9. The calculation of free cash flow to equity includes all of the following except for
a. Operating income
b. Preferred dividends
c. Change in working capital
d. Gross plant and equipment spending
e. Principal repayments
10. All of the following are true about the marginal tax rate for the firm except for
a. The marginal tax rate in the U.S. is usually about 40%.
b. The effective tax rate is usually less than the marginal tax rate.
c. Once tax credits have been used and the ability to further defer taxes exhausted, the effective rate
can exceed the marginal rate at some point in the future.
d. It is critical to use the effective tax rate in calculating after–tax operating income in perpetuity.
e. It is critical to use the marginal rate in calculating after-tax operating income in perpetuity.
11. For a firm having common and preferred equity as well as debt, common equity value can be estimated in
which of the following ways?
a. By subtracting the book value of debt and preferred equity from the enterprise value of the firm
b. By subtracting the market value of debt from the enterprise value of the firm
c. By subtracting the market value of debt and the market value of preferred equity from the
enterprise value of the firm
d. By adding the market value of debt and preferred equity to the enterprise value of the firm
e. By adding the market value of debt and book value of preferred equity to the enterprise value of
the firm
12. The zero growth model is a special case of what valuation model?
a. Variable growth model
b. Constant growth model
c. Delta growth model
d. Perpetuity valuation model
e. None of the above
13. Which of the following is true of the enterprise valuation model?
a. Discounts free cash flow to the firm by the cost of equity
b. Discounts free cash flow to the firm by the weighted average cost of capital
c. Discounts free cash flow to equity by the cost of equity
d. Discounts free cash flow to equity by the weighted average cost of capital
e. None of the above
14. Which of the following is true of the equity valuation model?
a. Discounts free cash flow to the firm by the weighted average cost of capital
b. Discounts free cash flow to equity by the cost of equity
c. Discounts free cash flow the firm by the cost of equity
d. Discounts free cash flow to equity by the weighted average cost of capital
e. None of the above
15. Which of the following is true about the variable growth model?
a. Present value equals the discounted sum of the annual forecasts of cash flow
b. Present value equals the discounted sum of the annual forecasts of cash flow plus the discounted
value of the terminal value
c. Present value equals the discounted value of the next year’s cash flow grown at a constant rate in
perpetuity
d. Present value equals the current year’s free cash flow discounted in perpetuity
e. None of the above
16. When evaluating an acquisition, you should do which of the following:
a. Ignore market values of assets and focus on book value
b. Ignore the timing of when the cash flows will be received
c. Ignore acquisition fees and transaction costs
d. Apply the discount rate that is relevant to the incremental cash flows
e. Ignore potential losses of management talent
17. The incremental cash flows of a merger can relate to which of the following:
a. Working capital
b. Profits
c. Capital spending
d. Income taxes
e. All of the above
Additional Problems/Case Studies
COURT RULES DELL UNDERPAID PUBLIC SHAREHOLDERS
HIGHLIGHTING LEGAL DISTINCTION BETWEEN FAIR VALUE AND FAIR MARKET VALUE
______________________________________________________________________________
Case Study Objectives: To illustrate
• When “fair value” can trump “fair market value;”
• The subjectivity inherent in determining “fair value,” and
• How appraisal rights’ legal rulings could impact future deal negotiations.
_________________________________________________________________________
Financial theory postulates that the value of a firm is determined by discounting projected net cash flows at an
appropriate discount rate. In practice, buyers and sellers estimate the value of a firm using an array of valuation
methodologies discussed in Chapters 7 and 8 of this text. The actual price paid by the buyer to selling firm
shareholders is determined when the parties to the negotiation reach an agreement on what is a mutually acceptable
price. Assuming neither party was under duress to accept the price, the price paid by the buyer and accepted by the
seller is said to represent the “fair market value” of the firm.
