Exam 9: Applying Financial Models to Value, structure, and Negotiate Mergers and Acquisitions

Common size financial statements are useful for comparing businesses of different sizes in the same industry at different points in time.

A "floating or flexible" share exchange ratio is used to

Common size financial statements may be constructed by calculating the percentage each line item of the income statement,balance sheet,and cash flow statement is of annual sales for each quarter or year for which historical data are available.

Case Study Short Essay Examination Questions Mars Buys Wrigley in One Sweet Deal Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley Corporation, a U.S.-based leader in gum and confectionery products, faced increasing competition from Cadbury Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation. On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23 billion in cash. Under the terms of the agreement, which were unanimously approved by the boards of the two firms, shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding, a 28 percent premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would have a 14.4 percent share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees worldwide. The merger of the two family-controlled firms represents a strategic blow to competitor Cadbury Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate business. Prior to the announcement, Cadbury had a 10 percent worldwide market share. As of the September 28, 2008 closing date, Wrigley became a separate stand-alone subsidiary of Mars, with $5.4 billion in sales. The deal is expected to help Wrigley augment its sales, marketing, and distribution capabilities. To provide more focus to Mars's brands in an effort to stimulate growth, Mars would in time transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley Jr., who controls 37 percent of the firm's outstanding shares, remained the executive chairman of Wrigley. The Wrigley management team also remained in place after closing. The combined companies would have substantial brand recognition and product diversity in six growth categories: chocolate, nonchocolate confectionary, gum, food, drinks, and pet care products. While there is little product overlap between the two firms, there is considerable geographic overlap. Mars is located in 100 countries, while Wrigley relies heavily on independent distributors in its growing international distribution network. Furthermore, the two firms have extensive sales forces, often covering the same set of customers. While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of transactions of this type. Almost 90 percent of the purchase price would be financed through borrowed funds, with the remainder financed largely by a third-party equity investor. Mars's upfront costs would consist of paying for closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors, such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing $2.1 billion in equity financing for a 9.1 percent ownership stake in Wrigley. : -Why was market share in the confectionery business an important factor in Mars' decision to acquire Wrigley?

Case Study Short Essay Examination Questions Mars Buys Wrigley in One Sweet Deal Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley Corporation, a U.S.-based leader in gum and confectionery products, faced increasing competition from Cadbury Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation. On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23 billion in cash. Under the terms of the agreement, which were unanimously approved by the boards of the two firms, shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding, a 28 percent premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would have a 14.4 percent share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees worldwide. The merger of the two family-controlled firms represents a strategic blow to competitor Cadbury Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate business. Prior to the announcement, Cadbury had a 10 percent worldwide market share. As of the September 28, 2008 closing date, Wrigley became a separate stand-alone subsidiary of Mars, with $5.4 billion in sales. The deal is expected to help Wrigley augment its sales, marketing, and distribution capabilities. To provide more focus to Mars's brands in an effort to stimulate growth, Mars would in time transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley Jr., who controls 37 percent of the firm's outstanding shares, remained the executive chairman of Wrigley. The Wrigley management team also remained in place after closing. The combined companies would have substantial brand recognition and product diversity in six growth categories: chocolate, nonchocolate confectionary, gum, food, drinks, and pet care products. While there is little product overlap between the two firms, there is considerable geographic overlap. Mars is located in 100 countries, while Wrigley relies heavily on independent distributors in its growing international distribution network. Furthermore, the two firms have extensive sales forces, often covering the same set of customers. While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of transactions of this type. Almost 90 percent of the purchase price would be financed through borrowed funds, with the remainder financed largely by a third-party equity investor. Mars's upfront costs would consist of paying for closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors, such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing $2.1 billion in equity financing for a 9.1 percent ownership stake in Wrigley. : -How might the additional product and geographic diversity achieved by combining Mars and Wrigley benefit the combined firms?

Net synergy is the difference between the present value of the estimated sources of value and destroyers of value.True of False

The scrupulous application of GAAP ensures both consistency in comparing one firm's financial performance with another and the accuracy of the data.

