Chapter 14: Applying Financial Modeling

To Value, Structure, and Negotiate Mergers and Acquisitions

Answers to End of Chapter Discussion Questions

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

Answer: The valuation of the target firm on a standalone basis provides an estimate
of the minimum price that might have to be paid to acquire the firm, assuming the
market for such firms is efficient. Note that the notion of a minimum price does not
preclude the buyer from buying the target firm at a discount from its true value. For
example, the buyer may be able to acquire the target at a discount from its economic
value if the seller is in a hurry to sell, the market for such businesses is highly illiquid,
or the cost and risk associated with performing due diligence is high encouraging the
prudent buyer to offer less than the target’s intrinsic value. If the acquirer or target is
part of a larger firm, the projected cash flows must be adjusted to reflect all costs
and revenue associated with the acquirer’s or target’s operation. The failure to make
the proper adjustments can result in an over-or-understatement of value. Such costs
include all administrative expenses such as legal, tax, audit, benefits, and treasury
functions that may be heavily subsidized by the parent. Moreover, intercompany
revenues must be restated to reflect what they would have been if they had been
valued at current market prices.

14.2 Why should “in the money” options, warrants, and convertible preferred stock and
debt be included in the calculation of the purchase price to be paid for Target?

Answer: Such securities are likely to be converted to common shares. If Acquirer

wants to avoid minority shareholders, it must be prepared to buy these shares. This
also adds to the purchase price. Further, target firms often have change of control
clauses in their bylaws which automatically make these types of securities
convertible into the firm’s common stock in the event of a hostile takeover.

14.3 What are value drivers? How can they be misused in M&A models?

Answer: Value drivers are those variables that have the greatest impact on firm
value. They usually include revenue growth, cost of sales as a percent of sales,
discount rate used in the annual growth forecast period, and the discount rate and
growth rate used in calculating terminal values. For marketing oriented or service
businesses, value drivers often include SG&A as a percent of sales. Because they can
disproportionately impact firm value, changes in the variables can be manipulated to
get desired model outcomes rather than realistic ones.

14.4 Can the initial offer price ever exceed the maximum purchase price? If yes, why? If
no, why not?

Answer: Yes. Hubris on the part of acquiring company’s management may result in
an offer price that exceeds what is economically justifiable assuming the acquiring
firm has accurately identified all sources and destroyers of value.

14.5 Why is it important to clearly state assumptions underlying a valuation?

 Answer: The credibility of any valuation ultimately depends on the validity of its
underlying assumptions. Valuation-related assumptions tend to fall into five major
categories: (1) market, (2) income statement, (3) balance sheet, (4) synergy, and (5)
valuation. Note that implicit assumptions about cash flow are already included in
assumptions made about the income statement and changes in the balance sheet,
which together drive changes in cash flow. Market assumptions are generally those
that relate to the growth rate of unit volume and product price per unit. Income
statement assumptions include the projected growth in revenue, the implied market
share, and the growth in the major components of cost in relation to sales. Balance
sheet assumptions may include the growth in the primary components of working
capital and fixed assets in relation to the projected growth in sales. Synergy
assumptions relate to the amount and timing associated with each type of
anticipated synergy, including cost savings from workforce reductions, productivity
improvements due to the introduction of new technologies or processes, and revenue
growth because of increased market penetration. Finally, examples of important
valuation assumptions include the acquiring firm’s target debt to equity ratio used in
calculating the cost of capital, the discount rates used during the forecast and stable
growth periods, and the growth assumptions used in determining the terminal value.

14.6 Assume two firms have little geographic overlap in terms of sales and facilities. If they were to merge, how
might this affect the potential for synergy?

Answer: The potential for selling each firm’s products to the other firm’s customers (i.e., cross-selling) in
the absence of overlap could increase the combined firms’ aggregate revenue. However, the absence of
contiguous facilities could limit the opportunity for cost savings by sharing underutilized operations (e.g.,
closing one firm’s operations and moving its output to another nearby facility producing below its
capacity) or combining overhead functions.

14.7 Dow Chemical, a leading manufacturer of chemicals, announced that they had an agreement to acquire
competitor Rhom and Haas Company. Dow expects to broaden its current product offering by offering the
higher margin Rohm and Haas products. What would you identify as possible synergies between these two
businesses? In what ways could the combination of these two firms erode combined cash flows?

Answer: As competitors, the two firms should be able to generate sizeable cost savings by combining
certain overhead functions such as sales, marketing, human resources, finance, engineering, R&D, etc. In
addition, since they produce similar products, one could anticipate better utilization of existing facilities in
that products produced in underutilized facilities could be moved to other facilities to achieve better
economies of scale. Economies of scope realized by sharing common resources such as IT and R& D
centers also could provide significant efficiencies. Furthermore, cross-selling opportunities could exist for
each firm to sell its products to the other’s customers. Some loss of cash flow could be experienced as a
result of normal customer attrition during the integration period as product quality and delivery times
suffer. Moreover, customers may choose to diversify their sources of supply by shifting a portion of what
they formerly purchased from these businesses to other suppliers. Finally, key employees will inevitably be
lost as competitors exploit the uncertainty experienced by the employees of these two companies.

14.8 Dow Chemical’s acquisition of Rhom and Haas included a 74 percent premium over the firm’s pre-
announcement share price. What is the probable process Dow employed in determining the stunning
magnitude of this premium?

Answer: To gain a controlling interest in the target, Dow had to determine the range of value for Rhom and
Haas between the firm’s current market value and the market value plus 100 percent of the net synergy
resulting from combining the two firms. Dow could then determine how much of the difference in this
range it would have to share with Rohm and Haas’ shareholders in order to complete the transaction. This
determination could be made by identifying what portion of the net synergy would be contributed by the
target and the multiples paid on recent comparable transactions.
14.9 For most transactions, the full impact of net synergy will not be realized for many months. Why? What
factors could account for the delay?

Answer: The full effects of synergy are not realized immediately because of facility leases that must expire
or be bought out, severance expenses that offset savings that result from layoffs, management inertia,
employee resistance, morale concerns, the time required to sell redundant assets, and the tendency to
underestimate the time that is needed to implement savings programs. In addition, savings programs often
require retraining and relocating workers, which also offset some portion of the savings in the early years.

14.10 How does the presence of management options and convertible securities affect the calculation of the offer
price for the target firm?

Answer: While so-called “in the money” options (those whose exercise price is below the firm’s current
share price) and convertible securities (including preferred and debt) are likely to be converted to common
shares, “out of the money” options often are convertible to common stock whenever a firm faces a change
in control. Assuming the buyer wishes to buy all outstanding target shares, the increase in the number of
shares outstanding will add to the dollar value of the purchase price. In an all-cash purchase, the acquirer’s
cash outlay to buy 100 percent of outstanding shares will increase; in an all-stock purchase, the increase in
the number of new acquirer shares issued will dilute the acquirer’s current shareholders’ ownership share of
the combined businesses.

Practice Problems and Solutions

14.11 Acquiring Company is considering the acquisition of Target Company in a stock for stock transaction in
which Target Company would receive $50.00 for each share of its common stock. The Acquiring
Company does not expect any change in its price/earnings multiple after the merger.

Acquiring Co. Target Co.

Earnings available for $150,000 $30,000
common stock
Number of shares of 60,000 20,000
common stock outstanding
Market price per share $60.00 $40.00

Using the information provided above on these two firms and showing your work, calculate the following:

a. Purchase price premium = Offer price for target company stock / Target Company market price per
share
= $50.00 / $40.00
= 1.25 or 25% (i.e., 1.25 – 1.00)

b. Exchange ratio = Price per share offered for Target Company / Market price per share for Acquiring
Company
= $50.00 / $60.00 = .8333 (i.e., Acquiring Company issues .8333 shares of stock
for each share of Target Company’s stock)

c. New shares issued by Acquiring Company = 20,000 (shares of Target Company) x .8333 (Exchange
ratio) = 16,666

d. Total shares outstanding of the combined companies = 60,000 + 16,666 = 76,666

e. Post-merger EPS of the combined companies = ($150,000 + $30,000)/ 76,666 = $2.35

f. Pre-merger EPS of Acquiring Company = $150,000 / 60,000 = $2.50

 g. Post-merger share price = $2.35 x 24 (pre-merger P/E = $60.00/$2.50) = $56.40 (as compared to
$60.00 pre-merger)

h. Ownership distribution post-closing: Target shareholders 16,666/76,666 = 21.7%

Acquirer shareholders 1 - .217 = 78.3
100.0%

14.12 Acquiring Company is considering buying Target Company. Target Company is a small biotechnology
firm, which develops products that are licensed to the major pharmaceutical firms? Development costs are
expected to generate negative cash flows during the first two years of the forecast period of $(10) and $(5)
million, respectively. Licensing fees are expected to generate positive cash flows during years three
through five of the forecast period of $5, $10, and $15 million, respectively. Due to the emergence of
competitive products, cash flow is expected to grow at a modest 5 percent annually after the fifth year. The
discount rate for the first five years is estimated to be 20 percent and then to drop to 10 percent beyond the
fifth year. In addition, the present value of the estimated synergy by combining Acquiring and Target
companies is $30 million. Calculate the minimum and maximum purchase prices for Target Company.
Show your work.

