Using Financial Modeling
Techniques to Value and
Structure Mergers &
Acquisitions
Mariusz-Jan Radło PhD
Source: DePamphilis, 2010
Learning Objectives
Primary learning objective: Provide students with a basic
understanding of how to use financial models to value and
structure M&As
Secondary learning objectives: Provide students with a
knowledge of
¨ðHow to estimate the value of synergy;
¨ðCommonly used relationships in building M&A valuation
models; and
¨ðHow to use models to estimate the purchase price
range, initial offer price for a target firm, and to evaluate
the feasibility of financing the proposed offer price.
Source: DePamphilis, 2010
The limitations of financial data
Improper revenue recognition accounts for about 50% of fraudulent financial
statements. Key rules for properly stating revenue include the following:
¨ð Long-term contracts: For contracts spanning multiple accounting periods,
revenue is recognized based on the percentage of the contract completed.
¨ð False invoices: Common examples include recording revenue despite having not
yet shipped the products, creating false invoices, or holding the accounting
period open beyond the end of the quarter to boost revenue
¨ð Vendor financing: Inflating revenues by extending customers extremely favorable
payment terms.
Restructuring reserves often used to smooth earnings
Using in-process research and development write-offs to inflate future
earnings
Source: DePamphilis, 2010
M&A Model Building Process
Step 1: Value acquirer and target as standalone
firms
Step 2: Value acquirer and target firms including
synergy
Step 3: Determine initial offer price for target
firm
Step 4: Determine the combined firms ability to
finance the transaction
Source: DePamphilis, 2010
Step 1. Value acquirer and target as standalone firms
1. Understand specific firm and industry competitive
dynamics
2. Normalize 3-5 years of historical data
3. Project normalized cash flow based on expected market
and competitive industry conditions
Source: DePamphilis, 2010
Step 1.1: Value Acquirer & Target as
Standalone Firms
Understand determinants of profits and cash flow, i.e.,
bargaining strength of
¨ðCustomers (size, number, price sensitivity)
¨ðCurrent competitors (market share, differentiation)
¨ðPotential entrants (entry barriers, relative costs)
¨ðSubstitutes (availability, prices, switching costs)
¨ðSuppliers (size, number, uniqueness)
relative to industry participants.
Source: DePamphilis, 2010
Step 1.2: Value Acquirer & Target as
Standalone Firms
Normalize 3-5 years of historical financial information
¨ð Cleanse the data of anomalies, nonrecurring changes, and
questionable accounting practices:
Common-size financial statements: e.g.: each line item of the income
statement, balance sheet and cash flow statement can be presented as a
percentage of annual sale. Such normalization enables to compare financial
statements of companies of different sizes (cross-sectional comparison).
This may suggest that the company s capital spending are too low or its
competitors are catching up with the target.
To verify what is the truth use multiperiod comparison, i.e.: calculate c-zfs
of the target and its primary competitors over a number of consecutive
periods.
Identify abnormal fluctuations in ratios and normalize the data using average
values.
Perform financial ratio analysis (profitability, rate of return, liquidity, asset
usage, stock/debtors/creditors, gearing) and identify potential problems
Source: DePamphilis, 2010
Step 1.3: Value Acquirer & Target as
Standalone Firms
Project normalized cash flow based on expected market
growth and changes in profits/cash flow determinants
¨ð Projection for at least five years or more until they turn positive or
the growth rate slows to what is bepieved to be a sustainable
pace.
¨ð A simple model to project cash flows involve revenues and
varions cf components as a percentage of projected revenue.
¨ð Revenue projections can be based on the extrapolations of the
past trends or on the scenario analysis (scenarios will depend on
the different GDP growth rates, exchange rates fluctuations,
emergence of new technologies, etc.).
Source: DePamphilis, 2010
Step 2.1: Value Acquirer & Target
Firms Including Synergy
Estimate net synergy
¨ð Sources of value: potential cost savings (shared overhead, duplicate
facilities, overlapping distribution channels) + assets not included in the
balance sheet at the fair value (land, inventory, equipment, patents,
licenses, copyrights) + underutilized borrowing capacities.
¨ð Destroyers of value: e.g.: poor product quality, wage and benefits
levels above the comparable industry levels, poor productivity, high
employee turnover, lack of customer contracts, poorly written contacts,
environlemtal issues, product liabilities, unresolved lawsuits, etc.
¨ð Implementation costs incurred to realize synergy: e.g.: recruiting
and training, realizing cost savings, achieving productivity
improvements, etc.
