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

Question 1

If the acquisition of the target is believed to be very important to implement the acquirer's strategy,the acquirer should be willing to pay up to the maximum purchase price.

Answer 1

False

Question 2

Cost savings are likely to be greatest when firms with dissimilar operations are consolidated.

Answer 2

False

Question 3

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

Answer 3

True

Question 4

The share exchange ratio indicates the number of acquirer shares to be exchanged for each share of target stock based on the target firm's current share price.

Question 5

The acquiring firm's existing loan covenants need not be considered in determining the feasibility of acquiring the target firm.

Question 6

The maximum purchase price is the minimum price plus the present value of sources of value.True or False

Question 7

The effects of synergy resulting from combining the acquirer and target firms do not affect the acquirer's ability to finance the transaction.

Question 8

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

Question 9

Non-compliance with environmental laws,product liabilities,pending lawsuits,poor product quality, patents,poorly written or missing customer contracts,and high employee turnover are all considered destroyers of value.

Question 10

Net synergy may be estimated as the difference between the sum of the present values of the target and acquiring firms,including the effects of synergy,and the value of the target firm including the effects of synergy.

Question 11

Improper revenue recognition is the most common form of financial reporting fraud.

Question 12

Projecting as many of the key income,cash flow,and balance sheet components as a percent of projected revenue helps to ensure the internal consistency of the model.True or False

Question 13

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

Question 14

The current stock price of the acquiring firm may decline,reflecting a potential dilution of its EPS or a growth in EPS of the combined firms,which is less than the growth that investors had anticipated for the acquirer as a standalone business.

Question 15

In order to normalize the historical data of the target firm,it may be necessary to subtract large increases in
reserves and add back large decreases in reserves from cash flow.

Question 16

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

Question 17

A target firm's high employee turnover is often considered a destroyer of value.

Question 18

When the target firm is an operating division of a larger firm,it is common for the parent to provide services to the target at below market prices.In calculating the target's standalone value,it is necessary to subtract the difference between the market price of these services and actual cost paid to the parent from the target firm's net income.

Question 19

Minimum purchase price or initial offer price for a target is the target's standalone value or market value.

Question 20

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

Question 21

A standalone business is one whose financial statements reflect all the costs of running the business and all of the revenues generated by the business.

Question 22

When one company acquires another,year over year historical earnings comparisons for the acquiring firm are unaffected.

Question 23

Financial modeling refers to the application of spreadsheet software to define simple arithmetic relationships among variables within the firm's income,balance sheet,and cash-flow statements and to define the interrelationships among the various financial statements.

Question 24

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.

Question 25

The output of M&A models is only as good as the accuracy and timeliness of the numbers that are used to create the model and the quality of the assumptions used in making the projections.

Question 26

While it is legitimate for a firm to follow different accounting practices for financial reporting and tax purposes,the relationship between book and tax accounting is likely to remain constant over time,unless there are changes in tax rules or accounting standards.

Question 27

If the target firm's ratio of bad debt reserves as a percent of projected revenue is increasing,the analyst can be confident that the firm is boosting revenue by not reserving enough to cover probable future losses.

Question 28

Pro forma financial statements rarely deviate from those compiled in accordance with GAAP.

Question 29

In normalizing historical data,monthly revenue may be aggregated into quarterly or even annual data to minimize possible distortions in earnings or cash flow due to inappropriate accounting practices.True or False

Question 30

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

Question 31

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

Question 32

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.

Question 33

A clear statement of all assumptions underlying the model's projections forces the analyst to display their biases and to be prepared to defend their assumptions to others.

Question 34

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

Question 35

Financial models can be used to answer the following questions: How much is the target company worth without the effects of synergy? What is the value of expected synergy? What is the maximum price that the acquiring company should pay for the target?

Question 36

Although public companies still are required to file their financial statements with the Securities and Exchange Commission in accordance with GAAP,companies increasingly are using pro forma statements to portray their financial performance in what they argue is a more realistic (and usually more favorable)manner.

Question 37

Common size financial statements are among the most commonly used tools to uncover data irregularities.

Question 38

Discrepancies between the way a firm records its financial statements and GAAP accounting standards are common and should be ignored.

Question 39

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

Question 40

Collar agreements are employed in all cash purchases of the target's stock to preserve the value of the purchase price for acquirer shareholders.