Despite investment banking “fairness opinions,” some target firm shareholders will argue the price offered for
their shares is inadequate, contest it in court, and choose to have their shares valued by an independent appraiser,
state statutes permitting. Historically, judges in so-called “appraisal rights” hearings have relied on experts whose
opinions rely on conventional valuation methodologies. In recent years, judges frustrated by the often contradictory
opinions expressed by experts have deferred to the merger price or actual price paid for target firm shares as long as
the process used to determine the price was deemed fair. As such “fair market value” and “fair value” are the same,
under these circumstances.1
The concept of “fair value” is applied when no active market exists for a business, accurate cash flow projections
are problematic, or it is not possible to identify the value of similar firms. “Fair value” differs from “fair market
value,” which is the cash or cash-equivalent price that a willing buyer and a willing seller would accept for a
business. “Fair value” is, by necessity, more subjective because it represents the dollar value of a business based on
an independent appraisal of the net asset value (assets less liabilities) of a firm. What follows is a discussion of a
court ruling in which a judge concluded that the actual price paid (or “fair market value”) selling shareholders for
their shares did not represent “fair value.” The judge determined what was fair (rather than the market) despite
finding nothing unfair with the process employed by the parties to the negotiation. Was this an example of judicial
overreach (i.e., a judge in effect changing the statute rather than simply applying existing law to the facts of the
case) or an illustration of protecting shareholder rights? As you will see, the answer is not straight forward.
Vice Chancellor Travis Laster of the Delaware Court of Chancery exercised his legal right to determine what is
fair on June 16, 2016 in ruling that public shareholders were undercompensated for their shares in the 2013 $24.9
billion management buyout of Dell Corporation. The judge ruled that the price paid to such shareholders was
undervalued by 22% and should have been $17.62 per share, even though he found no wrongdoing with the process
Dell management and Silver Lake Partners employed in buying out public shareholders. With interest, investors who
sought appraisal will collect about $20.84 per share.
While finding the process fair, Vice Chancellor Laster viewed it as incomplete as he argued that the Dell board of
directors did not pay sufficient attention to all bidders (both private equity and strategic buyers). The judge also
argued that the purchase price was based on a leveraged buyout model valuation which he argued was not an actual
market determined price.
In an LBO model valuation,2 a buyer’s offer is based on its desired return which is often higher than what a
strategic buyer would require due to the amount of financial leverage involved in financing the LBO. The judge
claimed that the purchase price in the Dell deal reflected only what a private equity firm would pay and not a true
market price. The latter he reasoned would be higher because strategic buyers often pay higher prices than private
equity firms because they can exploit synergy opportunities. Concluding the buyout price was not reflective of “fair
value,” the judge used the DCF analyses provided by the experts to compute a “fair value” of $17.65 for each share
held by Dell’s public investors.
The judge’s conclusion ignored the absence of strategic bidders showing an interest in buying Dell. Thus, the
auction process included only private equity firms. The deal was widely contested in public by the likes of such
activist investors as Carl Icahn who argued relentlessly that the price offered by Michael Dell and Silver Lake
Partners undervalued the stock held by public shareholders. If the judge’s conclusion was correct, Dell’s public
shareholders acting rationally should have chosen to vote against the deal, as they did have access to Icahn’s
arguments. Instead, they voted for the transaction in large numbers.
While the ruling applied to 5.5 million Dell shares (out of the more than 40 million purchased by Dell) costing
the firm an additional $36 million, the potential impact could have been much greater. A number of shareholders
1 See the case study at the beginning of this chapter for a more detailed discussion of this point.
2 A leveraged buyout (LBO) valuation model analyzes the contribution of alternative sources of funds to the
determination of financial returns to equity investors (i.e., so-called financial buyers). The use of large amounts of
debt to finance the acquisition of a target firm improves significantly the return to equity investors, although
excessive amounts of debt add to the risk of the deal.
including T. Rowe Price were excluded from the appraisal case because they had voted for the deal. To qualify for
having shares appraised in most states, a shareholder must have voted against a deal. Consequently, had other
shareholders been included as plaintiffs, the ruling could have cost Dell hundreds of millions of dollars.
Will the ruling accelerate the trend toward “appraisal arbitrage” in which hedge funds buy a firm’s shares after
takeover announcements intent upon suing the bidder claiming the price was too low? The number of appraisal
rights petitions has indeed increased from a trickle of cases in early 2000s to over 20 a year in recent years, or close
to one-quarter of all transactions where appraisal rights were available to target firm shareholders.3 Also, will deals
be more difficult to negotiate because of the additional uncertainty posed by the potential adverse impact from
appraisal arbitrage?
