FCF in final projected period g = growth rate in perpetuityWACC = weighted-avg. cost of capital
PV of terminal value = terminal value/(1+WACC)n-0.5
Terminal value = (FCFn+1)/(WACC g)
where FCFn+1 = FCF in year after projections g = growth rate in perpetuityWACC = weighted-avg. cost of capital
PV of terminal value = terminal value/(1+WACC)n-0.5
1 This step is taken because the perpetuity growth formula is based on the principle that the terminal value of a business is the value of its next cash flow, divided by the difference between the discount rate and a perpetual growth rate
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Growth in perpetuity method (contd)
Note that when using the mid-year convention, terminal value is discounted as if cash flows occur in the middle of the final projection period
Here the growth-in-perpetuity method differs from the exit-multiple method
Typical adjustments to normalize free cash flow in Year n include revising the relationship between revenues, EBIT and capital spending, which in turn affects CAPEX and depreciation
Working capital may also need to be adjusted Often CAPEX and depreciation are assumed to be equal
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Free cash flow
Terminal value
WACC
Other topics
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Example: Growth in perpetuity method
Key assumptions:Deal/valuation date = 12/31/04Marginal tax rate = 40%Discount rate = 10%Perpetuity growth rate = 3%
Fiscal year ending December 31,
2001 2002 2003 2004P 2005P 2006P 2007P 2008P
Net sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5
EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9
Less: Depreciation 12.0 13.2 14.5 16.0 17.6 19.3 21.3 23.4
EBITA 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5
Less: Taxes at marginal rate 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0
Tax-effected EBITA $40.8 $44.9 $49.4 $54.3 $59.7 $65.7 $72.3 $79.5
Plus: Depreciation 16.0 17.6 19.3 21.3 23.4
Plus: Deferred taxes
Less: Capital expenditures 20.0 22.0 24.2 26.6 29.3
Less: Incr./(decr.) in working capital 10.0 8.5 7.0 5.5 4.0
Unlevered free cash flow 40.3 46.8 53.8 61.4 69.6
Adjustment for deal date (40.3)
Unlevered FCF to acquirer $0.0 $46.8 $53.8 $61.4 $69.6
Memo: Discounting factor 0.0 0.5 1.5 2.5 3.5
Discounted value of unlevered FCF $0.0 $44.6 $46.7 $48.4 $49.9
Discounted value of FCF 2005P2008P 189.6
PV of Terminal Value 733.7
Total present value to acquirer $923.3
$733.6 =$69.6 * (1 + .03)
(.10 - .03)*(1+.10)3.5Formula
Overview
Free cash flow
Terminal value
WACC
Other topics
Stand-alone DCF analysis of Company X$ millions
Stand-alone DCF analysis of Company X$ millions
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Example: Growth in perpetuity method (contd)
A + B = C
Discounted Discounted terminal value Firm value
FCF at perpetuity growth rate of at perpetuity growth rate of
Discount rate 20052008 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 8% $196.8 $991.0 $1,095.4 $1,223.0 $1,187.8 $1,292.2 $1,419.8 9% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0
10% 189.6 681.5 733.7 794.0 871.1 923.3 983.6 11% 186.1 582.6 622.0 666.7 768.7 808.1 852.8 12% 182.7 505.1 535.8 570.1 687.9 718.5 752.8
D = E
Equity value Equity value per share1
Net debt at perpetuity growth rate of at perpetuity growth rate of
Discount rate 12/31/04 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 8% $100.0 $1,087.8 $1,192.2 $1,319.8 $26.59 $29.14 $32.26 9% 100.0 905.0 977.0 1,062.0 $22.12 $23.88 $25.96
10% 100.0 771.1 823.3 883.6 $18.84 $20.12 $21.59 11% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.40 12% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95
Overview
Free cash flow
Terminal value
WACC
Other topics
Note: DCF value as of 12/31/04 based on mid-year convention
1 Based on 40.91 million diluted shares outstanding
Stand-alone DCF analysis of Company X$ millions, except per share data
Stand-alone DCF analysis of Company X$ millions, except per share data
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M&A - DCF and M&A analysisTerminal multiples and perpetuity growth rates are often considered side-by-side
Assumptions regarding exit multiples are often checked for reasonableness by calculating the growth rates in perpetuity that they imply (and vice versa)
To go from the exit-multiple approach to an implied perpetuity growth rate:
g = [(WACC*terminal value) / (1+WACC)0.5 - FCFn] / [FCFn + (terminal value / (1 + WACC)0.5)]
To go from the growth-in-perpetuity approach to an implied exit multiple:
multiple = [FCFn * (1 + g)(1 + WACC)0.5] / [EBITDAn * (WACC - g)]
These formulas adjust for the different approaches to discounting terminal value when using the mid-year convention
Overview
Free cash flow
Terminal value
WACC
Other topics