Consolidate acquirer and target projected financials including
the effects of synergy
Estimate net synergy (consolidated firms less values of target
and acquirer)
Source: DePamphilis, 2010
Adjusting Combined Acquirer/Target Company
Projections For Estimated Synergy
Year 1 Year 2 Year 3 Year 4 Year 5
Net Sales1 $200 $220 $242 $266 $293
Cost of sales2 $160 $176 $194 $213 $234
Anticipated Cost Savings
Direct labor $2 $4 $6 $8 $8
Indirect labor $1 $2 $4 $4 $4
Purchased materials $2 $3 $5 $5 $5
Selling expenses $1 $3 $5 $5 $5
Total $6 $12 $20 $22 $22
Cost of sales (incl. synergy) $154 $164 $174 $191 $212
Cost of sales/Net sales 77.0% 74.6% 71.9% 71.8% 72.4%
1
Combined company net sales projected to grow 10% annually during forecast period.
2
Cost of sales before synergy assumed to be 80% of net sales during forecast period.
Source: DePamphilis, 2010
Discussion Questions
1. How would you adjust the combined firm s income
statement for cost savings due to improved worker
productivity? (Hint: Determine the line item most
directly affected by the improvement in productivity.)
2. How would you adjust the combined firm s income
statement for additional revenue generated from cross-
selling (i.e., Acquirer selling its products to the target s
customers and vice versa)?
3. How would you reflect the expenses incurred in
implementing the worker productivity improvement and
cross-selling programs on the combined firm s income
statement?
Source: DePamphilis, 2010
Step 3.1: Determine Initial Offer Price
for Target Firm
Estimate minimum and maximum purchase price
range
¨ð Minimum offer price = target s stand alone or present value (PVt) or its
current market value (MVt)
¨ð Maximum offer price = minimum price + present value of the net
synergy
Maximum price can be easily overstated when current market value reflects investors
expectations of an impending takeover. Such market price include part of the future
synergy!
¨ð Initial offer price (PViop): minimum purchase price + some percentage
between (1 and 100) of the present value of the net synergy
Determine amount of synergy willing to share with
target shareholders
Determine appropriate composition of offer price
Source: DePamphilis, 2010
Calculating Initial Offer Price (PVIOP)
1. PVMIN = PVT or PVMV, whichever is greater for a stock purchase
(liquidation value of net acquired assets for an asset purchase)
2. PVMAX = PVMIN + PVNS, where PVNS = PVSOV  PVDOV
3. PVMAX = PVMIN + PVNS
4. PVIOP = PVMIN + Ä…PVNS, where 0 d" Ä… d" 1
Offer price range = (PVT or MVT) < PVIOP < (PVT or MVT) + PVNS
Where PVMIN = PV minimum purchase price
PVT = PV standalone value of target firm
PVMV = Market value target firm
PVMAX = PV maximum purchase price
PVNS = PV of net synergy
PVSOV = PV of sources of value
PVDOV = PV of destroyers of value
Ä… = Portion of net synergy shared with target company shareholders
How is  Ä… determined?
Source: DePamphilis, 2010
Magnitude and composition of the initial offer price
Factors Magnitude Composition
" Estimated synergy " Current borrowing capacity
Acquirer s
" Willingness to share the synergy " After tax cost of debt vs. Cost of equity
perspective
" Alternative investment opportunities " Size and duration of potential EPS
" Number of potential bidders dilution (reduces attractiveness of share
" Effectiveness of the target s defense exchange)
" Public disclosure requirements " Size of transaction
" Degree of management risk averion " Desire for risk sharing
" Number of potential bidders " Perceived attractiveness of acquirer
Target s
" Perception of bidder (hostile or stock
perspective
fiendly) " Shareholder preference for cash
" Effectiveness of the desense versus stock
" Size of potential tax liability " Size of potential tax liability (share
" Standalone valuation exchange can be more attractive)
" Availability of comparable recent " Perceived upside upside potential of
transactions the target (may result in contingent
" Alternative investment opportunities payment)
Source: DePamphilis, 2010
Step 4: Determine Combined Firms
Ability to Finance Transaction
Estimate impact of alternative financing structures
Select financing structure that
¨ð Meets acquirer s required financial returns and desired financial
structure;
¨ð Meets target s primary financial and non-financial needs;
¨ð Does not raise borrowing costs; and
¨ð Is supportable by the combined firms.
Source: DePamphilis, 2010
Factors affecting postmerger share price
Earnings per share
Price to earnings ratio
Postmerger share price equals earnings per share times price to
earnings ratio
Share exchange ratio equals ratio of the target firm s share price
including any premium to the acquirer s share price
Postmerger EPS reflects the EPS of the combined firms, the price of
the acquirer s stock, the price of the target s stock, and the number
of shares of acquirer and target stock outstanding.
Source: DePamphilis, 2010
Post merger share price
How investors react to the merger
announcement?
¨ð Usually share prices of both the target and the acquirer adjust
immediately after the announcement of a pending acquisition,
The target s stock price usually increase to the level somewhat
below the purchase price
The acquirer s stock price may decline reflecting potential dilution of
its EPS or growth in EPS of the combined companies that is slower
than the growth rate investors have anticipated for the acquiring
company without the acquisition.