Answer:

Year Cash Flow Discount Rate Present Value

1 (10) 1.2 (8.33)
2 (5) 1.202 = 1.4400 (3.47)
3 5 1.203 = 1.7280 2.89
4 10 1.204 = 2.0736 4.82
5 15 1.205 = 2.4883 6.03
Present value = 1.94

Terminal Value = (15 x 1.05)/(.10-.05) = 15.75/.05 = 315 = 126.59

2.4883 2.4883 2.4883

Minimum Price = 126.59 + 1.94 = $128.5

Maximum Price = $128.5 + $30 = $158.5

14.13 Using the data given below, calculate fully diluted shares. Assume the firm uses proceeds received from the
conversion of options to common shares to repurchase as many of these new shares as possible.
Calculating Fully Diluted Shares Outstanding
$Million, except per share data, shares in millions
Current Share Price $30.00
Basic Shares Outstanding 200.00
Options that can be Exercised 40.0
Weighted Average Exercise Price $20.00

a. 224.52
b. 263.59
c. 213.33
d. 256.87
e. 233.47
Answer: C

Value of the options at the firm’s current share price = $30 x 40 = $1200
Proceeds firm receives from option holders = $20 x 40 = 800
 Value of shares firm cannot repurchase = $ 400

Net increase in shares due to option conversion = $400 / $30 = 13.33

Alternatively: [($30 – $20) x 40] / $30 = 13.33

Total shares outstanding = basic shares plus new option shares = 200 + 13.33 = 213.33

14.14 What is the fully diluted offer price (equity value) for a tender offer made to acquire a target whose pre-
tender shares are trading for $1.50 per share? The tender offer includes a 30% premium to the target’s pre-
tender share price. The target has basic shares outstanding of 70 million and 5 million options which may
be converted into common shares at $1.60 per share.

Answer: $138.25 million

Offer Price (Target’s Equity Value) = [Basic Shares x Price Per Share + Options Exercised x Price Per
Share] x (1 + % Premium) – Option Proceeds When Exercised

Offer Price (Target’s Equity Value) = [70 x $1.50 + 5 x $1.50] x 1.30 – 5 x $1.60 = $146.25 - $8.00 =
$138.25

That is, the offer price or target equity value equals the total number of shares the acquirer must purchase
including basic shares outstanding plus options converted into common shares. We increase the offer price
by 30% to reflect the premium. Using the so-called Treasury Method, we then subtract from the amount the
acquirer must pay the amount of cash received from option holders when they exercise their options since
this reduces the total cash outlay required by the acquirer. We can assume that all options will be exercised
because the offer price per share will exceed the option exercise price per share (i.e., $1.50 x 1.3 is greater
than $1.600).

14.15 Using the M&A Valuation & Deal Structuring Model on the website accompanying this text (see the
website address in the Chapter Overview section at the beginning of this chapter) and the data contained in
the cells as a starting point, complete the following:
a. What is the enterprise and equity value of Target on the Valuation Worksheet?
b. Increase the sales growth rate by one percentage point (i.e., to 6.5%) on the Target Assumptions
Worksheet. What is the impact on the Target’s enterprise and equity values? (Hint: See Valuation
Worksheet.) Undo change or close model but do not save results in order to restore the model’s original
data.
Answers:
a. Before change to revenue growth assumption by one percentage point:
1. Target enterprise value: $11,582.2
2. Target equity value: $9,796.8
b. After change in revenue growth assumption by one percentage point
1. Target enterprise value: $12,356.3
2. Target equity value: $10,570.9

14.16 Using the M&A Valuation & Deal Structuring Model accompanying this text (see the website address in the
Chapter Overview section at the beginning of this chapter) and the data contained in the cells as a starting
point, complete the following:
a. What is the enterprise and equity value of Target on the Valuation Worksheet?
b. On the worksheet named Target Assumptions, increase COGS (cost of goods sold)
as a percent of sales by one percentage point (i.e., .43 to .44) on the Target
Assumptions Worksheet. What is the impact on the Target’s enterprise and equity
values? (Hint: See Valuation worksheet.) Undo change or close the model but do not
save the results in order to restore the model’s original data.
Answers:
 a. Before change to COGS ratio by one percentage point:
1. Target enterprise value: $11,582.2
2. Target equity value: $9,796.8
b. After change in COGS ratio by one percentage point:
1. Target enterprise value: $11,104.8
2. Target equity value: $9,319.4

14.17 Using the M&A Valuation & Deal Structuring Model accompanying this text (see the website address in the
Chapter Overview section at the beginning of this chapter):
a. On the Valuation worksheet, note the enterprise and equity values for Newco.
b. On the Summary worksheet under Incremental Sales Synergy, change incremental
revenue to $200 million in the first year, $250 million in the second year, and
$350 in the third year. What is the impact on Newco’s enterprise and equity values?
(Hint: See Valuation worksheet.) Undo changes or close the model but do not save
the results.
Answers:

a. Before incremental sales growth:

1. Newco enterprise value: $32,813.7
2. Newco equity value: $20,970.8
b. After change in incremental sales:
1. Newco enterprise value: $33,766.5
2. Newco equity value: $21,923.6

14.18 Using the M&A Valuation & Deal Structuring Model accompanying this text (see the website address in the
Chapter Overview section of this chapter):
a. On the Transaction Summary Worksheet, under the heading Form of Payment,
change the composition of the purchase price to 100% cash. Assume the purchase price is partially
financed by reducing Acquirer excess cash by $1 billion and by raising $4 billion by issuing new
Acquirer equity. Under the Sources and Uses heading, how is the remainder of the purchase price
financed?
b. Change the composition of the purchase price to 100% equity, what is the impact on
how the purchase price is financed? Close model but do not save the results.
Answers:

a. Form of Payment = 100% cash. Senior debt is increased by $10,129.8 million.

b. Form of Payment = 100% equity. Senior debt shows a negative $4,365 million,
which does not make sense. Set excess cash and new common shares issued to
public equal to zero. Senior Debt automatically increases by $635 million.

Solutions to Chapter Case Study Questions

Case Study 9.1 Thermo Fisher Acquires Life Technologies

Discussion Questions and Answers:

Answer questions 1 to 4 using as the base case the firm valuation and deal structure data in the model available on
MyLMU Connect entitled Thermo Fisher Buys Life Technologies Financial Model. Assume that the base case
assumptions were those used by Thermo Fisher in its merger with Life Tech. The base case reflects the input data
described in this case study. To answer each question you must change selected input data in the base case, which
will change significantly the base case projections. After answering a specific question, do not save the model
results. This will cause the model to revert back to the base case. In this way, it will be possible to analyze each
question in terms of how it is different from the base case.
1. Thermo Fisher paid $76 per share for each outstanding share of Life Tech. What is the maximum offer
price Thermo Fisher could have made without ceding all of the synergy value to Life Tech shareholders?
(Hint: Using the Transaction Summary Worksheet, increase the offer price until the NPV in the section
entitled Valuation turns negative.)

Answer: At an offer price of $81 per share, NPV equals a negative ($13.80) million. At this price, not only
would all value created by the merger be transferred to Target shareholders but $13.8 million of Acquirer
shareholder value would be destroyed.

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

Answer: If 100% debt financing had been used, Thermo Fisher would have borrowed $14,104.6 billion. It
could have considerable difficulty in retaining its investment grade credit rating as its debt-to-total capital
ratio would have been significantly above the industry average until the fifth year following closing and its
interest coverage ratio significantly below the industry average until three years after closing.

3. Assuming Thermo Fisher would have been able to purchase the firm in a share for share exchange, what
would have happened to the EPS in the first year? (Hint: In the form of payment section of the Acquirer
Transaction Summary Worksheet, set the percentage of the payment denoted by “% Stock” to 100%. In the
Sources and Uses Section, set excess cash, new common shares issued, and convertible preferred shares to
zero.)

Answer: Despite issuing 176.5 million new shares issued, unadjusted EPS is $.46 per share as compared to
the unadjusted EPS under the base case of $(.13). The improvement results from the elimination of the
substantial additional interest expense associated with the incremental borrowing in the base case used to
finance the deal.

4. Mark Fisher, CEO of Thermo Fisher, asked rhetorically what if synergy were not realized as quickly and in
the amount expected. How patient would shareholders be if the projected impact on earnings per share was
not realized? Assume that the integration effort is far more challenging than anticipated and that only one-
fourth of the expected SG&A savings, margin improvement, and revenue synergy are realized.
Furthermore, assume that actual integration expenses (shown on Newco’s Assumptions Worksheet) due to
the unanticipated need to upgrade and co-locate research and development facilities and to transfer
hundreds of staff are $150 million in 2014, $150 million in 2015, $100 million in 2016, and $50 million in
2017. The model output resulting from these assumption changes is called the Impaired Integration Case.
What is the impact on Thermo Fisher’s earning per share (including Life Tech) and the net present value
of the combined firms? Compare the difference between the model “Base Case” and the model output from
the “Impaired Integration Case” resulting from making the changes indicated in this question. (Hints: In the
Synergy Section of the Acquirer (Thermo Fisher) Worksheet, reduce the synergy inputs for each year
between 2014 and 2016 by seventy-five percent and allow them to remain at those levels through 2018.

New Synergy Inputs

Year SG&A Synergies Gross Margin Incremental Sales
Improvement Revenue
2014 5.0 18.75 6.25
2015 12.5 50.0 25.0
2016 25.0 56.25 75.0
 On the Newco Assumptions Worksheet, change the integration expense figures to reflect the new numbers:
2014 = $150 million, 2015 = $150 million, 2016 = $100 million, and 2017 = $50 million.).

Answer: If synergy is not realized in the amount and at the pace expected, Newco EPS is significantly
below what it would have been had the merger not taken place and the NPV is negative. Consequently,
from a financial perspective, the merger should not have been undertaken.