Question 41

The appropriate discount rate for the combined firms is generally the target's cost of capital unless the two firms have similar risk profiles and are based in the same country.

Question 42

A simple model to project cash flow rarely involves the projection of revenue and the various components of cash flow as a percent of projected revenue.

Question 43

Financial models are of little value in determining whether the proposed purchase price can be financed by the acquirer.

Question 44

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.

Question 45

In calculating the value of net synergy,the costs required to realize the anticipated synergy should be ignored because they are difficult to forecast.

Question 46

By expressing the target's line-item data as a percentage of sales,it is possible to compare the target company with other companies' line item data expressed in terms of costs to highlight significant differences.

Question 47

Historical cash flow may be adjusted by deducting unusually large increases in reserves or by adding back large decreases in reserves from free cash flow to the firm.

Question 48

Examples of relevant historical relationships that are useful for forecasting cash flows include the relationship between fixed and variable expenses,and the impact on revenue of changes in product prices and unit sales.If these relationships can reasonably be expected to continue through the forecast period,they can be used to project the earnings and cash flows used in the valuation process.However,it is important to ignore cyclical movements in the data.

Question 49

Trend extrapolation,which entails extending present trends into the future using historical growth rates or multiple regression techniques,is rarely used to forecast cash flow.

Question 50

Potential sources of value rarely include factors not recorded on a firm's balance sheet.

Question 51

Value drivers are factors such as product volume,selling price,and cost of sales that have a significant impact on the value of the firm whenever they are altered.

Question 52

In determining the initial offer price,the acquiring company must decide how much of anticipated synergy it is willing to share with the target firm's shareholders.

Question 53

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

Question 54

Financial ratio analysis is the calculation of performance ratios from data in a company's financial statements to identify the firm's financial strengths and weaknesses.

Question 55

The accuracy of any valuation is heavily dependent on understanding the historical competitive dynamics of the industry,the historical performance of the company within the industry,and the reliability of the data used in the valuation.

Question 56

The appropriate financial structure can be determined from a range of different scenarios created by making small changes in selected value drivers.

Question 57

Revenue-related synergy may result from the acquirer being able to sell their products to the target firm's customers.

Question 58

It is unimportant whether the acquirer uses the target's or its own weighted average cost of capital when valuing the target firm.

Question 59

Competitive dynamics simply refer to the factors within the industry that determine industry profitability and cash flow.

Question 60

Assume Firm A's acquisition of Firm B results in a reduction in the combined firms' debt-to-total capital ratio to .25.If the same ratio for the industry is .5,the combined firm may be able to increase its borrowing to the industry average,assuming no extenuating circumstances.However,this should not be viewed as a source of value to the acquiring firm.

Question 61

Which of the following are examples of cost-related synergy?

A) Spreading fixed costs over increased output levels
B) Eliminating duplicate jobs
C) Discounts from suppliers due to bulk purchases
D) Paying termination expenses
E) A, B, and C only

Question 62

Acquiring Corp agrees to buy 100% of the outstanding shares of Target Corp in a share for share exchange.How would Acquiring Corp determine how many new share of its
Stock it would have to issue?

A) Multiply the purchase price premium paid for Target's stock by the number of shares of target stock outstanding.
B) Multiply the share exchange ratio by the number of Acquirer shares outstanding.
C) Add the number of Acquirer and Target shares outstanding
D) Multiply the share exchange ratio by the number of Target shares outstanding.
E) Divide the share exchange ratio by the purchase price premium

Question 63

A merger which is expected to produce synergy

A) Should be rejected because the synergy will dilute the combined firm's earnings per share
B) Should be rejected because the first year's cash flow is negative
C) Has a negative NPV
D) Should be pursued because it creates value
E) Reduces target firm revenues

Question 64

Target is a wholly owned subsidiary of MegaCorp Inc.MegaCorp supplies a number of services to target.Target sells some of its products to other MegaCorp subsidiaries.Target also buys products from other MegaCorp subsidiaries that are used as inputs in producing Target's products.Which of the following adjustments should the acquirer make to Target's financial statements before valuing the firm?

A) Deduct the actual cost of services required by Target that are being supplied by the parent without charge from target's cost of sales.
B) Deduct the difference between the cost of products purchased from other MegaCorp subsidiaries at below market prices and the actual market prices for such products from Target's cost of sales.
C) Deduct the difference between the cost of products purchased from other MegaCorp subsidiaries at above market prices and the actual cost of such products if purchased from other sources from Target's cost of sales
D) A and B only.
E) None of the above.