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Terminal multiple method and implied growth rates
A + B = C
Discounted Discounted terminal value Firm value Terminal value as percent Discount FCF at 2008P EBITDA multiple of at 2008P EBITDA multiple of of total firm value
rate 20052008 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 8% $196.8 $687.5 $802.1 $916.7 $884.4 $999.0 $1,113.6 78% 80% 82% 9% 193.1 662.6 773.1 883.5 855.8 966.2 1,076.7 77% 80% 82%
10% 189.6 638.9 745.4 851.8 828.4 934.9 1,041.4 77% 80% 82% 11% 186.1 616.2 718.9 821.6 802.3 904.9 1,007.6 77% 79% 82% 12% 182.7 594.5 693.5 792.6 777.2 876.3 975.3 76% 79% 81%
D = E
Equity value Equity value per share1 Implied perpetuity growth rate Discount Net debt at 2008P EBITDA multiple of at 2008P EBITDA multiple of at 2008P EBITDA multiple of
rate 12/31/04 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 6.0x 7.0x 8.0x 8% $100.0 $784.4 $899.0 $1,013.6 $19.17 $21.97 $24.77 0.2% 1.3% 2.1% 9% 100.0 755.8 866.2 976.7 $18.47 $21.17 $23.87 1.1% 2.2% 3.0%
10% 100.0 728.4 834.9 941.4 $17.80 $20.41 $23.01 2.0% 3.1% 3.9% 11% 100.0 702.3 804.9 907.6 $17.16 $19.67 $22.18 2.9% 4.0% 4.8% 12% 100.0 677.2 776.3 875.3 $16.55 $18.97 $21.39 3.8% 4.9% 5.8%
Overview
Free cash flow
Terminal value
WACC
Other topics
Standalone Company X DCF analysis$ millions
Standalone Company X DCF analysis$ millions
At a 9% discount rate and an 8.0x exit multiple the price is $23.87 and the implied terminal growth rate is 3.0%
Note: DCF value as of 12/31/04 based on mid-year convention
1 Based on 40.91 million diluted shares outstanding
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Perpetuity growth rate and implied terminal multiples
Overview
Free cash flow
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Other topics
A + B = C
Discounted Discounted terminal value Firm value Terminal value as percent Discount FCF at perpetuity growth rate of at perpetuity growth rate of of total firm value
rate 20052008 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 8% $196.8 $991.0 $1,095.4 $1,223.0 $1,187.8 $1,292.2 $1,419.8 83% 85% 86% 9% 193.1 811.9 883.8 968.9 1,005.0 1,077.0 1,162.0 81% 82% 83%
10% 189.6 681.5 733.7 794.0 871.1 923.3 983.6 78% 79% 81% 11% 186.1 582.6 622.0 666.7 768.7 808.1 852.8 76% 77% 78% 12% 182.7 505.1 535.8 570.1 687.9 718.5 752.8 73% 75% 76%
D = E
Equity value Equity value per share1 Implied EBITDA exit multiple Discount Net debt at perpetuity growth rate of at perpetuity growth rate of at perpetuity growth rate of
rate 12/31/04 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 2.5% 3.0% 3.5% 8% $100.0 $1,087.8 $1,192.2 $1,319.8 $26.59 $29.14 $32.26 8.6x 9.6x 10.7x 9% 100.0 905.0 977.0 1,062.0 $22.12 $23.88 $25.96 7.4 8.0 8.8
10% 100.0 771.1 823.3 883.6 $18.84 $20.12 $21.59 6.4 6.9 7.5 11% 100.0 668.7 708.1 752.8 $16.34 $17.31 $18.40 5.7 6.1 6.5 12% 100.0 587.9 618.5 652.8 $14.37 $15.12 $15.95 5.1 5.4 5.8
Standalone Company X DCF analysis$ millions
Standalone Company X DCF analysis$ millions
At a 9% discount rate and a terminal growth rate of 3.0%, the price is $23.88 and the implied exit multiple is 8.0x
Note: DCF value as of 12/31/04 based on mid-year convention 1 Based on 40.91 million diluted shares outstanding
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M&A - DCF and M&A analysisChoosing the discount rate is a critical step in DCF analysis
The discount rate represents the required rate of return given the risks inherent in the business, its industry, and thus the uncertainty regarding its future cash flows, as well as its optimal capital structure
Typically the weighted average cost of capital (WACC) will be used as a foundation for setting the discount rate
The WACC is always forward-looking and is predicted based on the expectations of an investment's future performance; an investor contributes capital with the expectation that the riskiness of cash flows will be offset by an appropriate return
The WACC is typically estimated by studying capital costs for existing investment opportunities that are similar in nature and risk to the one being analyzed
The WACC is related to the risk of the investment, not the risk or creditworthiness of the investor
Overview
Free cash flow
Terminal value
WACC
Other topics
1 In valuing a company, always use the riskiness of its cash flows or comparable companies in estimating a weighted average cost of capital. Never use the acquirers cost capital unless, by some chance, it is engaged in an extremely similar line of business. However, if a business is small relative to an acquirors, sometimes ti may be appropriate to consider the use of the acquirors WACC in performing the valuation. The additional value created by using the acquirors WACC can be viewed as a synergy to the acquiror in the context of the transaction.