Source: DePamphilis, 2010
Estimating postmerger share price
Step 1: Calculate share exchange ratio in a share for share exchange.
Step 2: Estimate new shares issued by acquirer to purchase target shares
Step 3: Estimate total shares outstanding for the combined firms based on
acquirer s current shares outstanding plus new shares issued.
Step 4: Estimate postmerger earnings per share by dividing the combined
firms earnings by the total shares outstanding determined in Step 3
Step 5: Calculate postmerger share price by multiplying postmerger EPS by
assumed price-to- earnings ratio
For all cash or cash and stock transactions, adjust step 4 to reflect the
different characteristics of the purchase price.
Source: DePamphilis, 2010
Share exchange ratio
Share exchange ratio can be negotiated as a fixed
number of shares of the acquirer s stock to be
exchanged for each share of the target s stock,
or
Value of the offer price per share of target stock to the
value (Pto) of the acquirer s share price (Pa):
SER=Pto/Pa
Source: DePamphilis, 2010
Post merger Earnings per Share
EPS is one of the most followed indicators
by analysts and investors. Earning dilution
 even temporary  may result in dramatic
loss of market value for the acquiring
company.
Source: DePamphilis, 2010
Calculating EPS and
Post-Merger Share Price Ex. 1
Acquiring Target
Acquiring Company is considering
Company Company
the acquisition of Target
Company in a share for share
transaction in which Target
Net Earnings $281,500 $62,500
Company would receive $84.30
for each share of its common
stock. Acquiring Company does
Shares 112,000 18,750
not expect any change in its
Outstanding
price/earnings multiple after the
merger. Selected data are
presented as follows:
Market Price $56.25 $62.50
Per Share
Source: DePamphilis, 2010
Calculating EPS and
Post-Merger Share Price: Solution
1. Exchange ratio = Price per share offered for Target Company/ Price
per share for Acquiring Company = $84.30 / $56.25 = 1.5
2. New shares issued by Acquiring Company = 18,750 (shares of
Target Company) x 1.5 (share exchange ratio) = 28,125
3. Total shares outstanding of the combined firms = 112,000 + 28,125
= 140,125
4. Post merger EPS of the combined firms = ($281,500 + $62,500) /
140,125 = $2.46
5. Pre merger P/E = Pre-merger price per share / pre-merger EPS =
56.25 /($281,500/112,000) =$56.25/$2.51 = 22.4
6. Post-merger share price = Post-merger EPS x Pre-merger P/E =
$2.46 x 22.4 = $55.10 (as compared to $56.25 pre-merger share price)
Note: Example assumes no increase in EPS due to synergy for simplicity.
Source: DePamphilis, 2010
Calculating EPS and
Post-Merger Share Price Ex. 2
Acquiring Target Co.
Acquiring Company is
considering the acquisition of
Target Company in a stock for
Earnings $150,000 $30,000
stock transaction in which
available for
common
Target Company would
stock
receive $50.00 for each share
Number of 60,000 20,000
shares of
of its common stock. The
common
Acquiring Company does not
stock
outstanding
expect any change in its
Market price $60.00 $40.00
price/earnings multiple after
per share
the merger.
Source: DePamphilis, 2010
Calculating EPS and
Post-Merger Share Price: solution
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)
Exchange ratio = Price per share offered for Target Company / Market price per
share for Acquiring Company = $50.00 / $60.00 = 0.8333 (i.e., Acquiring
Company issues 0.8333 shares of stock for each share of Target Company s
stock)
New shares issued by Acquiring Company = 20,000 (shares of Target
Company) x 0.8333 (Exchange ratio) = 16,666
Total shares outstanding of the combined companies = 60,000 + 16,666 =
76,666
Post-merger EPS of the combined companies = ($150,000 + $30,000)/ 76,666 =
$2.35
Pre-merger EPS of Acquiring Company = $150,000 / 60,000 = $2.50
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)
Source: DePamphilis, 2010
Key valuation modeling issues
1. What is the standalone value of the acquiring firm? From the viewpoint of the acquirer s shareholders, an
acquisition makes sense only if the per share value of the combined firm is higher than that of the
standalone value of the acquiring firm.
2. What is the standalone value of the target firm? This or the firm s current public market value establishes
the logical minimum offer price for the target firm.
3. What is the potential value that can be created (i.e., synergy) for shareholders in the new firm by
combining the target and acquirer firms.
4. How rapidly can the potential synergy be realized?
5. How much will have to be spent to realize the potential synergy?
6. How much of the synergy must be shared with the target firm s shareholders to offer a price that will
induce target shareholders to surrender control?
7. What portion of the new firm s equity will be held by acquirer shareholders and what portion by target
shareholders.
8. Can the proposed purchase price for the target firm be financed by the aggregate resources of the
combined firms without violating existing loan covenants?
9. Are the key assumptions underlying the model realistic?
Source: DePamphilis, 2010