Critics of the Delaware Court of Chancery’s decision expressed concern over the broad implications for the future
of corporate takeovers, arguing that the judge’s ruling exceeded a reasonable interpretation of the law. Critics also
argued that seller shareholders could be hurt in the future because fewer private equity firms might participate in
auctions for fear the price agreed to by the buyer and seller can be increased postmerger by hedge funds encouraged
to profit from activist judges presiding over appraisal rights hearings. The decision means that companies, critics
contend, do not simply have a fiduciary duty to find a buyer willing to pay the highest price, but that a judge may
ultimately deem what the price should be. Buyers may insist on an appraisal cap in buyout agreements allowing
them to walk away if, as a result of appraisal litigation, the agreed upon price is increased above the cap by a court
ruling. Selling company boards might find such caps onerous, making closing deals that much more difficult.
Supporters of the judge’s ruling argue it is a victory for shareholder rights particularly in management buyouts
which often are rife with conflicts of interest. They argue that the ruling is unlikely to discourage bidders and
contribute to an increase in appraisal litigation because it is likely to be applied primarily to management buyouts
which are relatively rare. Also, the number of shareholders affected by this specific ruling was small, even though
the impact could have been much greater as explained earlier. In addition, the ruling occurred during an appraisal
rights hearing. Shareholder appraisal rights statutes differ by state and how they are worded tends to be nebulous.
This means that “fair market value” and “fair value” can have different meanings from state to state and that what is
considered “fair value” is not necessarily the price actually paid for a business. Consequently, judicial rulings in
appraisal rights cases could vary widely and result in significantly different outcomes. As with many things, whether
Chancellor Laster’s ruling is an example of judicial overreach or of protecting shareholder rights depends on one’s
perspective.
Discussion Questions and Solutions:
1. What’s the appropriate way to determine a takeover price? (Consider the application of conventional
valuation methodology, the negotiating process in which the parties involved are not subject to duress,
and an impartial arbiter’s (i.e., a judge) determination)
2. Do you believe this court ruling is appropriate considering the facts of the case? Explain your answer.
3 W. Jiang, 2016.
3. Should a freely negotiated purchase price always be used as the appropriate valuation of a target firm’s
shares assuming the process was fair? Explain your answer.
4. How does this case illustrate the shortcomings of discounted cash flow (and other methodologies) in
valuing a business?
The Role of Valuation Methods in Fairness Opinions and Appraisal Rights
____________________________________________________________________________
KEY POINTS
• Investment bankers often are hired to provide opinions about whether a proposed purchase price is “fair” to
shareholders.
• Alternative valuation methods often result in different estimates of value.
• Dissenting shareholders may have their shares valued by an independent appraiser according to the
appraisal rights described in state statutes.
____________________________________________________________________________
Discounted cash flow (DCF), relative valuation, recent comparable sales, and asset based valuation methods often
are used in “fairness opinions” to assess the reasonableness of an offer made to target firm shareholders. They are
designed to help protect the target firm’s board and management from future litigation in which it is argued that the
sale price was too low. Acquirers also may use fairness opinions if the board and management are sued over having
allegedly paid too much for a target firm.
If subsequent to closing, minority shareholders dispute the accuracy of the price offered for their shares, they can
exercise their “appraisal rights” specified in the statutes of the state in which the target is incorporated. Appraisal
rights represent the statutory option of a firm’s minority shareholders to have the fair market value of their stock
price determined by an independent appraiser and the obligation of the acquiring firm to buy back shares at that
price. While alternative valuation methodologies often are used to estimate the fair market value of shares in dispute,
courts often defer to the merger price or actual price paid as long as the process used to determine the price was fair.
A recent court case illustrates this point.
Most U.S. companies are incorporated in Delaware and are covered by the state’s corporate law. The Delaware
Chancery Court’s opinion in Merlin Partners v Autoinfo Inc. in mid-2015 provided guidance regarding the court’s
determination of fair value in an appraisal action. Private equity company Comvest Partners completed its takeover
of Autoinfo, a supply chain logistics company, on April 13, 2013 for $1.05 per share in cash. This price constituted a
7% premium to Autoinfo’s closing share price on February 28, 2013 and a 21% premium over its average closing
price for the six months ending February 28, 2013.
