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Chapter 9: Applying Financial Modeling
To Value, Structure, and Negotiate Mergers and Acquisitions
Examination Questions and Answers
1. The scrupulous application of GAAP ensures both consistency in comparing one firm’s financial
performance with another and the accuracy of the data. True or False
2. Improper revenue recognition is the most common form of financial reporting fraud. True or False
3. 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. True or False
4. Common size financial statements are useful for comparing businesses of different sizes in the same
industry at different points in time. True or False
5. 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
6. The present value of net synergy is the difference between the present value of projected cash flows from
sources and destroyers of value. True or False
7. 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. True or False
8. 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. True or False
9. The target firm’s underutilized borrowing capacity is often considered a source of value. True or False
10. A target firm’s high employee turnover is often considered a destroyer of value. True or False
11. 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. True or False
12. Cost savings are likely to be greatest when firms with dissimilar operations are consolidated. True or False
13. Minimum purchase price or initial offer price for a target is the target’s standalone value or market value.
True or False
14. The maximum purchase price is the minimum price plus the present value of sources of value. True or
False
15. 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. True or False
16. The acquiring firm’s existing loan covenants need not be considered in determining the feasibility of
acquiring the target firm. True or False
17. The effects of synergy resulting from combining the acquirer and target firms do not affect the acquirer’s
ability to finance the transaction. True or False
18. 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. True or False
19. The share exchange ratio is defined as offer price divided by the target firm’s current share price. True or
False
20. 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. True or False
21. Collar agreements are employed in all cash purchases of the target’s stock to preserve the value of the
purchase price for acquirer shareholders. True or False
22. 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. True or False
23. 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. True or False
24. 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.
True or False
25. 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
26. Common size financial statements are among the most commonly used tools to uncover data irregularities.
True or False
27. Net synergy is the difference between the present value of the estimated sources of value and destroyers of
value. True of False
28. In determining the initial offer price, the acquirer must decide how much of the anticipated synergy to
share with the target firm’s shareholders. True or False
29. Complex models because of their greater sophistication are necessarily more accurate than simple models.
True or False
30. 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. True or False
31. 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. True or False
32. 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? True or False
33. 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. True or False
34. Discrepancies between the way a firm records its financial statements and GAAP accounting standards are
common and should be ignored. True or False
35. Pro forma financial statements are simply another name for GAAP financial statements. True or False
36. Pro forma financial statements rarely deviate from those compiled in accordance with GAAP. True or
False
37. When one company acquires another, year over year historical earnings comparisons for the acquiring firm
are unaffected. True or False
38. 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. True or False
39. 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. True or False
40. 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. True or False
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. True or false
42. It is unimportant whether the acquirer uses the target’s or its own weighted average cost of capital when
valuing the target firm. True or False
43. Financial models are of little value in determining whether the proposed purchase price can be financed by
the acquirer. True or False
44. The appropriate financial structure can be determined from a range of different scenarios created by making
small changes in selected value drivers. True or False
45. 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. True or False
46. 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. True or False
47. Competitive dynamics simply refer to the factors within the industry that determine industry profitability
and cash flow. True or False
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. True or False
49. 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. True or False
50. It is rarely useful to review more than one or two years of historical data for the acquiring or target firms.
True or False
51. 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. True or False
52. 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. True or False
53. 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. True or False
54. 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. True or False
55. 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. True or False
56. Potential sources of value rarely include factors not recorded on a firm’s balance sheet. True or False
57. 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. True or False
58. In calculating the value of net synergy, the costs required to realize the anticipated synergy should be
ignored because they are difficult to forecast. True or False
59. 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. True or False
60. Revenue-related synergy may result from the acquirer being able to sell their products to the target firm’s
customers. True or False
1. 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.
2. 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.
3. 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.
4. 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
5. 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
6. 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
7. 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
8. 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.
9. 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
10. 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.
11. 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.
12. 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
13. 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
14. 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
15. 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
16. 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
17. 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
18. 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
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.
Discussion Questions:
1. Why was market share in the confectionery business an important factor in Mars’ decision to acquire
Wrigley?
2. It what way did the acquisition of Wrigley’s represent a strategic blow to Cadbury?
3. How might the additional product and geographic diversity achieved by combining Mars and Wrigley
benefit the combined firms?
