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Exam 2
Wednesday, October 21, 2015

7:08 PM

Accretion/Dilution Analysis
• Accretion/Dilution analysis
○ Assess the impact of an acquisition on the acquirer's EPS
 Accretive: adds to earnings; combined (pro forma) EPS > acquirer's standalone EPS
 Dilutive: earnings go down; combined EPS < acquirer's standalone EPS
 Breakeven: combined EPS = standalone EPS
• Wall Street generally frowns on dilutive deals
...

 Dilutive EPS = 4
...

○ Cash flow based is more accurate

Steps
1
...
Potential Adjustments:
i
...
Excess cash and liquid securities used to finance the acquisition
iii
...
Option proceeds
v
...
Underwriting fees
vii
...
Calculate the combined company's new share counts
a
...
Acquirer's share count + new shares created to finance deal
3
...
Compare pro forma EPS to acquirer's EPS without the transaction
• What factors can lead to dilution?
• Target negative net income
• Target P/E > Acquirer P/E
• Transaction results in a significant amount of intangible assets to amortize
• Increased interest expense
○ Borrow $ and increase interest expense
• Decreased interest income
• Low (negative synergies)
• Calculating fully diluted shares outstanding:
• What kind of options do we grant to managers?
○ Call options
○ Option vs
...
Fully diluted shares outstanding?
○ FDSO: captures equity based securities not yet converted to shares
 Ex:// manager of a target company w/ stock options that can't be exercised for 3 years
...
If Shares are in the money exercise those options and change to shares
...
The resulting proceeds are used to repurchase outstanding shares at the company's current
share price
...

• If converted vs
...
Value in excess of the conversion price is settled
with additional, newly issued shares of stock
○ (will be obvious which of these 2 to choose)

Example:
P = $20

BSO = 100M

In the Money

X = $18 (weighted average price) when managers exercise

FIN 465 Page 1

P = $20

BSO = 100M

Nominal Amount
Convert = $150M

In the Money
Options = 5M

X = $18 (weighted average price) when managers exercise
these options
...
5M shares; use cash we have to buy as many as we can then the
rest goes to:
○ New Share Issues = 5
...
5 = 0
...
FV = 1000 conversion of 15 = 15 1000/15=
value on that bond
...
If converted: How many shares are going to be created?
a
...
Conversion P
...
150M/15 = Incremental shares 10M
i
...
Incremental shares = 10M; what is the value of those 10M shares today?
2
...
Nominal Value = $150 (settled in cash)
4
...
New Shares Issued = $50M/$20 = 2
...
5M + 10M = 110
...
5M + 2
...


Answer: Diluted Transaction
• Can look @ P/E ratio
w/o calculating to know
this

1
...

3
...

5
...


Pro Forma NI: (5 x 1000) + (2
...
00
New Shares Issued: 60,000/$25 (our shares) = give them 2,400 shares
Pro Forma Shares Outstanding: 4,000 + 2,400 = 6,400
Pro Forma EPS: 15,000/6400 shares = 2
...
50) by 6
...


1
...

3
...


Pro Forma NI: 15,000 (same as above)
Pro Forma Shares Outstanding = Remain @ 4,000
Pro forma EPS = 15,000/4,000 = 3
...
65 > 2
...
3
...
50 Deal is Accretive by 50%
3
...
Premium: pushes toward dilution
b
...
P/E pushes toward dilution
1
...
5 x 4,000)] x 1
...
Deal Value: $60 x 1000 x 1
...
New Shares Issued = 72,000 worth of shares/ $25 = $25
...

○ What do they do?
 Raise the funds
 Identify suitable targets for investment
 Perform in-depth research and due diligence on target companies
 Manage the investment in behalf of their investors
• Structure
○ Usually organized as management partnerships or limited liability partnerships that act as holding companies for
several PE funds
...
g
...