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M&A - DCF and M&A analysisJPMorgan estimates the cost of equity using the capital asset pricing model
The Capital Asset Pricing Model (CAPM) classifies risk as systematic and unsystematic. Systematic risk is unavoidable. Unsystematic risk is that portion of risk that can be diversified away, and thus will not be paid for by investors
The CAPM concludes that the assumption of systematic risk is rewarded with a risk premium, which is an expected return above and beyond the risk-free rate. The size of the risk premium is linearly proportional to the amount of risk taken. Therefore, the CAPM defines the cost of equity as equaling the risk-free rate plus the amount of systematic risk an investor assumes
The CAPM formula follows:
Cost of equity = Risk-free rate + (beta * market risk premium)re = rf + * (rm - rf)
There is also an error term in the CAPM formula, but this is usually omitted
Where re = the required market return on the equity of the company rf = the risk-free rate rm = the return on the market = the companys projected (leveraged) beta
Overview
Free cash flow
Terminal value
WACC
Other topics
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The cost of equity is the major component of the WACC
The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation)
Risk-free rate based on the 10 year bond yield
Incorporates the undiversifiable risk of an investment (beta)
Equity risk premium reflects expectations of todays market
The market risk premium (rm - rf; i.e., the spread of market return over the risk-free rate) is periodically estimated by M&A research based on analysis of historical data
Cost of equity = Risk free rate + Beta x Equity risk premium
Long-term return on equity investment in
todays market
=
Long-term risk-free rate of return
(beta=0)
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Adjustment for correlation to stock market
returns
x
Appropriate extra return above risk free
rate
= 10-year bond yield (annual average)
+ Predicted betas x Estimated using various techniques
For market average = 4.97% + 1.00 x 5.00%
= 9.97%
Overview
Free cash flow
Terminal value
WACC
Other topics
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JPMorgan estimates the equity risk premium at 5.0%
Equity risk premiums is estimated based on expected returns and recent historical returns
Overview
Free cash flow
Terminal value
WACC
Other topics
Equity premiumsRolling average over 10-year bond
Equity premiumsRolling average over 10-year bond
Equity returns less 10-year bond yieldArithmetic average
Equity returns less 10-year bond yieldArithmetic average
2%
4%
6%
8%
10%
12%
14%
1955 1959 1963 1968 1972 1976 1980 1984 1988 1993 1997 2001
Rolling 30 years Rolling 40 years Rolling 50 years
30 years ending Equity risk premium (%)
1994 2.7
1995 3.4
1996 4.4
1997 4.7
1998 5.2
1999 6.2
2000 5.8
2001 5.0
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M&A - DCF and M&A analysis
Beta
Beta provides a method to estimate an asset's systematic (non-diversifiable) risk
Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market
A company whose equity has a beta of 1.0 is as risky as the overall stock market and should therefore be expected to provide returns to investors that rise and fall as fast as the stock market; a company with an equity beta of 2.0 should see returns on its equity rise twice as fast or drop twice as fast as the overall market
Returning to our CAPM formula, the beta determines how much of the market risk premium will be added to or subtracted from the risk-free rate
Since the cost of capital is an expected value, the beta value should be an expected value as well
Although the CAPM analysis, including the use of beta, is the overwhelming favorite for DCF analysis, other capital asset pricing models exist, such as multi-factor models like the Arbitrage Pricing Theory
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Free cash flow
Terminal value
WACC
Other topics
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Historical Beta Predicted Beta
JPMorgan uses predicted betas to calculate the cost of equity
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Predicted betasSupermarkets0.78
Utilities0.43
Food0.52
Internet2.09
Cellular1.62
Distribution of predicted and historical betas for 5,600 publicly-traded companiesDistribution of predicted and historical betas for 5,600 publicly-traded companies
Predicted betas are constructed to adjust for many risk factors, incorporating firms earnings volatility, size, industry exposure, and leverage
Predicted betas are more consistent and less volatile than historical betas
Historical betas only measure the past relationship between a firms return and market returns and are often distorted
Projected betas can be obtained from Barra or an online database (e.g., IDD) Barra predicted betas can be found through the Investment Bank Home Web page1 Note that Bloomberg betas are based on historic prices and are therefore not forward-looking Impute unlevered beta for private company from public comparables
Overview
Free cash flow
Terminal value
WACC
Other topics