While GAAP does not ensure accuracy,it is helpful to the analyst in that statements that conform to GAAP rules must adhere to certain standards.

Case Study Short Essay Examination Questions Mars Buys Wrigley in One Sweet Deal Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley Corporation, a U.S.-based leader in gum and confectionery products, faced increasing competition from Cadbury Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation. On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23 billion in cash. Under the terms of the agreement, which were unanimously approved by the boards of the two firms, shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding, a 28 percent premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would have a 14.4 percent share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees worldwide. The merger of the two family-controlled firms represents a strategic blow to competitor Cadbury Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate business. Prior to the announcement, Cadbury had a 10 percent worldwide market share. As of the September 28, 2008 closing date, Wrigley became a separate stand-alone subsidiary of Mars, with $5.4 billion in sales. The deal is expected to help Wrigley augment its sales, marketing, and distribution capabilities. To provide more focus to Mars's brands in an effort to stimulate growth, Mars would in time transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley Jr., who controls 37 percent of the firm's outstanding shares, remained the executive chairman of Wrigley. The Wrigley management team also remained in place after closing. The combined companies would have substantial brand recognition and product diversity in six growth categories: chocolate, nonchocolate confectionary, gum, food, drinks, and pet care products. While there is little product overlap between the two firms, there is considerable geographic overlap. Mars is located in 100 countries, while Wrigley relies heavily on independent distributors in its growing international distribution network. Furthermore, the two firms have extensive sales forces, often covering the same set of customers. While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of transactions of this type. Almost 90 percent of the purchase price would be financed through borrowed funds, with the remainder financed largely by a third-party equity investor. Mars's upfront costs would consist of paying for closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors, such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing $2.1 billion in equity financing for a 9.1 percent ownership stake in Wrigley. : -Given the terms of the agreement,Wrigley shareholders would own what percent of the combined companies? Explain your answer

The share exchange ratio is defined as offer price divided by the target firm's current share price.True or False

Pro forma financial statements are frequently used to show what the acquirer and target's combined financial statements would look like if they were merged.

Complex models because of their greater sophistication are necessarily more accurate than simple models.

The target firm's underutilized borrowing capacity is often considered a source of value.

Case Study Short Essay Examination Questions Ford Acquires Volvo's Passenger Car Operations This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only- they include revenue and costs for all of the firm's product lines. For purposes of exposition, we shall assume that Ford's acquisition strategy with respect to Volvo was to acquire all of Volvo's operations and later to divest all but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the standalone values for the Ford and Volvo passenger car operations from their combined value including the effects of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations. Background By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain market share in this highly competitive environment. By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution channels, entering new markets, reducing development and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford's Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its size. Historical and Projected Data The initial review of Volvo's historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo's cash flow is steadily trending downward from its high in 1997. Table 9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast period. Ford's acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration. PAGE 15 PAGE 19 Determining the Initial Offer Price Volvo's estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the entire company and Volvo's urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo's total common shares outstanding of 442 million. Determining the Appropriate Financing Structure Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford's cost of capital, which is estimated to be 11.5%-about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a potential acquisition target. The acquisition is expected to increase Ford's EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo's pretax earnings. Epilogue Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was acquiring only Volvo's passenger-car operations. Ford acquired Volvo's passenger car operations on March 29, 1999, for $6.45 billion. At $16,000 per production unit, Ford's offer price was considered generous when compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo in the case was estimated to be $15 billion. This included Volvo's trucking operations.) and Answers: -Ford anticipates substantial synergies from acquiring Volvo.What are these potential synergies? As a consultant hired to value Volvo,what additional information would you need to estimate the value of potential synergy from each of these areas?

In determining the initial offer price,the acquirer must decide how much of the anticipated synergy to share with the target firm's shareholders.

It is rarely useful to review more than one or two years of historical data for the acquiring or target firms.

The present value of net synergy is the difference between the present value of projected cash flows from sources and destroyers of value.

Real Value Autos acquired Automotive Industries in a transaction that produced an NPV of $3.7 million. This NPV represents

Pro forma financial statements are simply another name for GAAP financial statements.

The share exchange ratio is defined as