Read Case 42: Methods of Valuation for Mergers and Acquisitions. This case DOES NOT require a written case analysis. It does, however, require exacting attention to the formula and calculation techniques outlined therein.

Why is the DCF model better in M&A analysis (page 586)? Please pay special attention to Tables 1, 2, & 3.

What is Free Cash Flow (FCF) used in the model and how do we arrive at FCF?

(Use the 3 tables below to help answer the questions above)

TABLE 1 | Valuation of Company B as a stand-alone unit. (assume that Company A will allow Company B to run as a stand-alone unit with no synergies)

Revenue growth 6.0% Steady state growth 5.9%

COGS 55% WACC 10.9%

SG&A 20% Tax rate 39%

Year 0 year1 year2 year3 year4 year5 year6steady rate

Revenues ($thousands) 9,750 10,000 10,600 1,236 11,910 12,625 13,370

COGS 5,500 5,830 6,180 6,551 6,944

Gross profit 4,500 4,770 5,056 5,360 5,681

SG&A 2,000 2,120 2,247 2,382 2,525

Depreciation 1,000 1,000 1,000 1,000 1,000

EBIT 1,500 1,650 1,809 1,978 2,156

Less Taxes (585) (644) (706) (771) (841)

NOPAT 915 1,007 1,103 1,207 1,315 1,393

Add: depreciation 1,000 1,000 1,000 1,000 1,000

Less: capital expenditures (1,250) (1,250) (1,250) (1,250) (1,250) 664

Less: Increase in NWC (55) (132) (140) (148) (157) (164)

= Free cash flow 610 625 713 809 908 565

Terminal value 11,305

Free Cash Flows + Terminal value 610 625 713 809 12,213

Enterprise Value PV 10.9%(FCF)= 9,396

NWC (22% Sales) 2,145 2,200 2,332 2,472 2,620 2,777 2,941

NPPE(+CAPEX-Depr. Each year) 10,000 10,250 10,500 10,750 11,000 11,250 11,914

Operating margin[NOPAT/Sales] 9.2% 9.5% 9.8% 10.1% 10.4% 10.4%

PPE turnover[Sales/NPPE] 0.98 1.01 1.05 1.08 1.12 1.12

RONA[NOPAT/(NWC+NPPE)] 7.3% 7.8% 8.3% 8.9% 9.4% 9.4%

Year 6 Steady-State Calculations:

Sales= Year 5 Sales x (1+ Steady-State Growth) = 12,625 x 1.059 = 13,370

NOPAT = Year 5 NOPAT x (1+ Steady-State Growth) = 1,315 x 1.059 = 1,393

NWC = Year 5 NWC x (1 + Steady-State Growth) = 2,777 x 1.059 = 2,941

NPPE = Year 5 NPPE x (1+ Steady-State Growth) = 11,250 x 1.059 = 11,914

Increase in NPPE = Capital Expenditures less Depreciation = 11,250 - 11,914 = -664 Year 5 Terminal Value = Steady-State FCF / (WACC - Steady-State Growth) = 565 (0.109 - 0.059) = 11,305

(We dont use Company As WACC because it does not reflect the risk associated with the merger cash flows. In this case, one is better advised to focus on where the money is going rater that where the money comes from in determining the risk associated with the transaction)

Table 2 Inputs to WACC

Bidder Target

A-Co. B-Co.

Bond rating A BBB

Yield to maturity of bonds 7.2% 7.42%

Tax rate 39.0% 39.0%

After-tax cost of debt 4.39% 4.53%

Beta 1.05 1.20

Cost of Equity 12.18% 13.08%

Debt as % of capital 20.0% 25.0%

Equity as % of capital 80.0% 75.0%

10-year Treasury bond yield 5.88% 5.88%

Market risk premium 6.0% 6.0%

WACC 10.6% 10.9%

TABLE 3 | Valuation of Company B with synergies. (assume that Company B merges with Company A and realizes operational synergies)

Revenue growth 8.0% Steady-state growth 5.9%

COGS 53% WACC 10.9%

SG&A 19% Tax rate 39%

Net working capital(NWC) 22%

Year0 year1 year2 year3 year4 year5 year 6 steady state

Revenues ($thousands) 9,750 10,000 10,800 11,664 12,597 13,605 14,408

COGS 5,300 5,724 6,182 6,676 7,211

Gross profit 4,700 5,076 5,484 5,921 6,394

SG&A 1,900 2,052 2,216 2,393 2,585

Depreciation 1,000 1,000 1,000 1,000 1,000

EBIT 1,800 2,024 2,266 2,527 2,809

Less Taxes (702) (789) (884) (986) (1,096)

NOPAT 1,098 1,235 1,382 1,542 1,714 1,815

Add: Depreciation 1,000 1,000 1,000 1,000 1,000

Less: Capital expenditures (1,250) (1,250) (1,250) (1,250) (1,250) (664)

Less: Increase in NWC (55) (176) (190) (250) (222) (177)

=Free cash flow 793 809 942 1,086 1,242 974

Terminal value 19,490

Free cash flows + terminal value: 793 809 942 1,086 20,732

Enterprise Value PV 10.9%(FCF)= 15,140

NWC (22% sales) 2,145 2,200 2,376 2,566 2,771 2,993 3,170

NPPE (+CAPEX-depr. / year) 10,000 10,250 10,500 10,750 11,00011,250 11,914

Operating margin[NOPAT/sales] 11.0% 11.4% 11.9% 12.2% 12.6% 12.6%

PPE turnover[sales/NPPE] 0.98 1.03 1.09 1.15 1.21 1.21

RONA[NOPAT/(NWC+NPPE)] 8.8% 9.6% 10.4% 11.2% 12.0% 12.0%

Year 6 Steady-State Calculations:

Sales = Year 5 Sales x (1 + Steady-State Growth) = 13,605 x 1.059 = 14,408

NOPAT = Year 5 NOPAT x (1 + Steady-State Growth) = 1,714 x 1.059 = 1,815

NWC = Year 5 NWC x (1 + Steady-State Growth) = 2,993 x 1.059 = 3,170

NPPE = Year 5 NPPE x (1 + Steady-State Growth) = 11,250 x 1.059 = 11,914

Increase in NPPE = Capital Expenditures less Depreciation = 11,250 - 11,914 = -664 Year 5 Terminal Value = Steady-State FCF / (WACC - Steady-State Growth) = 974 (0.109 - 0.059) = 19,490