“Base Case” Versus the “Impaired Integration Case”

Year Newco Base Case Newco Impaired Integration Case
EPS NPV EPS NPV
2014 $(.13) $1,782.7 $(.79) $(2,573.8)
2015 $1.63 $.84
2016 $2.67 $1.85
2017 $3.27 $2.55
2018 $3.92 $3.29

Examination Questions and Answers

True/False Questions: Answer True or False to each of the following questions:

1. The present value of net synergy is the difference between the present value of projected cash flows from
sources and destroyers of value. True or False
Answer: True

2. Net synergy may be estimated as the difference between the sum of the present values of the target and
acquiring firms, including the effects of synergy, and the value of the target firm including the effects of
synergy. True or False
Answer: False

3. The target firm’s underutilized borrowing capacity is often considered a source of value. True or False
Answer: True

4. A target firm’s high employee turnover is often considered a destroyer of value. True or False
Answer: True

5. Non-compliance with environmental laws, product liabilities, pending lawsuits, poor product quality,
patents, poorly written or missing customer contracts, and high employee turnover are all considered
destroyers of value. True or False
Answer: False

6. Cost savings are likely to be greatest when firms with dissimilar operations are consolidated. True or False
Answer: False

7. Minimum purchase price or initial offer price for a target is the target’s standalone value or market value.
True or False
Answer: True

8. The maximum purchase price is the minimum price plus the present value of sources of value. True or
False
Answer: False

9. If the acquisition of the target is believed to be very important to implement the acquirer’s strategy, the
acquirer should be willing to pay up to the maximum purchase price. True or False
Answer: False
10. The acquiring firm’s existing loan covenants need not be considered in determining the feasibility of
acquiring the target firm. True or False
Answer: False

11. The effects of synergy resulting from combining the acquirer and target firms do not affect the acquirer’s
ability to finance the transaction. True or False
Answer: False

12. The current stock price of the acquiring firm may decline in a share for share exchange due to the potential
dilution in earnings per share. True or False
Answer: True

13. The share exchange ratio is defined as offer price divided by the target firm’s current share price. True or
False
Answer: False

14. The share exchange ratio indicates the number of acquirer shares to be exchanged for each share of target
stock based on the target firm’s current share price. True or False
Answer: False

15. Pro forma financial statements are frequently used to show what the acquirer and target’s combined
financial statements would look like if they were merged. True or False
Answer: True

16. Net synergy is the difference between the present value of the estimated sources of value and destroyers of
value. True of False
Answer: True

17. In determining the initial offer price, the acquirer must decide how much of the anticipated synergy to
share with the target firm’s shareholders. True or False
Answer: True

18. Complex models because of their greater sophistication are necessarily more accurate than simple models.
True or False
Answer: False

19. A clear statement of all assumptions underlying the model’s projections forces the analyst to display their
biases and to be prepared to defend their assumptions to others. True or False
Answer: True

20. Financial modeling refers to the application of spreadsheet software to define simple arithmetic
relationships among variables within the firm’s income, balance sheet, and cash-flow statements and to
define the interrelationships among the various financial statements. True or False
Answer: True

21. Financial models can be used to answer the following questions: How much is the target company worth
without the effects of synergy? What is the value of expected synergy? What is the maximum price that the
acquiring company should pay for the target? True or False
Answer: True

22. When one company acquires another, year over year historical earnings comparisons for the acquiring firm
are unaffected. True or False
Answer: False

23. A standalone business is one whose financial statements reflect all the costs of running the business and all
of the revenues generated by the business. True or False
 Answer: True

24. The appropriate discount rate for the combined firms is generally the target’s cost of capital unless the two
firms have similar risk profiles and are based in the same country. True or false
Answer: True

25. It is unimportant whether the acquirer uses the target’s or its own weighted average cost of capital when
valuing the target firm. True or False
Answer: False

26. Financial models are of little value in determining whether the proposed purchase price can be financed by
the acquirer. True or False
Answer: False

27. The appropriate financial structure can be determined from a range of different scenarios created by making
small changes in selected value drivers. True or False
Answer: True

28. Potential sources of value rarely include factors not recorded on a firm’s balance sheet. True or False
Answer: False

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

30. In calculating the value of net synergy, the costs required to realize the anticipated synergy should be
ignored because they are difficult to forecast. True or False
Answer: False

31. In determining the initial offer price, the acquiring company must decide how much of anticipated synergy
it is willing to share with the target firm’s shareholders. True or False
Answer: True

32. Revenue-related synergy may result from the acquirer being able to sell their products to the target firm’s
customers. True or False
Answer: True

33. M&A valuation and deal structuring models commonly require the estimation of the standalone value of
target firm but never the acquirer. True or False
Answer: False.

34. The acquirer’s standalone value represents a reference point against which the value of the combined
businesses (Newco) must be compared to determine if a deal makes sense.
Answer: True

35. The valuation of the combined businesses should reflect only the sum of their standalone values but
not the incremental value of synergy. True or False
Answer: False

36. The offer price for a target firm is considered appropriate if the NPV of the difference between the present
value of target plus anticipated synergy and the offer price including any transaction-related expenses is
less than zero. True or False
Answer: False.
37. Value drivers are variables which exert the greatest impact on firm value, often including the revenue
growth rate, cost of sales as a percent of sales, S,G,&A as a percent of sales, WACC assumed during
annual cash flow growth and terminal periods, and the cash flow growth rate assumed during terminal
period. True or False
Answer: True

38. To evaluate the credibility of a financial model’s results it is important to examine the credibility of the
assumptions used to project the value drivers. True or False
Answer: True

39. Although public firms are required to file their financial statements with the Securities and Exchange
Commission in accordance with GAAP, so-called pro forma financial statements are used as hypothetical
representations of the potential performance of the acquirer and target firms if they were merged. True or
False
Answer: True

40. To determine if certain cash flows result from synergy ask if they can be generated only if the businesses
are combined. If the answer is yes, then the cash flow in question is due to synergy. True or False
Answer: Yes

41. Underutilized borrowing capacity or significant excess cash balances also can make an acquisition target
less attractive. True or False
Answer: False

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

43. The maximum offer price is equal to the sum of the standalone value (or minimum price) plus some
fraction of present value net synergy. True or False
Answer: False

44. The initial offer price for the target firm should lie between the minimum and maximum offer prices. True
or False
Answer: True

45. Ultimately, what fraction of synergy is negotiated successfully by the target depends on its leverage or
influence relative to the acquirer. True or False
Answer: True

46. If the acquirer were to pay the target firm shareholders the maximum estimated offer price it would be
ceding all of the net synergy created by combining the two firms to the target’s shareholders. True or False
Answer: True

47. The number of new acquirer shares that must be issued to complete a deal is unaffected by such
derivative securities as options issued to Target’s employees and warrants, as well as convertible securities.
True or False
Answer: False

48. Fully diluted shares outstanding, that is, the number of Target’s “basic” shares outstanding (i.e., pre-
transaction shares outstanding) plus the number of shares represented by the firm’s “in the money” options,
warrants, and convertible debt and preferred securities should be used in the calculation of the total cost of
a takeover. True or false
Answer: True
49. M&A modeling facilitates deal valuation and structuring but not financing decisions. True or False
Answer: False

50. Assume a firm’s debt to equity ratio is currently below its industry average. Increasing it to the industry
average can represent a source of value. True or False
Answer: True

51. The value of the firm created by combining an acquiring and target firms is impacted only by changes in
the value drivers of the target firm. True or False
Answer: False

Multiple Choice Questions

1. Which of the following is not true about generally accepted accounting principles (GAAP)?

a. GAAP provide specific guidelines as to how to account for specific events impacting the financial
performance of the firm.
b. The scrupulous application GAAP accounting rules does ensure consistency in comparing one
firm’s financial performance to another.
c. It is customary for definitive agreements of purchase and sale to require that a target company
represent that its financial books are kept in accordance with GAAP.
d. GAAP guarantees that a firm’s financial books are accurate.
e. Differences between how a firm records actual financial transactions and how they should be
recorded based on GAAP may indicate fraud or mismanagement.
Answer: D

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

a. Such statements are used to uncover data irregularities.

b. Such statements are constructed by calculating the percentage each line item of the income
statement, balance sheet, and cash flow statement is of annual sales.
c. Such statements are useful for comparing businesses of different sizes in the same industry at
different moments in time.
d. Common size statements applied over a number of consecutive periods may be used to determine
if the target firm is deferring necessary spending.
e. Common size statements may be calculated for both quarterly and annual financial data.
Answer: C

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

a. Deduct the actual cost of services required by Target that are being supplied by the parent without
charge from target’s cost of sales.
b. Deduct the difference between the cost of products purchased from other MegaCorp subsidiaries
at below market prices and the actual market prices for such products from Target’s cost of sales.
c. Deduct the difference between the cost of products purchased from other MegaCorp subsidiaries
at above market prices and the actual cost of such products if purchased from other sources from
Target’s cost of sales
d. A and B only.
e. None of the above.
Answer: C

4. Which of the following is generally not considered a source of value to the acquiring firm?
 a. Duplicate facilities
b. Patents
c. Land on the balance sheet at below market value
d. Warranty claims
e. Copyrights
Answer: D

5. The initial offer price for the target firm is defined as

a. The minimum price

b. The present value of the minimum price plus some fraction of the present value of net synergy
c. The present value of net synergy plus the current market value of the target firm
d. The maximum price less the minimum price
e. The maximum price less the present value of net synergy
Answer: B

6. The share exchange ratio is defined as

a. Offer price for the target divided by the acquirer’s share price
b. Offer price for the target divided by the target’s share price
c. Acquirer’s share price divided by the target’s share price
d. Target’s share price divided by the offer price
e. Acquirer’s share price divided by the offer price
Answer: A

7. Acquiring Corp agrees to buy 100% of the outstanding shares of Target Corp in a share for share exchange.
How would Acquiring Corp determine how many new share of its stock it would have to issue?
a. Multiply the purchase price premium paid for Target’s stock by the number of shares of target
stock outstanding.
b. Multiply the share exchange ratio by the number of Acquirer shares outstanding.
c. Add the number of Acquirer and Target shares outstanding
d. Multiply the share exchange ratio by the number of Target shares outstanding.
e. Divide the share exchange ratio by the purchase price premium
Answer: D