• Deal Structure

•

○ PPX = purchase price multiple
 paying more in 2007
○ FDX = funded debt multiple (how much debt did we put onto firm as a result of the transaction)
 put 100 m in the capital structure 2007 600M worth of leverage
○ Senior bank loans 2003: 100m dollar ebitda firm buying for 700M of that 500M debt 400M bank loans
...
Of bank loans 40-60 split
...
Primarily servicing the debt
○ By 2007:
○ -higher prices w/ more debt
○ -less equity contribution
○ -bank loans: shifted more towards B/c tranches not being amortized
○ -more sophisticated capital structure (risky mechanisms)
 -SL lean loans
 -PIK (payment in kinds): borrow money at 8%, 1 st interest payment borrow 80 more now owe 1080
instead of paying interest, just borrowing more of what you owe
• Exit Strategies

•

•
•
•
•
•
•
•
•

Investments: not in it for the long term
-Pe enters w/ exit on the horizon
Several ways to exit:
-sell the firm to strategic buyer
-sell to another PE firm (secondary buyout)
Sale vs
...


FIN 465 Page 4

Leveraged Buyouts
• Premise
○ Acquisition of a target using debt to finance a large portion of the purchase price
 Targets include both public and private companies, divisions and their subsidiaries
 Historically, 60-70% debt and 30-40% equity
 Equity contribution comes from a financial sponsor
 Interest is tax deductible
 Real estate transactions resembles LBOs
○ Leverage is key to LBOs
 Enables a sponsor to contribute small equity investment
 Enables sponsor to achieve desired returns (20% annualized)
 Tax savings due to tax deductibility of interest payments
 Some argue leverage improves firm governance (Jensen, "eclipse of the public corporation")
• LBO Analogy
○ Consider the purchase of a rental property in Oxford:
 Real estate is often purchased using a large amount of leverage
 Investor hopes cash flows (Rent) are sufficient to cover debt service (pay mortgage) and property upkeep
 Excess cash can be reinvested, used to retire debt, and/or kept by the property owner for other purposes (i
...
a
dividend)
 In the future, the property owner may choose to exit (sell) the investment
 Overall return on the investment is determined by:
□ Purchase price
□ Initial financing
□ Debt repayment
□ Dividends
□ Exit price
 80/20 real estate term
□ Pay interest on debt
□ Investments for higher prices in rent
□ Minimum: pay interest on debt and upkeep w/ maintenance
 Exit strategy
 Return: buy right (did we pay too much)
 How did we finance, could we repay debt, dividends and exit price
• LBO Participants
○ Financial sponsors
 Pe firms, IB merchant banks, hedge funds etc
○ Investment banks: financial needs
○ Lenders
 Commercial banks and institutional lenders
 Source of capital
○ Bond investors
 High yield funds, hedge funds, pension funds, insurance companies, distressed debt funds, and CDOs)
 Public debt markets
○ Target management
 Private equity firms don’t want to manage; in search of businesses w/ good management team in place
(incentive for management team to perform)
• LBO Candidates
○ Attractive LBO candidates are targets that can be purchased at a price and utilizing a financing structure that provides
sufficient returns w/ a viable exit strategy
○ Attractive candidates
 Proven management team
 Strong and stable cash flows (pay down debt)
 Leading and defensible market positions (high barriers to entry reduces competition increases cash flow)
 Growth opportunities
 Efficiency enhancement opportunities: more profitable, generates returns
 Low capital expenditure and research and development requirements: burn through cash
FIN 465 Page 5

 Low capital expenditure and research and development requirements: burn through cash
 Strong asset base: collateral for better, term and volume borrowing
 Untapped assets (e
...
real estate, licenses, contracts, patents, etc)
□ Don’t need: sell them to generate cash
• LBO economics
○ During sponsor's ownership of LBO target, cash flow is used primarily to service and repay debt
 Successfully repaying debt increases the equity portion of the capital structure
 Sponsor aims to improve target financial performance
 Sponsor aims to grow the existing business
 Repaying debt drives returns and increases shift to equity w/ increased performance
○ Return analysis:
 IRR: internal rate of return
□ Primary drivers:
 Purchase price
 Projected financial performance
 Financing structure
 Exit price and time
 IRR recorded as times passes if not growing
 Cash return: cash on cash (how much cash did they take out divided by how much the put in)
• Example
○ Initial equity contribution (t=0): $250MM
○ Equity proceeds at sale (t=5): 750MM
○ Dividends/investment in remaining years: $0 whats IRR? Cash return?