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Delevering and relevering beta
Recalling our previous discussion regarding the difference between asset values and equity values, a similar argument exists for betas. The predicted equity beta, i.e., the observed beta, included the effects of leverage. In the course of performing a variance analysis, which looks at different target capitalizations, the equity beta must be delevered to get an asset, or unlevered, beta. This asset beta is then used in the CAPM formula to determine the appropriate cost of capital for various debt levels
The formula follows:
U= L/[1 = ((1 T) * (Debt/Equity))]Where:
U = unlevered (asset) betaBL = leveraged beta
T = marginal tax rate
To relever the beta at a target capital structure:
L= U*[1 + ((1 T) * (Debt/Equity))]
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Delevering and relevering beta (contd)
Note that JPMorgan M&A sometimes uses a factor, tau, in place of the marginal tax rate, T
Tau, currently equal to 0.26, represents the average blended benefit a shareholder gets from a company borrowing (reflects many factors)
The value of Tau is derived by researchers using complicated statistical analyses
Although the delevering/relevering methodology is standard for WACC analyses, the formula does not produce a highly accurate result
Remember the fundamentals: the market charges more for equity of companies that are financially risky
Exercise 1. Levered Beta = 1.25, T = 40%, D/E= 0.75; What is the Beta Unlevered? 2. Find the levered Beta at a D/E = 1.0
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The cost of a firms equity should be adjusted for size
Investors typically expect higher returns when investing in smaller companies
Increased risk Lower liquidity
Betas vary very little by size
Historical equity returns suggest higher return required by investors in smaller companies
P/E growth ratios (PEG) tend to decline with size
Empirical data combined with judgementshould be applied when estimating the cost of equity for smaller firms
Size premium by market capBased on PE/growth (PEG)
Size premium by market capBased on PE/growth (PEG)
Size premium by market capBased on historical returns analysis
Size premium by market capBased on historical returns analysis
5.2%
3.1%2.5%
1.9% 1.7% 1.4% 1.1% 0.8%0.0%
2.2%
1.6%
1.1%0.8%
0.0%
$100500 $5001,000 $1,0002,500 $2,5005,000 $5,000+
Market cap ($mm)
$0100
$100250
$250500
$500700
$700-1,000
$1,0001,500
$1,5002,500
$2,5005,000 $5,000+
Market cap ($mm)
Overview
Free cash flow
Terminal value
WACC
Other topics
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M&A - DCF and M&A analysisJPMorgan uses the long-term cost of debt in estimating WACC
The long-term cost of debt is used because the cost of capital is normally applied to long-term cash flows
Using the long-term cost of debt removes any refinancing costs/risks from the valuation analysis
To the extent a company can fund its investments at a lower cost of debt (with the same risk), this value should be attributed to the finance staff
JPMorgan uses the companys normalized cash tax rate
Overview
Free cash flow
Terminal value
WACC
Other topics
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Cost of equity Cost of capital 10-year T-bond (Avg) 4.97% Market risk premium 5.00% (x) Beta (current predicted) 0.62 Adjusted market premium 3.10% Cost of equity = 8.07%
Cost of debt Cost of debt 6.25% (-) Tax shield1 2.19% After-tax cost of debt 4.06%
The cost of equity and debt are blended together based on a target capital structure
The target capital structure reflects the companys rating objective Firms generally try to minimize the cost of capital through the appropriate use of leverage
The percentage weighting of debt and equity is usually based on the market value of a firms equity and debt position
Most firms are at their target capital structure Adjustments should be made for seasonal or cyclical swings, as well as for firms moving toward a target
Using a weighted average cost of capital assumes that all investments are funded with the same mix of equity and debt as the target capital structure
Target capital structure(Assumes current = optimal)Debt/total capital2 = 6.1%
Nominal WACC = 7. 82%
WACC = rd * [D *(1-T)] + re * E D+E D+E
Where: E = Market value of equity D = Market value of debt
T = Marginal tax rate re = Return on equity rd = Return on debt
Overview
Free cash flow
Terminal value
WACC
Other topics
Illustrative SYSCO weighted average cost of capital calculationIllustrative SYSCO weighted average cost of capital calculation
WACC formulaWACC formula
1 Assumes 35% marginal tax rate2 Total capital = debt + market value of equity
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Administrator
Administrator
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M&A - DCF and M&A analysisExample: Calculating WACC based on comparable companies
Risk free rate1 5.40% Projected Target marginal tax rate 40.0%
Estimated market equity risk premium 4.0%
Target WACC analysis as of 1/1/01Target WACC analysis as of 1/1/01
Macroeconomic assumptionsMacroeconomic assumptions
Comparable company
Projected levered beta3
Net debt/mkt.