In the sales process, Autoinfo, the target, with the assistance of its investment bank, contacted 164 potential
strategic and financial buyers, 70 of which entered into non-disclosure agreements. The company eventually signed
a letter of intent that provided for an acquisition of Autoinfo at $1.30 per share. After that deal fell through. Autoinfo
reached an agreement to sell the firm to Comvest for $1.26 per share. During due diligence, Comvest uncovered
numerous accounting issues, and subsequent negotiations resulted in an agreement for Comvest to acquire the
company at $1.05 per share.
Merlin Partners, a private equity firm with a minority stake in Autoinfo, filed an appraisal action, arguing that the
fair value of the company was $2.60 per share. Merlin presented two comparable companies analyses and a
discounted cash flow (“DCF”) analysis prepared by Merlin’s financial expert. In its defense, AutoInfo’s management
argued that comparable companies and DCF analyses could not be reliably performed with the available data and
that the sales price represented fair value based on the integrity of the sales process and the merger price paid by
Comvest (an unrelated third party). The Chancery Court on April 30, 2015 rejected Merlin Partners’ claims,
concluding that the DCF and comparable company methods were unreliable, and the actual price paid (i.e., merger
price) was the most dependable indicator of fair market value as long as the negotiating process was viewed as fair.
The obvious lesson is that valuation methodologies are only as meaningful as the reliability of their inputs. The
court case highlights the importance of process in M&A transactions. The actual merger price paid for a target firm
may be the best indicator of fair value as long as the price was determined in a fair auction. The court viewed the use
of alternative valuation methods like DCF analysis as “necessarily a second–best method to derive value.”
HEWLETT PACKARD OUTBIDS DELL COMPUTER TO ACQUIRE 3PAR
Case Study Objectives: To illustrate
• The application of discounted cash flow valuation methodology;
• The importance of selecting the proper length of the forecast period, and
• How seemingly small changes in assumptions can impact valuation substantially.
_________________________________________________________________________
On September 2, 2010, a little more than two weeks after Dell’s initial bid for 3PAR, Dell Computer withdrew
from a bidding war with Hewlett-Packard when HP announced that it had raised its previous offer by 10% to $33 a
share. Dell’s last bid had been $32 per share, which had trumped HP’s previous bid the day before of $30 per share.
The final HP bid valued 3PAR at $2.1 billion versus Dell’s original offer of $1.1 billion.
3Par was sought after due to the growing acceptance of its storage product technology in the emerging “cloud
computing” market. 3PAR’s storage products enable firms to store and manage their data more efficiently at
geographically remote data centers accessible through the Internet. While 3Par has been a consistent money loser, its
revenues had been growing at more than 50% annually since it went public in 2007. The deal valued 3Par at 12.5
times 2009 sales in an industry that has rarely spent more than five times sales to acquire companies. HP’s
motivation for its rich bid seems to have been a bet on a fast–growing technology that could help energize the firm’s
growth. While impressive at $115 billion in annual revenues and $7.7 billion in net income in 2009, HP’s revenue
and earnings have slowed due to the 2008–2009 global recession and the maturing markets for its products.
Table 7.1 provides selected financial data on 3PAR and a set of valuation assumptions. Note that HP’s marginal
tax rate is used rather than 3PAR’s much lower effective tax rate, to reflect potential tax savings to HP from 3PAR’s
cumulative operating losses. Given HP’s $10 billion–plus pretax profit, HP is expected to utilize 3PARs deferred tax
assets fully in the current tax year. The continued 3PAR high sales-growth rate reflects the HP expectation that its
extensive global sales force can expand the sale of 3PAR products. To support further development of the 3PAR
products, the valuation assumptions reflect an increase in plant and equipment spending in excess of depreciation
and amortization through 2015; however, beyond 2015, capital spending is expected to grow at the same rate as
depreciation as the business moves from a growth mode to a maintenance mode. 3PAR’s operating margin is
expected to show a slow recovery, reflecting the impact of escalating marketing expenses and the cost of training the
HP sales force in the promotion of the 3PAR technology.
