Valuation

1. Valuation J.V. Rizzi August, 2007

2. Transaction Framework Strategic Issues • Do I make the acquisition? Market • What is the price? Valuation • How much do I pay? Tactics • How do I make the offer? Financing • How do I pay? Market Conditions • Product availability Integration • Implementation of acquisition Fin 70410 M&A Fall 2007

3. Overview • Conversion • Accrual to Cash • Cost to Market • Starting Point • Private Firm: Asset Valuation (LHS) • Public Firm: Liabilities (RHS) • Note: Private/Public Market arbitrage • Value Gaps • Expectation • Strategic • Price ≠ Value • Note: Both price and value are dynamic concepts • Firms Compete in Two Markets • Product Markets: For Customers • Financial Markets: For Capital • Passive Trading Price • Control Price Fin 70410 M&A Fall 2007

4. Claims on a Firm • Other • Distress • Employees • Other (community, retirees, etc.) • Ordinarily, value is independent of claims issued • Claims can impact value through their incentive on management behavior = Fin 70410 M&A Fall 2007

5. Buffett Principles (1) • A bird in the hand is worth …. two in the bush • How certain are you that there are birds in the bush? • When will they emerge and how many will there be? • What is the risk-free interest rate (i.e. the yield on long term sovereign bonds)? Answer these three questions and … you will know the maximum value of the bush! Fin 70410 M&A Fall 2007

6. Buffett Principles (2) • When new businesses and rapidly changing industries are under examination, no one can anticipate the number of birds about to emerge. • In these cases, any investment would be considered speculative • - Speculation - the focus is not on what the asset will produce, but rather on what the next fellow will pay for it… Fin 70410 M&A Fall 2007

7. Valuation Overview (1) Valuation Overview V = MAX (liquidation, Going Concern, Third Party Sale) method used depends on point of life cycle and market conditions – value of asset with no cash flow is only what someone will pay you for it (Sardine theorem) TPS – Startup GC – Mature Liq - Decline Fin 70410 M&A Fall 2007

8. Valuation Overview (2) Timing Market Size Independent Value Buyer Driven Value Emerging High Growth Mature Market Stage Fin 70410 M&A Fall 2007

9. Relative Levels of Value Enterprise (or controlling interest value) Controlling shareholders (those who own more than 50% in most cases) have the power to declare dividends, sell assets, Change corporate bylaws , and more Premium for Control Marketable minority-interest value (Wall Street Journal Listed Price) Non-marketable minority-interest value Fin 70410 M&A Fall 2007

10. Going Concern Overview • Free Cash Flow (WACC) – Focus of our discussion • Best known method • Best used for stable capital structure • Adjust to fit rapidly changing capital structure by using an assumed target capital structure (BBB+/A-) • Capital Cash Flow (APV) • Less well known • Best for rapidly changing capital structures • Equity Cash Flows • Best used with complex equity flows • Used by financial sponsors Fin 70410 M&A Fall 2007

11. Cash Flow Valuation Techniques Earning Before Interest and Taxes EBIT Plus Depreciation Less Capital Expenditures Less Working Capital Increases Operating Cash Flow Subtract Actual Taxes Tax Rate + (EBIT – Interest) Subtract Actual Taxes Tax Rate + (EBIT – Interest) Subtract Hypothetical Taxes Statutory Tax Rate x EBIT Less Interest Less Debt Payments Plus Debt Issuance Capital Cash Flow Free Cash Flow Equity Cash Flow Discount at Expected Asset Return Discount at WACC Discount at Expected Equity Return Fin 70410 M&A Fall 2007

12. Going Concern Valuation(Free Cash Flow WACC Technique) • A Discounted Cash Flow method that applies a discount rate to the projected free cash flows generated by the firm. There are three primary inputs in the DCF analysis: • Project Cash Flows are prepared using management’s best estimate of company and industry factors (seasonality, cyclicality, etc.) or implied from the current stock price. Should reflect the period of abnormal growth based on competitive considerations. • Terminal value is the portion of the firm value after the forecast horizon. It can often represent a significant percentage of the total firm value. Represents the value of assets in place. • Discount rate Fin 70410 M&A Fall 2007