cap
Total debt/mkt.
equity Tax rate Unlevered
beta4
Cost of levered equity
Cost of unlevered
equity
Company A 1.06 17.2% 22.5% 0.40 0.93 9.6% 9.1%
Company B 0.90 18.0 22.2 0.40 0.79 9.0 8.6
Company C 0.90 40.3 78.4 0.40 0.61 9.0 7.8
Company D 0.89 8.6 10.1 0.40 0.84 9.0 8.8
Average 0.94 21.0% 33.3% 0.40 0.79 9.1% 8.6%
Industry beta analysisIndustry beta analysis
Optimal debt/market capitalization Optimal debt/equity
Spread to 10-yr
treasuries (bp)
Country risk premium
Pre-tax long term cost of
debt
Levered beta assuming
unlevered beta of 0.79
Cost of levered equity
Target nominal
WACC
30.0% 42.9% 175.0 0.00% 7.1% 1.00 9.4% 7.9%
40.0 66.7 200.0 0.00 7.4 1.11 9.8 7.7
50.0 100.0 300.0 0.00 8.4 1.27 10.5 7.8
60.0 150.0 400.0 0.00 9.4 1.51 11.4 8.0
70.0 233.3 500.0 0.00 10.4 1.91 13.0 8.3
Target WACC calculationTarget WACC calculation
1 Risk-free rate=yield-to-maturity of 10-year U.S. Treasury bond as of 1/1/01 (Source: Bloomberg)2 Source: JPMorgan M&A research3 Source: Barra predicted betas4 Unlevered beta=Levered beta/(1 + (total debt/market value of equity)*(1-tax rate)). Assumes beta of debt equals zero
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M&A - DCF and M&A analysisThe appropriate cost of capital will depend on the entity which is being valued
Company Risk
premium Unlevered
beta Optimal
debt/equity Re-levered
beta Cost of equity
Cost of financing WACC
SYSCO 5.0% 0.70 20% 0.80 9.0% 6.25% 8.2%
$1BN target 5.0%-6.5% 0.70 20% 0.80 9.0%10.3% 6.25%7.50% 8.3%9.3%
$500mm target 5.0%-7.0% 0.70 20% 0.80 9.0%10.6% 6.25%8.00% 8.4%9.7%
$200mm target 5.0%-7.5% 0.70 20% 0.80 9.0%11.0% 6.25%8.50% 8.4%10.1%
For illustrative purposesFor illustrative purposes
Debt/equity
10% 20% 30% 40%
0.65 7.8% 7.5% 7.3% 7.0%
0.70 8.1% 7.7% 7.5% 7.2%
0.75 8.3% 7.9% 7.7% 7.4%
0.80 8.5% 8.2% 7.8% 7.6%
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0.85 8.8% 8.4% 8.0% 7.8%
SYSCO WACC sensitivitySYSCO WACC sensitivity $1bn target WACC sensitivity$1bn target WACC sensitivity $200mm target WACC sensitivity$200mm target WACC sensitivity
Debt/equity
10% 20% 30% 40%
0.70 9.1% 8.7% 8.4% 8.2%
0.75 9.4% 9.0% 8.7% 8.4%
0.80 9.7% 9.3% 8.9% 8.7%
0.85 10.0% 9.6% 9.2% 8.9%
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0.90 10.3% 9.8% 9.4% 9.1%
Debt/equity
10% 20% 30% 40%
0.70 9.8% 9.4% 9.1% 8.9%
0.75 10.1% 9.8% 9.4% 9.1%
0.80 10.5% 10.1% 9.7% 9.4%
0.85 10.8% 10.4% 10.0% 9.7%
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0.90 11.2% 10.7% 10.3% 10.0%
Note: Assumes 35% marginal tax rate1 Assuming an equity risk premium of 6.5%2 Assuming an equity risk premium of 7.5%
Overview
Free cash flow
Terminal value
WACC
Other topics
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DCF in-class exercise
The Forecasted EBITDA and FCF for the next three years (2005, 2006, 2007) are EBITDA (US $mm): 450, 500, 550 FCF (US $mm): 250, 261, 277
Other assumptions: Perpetuity growth rate of 3.0% Terminal exit multiple of 7.5x Unlevered beta of 0.80 Risk free rate= 4.6% Market risk premium= 6% Cost of debt: 6.2% Marginal tax rate: 35% Market value of equity=US $4,541mm Net debt= US $2,524mm
Overview
Free cash flow
Terminal value
WACC
Other topics
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DCF in-class exercise (contd)
Calculate The cost of equity WACC PV of FCF NPV of company Perpetual growth method PV of Exit multiple method What if we use end period discounting in:
Perpetual growth method Exit multiple method
What is the valuation if we need to value the company as on March 31, 2005? Use Exit/Perpetual growth methods using mid year conventions Use Exit/Perpetual growth methods using end year conventions
Overview
Free cash flow
Terminal value
WACC
Other topics
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Most common errors in calculating WACC
Cost of equity
Equity risk premium based on very long time frame (post 1926: Ibbotson data)
Substitute hurdle rate (goal) for cost of capital
Use of historical (or predicted) betas that are clearly wrong