8. What happens to the outstanding shares of the target firm when the acquirer purchases 100% of the target’s
outstanding stock?

a. They are added to the number of shares of Acquirer stock outstanding

b. They are cancelled.
c. They are converted into preferred stock.
d. They are shown as treasury stock on the books of the combined companies.
e. They are swapped for debt in the new company.
Answer: B

9. Which one of the following is not one of the steps in the M&A model building process?

a. Valuing the acquirer and the target firms as standalone businesses

b. Valuing the target and acquiring firms including synergy
c. Determining the initial offer price for the target firm
d. Establishing search criteria for the potential target firm
e. Determining the combined firm’s ability to finance the transaction.
Answer: D

10. Realizing synergy often requires spending money. Which of the following are examples of such
expenditures?
 a. Employee recruitment and training expenses
b. Severance expenses
c. Investment in equipment to improve employee productivity
d. Redesigning workflow
e. All of the above
Answer: E

11. Selecting the appropriate financing structure for the combined firms requires consideration of which of the
following:

a. The impact on the combined firm’s EPS

b. Potential violation of loan covenants
c. The extent to which the primary needs of both the buyer’s and seller’s shareholders are satisfied.
d. A and B only
e. A, B, and C
Answer: E

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

a. Acquiring firm’s outstanding shares

b. Price offered for the target company
c. Number of target firm’s outstanding shares
d. Current price of the acquiring company’s stock
e. Current price of the target firm’s stock
Answer: E

13. The share exchange ratio is impacted by all of the following except for

a. The current share price of the target firm

b. The current share price of the acquirer
c. The offer price for the target firm
d. The number of shares outstanding for the target firm
e. A and D
Answer: E

14. Real Cool Autos acquired Automotive Industries in a transaction that produced an NPV of $3.7 million.
This NPV represents
a. Synergy
b. Book value
c. Investment value
d. Diversification
e. None of the above
Answer: A

15. Which of the following are examples of cost-related synergy?

a. Spreading fixed costs over increased output levels
b. Eliminating duplicate jobs
c. Discounts from suppliers due to bulk purchases
d. Paying termination expenses
e. A, B, and C only
Answer: E

16. A merger which is expected to produce synergy

a. Should be rejected because the synergy will dilute the combined firm’s earnings per share
b. Should be rejected because the first year’s cash flow is negative
 c. Has a negative NPV
d. Should be pursued because it creates value
e. Reduces target firm revenues
Answer: D

17. Which one of the following is the correct calculation of fully diluted shares outstanding for a firm with in-
the-money options, warrants, as well as convertible preferred and convertible debt?
a. Out of the money options and warrants plus in the money convertible preferred and debt
b. Basic shares outstanding + in-the-money options and warrants + in the money convertible
preferred and debt
c. In the money options and warrants + in the money convertible preferred and debt
d. Basic shares outstanding + out of the money options and warrants.
e. Basic shares outstanding + convertible preferred and debt
Answer: B

18. How does a firm’s enterprise value change if the firm issues equity and uses the proceeds to repay debt?
a. No change
b. Decreases
c. Increases
d. Indeterminate
e. None of the above.
Answer: A

19. The value of combined businesses following a takeover should reflect:

a. The sum of their standalone values
b. The sum of their standalone values less anticipated synergy
c. The standalone value of the target plus net synergy less the standalone value of the acquirer
d. The sum of the standalone values of the target and acquirer plus net synergy
e. None of the above
Answer: D

20. A takeover creates value for the acquirer as long as which of the following statements is true:
a. The NPV of the standalone value of the target firm plus synergy less the offer price is greater than
or equal to zero
b. The NPV of the standalone value of the target firm less the offer price is greater than or equal to
zero
c. The NPV of the standalone value of the target firm plus synergy less the sum of the offer price and
transaction-related expenses is greater than or equal to zero
d. The NPV of the offer price less the standalone value of the target firm is less than or equal to zero
e. None of the above
Answer: C

21. Which of the following is most true about synergy in the context of M&A?
a. Synergy refers to the cash flows that can be generated only as a result of two businesses
combining
b. Realizing synergy usually does not require investment
c. Most often anticipated synergy is realized immediately following closing
d. The value of synergy should not be reflected in the purchase price paid for a target firm
e. None of the above
Answer: A

22. Which of the following statements is true in a deal involving the exchange of acquirer shares for target
shares?
a. The acquirer should consider the impact of the deal on fully diluted earnings
b. The acquirer should consider the likely conversion of “in the money” options held by target
employees
 c. Target convertible debt can impact the number of acquirer shares that must be issued to purchase
all of the target shares outstanding
d. Target convertible preferred stock can impact the number of acquirer shares that must be issued to
purchase all of the target shares outstanding
e. All of the above
Answer: E

23. Which of the following statements is true for M&A financial models?
a. They are used to address valuation questions only
b. They are used to address valuation and deal structuring questions only
c. They are used to address deal structuring questions only
d. They are used to address deal structuring, valuation, and financing questions
e. None of the above
Answer: D

24. Which of the following questions can be addressed by financial models?

a. What are the key drivers of firm value?
b. Can the proposed purchase be financed?
c. What is the value of expected synergy?
d. What is the impact of a deal on the acquirer’s fully diluted earnings per share?
e. All of the above
Answer: E

25. The most common sources of value include potential cost savings resulting from all of the following except
for which of the following:
a. Shared overhead
b. Elimination of duplicate facilities
c. Better utilization of existing facilities (i.e., economies of scale)
d. Warranty claims
e. Productivity improvements by applying the best practices of both firms
Answer: D

26. Factors destroying firm value following a merger or acquisition could include all but which of the
following:
a. Poor product quality
b. Excessive wage and benefit levels
c. Low labor productivity
d. High employee turnover
e. Incremental revenue due to product cross-selling
Answer: E

27. An acquirer will be more likely to finance a takeover using borrowed funds if
a. Its debt to equity ratio is increasing in the future
b. Its interest coverage ratio is decreasing in the future
c. Its interest coverage ratio is increasing and debt to equity ratio is decreasing in the future
d Its interest coverage ratio is decreasing and debt to equity ratio is decreasing in the future
e. Its interest coverage ratio is increasing and debt to equity ratio is increasing in the future
Answer: C

28. Which of the following is not true of share exchange ratios?

a. They are used to value target firms
b. They are used to determine the number of new shares that must be issued by the acquirer in a
share for share exchange
c. They provide useful information to determine the post transaction ownership distribution of the
combined firms
d. They are defined as the offer price divided by the acquirer share price
 e. The share exchange ratio can be less than, equal to, or greater than one
Answer: A

29. Assume that Acquirer pays $90 million to purchase $75 million in net acquired assets, consisting of $100
million of Target net property, plant and equipment (i.e., Net PP&E) less assumed Target current liabilities
of $25 million and that the book values of Target assets and liabilities are equal to their fair market value.
The implied purchase price multiple is
a. 1.2 times net acquired assets
b. 1.7 times net acquired assets
c. 3.4 times net acquired assets
d. .2 times net acquired assets
e. None of the above
Answer: A

30. A firm’s enterprise and equity values will increase in response to all of the following variables assuming
other things are equal except for
a. An increase in profitable revenue growth
b. A reduction in cost of sales as a percent of sales
c. An increase in the firm’s weighted average cost of capital
d. A decrease in the firm’s weighted average cost of capital
e. A decrease in SG&A as a percent of sales
Answer: C

Short Essay Examination Questions

M&A FINANCIAL MODEL APPLICATIONS

KEY POINTS: M&A models
 Address valuation, deal structuring, and financing questions;
 May be used by both buyers and sellers to assess alternative deal structures; and
 Help define risks associated with specific options in “real time.”
___________________________________________________________________________
In a deal fraught with tax and competitive risks, Shire PLC announced on January 11, 2016 that it had inked a deal
valued at about $32 billion to acquire Baxalta Inc., ending its six month pursuit of the firm. The pair had reached an
agreement earlier but had difficulty overcoming fears that the combination would run afoul of U.S. laws precluding
firms created as a result of a tax-free spinoff from acquiring another firm in the two year period following the
spinoff. As such, the deal could have created a substantial tax liability for Shire’s former parent, Baxter
International which had spun off Shire in July 2015. An additional risk in buying Baxalta was the intensifying
competition to its primary cash generating hemophilia drug from a promising series of similar treatments being
developed by rivals.

Shire PLC is an Irish-headquartered specialty pharmaceutical firm with global operations in more than 100
countries. Originating in the United Kingdom, the firm has substantial operations in the United States. Following the
withdrawal of American based pharmaceutical firm AbbVie’s bid to acquire Shire due to concerns about new tax
inversion rules, Shire’s stock plummeted almost 30%. To support its share price, Shire announced its intention to
acquire a string of smaller firms with proven treatments for rare diseases.

What would be the likely impact of such a strategy? Sophisticated firms typically utilize long range planning as
described in Chapters 4 and 5 to evaluate their ability to perform in what they perceive as their future competitive
environment. Financial models are commonly used to project a “baseline” forecast or reference point of cash flow
over a number of years to determine if the firm’s current strategy results in achieving its vision and long-term goals.
The baseline projection can subsequently be adjusted for the impact of future investments (including M&As) on the
firm’s market value. If it is determined that such investments would enhance current firm value, the baseline strategy
may be altered to include the impact of investments such as M&As on the firm’s consolidated balance sheet, income
statement, and cash flow statements. In this manner, the firm can assess its ability to finance future investments and
takeovers by determining their impact on current loan covenants, consolidated EPS, and their ability to earn the
firm's cost of capital.
 In addition to their role in the firm’s business planning process, financial models play a critical role in the
decision-making process underlying M&As. Shire initiated its largest takeover attempt in August 2015 when it made
an unsolicited offer to Acquire Baxalta for about $30 billion in an all-stock bid. Although the proposal included a
nearly 30% premium, Baxalta’s board rejected the offer claiming that it undervalued the firm and insisted that any
bid should contain a substantial amount of cash.