13. Steps for DCF Analysis • Forecast Free Cash Flow • Identify components of free cash flow • Develop integrated historical perspective • Determine forecast assumptions and scenarios • Calculate and evaluate the forecast • Estimating the cost of capital • Develop target market value debt and equity weights • Estimate cost of debt • Estimate cost of equity • Estimate Continuing (Terminal) Value • Determine the relationship between continuing value and DCF • Decide the forecast horizon • Discount to the present • Calculating and interpreting results • Develop and test results • Interpret results within decision context Fin 70410 M&A Fall 2007

14. Projected Cash Flows • Free Cash Flow • EBITDA – (Taxes + CAPEX +/- Working Capital) • An example is shown below: Source: PLI Fin 70410 M&A Fall 2007

15. Credibility of Cash Flow Projections • Issues • Adjustments (beware of solving for cash flows to justify price) • Normalization • Value Test • Reverse Engineer • Firm • Peers • Tie Into • Compensation • Covenants Fin 70410 M&A Fall 2007

16. Terminal Value • Terminal Value • Terminal Value is the value of the cash flows after the forecast period. • The formula for calculating the terminal value is given below: • After finding the terminal value, it must also be discounted at the same rate as the other cash flows. • Beware of using EBITDA multiples – overstates due to take-over premiums • On average, the Terminal Value accounts for over 80% of the total value. • The credibility of management’s projections can be tested by remembering that the terminal value calculation is nothing more than applying a multiple to the final years cash flow (the implied multiple based on the WACC and growth rate = 1/[WACC-g]). Fin 70410 M&A Fall 2007

17. Discount Rate • : Fin 70410 M&A Fall 2007

18. Discounted Cash Flow Analysis (DCF) - Overview Advantages Disadvantages • Theoretically, it is the most academically compelling valuation method. • It is forward-looking and incorporates an expected operating strategy. • Capital markets volatility has limited impact on the analysis. • Recognizes the time value of money. • Useful when there are not many comparable companies. • Highly sensitive to assumptions used (WACC, long term growth rate, terminal value, etc.). • Forecasted future cash flows are uncertain. • Terminal value can have a significant impact on valuation. Fin 70410 M&A Fall 2007

19. Adjusted Book Value (Liquidation Approach) • ABV is a cost based liquidation approach with mark to market adjustments • Balance sheets measure money spent, not value • Economic balance sheet needed (i.e. mark to market) • Concept is to adjust for hidden assets and liabilities • Potential Pitfall: Current Cost =/= Net Realizable Value Fin 70410 M&A Fall 2007

20. Breakup Value(Sum of the parts valuation [SOTP] ) Negative Synergies: Management as an off-balance sheet liability; conglomerate discount Analysis: Earnings PEX Value BU1 BU2 BU3 BU4 BU5 SOTP Current standalone value x Gap Fin 70410 M&A Fall 2007

21. Relative Value • Multiples measure firm value by comparing it to other similar entities or transactions. The most common multiples are: Fin 70410 M&A Fall 2007

22. Relative Value (continued) • Why multiples are easy to calculate and used by many market analysts, there are some shortfalls: • The approach is inexact and can be skewed by outliers • Each firm is unique and it is therefore difficult to find real comparables (companies or transactions) • Companies often manage around them • Multiples are useful for: • Validation of DCF approach • Private company analysis • Segment valuation for multi-segment businesses Fin 70410 M&A Fall 2007

23. Comparable Company Analysis (“Comps”) - Overview Advantages Disadvantages • Provides an objective comparison of companies accounting for industry trends, risk factors and profitability expectations. • Usually represented as forward looking, but also can be viewed as backward looking. • Effective way of determining company valuation when no control premium is involved. • Putting together a list of truly comparable companies can often be difficult. • Issues that are specific to a particular company may limit the strength of the valuation analysis. • Does not account for control premiums or synergies gained in an acquisition. • Analysis is focused on current market conditions, industry trends and growth prospects and ignores longer term issues. Fin 70410 M&A Fall 2007