Investment specific risk not fully incorporated (e.g., country risk premiums)
Incorrect releveraging of the cost of equity
Cost of equity based on book returns, not market expectations
Target capital structure
The actual, not target, capital structure is used
WACC calculated based on book weights
Overview
Free cash flow
Terminal value
WACC
Other topics
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Valuing synergies
When two businesses are combined, the term synergies refers to the changes in their aggregate operating and/or financial results attributable to their being operated as a combined enterprise. Synergies can take many forms
Revenue enhancements Cost savings
Raw material discounts/purchasing power Sales and marketing overlap, Corporate overhead reductions Distribution cost reductions, Facilities consolidation Tax savings
Merger related expenses (restructuring, additional CAPEX, integration expenses)
The value of achievable synergies is often a key element in whether to proceed with a proposed transaction
Calculate synergies for both the acquiring company and the target Remember incremental cash flow
Synergies are generally valued by toggling pre-tax changes to various financial statement line items into a DCF model of the combined enterprise and simply measuring the incremental impact
Overview
Free cash flow
Terminal value
WACC
Other topics
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Valuing synergies
Sources of synergy projections Management Research Estimates from comparable transaction (% of sales, increase in EBITDA
margin etc.)
DCF with synergies Valued separately from standalone DCF Run sensitivity on synergy valuations
Other considerations Timeline for achieving synergies Run as sensitivity various cases of realization e.g., 25%, 50%, 75%, 100% realization Tax impact Costs incurred to achieve synergies
Overview
Free cash flow
Terminal value
WACC
Other topics
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M&A - DCF and M&A analysisSensitivity analysis is vital when presenting the results of DCF analysis
Recall that DCF valuation is highly sensitive to projections and assumptions
So-called sensitivity tables chart the output based on ranges of input variables It is common to use a 3x3 table (i.e., showing three different values for each of
two input variables) to enable the reader to triangulate to the appropriate inferences
Since DCF results are by their nature approximate, depicting sensitivity tables enables users of DCF output to assess the degree of fuzziness in the results
As shown in our previous examples, DCF analyses using exit multiples and perpetuity growth rates generally show sensitivities for the method used to calculate terminal value and a range of discount rates
Sensitivities can be shown for any variable in the model (including financial projections)
Judge which sensitivities would be useful to decision makers
Overview
Free cash flow
Terminal value
WACC
Other topics
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M&A - DCF and M&A analysisCompanies with multiple businesses are often valued on a sum-of-the-parts basis
This approach is sometimes referred-to as a break-up valuation Particularly common when the company is believed to be undervalued by
the public
Better accounts for discrepancies in market conditions facing the businesses
The methodology requires estimating financial results for each business (EBIT, EBITDA and/or net income), which can then be used with appropriate multiples or growth rates in order to arrive at a firm value for each part before the results are summed
Completing a sum-of-the-parts valuation can be more challenging than a straightforward (single-business/consolidated) DCF analysis
Typically less detailed financial data is publicly-available for segments Often assumptions must be made about how to allocate expenses,
especially those that are clearly shared across businesses (like corporate-level SG&A)
Need to consider different characteristics of each business segment (discount rate, terminal value assumptions, etc.)