Shire countered that since 80.5% of its shares1 had been spun off from Baxter International in July 2015 that any
cash used in the Baxalta takeover bid could jeopardize the nontaxable status under U.S. law of the of the spin-off to
its shareholders.2 Despite its reservations, Shire revised the cash and stock bid to include $18 billion in cash
plus .1482 shares of its American Depository Shares3 for each outstanding common share of Baxalta in January
2016. At closing, Shire shareholders will own 66% of the combined firms and Baxalta shareholders the remainder,
which appeared to preserve the tax status of the spinoff.4

M&A negotiations are by their nature dynamic in that the circumstances surrounding a takeover attempt can
change quickly requiring decision makers to evaluate their options in “real time” to bring the negotiations to a
satisfactory conclusion. Financial models often serve as an important tool in such situations as their proforma (or
adjusted) financial statements illustrate what the combined firms would look like under alternative scenarios. For
example, Shire announced that the combined firms could deliver $20 billion in revenue by 2020 and that the deal
would be accretive to earnings by the second year following closing based on the firm’s estimates of the amount and
timing of anticipated synergies.

Shire would be able to determine the implications of an all stock versus a cash and stock deal on the combined
firms’ earnings per share and credit rating due to the resulting increased leverage, as well as postclosing ownership
distribution. Such models provide estimates of synergy from potential cost savings or revenue enhancements needed
to determine if the proposed purchase premium could be earned back within a reasonable time period enabling the
firm to earn its cost of capital. Moreover, models could be used to display on a proforma (or adjusted) basis the
impact of tax savings resulting from Baxalta paying an effective U.S. tax rate of 23% versus 17% if incorporated in
Ireland. Models also are helpful in determining the impact of concessions demanded by the regulators to approve the
deal on the attractiveness of the deal.

Baxalta could have used models to evaluate the attractiveness of the various offers made by Shire and to provide
their own their own estimate of potential synergy, allowing it to argue that Baxalta shareholders should be
compensated at least for the amount of additional value they are contributing to the merged companies.

Models also assist in evaluating the impact of target defenses such as a poison pill on the cost of the deal to the
acquirer. Baxalta’s poison pill defense would have been triggered when a suitor unwanted by the board acquired
more than a 9.9% stake in the business. Removing this pill would have been particularly difficult because of
Baxalta’s staggered board in which its directors serve three-year, overlapping terms, meant that it would take Shire
two years to gain control.

1
Baxter International retained a 19.5% interest in Shire following the spinoff.
2
For spinoffs to be non-taxable to a firm’s shareholders, it must satisfy certain IRS rules. One requirement is the
parent’s shareholders must retain a continuing interest in both the parent and subsidiary (subject to a spinoff) for a
period of 4 years beginning 2 years prior to the spinoff and extending 2 years after the spinoff. The continuity of
interest principle stipulates that an acquisition can be tax free to target shareholders if the acquirer’s shareholders
hold an ongoing equity stake in the target firm. This requirement may be satisfied if the parent’s shareholders
collectively maintain a 50% equity ownership interest in both the parent firm and the spun off firm. If this condition
is not satisfied, the parent can be subject to a tax penalty. This is called the “anti-Morris Trust rule.”
3
An American Depository Share is a stock trading on a U.S. exchange that represents a specific number of shares in
a foreign firm.
4
Shire’s revised bid is predicated on their belief that the deal will not trigger a tax liability for Baxter International
as long as it can show that there the deal negotiated with Baxalta was not negotiated as part of a plan developed
prior to the spin-off by Baxter. As part of the spinoff agreement with Baxter, Shire would be required to reimburse
Baxter for tax liability it might incur as a consequence of the spinoff.
 Thus, from start to finish, financial models can play a key role in the M&A process. First by providing a baseline
financial projection reflecting the firm’s current strategy and later the ability to see how certain acquisitions and
investments could impact the baseline projection. In addition, once a target has been identified, financial models
assist in the valuing the target and assessing the attractiveness of alternative offers and counter-offers and the ability
of the acquirer to finance the deal.

Comcast Bids for Time Warner Cable—Evaluating Proposals and Counter Proposals

A sometimes bitter eight month long struggle between Charter Communications Inc. (Charter) and Time Warner
Cable Inc. (TWC) came to an end with the joint announcement by Comcast Corporation (Comcast) on February 14,
2014 that it had signed a merger agreement with TWC. The deal involved the merger of the largest and second
largest cable companies in terms of subscribers in the U.S. and faced major regulatory hurdles if it were to reach
completion. What follows is a discussion based on SEC filings of the dynamic ebb and flow of the negotiating
process involving at various times three different parties: TWC, Charter, and Comcast. Given the sophistication of
the participants, it is highly likely that financial models played a critical role in the underlying decision-making
process.

At the time of this writing, the combination of Comcast and Time Warner had not yet received regulatory
approval. The reasons for regulatory concerns are explained later in this case. However, regardless of the final
decision made by the regulators, the negotiation between these firms illustrates how financial models can be used in
M&A deal making.

The drama started on May 22, 2013 when Charter, the nation’s fourth largest cable operator backed by its largest
investor Liberty Media Corporation (Liberty) led by cable industry pioneer John Malone, approached TWC about
the possibility of a takeover. Charter’s pursuit of TWC began shortly after Liberty bought a 27% stake in Charter in
late 2012. Charter had made three offers consisting of cash and stock, the most recent of which was valued at
$132.50. All three were rejected by TWC as too low. TWC CEO Rob Marcus clearly set expectations by saying
publicly he wanted $160 per share.

While Liberty and Charter’s approaches to TWC had been public for months, Comcast’s interest did not become
public until November 2013. Comcast had entered the fray in mid-2013 when the firm’s CEO Brian Roberts queried
informally TWC’s then CEO Glenn Britt about the possibility of a merger. These discussions stalled over the size of
the purchase price and its composition.

Comcast had also been talking with Charter about possibly participating in Charter’s bid for TWC during late
2013, but those talks broke down on February 4, 2014 according to SEC filings. Within a few days Comcast’s board
authorized CEO Brian Roberts to offer $150 per share for all outstanding TWC shares to be paid in Comcast shares
on the condition there would be no breakup fee if regulatory approval could not be achieved. The pace of
discussions intensified with TWC responding on February 6, 2014 saying it would agree to a deal without a breakup
fee as long as Comcast offered a price of $160 per share. The final all-stock deal was signed a week later based on
Comcast’s closing share price on February 12, 2014 of $158.82.

The catalyst fueling the acceleration in discussions may have been the news on February 2, 2013 that Charter had
nominated in advance of the TWC spring 2014 annual meeting a group of thirteen candidates to replace the entire
TWC board. TWC had long seen Comcast as the preferred buyer as a deal with Charter would have burdened the
combined firms with substantial amounts of additional debt. Settling with Comcast also meant avoiding an
expensive and perhaps protracted proxy battle with Charter over TWC’s board representation.

The final agreement reflected the intensity of the last minute discussions with neither side getting all it wanted.
Comcast paid far more than what it had hoped but did avoid a breakup fee and having to use cash as a portion of the
purchase price. The final purchase price was very close to what TWC’s CEO Rob Marcus had stated publicly as the
firm’s asking price. However, TWC did not get the cash and stock deal it had sought earlier and incurred the risk
that the firm would not be compensated for the substantial expenses incurred during the negotiations with the
various parties if regulatory approval could not be achieved.
 Valued at $45.2 billion, the deal represented an 18% premium to TWC’s closing price the day before the deal
was announced and would result in TWC shareholders owning 23% of the combined firms. As part of the
announcement, Comcast said it would expand its share repurchase program to $10 billion to begin at the end of 2014
to offset some of the potential dilutive effects of issuing new Comcast shares in exchange for TWC shares.

Strategically, the deal made sense for Comcast. Combining TWC and Comcast is expected to generate $1.5
billion in ongoing annual cost savings, with one-half occurring in the first year. The deal is expected to be accretive
(increasing EPS) for Comcast shareholders and reflected an attractive premium for TWC shareholders. However,
TWC’s stock jumped 7.4% on the announcement to $145.36, while Comcast fell 3% to $53.59. Why did TWC’s
share price rise by less than one-half of the implied premium and Comcast’s share price plummet? Because
investors were skeptical the deal would be approved by the U.S. Justice Department and the Federal
Communications Commission.

Even though the two firms do not compete directly in most markets, there are concerns that an even bigger
Comcast could wield too much power in negotiating with content owners. In addition, critics opined that Comcast
could exert too much influence over the broadband infrastructure by unfairly blocking or slowing the traffic of
online video competitors to the benefit of their own services (thereby violating the so-called net neutrality
principle).5

Comcast stated publicly that they would sell three million of TWC’s eleven million subscribers to other cable
companies such as Cox and Charter and would agree to other reasonable conditions to lessen these concerns. By
selling these TWC subscribers, Comcast would keep its market share nationwide below 30%, a figure that had
proven acceptable to regulators in two previous acquisitions of cable firms by Comcast in 2002 and 2006.

After eight months of exchanging proposals and counter-proposals with various parties, the final deal came
together in less than two weeks. The dynamic nature of the negotiations required the decision makers to evaluate
their options quickly to bring the negotiations to a satisfactory conclusion. Financial models often serve as an
important tool in such situations.
Using proforma financial statements to illustrate what the combined firms would look like, Comcast was able to
determine the implications of an all stock versus a cash and stock deal on the combined firms’ earnings per share
and credit rating. Such models provided estimates of potential synergy needed to determine if the proposed purchase
premium could be earned back within a reasonable time period enabling the firm to earn its cost of capital. TWC
could have used models to evaluate the attractiveness of various offers made by Comcast and Charter and to provide
their own estimate of potential synergy, allowing it to argue that TWC shareholders should be compensated at least
for the amount of additional value they are contributing to the merged companies. Models also are helpful in
determining the impact of concessions demanded by the regulators on the attractiveness of the deal. Thus, from start
to finish, financial models can play a key role in the M&A process.