24. Precedent Transactions Analysis (“Precedents”) - Overview Advantages Disadvantages • Based on public information • Information is based on historical information. • Provides index of premiums paid by buyers and accepted by sellers. • Important to know price that was paid for similar assets in determining present value of a comparable asset for sale. • Public data can be limited. • Hard to know all the factors and motives that went into formulation of acquisitions prices. • The fact that a particular multiple was paid in the past does not necessarily mean it still applies today. • Market conditions at the time of a transaction can have a large impact on valuation. Fin 70410 M&A Fall 2007

25. Additional Valuation Issues • International Valuation • Real Option Valuation • LBO Valuation • Projection Credibility • Restructuring Context Fin 70410 M&A Fall 2007

26. International Valuation • International Valuation creates a number of additional issues. There are two basic ways to handle international valuation: • Value (and then present value) the cash flows in local currency at local rates and then spot into the home currency. • Convert the local cash flows into the home currency and discount those cash flows. • Other issues to be aware of: • Cash flows depend on foreign inflation and exchange rate • The appropriate tax rate depends on the different tax laws in the home and the foreign country • There are two relevant interest rates (foreign and domestic) • Political risk Fin 70410 M&A Fall 2007

27. Real Option Valuation • DCF analysis was originally intended for passive investments where there is a direct cash flow to analyze (dividends). • When valuing business acquisitions (or real assets), DCF fails to account for indirect cash flows. There are cash flows which arise due to the sequential interdependence between acquisitions / projects (i.e. an initial acquisition may have unattractive direct cash flows when viewed in isolation, but may be attractive when considering that it allows for a future opportunity to undertake another valuable investment / project. • To overcome this shortfall, it is useful to think of a firm’s value in two parts. The first part is the DCF of the assets already in place, and the second is the value of the opportunity (or option) to invest in potentially valuable future projects. Fin 70410 M&A Spring 2007

28. Real Option Valuation • The following table classifies the factors involved in determining a firm’s value under the real option valuation approach: • By failing to use the real option value approach, the value of the strategic acquisitions involving indirect cash flows will be understated by a DCF analysis. • Analogy: valuing a convertible bond by only analyzing its coupon yield. • Internet Firms: Today’s real options become tomorrow’s cash cows. Fin 70410 M&A Fall 2007

29. LBO Valuation • Usefulness depends on market conditions: • Financial Buyers • Strategic Buyers • Approach: Maximize utilization of debt capacity • Evaluate against expected ROI on required equity Fin 70410 M&A Fall 2007

30. Valuation Problems (1) Fin 70410 M&A Fall 2007

31. Valuation Problems (2) Fin 70410 M&A Fall 2007

32. Valuation Range • Finding a valuation range: • Use many estimators. • Exercise the estimators to get many estimates. • Scrutinize the assumptions and “key bets”. • Assess hidden options. • Consider unquantifiable factors. • Triangulate. Source: Robert F. Bruner Fin 70410 M&A Fall 2007

33. Triangulation Graph Source: Robert F. Bruner Fin 70410 M&A Fall 2007

34. Summary: Valuation Process Source: Robert F. Bruner Fin 70410 M&A Fall 2007

35. Fin 70410 M&A Fall 2007

36. M&A Accretion/Dilution Analysis - Overview Advantages Disadvantages • Relative Ownership Analysis • Intuitive and straightforward • Preliminary approach to understand how the companies combine. • Accretion/Dilution Analysis • Determines effect of the transaction • Primarily focused on EPS • Value Creation Analysis • Assesses market reaction. • Relative Ownership Analysis • Provides information on transaction consideration that should be further analyzed by accretion/dilution analysis. • Accretion/Dilution Analysis • Evaluating synergies can be very subjective • Value Creation Analysis • It can be difficult to understand how he market may react to long term strategic objectives. Fin 70410 M&A Fall 2007

37. Net Value Added • Vr = Standalone + Va • Vp = Pre-Bid Price + Premium • NVA = Va - Premium • Tie into management compensation to projected synergies and real option value • Ensure liquidity available for business plan tied to this Source: Robert F. Bruner Fin 70410 M&A Fall 2007

38. Conclusion • Although there is no right answer, the results of the different valuation methodologies are a useful starting point for structuring a transaction. Fin 70410 M&A Fall 2007

39. Questions? Fin 70410 M&A Fall 2007