4. Speculate as to the potential sources of synergy associated with the deal. Based on this speculation what
additional information would you want to know in order to determine the potential value of this synergy?
5. Given the terms of the agreement, Wrigley shareholders would own what percent of the combined
companies? Explain your answer
Tribune Company Acquires the Times Mirror Corporation
in a Tale of Corporate Intrigue
Background: Oh, What Tangled Webs We Weave. .
.
CEO Mark Willes had reason to be optimistic about the future. Operating profits had grown at a double-digit rate,
and earnings per share had grown at a 55% annual rate between 1995 to 1999. Many shareholders appeared to be
satisfied. However, some were not. Although pleased with the improvement in profitability, they were concerned
about the long-term growth prospects of the firm. Reflecting this disenchantment, Times Mirror’s largest
shareholder, the Chandler family, was contemplating the sale of the company and along with it the crown jewel Los
Angeles Times. It had been assumed for years that the Chandler family trusts made a sale of Times Mirror out of the
question. The Chandler’s super voting stock (i.e., stock with multiple voting rights) allowed them to exert a
disproportionate influence on corporate decisions. The Chandler Trusts controlled more than two-thirds of voting
shares, although the family owned only about 28% of the total shares of the outstanding stock.
In May 1999 the Tribune Chairman John Madigan contacted Willes and made an offer for the company, but Willes,
with the help of his then-chief financial officer (CFO), Thomas Unterman, made it clear to Madigan that the
company was not for sale. What Willes did not realize was that Unterman soon would be serving in a dual role as
CFO and financial adviser to the Chandlers and that he would eventually step down from his position at Times
Mirror to work directly for the family. In his dual role, he worked without Willes’ knowledge to structure the deal
with the Tribune.
Following months of secret negotiations, the Chicago-based Tribune Company and the Times Mirror Corporation
announced a merger of the two companies in a cash and stock deal valued at approximately $7.2 billion, including
$5.7 billion in equity and $1.5 billion in assumed debt. The transaction, announced March 13, 2000, created a media
giant that has national reach and a major presence in 18 of the nation’s top 30 U.S. markets, including New York,
Los Angeles, and Chicago. The combined company has 22 television stations, four radio stations, and 11 daily
newspapers—including the Los Angeles Times, the nation’s largest metropolitan daily newspaper and flagship of the
Times Mirror chain.
Transaction Terms: Tribune Shareholders Get Choice of Cash or Stock
The Tribune agreed to buy 48% of the outstanding Times Mirror stock, about 28 million shares, through a tender
offer. After completion of the tender offer, each remaining Times Mirror share would be exchanged for 2.5 shares of
Tribune stock. Under the terms of the transaction, Times Mirror shareholders could elect to receive $95 in cash or
2.5 shares of Tribune common stock in exchange for each share of Times Mirror stock. Holders of 27.2 million
shares of Times Mirror stock elected to receive Tribune stock, whereas holders of 10.6 million elected to receive
cash. Because the amount of cash offered in the merger was limited and the cash election was oversubscribed, Times
Mirror shareholders electing to receive cash actually received a combination of cash and stock on a pro rata basis
(Table 1).
Table 1. Times Mirror Transaction Terms
As of June 12, 2000 Transaction Value
Times Mirror Shares Outstanding @ 3/13/00 59,700,000
No. of Times Mirror Shares Exchanged for 2.3
Shares of Tribune Stock 27,238,253 $2,587,634,0351
No. of Times Mirror Shares Exchanged for Cash 10,648,318 $1,011,536,9682
Times Mirror Shares Outstanding after Tender Offer 21,813,429
No. of New Tribune Shares Issued for Remaining
Times Mirror Shares 54,533,5735 $2,072,275,7743
Equity Value of Offer $5,671,446,777
Market Value of Times Mirror on
Merger Announcement Date $2,805,900,0004
Premium 102%
127,238,253 2.5 $38/share of Tribune stock.
2$41.70 in cash + 1.4025 shares of Tribune stock $38 per share for each Times Mirror share remaining
10,648,318.
3Equals 2.5 shares 21,813,429 $38 per Tribune share.
4Times Mirror share price on announcement date of $47 times 59,700,000.
5The total number of new Tribute shares issued equals 27,238,318 2.5 + 10,648,318 2.5 + 54,533, 573 or
137,537,013.
Newspaper Advertising Revenues Continue to Shrink