Overview
Free cash flow
Terminal value
WACC
Other topics
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Agenda
Page
M&A - DCF and M&A analysis
Merger consequences
Relative value analysis
Discounted cash flow analysis
Introduction 1
56
6
56
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Introduction to relative valuation
Relative valuation is utilized to illustrate how the value of one company compares to another company
Typically, relative valuation analysis is utilized in the context of stock-for-stock exchanges to determine the appropriate exchange ratio offered to shareholders in a transaction
The exchange ratio reflects the number of acquiror shares offered for each target share
So if you are a target shareholder and you are offered an exchange ratio of 0.500x, you are being offer 1/2 of an acquiror share for each share of the target you own
Several relative valuation approaches exist Historical trading and exchange ratio analysis Contribution analysis Relative multiple and discounted cash flow analysis Valuation of synergies
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Historical trading and exchange ratio analysis
Historical exchange ratio analysis Illustrates the relative movement in stock prices (and implied exchange ratios, aka natural exchange ratios) looking back over a certain timeframe
Calculated simply as the target share price on a given date divided by the acquirorshare price on the same date
Does not include any premium to the target
Provides a historical benchmark to justify the contemplated exchange ratio
Issues to consider when analyzing data include Liquidity of shares / trading volume (small vs. large cap) Relative market attention / analyst coverage Multiple expansion of one of the companys peer group versus the other over the
selected time horizon
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Ratio at $12.00 Current1
Last month1
Last 3 months1
Last 6 months1
Last 12 months1
Acquiror shares per Target share 0.347x 0.194x 0.184x 0.203x 0.236x 0.270x
Implied Target share price3 $12.00 $6.70 $6.38 $7.02 $8.15 $9.33
$12.00 ratio as a premium 0% 79.1% 88.2% 71.0% 47.3% 28.7%
Implied Target pro forma ownership 38.7% 24.6% 23.6% 25.6% 28.9% 32.2%
Source:
Illustrative historical trading and exchange ratio analysis
0.00x
0.05x
0.10x
0.15x
0.20x
0.25x
0.30x
0.35x
0.40x
0.45x
Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02
Historical exchange ratioHistorical exchange ratio
At $12 per share = 0.347x
Current = 0.194x
More favorableto Target
Less favorableto Target
Current stock price2 Current market capitalization2
Acquiror Target Acquiror Target
$34.60 $6.70 $274.8 $89.7
# of acquiror shares per target share
1 Represents average exchange ratio over the trailing period ended June 27, 20022 Closing prices as of June 27, 20023 Assumes acquirors current price of $34.60 per share
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Contribution analysis
Compares the relative equity valuation of two parties to their respective contribution to a combined companys financial performance
Typical firm value metrics would include Revenues EBITDA EBIT Unlevered free cash flow measures Industry-specific (i.e. customers, reserves, etc.)
Typical equity value metrics would include Net income Levered free cash flow measures
Cautionary note: contribution analysis does not measure the growth and risk profile of the two companies financial performance and differing multiples may be justifiablie when assessing relative value
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Relative contribution analysis
Implied equity value Implied
Acquiror Target Total Acquiror Target exchange ratio
Market value $18,150 $7,653 $25,803 $18,150 $7,653 0.4340x
% contribution 70.3% 29.7% 70.3% 29.7%
Firm value $38,450 $19,592 $58,042 $18,150 $7,653 0.4340x
% contribution 66.2% 33.8% 70.3% 29.7%
EBITDA
2004E $5,275 $3,528 $8,803 $14,482 $11,322 0.8046x
% contribution 59.9% 40.1% 56.1% 43.9%
2005E $5,320 $3,253 $8,573 $15,716 $10,087 0.6606x
% contribution 62.1% 37.9% 60.9% 39.1%
Net income
2004E $1,790 $1,210 $3,000 $15,397 $10,406 0.6956x
% contribution 59.7% 40.3% 59.7% 40.3%
2005E $2,018 $1,380 $3,398 $15,326 $10,477 0.7036x
% contribution 59.4% 40.6% 59.4% 40.6%
$ millions$ millions
1 As of 2/6/02; net debt for ACQUIROR as of 12/31/01 (per press release) and for TARGET as of 9/30/01 (per 10-Q); pro forma for acquisitions2 2001A for ACQUIROR; based on company press release; other estimates based on JPMorgan Equity Research3 Based on I/B/E/S consensus estimates; ACQUIROR 2002E EPS based on company guidance; TARGET EPS estimates based on I/B/E/S consensus estimates post 1/29/02
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29.7% 29.7%
43.9% 39.1% 40.3% 40.6%
70.3% 70.3%
56.1% 60.9% 59.7% 59.4%
Market value Firm value 2002E EBITDA 2003E EBITDA 2002E Net Income 2003E Net Income
Target Acquiror
Sample contribution analysis
ImpliedER .4340x .4340x .8046x .6606x .6956x .7036x
$25,308 $58,042 $8,803 $8,573 $3,000 $3,398