(250)

750 t=5

•

•

○ IRR discount rate that makes a 0 NPV calculation for project
○ CR – Cash out to cash in ratio
○ IRR will go down, CR will remain same in case of TVM
• LBOs generate returns through debt repayments and growth in enterprise value
○ Modeled impact on IRR/CR based on capital structure
• Example
Assumptions
Purchase price

$1,000

• Equity contribution
Debt repayment
Sale price (year 5)
T =0

$250
$0
$1,500

t=5

TV = 1000

Exit TV = 1,000

E= $250

E = $750

D= $750

D = $250

Sponsor Perspective: IRR = 0= (250) + 750/(1+I)^5 to IRR = 24
...
5x senior debt, 0
...
5x equity (3
...
7 = 36
...


• Debt covenants
• -terms they can and cant do for accepting loan

• Violations of covenant imply default
• LBO Analysis

• -can require immediate repayment etc

○ LBO analysis is more complex than prior valuation techniques discussed because it requires knowledge of the
following:

 Financial modeling
 Leveraged debt capital markets
 M&A
 Accounting
○ LBO valuation key variables include:
 Financial projections
 Purchase price
 Financing structure
 Exit multiple
 Exit year

Other Restructuring Topics:
• Business Alliances: are an alternative to M&A
○ Types

 Joint Ventures
○ Entity created by multiple parties who contribute equity and share in revenues, expenses, and control of
the entity (contribute time, capital
...
Do not involve creation
of a separate legal entity
 Creates alliance to work towards a common goal

 Ex:// star alliance and alliance btwn
...
debt financing
• Control
• Dispute resolution
• Contract termination
• Transfer of interests
• Taxes
• Management and organizational issues

 Market tends to react + to equity partnerships and alliances (1
...

○ ~33% of total M&A between 1970 and 2008 (1/3 m&a activity)
○ often highly diversified firms w/ need for focus and cash (if taxes are a big concern divestitures not a good
choice)
○ Motives
 Raise cash
 Sell undervalued/underperforming assets to fund investments, pay off debt, and/or pay
shareholders a dividend
 Operating unity may be worth more if sold than retained
○ Tax considerations
 Divesting firm must recognize a gain/loss equity to the difference between
○ Ex:// P&G sold Pringles to Kellogg (2
...

○ Often highly diversified w/ little need for cash

FIN 465 Page 8

 Distributions are direct proportion to shareholders' ownership of parent-firm stock
 New entity has its own management and operates independently of the parent

 Does not raise cash for the parent firm
○ Motives
 Low tax basis business can be spun off tax free

 Spun-off unit has its own stock
 Managers have greater autonomy
○ Ex:// ITT created 2 new legal subsidiaries (retained their engineering businesses)
1
...
Xylem: water assets
○ Pre spin off: owned 10 shares of differsified ITT
○ Post spin off: own 10 shares of Exelis, 10 shares of Xylem, 5 shares of ITT (reverse split shares)
1
...
Advantage:
1
...
Specialization
3
...
Currency to buy something in future
3
...
ITT didn’t raise any cash from spin off vs
...
(there would be no GE going forward just 4
separate companies)
○ Examples:
 Family Guy Cleveland Show; American Airlines American Eagle;
ITT Exelis (defense) and Xylem (water); Kraft Mondelēz International
*divestitures raise cash and are taxable transactions vs
...
Similar to
divestitures in that they raise cash for the parent firm
○ Less diversified business with some synergies and a desire to raise cash
 Parent retains control
□ 80% enables consolidation for tax purposes
□ 50% enables consolidation for financial reporting purposes
○ Motives
 Raise funds
 Often a prelude to a divestiture: stock allows public to value the business
 Carve out unit has its own stock
○ Example: Goldcorp carve out of Primeraming and Tahoe Resources; Phillip Morris carve out of Kraft
• How to choose? The decision generally boils down to 3 factors:
1
...
Degree of synergy between business being divested and the parent's other operating units
3
...
Bought house for 1m for home that was only worth
...
Try to fix firm problems and reemerge as a stronger
entity

 Process
○ File in federal bankruptcy court
 Voluntary vs
...