Mars Buys Wrigley in One Sweet Deal

Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley
Corporation, a U.S.-based leader in gum and confectionery products, faced increasing competition from Cadbury
Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars
Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to
achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation.

On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23
billion in cash. Under the terms of the agreement, which were unanimously approved by the boards of the two firms,
shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding, a 28 percent
premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would
have a 14.4 percent share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees
worldwide. The merger of the two family-controlled firms represents a strategic blow to competitor Cadbury
5
Net neutrality refers to internet service providers and governments treating all data on the internet equally and
not discriminating or charging different users and content providers different rates.
Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate
business. Prior to the announcement, Cadbury had a 10 percent worldwide market share.

As of the September 28, 2008 closing date, Wrigley became a separate stand-alone subsidiary of Mars, with $5.4
billion in sales. The deal is expected to help Wrigley augment its sales, marketing, and distribution capabilities. To
provide more focus to Mars's brands in an effort to stimulate growth, Mars would in time transfer its global
nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley Jr., who controls 37 percent of the firm's
outstanding shares, remained the executive chairman of Wrigley. The Wrigley management team also remained in
place after closing.

The combined companies would have substantial brand recognition and product diversity in six growth
categories: chocolate, nonchocolate confectionary, gum, food, drinks, and pet care products. While there is little
product overlap between the two firms, there is considerable geographic overlap. Mars is located in 100 countries,
while Wrigley relies heavily on independent distributors in its growing international distribution network.
Furthermore, the two firms have extensive sales forces, often covering the same set of customers.

While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of
transactions of this type. Almost 90 percent of the purchase price would be financed through borrowed funds, with
the remainder financed largely by a third-party equity investor. Mars's upfront costs would consist of paying for
closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would
consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An
additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire
Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided
by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors,
such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit
markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to
strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing
$2.1 billion in equity financing for a 9.1 percent ownership stake in Wrigley.

Discussion Questions:

1. Why was market share in the confectionery business an important factor in Mars’ decision to acquire
Wrigley?

Answer: Firm’s having substantial market relative to their next largest competitor are likely to have lower
cost structures due to economies of scale and purchasing, as well as lower sales, general and administrative
costs. Such costs can be spread over a larger volume of revenue. Also, the confectionery market is expected
to be among the most rapidly growing market and can be expected to accelerate earnings growth and that
firm’s share price. The increased brand recognition also allowed the firm’s to gain additional retail
merchant shelf space and to introduce each firm’s traditional customers to the other’s products.

2. It what way did the acquisition of Wrigley’s represent a strategic blow to Cadbury?

Answer: Not only did this acquisition topple Cadbury from its number one position in the confectionery
business but it also eliminated a potential acquisition target for Cadbury. By acquiring Wrigley, Cadbury
could have solidified their top spot.

3. How might the additional product and geographic diversity achieved by combining Mars and Wrigley
benefit the combined firms?

Answer: The broader array of products from chocolate to gum to pet care could insulate the firm to
fluctuations in the business cycle. Traditionally, the impact of a downturn in the economy is comparatively
mild on these types of firms. The greater product and geographic diversity would tend to reduce the effect
even further.
 4. Speculate as to the potential sources of synergy associated with the deal. Based on this speculation what
additional information would you want to know in order to determine the potential value of this synergy?

Answer: The product offerings of the two firms show little duplication. Therefore, there is significant
potential for cross-selling each firm’s products into the other’s customers. This would require training the
sales forces in each firm’s product offering. The cost of this training would need to be estimated and
deducted from cash flows generated by cross-selling.

The two firms operate and distribute products in many of the same countries. This offers the opportunity to
eliminate overlapping administrative, sales, and marketing activities. The combined firms would find it
advisable to merge their sales forces in order to represent a “single face to the customer.” A single
representative could market both firms’ products to the same customers.

To value the impact of cross-selling, it would be necessary to understand any contracts each firm had with
customers, the terms of such contracts, and when each contract is set to expire. It would also be helpful to
determine the extent to which “product bundling” would be attractive to customers. With respect to cost
savings associated with facilities, it would be critical to know the terms and expiration dates of leases
associated with any facilities that might be shutdown and estimates of the cost to “buy out” leases whose
expiration date is far into the future. Labor related cost savings require understanding the monthly income
and benefits by major job category and the number of months of severance pay to be offered to those
employees laid off.

5. Given the terms of the agreement, Wrigley shareholders would own what percent of the combined
companies? Explain your answer

Answer: Wrigley shareholders would not own any portion of the combined firms, as the purchase was an
all-cash transaction. Wrigley shares were cancelled and each shareholder paid $80 in cash. As such, the
former Wrigley shareholders surrendered any claims to ownership in the new company.

Tribune Company Acquires the Times Mirror Corporation

in a Tale of Corporate Intrigue

Background: Oh, What Tangled Webs We Weave. .

.
CEO Mark Willes had reason to be optimistic about the future. Operating profits had grown at a double-digit rate,
and earnings per share had grown at a 55% annual rate between 1995 to 1999. Many shareholders appeared to be
satisfied. However, some were not. Although pleased with the improvement in profitability, they were concerned
about the long-term growth prospects of the firm. Reflecting this disenchantment, Times Mirror’s largest
shareholder, the Chandler family, was contemplating the sale of the company and along with it the crown jewel Los
Angeles Times. It had been assumed for years that the Chandler family trusts made a sale of Times Mirror out of the
question. The Chandler’s super voting stock (i.e., stock with multiple voting rights) allowed them to exert a
disproportionate influence on corporate decisions. The Chandler Trusts controlled more than two-thirds of voting
shares, although the family owned only about 28% of the total shares of the outstanding stock.

In May 1999 the Tribune Chairman John Madigan contacted Willes and made an offer for the company, but Willes,
with the help of his then-chief financial officer (CFO), Thomas Unterman, made it clear to Madigan that the
company was not for sale. What Willes did not realize was that Unterman soon would be serving in a dual role as
CFO and financial adviser to the Chandlers and that he would eventually step down from his position at Times
Mirror to work directly for the family. In his dual role, he worked without Willes’ knowledge to structure the deal
with the Tribune.

Following months of secret negotiations, the Chicago-based Tribune Company and the Times Mirror Corporation
announced a merger of the two companies in a cash and stock deal valued at approximately $7.2 billion, including
$5.7 billion in equity and $1.5 billion in assumed debt. The transaction, announced March 13, 2000, created a media
giant that has national reach and a major presence in 18 of the nation’s top 30 U.S. markets, including New York,
Los Angeles, and Chicago. The combined company has 22 television stations, four radio stations, and 11 daily
newspapers—including the Los Angeles Times, the nation’s largest metropolitan daily newspaper and flagship of the
Times Mirror chain.

Transaction Terms: Tribune Shareholders Get Choice of Cash or Stock

The Tribune agreed to buy 48% of the outstanding Times Mirror stock, about 28 million shares, through a tender
offer. After completion of the tender offer, each remaining Times Mirror share would be exchanged for 2.5 shares of
Tribune stock. Under the terms of the transaction, Times Mirror shareholders could elect to receive $95 in cash or
2.5 shares of Tribune common stock in exchange for each share of Times Mirror stock. Holders of 27.2 million
shares of Times Mirror stock elected to receive Tribune stock, whereas holders of 10.6 million elected to receive
cash. Because the amount of cash offered in the merger was limited and the cash election was oversubscribed, Times
Mirror shareholders electing to receive cash actually received a combination of cash and stock on a pro rata basis
(Table 1).

Table 1. Times Mirror Transaction Terms

As of June 12, 2000 Transaction Value
Times Mirror Shares Outstanding @ 3/13/00 59,700,000
No. of Times Mirror Shares Exchanged for 2.3
Shares of Tribune Stock 27,238,253 $2,587,634,0351
No. of Times Mirror Shares Exchanged for Cash 10,648,318 $1,011,536,9682
Times Mirror Shares Outstanding after Tender Offer 21,813,429
No. of New Tribune Shares Issued for Remaining
Times Mirror Shares 54,533,5735 $2,072,275,7743
Equity Value of Offer $5,671,446,777
Market Value of Times Mirror on
Merger Announcement Date $2,805,900,0004
Premium 102%
1
27,238,253  2.5  $38/share of Tribune stock.
2
$41.70 in cash + 1.4025 shares of Tribune stock  $38 per share for each Times Mirror share remaining 
10,648,318.
3
Equals 2.5 shares  21,813,429  $38 per Tribune share.
4
Times Mirror share price on announcement date of $47 times 59,700,000.
5
The total number of new Tribute shares issued equals 27,238,318  2.5 + 10,648,318  2.5 + 54,533, 573 or
137,537,013.

Newspaper Advertising Revenues Continue to Shrink

Most U.S. newspapers are mired in the mature or declining phase of their product life cycle. For the past half-
century, newspapers have watched their portion of the advertising market shrink because of increased competition
from radio and television. By the early 1990s, all major media began taking a significant hit in their advertising
revenue streams as businesses discovered that direct mail could target their message more precisely. Moreover,
consolidation among major retailers further reduced the size of advertising dollar pool. The same has happened with
numerous large supermarket chain mergers. Newspaper advertising revenues also have been threatened by
increasing competition from advertising and editorial content delivered on the internet. Finally, newspapers simply
have become less attractive places to advertise as readership continues to decline as a result of an aging population
and new generations that do not see newspapers as relevant.