Relative ownership
Exchange ratio 0.5385x
Target 35.0%
Acquiror 65.0%
Offer =35.0%
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Calculating the implied exchange ratio
Implied exchange ratio (equity value metrics)Implied exchange ratio (equity value metrics)Company statisticsCompany statistics
Acquiror
Current share price $34.22
Fully-diluted share count 531
Fully-diluted market cap 18,150
Net debt 20,300
EBITDA 5,320
Net income 1,790
Target
Current share price $14.85
Fully-diluted share count 515
Fully-diluted market cap 7,653
Net debt 11,939
EBITDA 3,253
Net income 1,210
% of net income contributed by acquiror 59.7%
Fully-diluted acquiror shares 530
Pro forma shares outstanding to yield 59.7% ownership
888
Implied shares issued to target 358
Current target shares outstanding 515
Implied exchange ratio based on net income (358 / 515)
0.6956x
Natural exchange ratio based on current share prices ($14.85 / $34.22)
0.4340x
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Calculating the implied exchange ratio (contd)
Company statisticsCompany statistics
Acquiror
Current share price $34.22
Fully-diluted share count 531
Fully-diluted market cap 18,150
Net debt 20,300
EBITDA 5,320
Net income 1,790
Target
Current share price $14.85
Fully-diluted share count 515
Fully-diluted market cap 7,653
Net debt 11,939
EBITDA 3,253
Net income 1,210
Implied exchange ratio (firm value metrics)Implied exchange ratio (firm value metrics)
Combined firm value 58,042
Combined equity value 25,803
% EBITDA contributed by acquiror 62.1%
Firm value based on EBITDA contribution 36,044
Implied equity value 15,744
As a % of total equity value 60.9%
Fully-diluted acquiror share count 531
Pro forma shares outstanding to yield 61.0% acquiror ownership
871
Implied shares issued to target 340
Fully-diluted target share count 515
Implied exchange ratio based on EBITDA (338 / 515) 0.66x
Natural exchange ratio based on current share prices ($14.85 / $34.22)
0.43x
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Class exercise
Company statisticsCompany statistics
Acquiror
Current share price $12.1
Fully-diluted share count (mm) 110.3
Net debt 450
EBITDA 172
Net income 65
Target
Current share price $14.1
Fully-diluted share count 30.4
Net debt 295
EBITDA 81
Net income 25
Calculate the % contribution based on the EBITDA and the Net income
What is the implied exchange ratio?
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M&A - DCF and M&A analysis
Relative multiple and discounted cash flow valuation
Compares the ranges suggested by stand-alone valuations of two companies on a multiples or discounted cash flow basis
Step 1: Valuation the acquiror and the target separately Step 2: Create a relative value summary
Need to consider which ends of the range it is appropriate to compare when determining an appropriate exchange ratio / ownership percentage
High/Low and Low/High High/High and Low/Low
66RE
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A
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E
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A
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M&A - DCF and M&A analysis
Sample relative value football field: Target valuation
$15.00
$9.75
$5.50
$26.75
$5.00
$4.00$5.00
$3.50
$4.94
$3.00$4.00
$10.25
$6.00
$3.75
$0.00
$5.00
$10.00
$15.00
$20.00
Implied offer1 = $8.46
1 Based on the offer exchange ratio of 0.311x and Pedros closing price $27.19 as of 7/12/012 Certain of the multiples implied by precedent transactions have been adjusted by indexing them to the movement in an index of stock prices of companies comparable to Pablo
3 Based on IBES EPS growth estimate and average margin estimates of brokerage reports
Public trading comparablesTransaction comparables2
DCF analysis
52-weekhigh/low
19.0x to 25.0x2001E cash
EPS of $0.16
15.0x to 19.0x2001E EBITof $20.6
2.5x to 4.0xLTM revenue
of $185.712% to 15%
Discount RateEBIT exit mult.
of 15.0x to 20.0x
15.0x to 20.0x2002E cash
EPS of $0.25
Mgmt. Case Street Case3
12% to 15% Discount RateEBIT exit mult.
of 15.0x to 20.0x
Lowest public comp price
Highest public comp price
Street case DCF
Price per sharePrice per share
67RE
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M&A - DCF and M&A analysis
Sample relative value football field: Acquiror valuation
$43.25
$29.50$29.25$28.00
$33.00
$22.50$20.50
$30.75
$26.50
$21.00$21.28
$0.00
$10.00
$20.00
$30.00
$40.00
$50.00
Current = $27.19
52-weekhigh/low
Discount rate 9% to 13%EBITDA with exit multiple
of 11.0x to 13.0x
DCF analysis2Public company analysis
Sum-of-the-parts12.0x to 15.0x2001E EBIT
of $239
10.0x to 12.0x2001E EBITDA
of $346
19.0x to 25.0x2001E EPSof $1.18
Comparable diversified company analysis
1 Comparable diversified company analysis and public company analysis are based on brokerage report estimates2 Based on management projections
Lowest public comp price
Highest public comp price
DCF
Price per sharePrice per share
68RE
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A