 Court appointed trustee handles administrative aspects of liquidation
○ Liquidate assets
○ Keeps records
○ Examines creditor claims

○ Disburse proceeds
○ Submit final liquidation report
 Proceeds are distributed according to the following priorities;
priority of claims make each whole before moving onto the next group
-100%, 100%, 0%,0% however usually ends up 95%, 20%, 10%, 5%
○ Secured creditors' claims
○ Administrative claims (eg lawyers, court costs, accountants)
○ Statutory claims (eg taxes, rent, unpaid wages/benefits)
○ Unsecured creditors' claims
○ Equity claims
 US is bias toward ch 7
...
Informed investors bid only on the offerings
they think will gain superior return
...

Underwriters need uninformed investors to bind
...
Other
costs include:

○ Administrative Costs
 Preparing the new issue
 Accountants lawyers etc
 Divert attention away from day to day operations
○ Spread
 The difference between the public offer price and the price the underwriters pay for the shares
 Ex:// Rosetta Stone

○ Public offer price: $18
...
74
○ Spread = $1
...
00 = 7
...
12

○ Cost of going public = (25
...
74)/ 25
...
38/25
...
4%
 Does not include administration costs, which are not directly measurable
• IPO firm valuation: Pre-money vs
...

• Example:
○ Investor is looking to invest in a hi-tech startup
...


○ Ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation
...
25 million
...


FIN 465 Page 11

Ray Eckert, Wilton Re:
• What does Wilton Re do?
○ M&A specialist in North American life insurance industry
○ Stock acquisitions
 Non-strategic subsidiary of larger organizations
 All the assets and liabilities of the business
 Generally in run - off
 Executed through Stock Purchase Agreements
○ Reinsurance
 Bulk insurance policy that assumes the risks of an insurance companies' business
 Can assume all the risk of the business through reinsurance including operations
 May represent a line of business or a block of policies
 Executed through reinsurance agreements
• Types of buyers
○ Strategic
 New business revenues
 Distribution methods; clients
 Product expansion
 Intellectual property
 Operations platform
 Methods/processes
 Goodwill
 Other intangibles
○ Financial
 No synergistic opportunities
 New business value dependent on hurdle rate
 Strict underwriting and financial analysis
○ Key variables
 Financing approach/ lower cost of capital
 Cost savings
 Tax
• M&A Process
○ Who's involved in M&A
 CEO: Thesis proposal/governance
 HR: value of employee benefits, hr conforming policies, staff reduction + outplacement
 CIO: systems integrations, IT standards
 COO: integration, go-forward processes, expense savings
 General counsel/legal: regulatory approvals, litigation, contracting
 CMO/Sales: revenue projections, sales plans, client management
 CFO: ROE accretion, rating agencies, financing
○ Process
 Planning
○ Thesis development, bankers hired, appraisal completed, confidential information, pre-marketing by
bankers
 1st and 2nd round (auction)
○ Invitation to bid
 Finals
 Closing
○ Regulatory filings made
○ Shareholder approvals
 Transition
○ New ownership, plan of operation
○ Disconnecting from seller/transition services
○ Earn outs

Dell Buyout Example
•
•
•
•

Approved by shareholders 9/2013
Completed 10/29/2013
10
...
6% premium)
Purchase
○ $13
...
13 special dividend = $13
...
98 B @ L + 175 (3 year term)
○ Revolver/consumer receivables: $1
...
165B/4
...
75x EBITDA @ 4
...
66B TL/B @ LIBOR + 350 (10% amortization 5 year term)
○ 1
...
5 year term)
○ 4
...
5 +
...
86 686B/4
...
63x @ 5
...
5B @ 5
...
05B @ 7
...
5B/4
...
83x @ 6
...
569B
• 3
...
Dell
• 1
...
5B from M
...
25B from MSD Capital
• 750m Termination Fee
Pre-LBO
• Debt: 9
...
569B
• EBITDA: 4
...
7472B
Restricted Stock Unit:
• Managers have to wait to take possecion of stocks granted to them
• Assume enter and exit @ same multiple
Beta:
• Prior Transaction: 1
...
65%
MPP = 7
...
68 →rE = 2
...
68(7
...
25%
rd = 3
...
3636
WACC = (
...
20) (9085/34069) + 15
...
93%
Post LBO: D/E = 1
...
68| [1 + (1-
...
3636)] = 1
...
30 [1+ (1-
...
64513)] = 3
...
65 + 3
...
5) = 25
...
46% [weighted average of debt]
WACC = (5
...
20)(13
...
225)(8234/21780) = 12

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