Times Mirror: A Largely Traditional Business Model

As essentially a traditional newspaper, Times Mirror publishes five metropolitan and two suburban daily
newspapers, a variety of magazines, and professional information such as flight maps for commercial airline pilots.
 The Los Angeles Times, a southern California institution founded in 1881, is Times Mirror’s largest holding and
operates some two dozen expensive foreign news bureaus—more than any other newspaper in the country. The Los
Angeles Times has more than 1200 Los Angeles Times reporters and editors around the world (CNNfn, March 13,
2000).

Tribune Company Profile: The Face of New Media?

Unlike the Times Mirror, Tribune has built its strategy around four business groups: broadcasting, publishing,
education, and interactive. The Tribune is also an equity investor in America Online and other leading internet
companies, underscoring the company’s commitment to new-media technologies. Applying leading edge new-media
technology has allowed the Tribune to transform they way it does business, and the technology commitment creates
the opportunity for future growth. The internet has been the greatest driver for change, and the Tribune’s interactive
business group continues to focus on capitalizing on emerging Web technologies. Throughout the company, new
technologies have been applied aggressively to create new products, improve existing products, and make operations
more efficient. The Tribune’s non-newspaper revenues accounted for more than half of its earnings by 2000.

Anticipated Synergy

Cost Savings: Opportunities Abound

Cost savings are expected because of the closing of selected foreign and domestic news bureaus, a reduction in the
cost of newsprint through greater volume purchases, the closing of the Times Mirror corporate headquarters, and
elimination of corporate staff. Such savings are expected to reach $200 million per year (Table 2).

Table 2. Annual Merger-Related Cost Savings

Source of Value Annual Savings
Bureau Closings1 $73,000,000
Newsprint Savings2 $93,000,000
Other Office Closings (e.g., Corporate Office in Los Angeles)3 $34,000,000
Total Annual Savings $200,000,000

1
Assumes Tribune will close overlapping bureaus in United States (9) and most of the Times Mirror’s foreign
bureaus (21 abroad).
2
As a result of bulk purchasing and more favorable terms with different suppliers, 15% of the newsprint expense of
the combined companies is expected to be saved.
3
Layoffs of 120 L.A. Times Mirror Corporate Office personnel at an average salary of $125,000 and benefits equal
to 30% of base salaries. Total payroll expenses equal $19,500,000 (i.e., $125,000  1.3  120). Lease, travel and
entertainment, and other support expenses added another $14.5 million.
Source: Moore, Kathryn, Tim Schnabel, and Mark Yemma, “A Media Marriage,” paper prepared for Chapman
University, EMBA 696, May 18, 2000, p. 9.

Revenue: Great Potential . . . But Is It Achievable?

The combined companies will have a major presence in 18 of the nation’s top 30 U.S. advertising markets, including
New York, Los Angeles, and Chicago. The combined companies provide unprecedented opportunities for
advertisers to reach major market consumers in any media form—broadcast, newspapers, or interactive. In addition,
the combined companies will benefit consumers by giving them rich and diverse choices for obtaining the news,
information, and entertainment they want anytime, anywhere. These factors provide an increased ability to capture
national advertising in the most important U.S. population centers. The significantly greater breadth of the combined
firm’s geographic coverage is expected to boost advertising revenues from about 3% to 6% annually.

Integration Challenges: Cultural Warfare?

Based on the current, traditional culture found at the Los Angeles Times and other Times Mirror properties,
integration following the merger was likely to be slow and painful. Concerns among journalists about spreading
their talents thin across three or four media—print, television, online, and radio—in the course of a day’s work
raised the stress level. Although the Tribune has been able to make the transition to a largely multimedia company
more rapidly than the more traditional newspapers, it has been costly. For example, development losses in 1999
were $30–35 million at Chicagotribune.com and an estimated $45 million in 2000. The bleeding was expected to
continue for some time and to constitute a major distraction for the management of the new company.

Financial Analysis

The present values of the Tribune, Times Mirror, and the combined firms are $8.5 billion, $2.4 billion, and $16.5
billion, respectively; the estimated present value of synergy is $5.6 billion (Table 3). This assumes that pretax cost
savings are phased in as follows: $25 million in 2000, $100 million in 2001, and $200 million thereafter. The cost
savings are net of all expenses related to realizing such savings such as severance, lease buyouts, and legal fees.
Table 4 describes how the initial offer price could have been determined and the postmerger distribution of
ownership between Times Mirror and Tribune shareholders.
 Table 3. Merger Evaluation
1997 1998 1999 2000 2001 2002 2003 2004 2005
Tribune ($ Millions)
Sales 2891.5 2980.9 3221.9 3261.5 3473.5 3699.3 3939.7 4195.8 4468.5
Operating 2232.5 2279.0 2451.0 2283.1 2431.4 2589.5 2757.8 2937.1 3128.0
Expenses
EBIT 559.0 701.9 770.9 978.5 1042.0 1109.8 1181.9 1258.7 1340.6
EBIT(1 – t) 395.4 421.1 462.5 587.1 625.2 665.9 709.2 755.2 804.3
Depreciation 172.5 195.5 221.1 212.0 225.8 240.5 256.1 272.7 290.5
Gross Plant & 103.8 139.7 134.7 163.1 173.7 185.0 197.0 209.8 223.4
Equipment
Change in 147.7 49.0 1107.0 260.9 243.1 258.9 275.8 293.7 312.8
Working Capital
Free Cash Flow 511.8 427.9 -558.1 375.1 434.2 462.4 492.5 524.5 558.6
to Firm
PV (2001–2005) 51.5
@8.5
PV (Terminal 11144.2
Value) @8.5
Total Present 11195.7
Value
Less: Long- 2694.2
Term Debt
Plus: Excess 0
Cash Balances
Equity Value 8501.5
Shares
Outstanding 237.4
Equity Value Per
Share 35.81

Times Mirror ($Millions)

Sales 2728.2 2783.9 3029.2 3140.0 3297.0 3461.9 3634.9 3816.7 4007.5
Operating 2337.0 2380.5 2558.7 2449.2 2571.7 2700.2 2835.3 2977.0 3125.9
Expenses
EBIT 391.2 403.4 470.5 690.8 725.3 761.6 799.7 839.7 881.7
EBIT(1 – t) 234.7 242.0 282.3 414.5 435.2 457.0 479.8 503.8 529.0
Depreciation 133.4 152.1 166.4 188.4 197.8 207.7 218.1 229.0 240.5
Gross Plant & 173.4 131.5 113.0 125.6 131.9 138.5 145.4 152.7 160.3
Equipment
Change in 199.2 551.1 -791.1 251.2 257.2 270.0 283.5 297.7 312.6
Working Capital
Free Cash Flow -4.5 -288.5 1126.8 226.1 244.0 256.2 269.0 282.4 296.6
to Firm
PV (2001–2005) 25.8
@ 9.5%
PV (Terminal 3937.2
Value) @ 9.5%
Total Present 3963.0
Value
Less: Long- 1562.2
Term Debt1
Plus: Excess 0
Cash Balances
Equity Value 2375.0
Shares 59.7
Outstanding
Equity Value Per 39.8
Share

Combined ($Millions)
Firms
Sales 5619.7 5764.8 6251.1 6401.5 6770.5 7161.1 7574.7 8012.5 8476.1
Operating 4569.5 4659.5 5009.7 4732.3 5003.1 5289.7 5593.1 5914.1 6253.8
Expenses
Synergy 25.0 100.0 200.0 200.0 200.0 200.0
EBIT 1050.2 1105.3 1241.4 1694.3 1867.4 2071.4 2181.6 2298.4 2422.2
EBIT(1 – t) 630.1 663.2 744.8 1016.6 1120.4 1242.8 1309.0 1379.0 1453.3
Depreciation 305.9 347.6 387.5 400.4 423.6 448.2 474.2 501.7 530.9
Gross Plant & 277.2 271.2 247.7 288.7 305.6 323.4 342.4 362.5 383.7
Equipment
Change in 151.5 600.1 315.9 512.1 500.3 529.0 559.3 591.4 625.4
Working Capital
Free Cash Flow 507.3 139.5 568.7 616.2 738.2 838.6 881.5 926.9 975.1
to Firm
PV (2001–2005) 88.1
@ 9.5%
PV (Terminal 22805.6
Value) @ 9.5%
Total PV 22893.8
Less: Long- 4256.4
Term Debt
Less: 2193.7
Acquisition-
Related Debt
Plus: Excess 0
Cash Balances
Equity Value 16443.7

Shares 374.9
Outstanding
Equity Value Per
Share 43.9
1
Book values for long-term debt may be used if the coupon rate on the debt approximates competitive market rates.
 Table 4. Offer Price Determination
Tribune Times Mirror Combined Incl. Value of Synergy
Synergy
Equity Valuations 8501.5 2375.0 16443.7 5567.3
Minimum Offer 2805.9
Price1
Maximum Offer 8373.2
Price
Actual Offer Price 5671.4
% Maximum Offer 67.7%
Price
Purchase Price 1.02
Premium
New Tribune Shares
Issued 137.50
Ownership
Distribution
TM Shareholders 0.37
Tribune 0.63
Shareholders
1
Market value of Times Mirror on the merger announcement date.

Epilogue

Only time will tell if actual returns to shareholders in the combined Tribune and Times Mirror company exceed the
expected financial returns provided in the valuation models in this case study. Times Mirror shareholders earned a
substantial 102% purchase price premium over the value of their shares on the day the merger was announced. Some
portion of those undoubtedly “cashed out” of their investment following receipt of the new Tribune shares.
However, for those former Times Mirror shareholders continuing to hold their Tribune stock and for Tribune
shareholders of record on the day the transaction closed, it is unclear if the transaction made good economic sense.

