Exam 7: Merger and Acquisition Cash Flow Valuation Basics

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.

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.

Which of the following is not true about the constant growth valuation model?

The after-tax cost of borrowed funds to the firm is estimated by multiplying the pretax interest rate,i,by (1 - t),where t is the marginal tax rate for the firm.

Free cash flow to the firm is often called enterprise cash flow.

The cost of capital reflects all of the following except for

The cost of equity is the minimum financial return required by investors to invest in stocks of comparable risk.

The weighted average cost of capital (WACC)is the broadest measure of the firm's cost of funds and represents the return that a firm must earn to induce investors to buy its common stock.

The zero growth model is a special case of what valuation model?

A firm's beta is affected by the amount of debt a firm maintains relative to its equity.

Studies show that it is generally unnecessary to adjust the capital asset pricing model for the size of the firm.

Net debt is defined as all of the firm's interest bearing debt less the value of cash and marketable securities.

Additional Problems/Case Studies The Importance of Distinguishing Between Operating and Nonoperating Assets In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon's management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI's cash in excess of what was required to meet its normal operating cash requirements. To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI's stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion. In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon's shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise. 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. Discussion Questions 1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite. 2. What other assumptions might you consider in addition to those identified in the case study? 3. What are the limitations of the discounted cash flow method employed in this case? -What are the limitations of the valuation methodology employed in this case?

Which of the following is not true about the variable growth valuation model?

The weighted average cost of capital consists only of debt and equity.

The relationship between the overall market and a specific firm's beta may change significantly if a large sector of stocks that make up the overall index increase or decrease substantially.

The constant growth valuation model is primarily applicable to firms in mature markets.

Beta is a measure of non-diversifiable risk.

Additional Problems/Case Studies The Importance of Distinguishing Between Operating and Nonoperating Assets In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100% of MCI stock. Verizon's management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special dividend reduced MCI's cash in excess of what was required to meet its normal operating cash requirements. To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI's stock. Verizon would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset. Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was reduced by $1.4 billion, and the purchase price was $5.3 billion. In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon's shareholders receiving $1.4 billion less in net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise. 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. Discussion Questions 1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite. 2. What other assumptions might you consider in addition to those identified in the case study? 3. What are the limitations of the discounted cash flow method employed in this case? -Did @Home overpay for Excite?

For a return to be considered risk-free over some future time period it must be free of default risk and there must not be any uncertainty about the reinvestment rate (i.e.,the rate of return that can be earned at the end of the investor's holding period).