Exam 7: Merger and Acquisition Cash Flow Valuation Basics

The market risk or equity premium refers to the additional rate of return in excess of the weighted average cost of capital that investors require to purchase a firm's equity.

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

If free cash flow to the firm is expected to remain at $10 million indefinitely and the firm's cost of equity is .10,the present value of the firm is $100 million.

The effective tax rate is calculated from actual taxes paid based on accounting statements prepared for tax reporting purposes.

Which of the following is true of the equity valuation model?

The capital asset pricing model is commonly used to estimate the cost of equity.

Growth rates can be calculated based on the historical experience of the firm or industry.

When the firm increases its debt in direct proportion to the market value of its equity,the level of the debt is perfectly correlated with the firm's market value.

When cash flow is temporarily depressed due to strikes,litigation,warranty claims,or other one-time events,it is generally safe to assume that cash flow will recover in the near term.

Investors require a minimum rate of return on an investment to compensate them for the level of perceived risk associated with that investment.

Whether an analyst should use a short or long-term interest rate for the risk free rate in calculating the CAPM depends on when the investor receives their future cash flows.

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.

Viewing preferred dividends as paid in perpetuity,the cost of preferred stock can be calculated as dividends per share of preferred stock divided by the market value of the preferred stock.

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

Betas do not vary over time and are quite insensitive to the time period and methodology employed in their estimation.

Free cash flow to equity is calculated using operating income.

In calculating the weighted average cost of capital,the weights should be estimated using the market value of the target firm's debt and equity.

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 other assumptions might you consider?

For firms whose market value is less than $50 million,the adjustment to the CAPM in estimating the cost of equity can be as large as 2 percentage points.

Both public and private firms are subject to non-diversifiable risk.