Exam 7: Merger and Acquisition Cash Flow Valuation Basics

Which discounted cash flow valuation methods require the estimation of a terminal value? Why?

Explain how you would value a patent under the following situations: a patent without any current application, a patent linked to an existing product, and a patent portfolio.

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

The Hunt for Elusive Synergy—@Home Acquires Excite Background Information Prior to @Home Network's merger with Excite for $6.7 billion, Excite's market value was about $3.5 billion. The new company combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home's agreements with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm's market value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary network, telephone company circuits, and through the cable companies' infrastructure. Subscribers paid $39.95 per month for the service. Assumptions • Excite is properly valued immediately prior to announcement of the transaction. • Annual customer service costs equal $50 per customer. • Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary services. • None of the current Excite user households are current @Home customers. • New @Home customers acquired through Excite remain @Home customers in perpetuity. • @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households. • @Home's cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period; its combined federal and state tax rate is 40 percent. • Capital spending equals depreciation; current assets equal current liabilities. • FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high-growth period drops to 10 percent. • The maximum purchase price @Home should pay for Excite equals Excite's current market price plus the synergy that results from the merger of the two businesses. -What other assumptions might you consider in addition to those identified in the case study?

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

What are the primary differences between FCFE and FCFF?

What portion of the purchase price can be financed by 3PAR's nonoperating assets?

Under what circumstances is it important to adjust the Capital Asset Pricing Model for firm size? Why?

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

What is the significance of the weighted average cost of capital? How is it calculated? Do the weights reflect the firm's actual or target debt to total capital ratio? Why?

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

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

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

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

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

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

Assume the firm size premium for a firm with a market value of $20 million is 7.2%. Also, assume the risk-free rate of return, equity premium, and $\beta$ are 5.0%, 5.5%, and 1.75 respectively. The firm's cost of equity using the CAPM method adjusted for firm size is 21.8%.

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

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

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