Discussion Questions:

1. In your judgment, did it make good strategic sense to combine the Tribune and Times Mirror
corporations? Why? / Why not?

Yes, the combination of the two firms offers substantial cost savings in closing overlapping news bureaus
and substantial economies in purchasing major cost items such as newsprint. The merger also gives both
firms larger coverage in the nation’s major metropolitan areas in which they can offer consumers both
online and print access to the content. By expanding their reach in this manner, both firms will be
significantly more attractive to advertisers. Moreover, this geographic diversification will help consolidated
earnings as slower economic activity in one area is offset by relatively stronger growth in another.

2. Using the Merger Evaluation table given in the case, determine the estimated equity values of Tribune,
Times Mirror and the combined firms. Why is long-term debt deducted from the total present value
estimates in order to obtain equity value?

The estimated equity values for the Tribune, Times Mirror, and combined firms are $8.5 billion, $2.4
billion, and $16.4 billion, respectively. The total value of the firm is estimated using free cash flow to the
firm, which includes cash flow available to both equity and bondholders. Consequently, deducting the
market value of debt from the firm’s total market value will give an estimate of the firm’s equity value.
3. Despite the merger having closed in mid-2000, the full effects of synergy are not expected until 2002.
Why? What factors could account for the delay?

The full effects of synergy are not realized immediately because of bureau leases that must expire or be
bought out, severance expenses that offset savings that result from layoffs, management inertia, employee
resistance, morale concerns, and the tendency to underestimate the time that is required to implement
savings programs. In addition, savings programs often require retraining and relocating workers, which
also offset some portion of the savings in the early years.

4. The estimated equity value for the Times Mirror Corporation on the day the merger was announced was
about $2.8 billion. Moreover, as shown in the offer price evaluation table, the equity value estimated using
discounted cash flow analysis is given has $2.4 billion. Why is the minimum offer price shown as $2.8
billion rather than the lower $2.4 billion figure? How is the maximum offer price determined in the Offer
Price Evaluation Table? How much of the estimated synergy value generated by combining the two
businesses is being transferred to the Times Mirror shareholders? Why?

The minimum offer price is the market value of the firm, because it is unlikely that Times Mirror
shareholders would sell their shares at below current market value. The maximum price is the minimum
price plus the present value of synergy. Two thirds of the estimated synergy is being transferred to the
Times Mirror shareholders as part of the offer price because of the relative bargaining power of the seller
versus the buyer.

5. Does the Times Mirror-Tribune Corporation merger create value? If so, how much? What percentage of
this value goes to Times Mirror shareholders and what percentage to Tribune shareholders? Why?

The merger creates $4.6 billion in value between the pre-merger and post-merger valuations, of which 37%
goes to Times Mirror shareholders reflecting their equity ownership in the new firm. The remainder goes
to Tribune shareholders.

Ford Acquires Volvo’s Passenger Car Operations

This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward
consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only
— they include revenue and costs for all of the firm’s product lines. For purposes of exposition, we shall assume
that Ford’s acquisition strategy with respect to Volvo was to acquire all of Volvo’s operations and later to divest all
but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by
valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the
standalone values for the Ford and Volvo passenger car operations from their combined value including the effects
of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations.

Background

By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the
auto manufacturers worldwide were losing money. Consumers continued to demand more technological
innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and
more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to
$3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain
market share in this highly competitive environment.

By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury
Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of
improving its product weaknesses, expanding distribution channels, entering new markets, reducing development
and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford’s Premier
Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted
operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have
been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next
decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its
size.

Historical and Projected Data

The initial review of Volvo’s historical data suggests that cash flow is highly volatile. However, by removing
nonrecurring events, it is apparent that Volvo’s cash flow is steadily trending downward from its high in 1997. Table
9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo,
including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004.
Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a
percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To
regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The
primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast
period. Ford’s acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a
result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches
because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully
realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market
penetration.
<A>Table 9-10. Volvo Common-Size Normalized Income Statement, Balance Sheet, and Cash-Flow Statement (Percentage of Net Sales)<A>
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Income Statement
Net Sales 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
Cost of Goods Sold .772 .738 .749 .777 .757 .757 .757 .757 .757 .757 .757 .757
Operation Expense .167 .101 .120 .077 .119 .133 .132 .131 .129 .128 .127 .126
Depreciation .034 .033 .033 .034 .029 .038 .038 .039 .040 .040 .041 .042
EBIT .027 .128 .098 .112 .088 .073 .073 .074 .074 .074 .075 .075
Interest on Debt .050 .023 .022 .021 .015 .023 .023 .022 .021 .021 .020 .020
Earnings Before Taxes .024 .017 .076 .091 .072 .049 .051 .052 .053 .054 .055 .056
Income Taxes .004 .018 .022 .012 .015 .014 .014 .015 .015 .015 .015 .016
Net Income .028 .087 .054 .079 .057 .035 .036 .037 .038 .039 .040 .040
Balance Sheet
Current Assets .632 .503 .444 .524 .497 .500 .500 .500 .500 .500 .500 .500
Current Liabilities .596 .400 .283 .298 .304 .350 .350 .350 .350 .350 .350 .350
Working Capital .036 .103 .161 .226 .192 .150 .150 .150 .150 .150 .150 .150
Total Assets 1.21 .889 .809 .905 .889 .906 .880 .858 .839 .822 .808 .795
Long-Term Debt .371 .211 .227 .236 .256 .234 .215 .196 .180 .165 .151 .307
Equity .244 .278 .299 .371 .329 .321 .316 .312 .309 .308 .307 .307
Selected Valuation Cash-Flow Items
EBIT (1 – t) .022 .150 .126 .126 .105 .093 .094 .094 .095 .095 .096 .096
Capital Expenditures .031 .027 .033 .053 .054 .061 .069 .078 .088 .099 .112 .126
 Working Capital .025 .077 .068 .049 .000 .017 .020 .020 .020 .020 .020 .020
Free Cash Flow .047 .079 .053 .059 .088 .087 .044 .036 .027 .017 .005 (.008)
to the Firm (FCFF)
Determining the Initial Offer Price

Volvo’s estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that
the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be
substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the
entire company and Volvo’s urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the
initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion,
reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation
methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To
gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid
for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share
estimated by dividing the initial offer price of $15.25 billion by Volvo’s total common shares outstanding of 442 million.

Determining the Appropriate Financing Structure

Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in
excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford’s cost of
capital, which is estimated to be 11.5%—about three times the prevailing interest on short-term marketable securities at that time. By
reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected
return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less
attractive as a potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss of interest earnings on the
excess cash balances would be more than offset by the addition of Volvo’s pretax earnings.

Epilogue

Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was
acquiring only Volvo’s passenger-car operations. Ford acquired Volvo’s passenger car operations on March 29, 1999, for $6.45
billion. At $16,000 per production unit, Ford’s offer price was considered generous when compared with the $13,400 per vehicle that
Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on
its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo
in the case was estimated to be $15 billion. This included Volvo’s trucking operations.)

Discussion Questions and Answers:

1. What is the purpose of the common-size financial statements developed for Volvo (see Table 8-8 in
the textbook)? What insights does this table provide about the historical trend in Volvo’s historical
performance? Based on past performance, how realistic do you think the projections are for 2000-
2004?

Answer: The common size financial statements for Volvo reveal the historical relationship between
key operating variables and sales. They revealed the deterioration in the firm’s long-term
operating efficiency and the subsequent decline in operating margins and cash flow. The
deterioration in cash flow underscored the inability of the firm to fund future cash flows at a level
necessary to remain competitive. The projections appear somewhat optimistic in that they assume
some acceleration in revenue, improvement in operating expenses, and a significant improvement
in asset turnover rates. The escalating capital outlays necessary to introduce new cars causes cash
flow to turn negative by 2004.

2. Ford anticipates substantial synergies from acquiring Volvo. What are these potential synergies? As
a consultant hired to value Volvo, what additional information would you need to estimate the value
of potential synergy from each of these areas?

Answer: By acquiring Volvo, Ford hoped to expand its global market share with a broader product
offering as well as to strengthen its presence in Europe. Specifically, Ford saw Volvo as a means of
improving its product weakness in luxury sedans and station wagons, gaining access to new
distribution channels and markets, reducing development and vehicle production costs, and gaining
greater penetration into the premium car market. To estimate the potential increase in luxury
 market penetration, it is necessary to know the potential size of each of Ford’s and Volvo’s targeted
markets in both dollars and units. In addition, it is necessary to know their current penetration in
those markets and an estimate of the probable lift to market share that might be achieved by
introducing Ford products into predominately Volvo markets and vice versa. To estimate cost
savings, it is necessary to know Volvo’s approximate cost per vehicle and the likely savings per
vehicle that might be achieved. These savings could come from economies of scale in centralizing
production and making uniform automotive platforms, as well as by introducing “best practices”
across the companies.

3. How was the initial offer price determined according to this case study? Do you find the logic
underlying the initial offer price compelling? Explain your answer.

Answer: The initial offer price for Volvo was determined by adding about one-fourth of the projected
net synergy generated from acquiring Volvo to its standalone value of $15 billion. The
reasonableness of the resulting price of $15.25 billion was confirmed by using other valuation
methods. When compared to the firm’s market value of $11.9 billion, this offer price represented
an approximate 28% premium. This premium was consistent with what Ford had paid for Jaguar
one year earlier.

4. What was the composition of the purchase price? Why was this composition selected according to
this case study?

Answer: The proposed purchase price was an all-cash offer. At the time, Ford’s cash balances were
substantially in excess of its required working capital needs. By re-deploying some portion of these
excess cash balances into an investment offering a higher return than the prevailing rate on short-
term securities, Ford was potentially enhancing shareholder value.

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