Question 65

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?

Question 66

Which of the following is generally not considered a source of value to the acquiring firm?

A) Duplicate facilities
B) Patents
C) Land on the balance sheet at below market value
D) Warranty claims
E) Copyrights

Question 67

The share exchange ratio is impacted by all of the following except for

A) The current share price of the target firm
B) The current share price of the acquirer
C) The offer price for the target firm
D) The number of shares outstanding for the target firm
E) A and D

Question 68

Which of the following is not true about common size financial statements?

A) Such statements are used to uncover data irregularities.
B) Such statements are constructed by calculating the percentage each line item of the income statement, balance sheet, and cash flow statement is of annual sales.
C) Such statements are useful for comparing businesses of different sizes in the same industry at different moments in time.
D) Common size statements applied over a number of consecutive periods may be used to determine if the target firm is deferring necessary spending.
E) Common size statements may be calculated for both quarterly and annual financial data.

Question 69

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.
:
It what way did the acquisition of Wrigley's represent a strategic blow to Cadbury?

Question 70

The initial offer price for the target firm is defined as

A) The minimum price
B) The present value of the minimum price plus some fraction of the present value of net synergy
C) The present value of net synergy plus the current market value of the target firm
D) The maximum price less the minimum price
E) The maximum price less the present value of net synergy

Question 71

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

A) Protect the value of the transaction for the acquirer's shareholders
B) Preserve the value of the transaction for the target's shareholders
C) Minimize the number of new acquirer shares that must be issued.
D) Increase the value of the transaction for the acquiring firm
E) Increase the value of the transaction for the target firm

Question 72

What happens to the outstanding shares of the target firm when the acquirer purchases 100% of the target's outstanding stock?

A) They are added to the number of shares of Acquirer stock outstanding
B) They are cancelled.
C) They are converted into preferred stock.
D) They are shown as treasury stock on the books of the combined companies.
E) They are swapped for debt in the new company.

Question 73

The share exchange ratio is defined as

A) Offer price for the target divided by the acquirer's share price
B) Offer price for the target divided by the target's share price
C) Acquirer's share price divided by the target's share price
D) Target's share price divided by the offer price
E) Acquirer's share price divided by the offer price

Question 74

Which one of the following is not one of the steps in the M&A model building process?

A) Valuing the acquirer and the target firms as standalone businesses
B) Valuing the target and acquiring firms including synergy
C) Determining the initial offer price for the target firm
D) Establishing search criteria for the potential target firm
E) Determining the combined firm's ability to finance the transaction.

Question 75

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

A) Synergy
B) Book value
C) Investment value
D) Diversification
E) None of the above

Question 76

Which of the following is not true about generally accepted accounting principles (GAAP)?

A) GAAP provide specific guidelines as to how to account for specific events impacting the financial performance of the firm.
B) The scrupulous application GAAP accounting rules does ensure consistency in comparing one firm's financial performance to another.
C) It is customary for definitive agreements of purchase and sale to require that a target company represent that its financial books are kept in accordance with GAAP.
D) GAAP guarantees that a firm's financial books are accurate.
E) Differences between how a firm records actual financial transactions and how they should be recorded based on GAAP may indicate fraud or mismanagement.

Question 77

Post merger earnings per share are affected by all of the following factors,except for

A) Acquiring firm's outstanding shares
B) Price offered for the target company
C) Number of target firm's outstanding shares
D) Current price of the acquiring company's stock
E) Current price of the target firm's stock

Question 78

Realizing synergy often requires spending money.Which of the following are examples of such expenditures?

A) Employee recruitment and training expenses
B) Severance expenses
C) Investment in equipment to improve employee productivity
D) Redesigning workflow
E) All of the above

Question 79

Which factors would be considered in determining the feasibility of financing a proposed takeover?

A) Potential dilution in EPS of the combined firms.
B) Impact on overall borrowing costs of the combined firms.
C) Possible violation of loan covenants on existing debt of the acquiring company
D) Return on total capital of the combined firms
E) All of the above.

Question 80

Selecting the appropriate financing structure for the combined firms requires consideration of which of the following:

A) The impact on the combined firm's EPS
B) Potential violation of loan covenants
C) The extent to which the primary needs of both the buyer's and seller's shareholders are satisfied.
D) A and B only
E) A, B, and C