Table 7.1
3PAR Valuation Assumptions and Selected Historical Data
History Projections
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Assumptions
Sales Growth Rate % 0.508 0.450 0.400 0.400 .400 0.350 0.300 0.250 0.200 0.100
0.100
Operating Margin % of Sales –0.020 –0.010 –0.010 0.020 0.040 0.080 0.100 0.120 0.150 0.150
0.150
Depreciation Expense % of Sales 0.036 0.034 0.060 0.060 0.060 0.060 0.060 0.070 0.070 0.070
0.060
Marginal Tax Rate % 0.400 0.400 0.400 0.400 0.400 0.400 0.400 0.400 0.400
0.400
Working Capital % of Sale 0.104 0.114 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100
0.100
Gross P&E % of Sales 0.087 0.050 0.080 0.080 0.080 0.080 0.080 0.070 0.070 0.060
0.060
WACC (2010–2019) % 0.093
WACC (Terminal Period) % 0.085
Terminal Period Growth Rate % 0.050
Working Capital ($ Million) 112.8 126.4
Total Cash ($ Million) 103.7 111.2
Minimum Cash (5% of Sales) 8.4 12.65
W Cap Excluding Excess Cash 17.5 27.85
Selected Financial Data ($ Million)
Sales 168
Depreciation Expense & Amortization 6.1
Gross Plant & Equipment 14.6
Excess Cash 98.55
Deferred Tax Assets 73.1
PV of Operating Leases 22.0
Number of Shares Outstanding 61.8
23
Answers to Discussion Questions:
1. Estimate 3PAR’s equity value per share based on the assumptions and selected 3PAR data provided in Table 7.2 below?
2. Why is it appropriate to utilize at least a 10–year annual time horizon before estimating a terminal value in valuing
firm’s such as 3PAR?
3. What portion of the purchase price can be financed by 3PAR’s nonoperating assets?
4. Does the deal still make sense to HP if the terminal period growth rate is 3 percent rather than 5 percent? Explain your
answer.
Table 7.2
Hewlett-Packard’s Valuation of 3PAR
(See Excel Spreadsheet Titled 3Par Valuation in Instructors’
Test Bank & Solutions Folder)
Projections
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Assumptions:
Sales Growth Rate % 0.508 0.450 0.400 0.400 0.400 0.350 0.300 0.250 0.200 0.150 0.100
Operating Margin % of Sales -0.02 -0.01 -0.01 0.02 0.04 0.08 0.1 0.12 0.15 0.15 0.15
Depreciation Exp. % of Sales 0.036 0.034 0.06 0.06 0.06 0.06 0.06 0.07 0.07 0.07 0.06
Marginal Tax Rate %1 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4
Net Working Capital % of Sales2 0.104 0.114 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100
Gross P&E % of Sales3 0.087 0.050 0.080 0.080 0.080 0.080 0.080 0.070 0.070 0.060 0.060
WACC (2010 – 2019) %4 9.31
WACC (Terminal Period) %5 8.50
Terminal Period Growth Rate % 0.05
Working Capital ($Mil) 112.8 126.4
Cash/Short-Term Investments 103.7 111.2
Minimum Cash (5% of Sales) 8.4 12.65
W Cap Excl. Excess cash 17.5 27.85
Selected Financial Data ($Mil.)
Sales 168
Depreciation Expense & Amort. 6.1
Net Working Capital 11.2
Gross Plant & Equipment 14.6
Excess Cash 98.55
Deferred Tax Assets 73.1
PV of Operating Leases6 22.0
Number of Shares Outstanding 61.8
24
Valuation:
Sales 168.4 244.2 341.9 478.7 670.2 904.7 1176.2 1470.2 1764.3 2028.9 2231.8
EBIIT(1-t) -2.0 -1.5 -2.1 5.7 16.1 43.4 70.6 105.9 158.8 182.6 200.9
Plus: Depreciation & Amort. 6.1 8.6 20.5 28.7 40.2 54.3 70.6 102.9 123.5 142.0 133.9
Minus: Δ Net Working Capital7 10.4 6.3 13.7 19.1 23.5 27.1 29.4 29.4 26.5 20.3
Minus: Gross P&E Expend. 14.6 10.1 27.4 38.3 53.6 72.4 94.1 102.9 123.5 121.7 133.9
Equals: Enterprise Cash Flow –13.3 -15.2 –17.5 -16.5 1.9 19.9 76.5 129.4 176.4 180.6
PV (2010 – 2019) 0.4
Terminal Value 2889.1
Total Operating Value 2889.5
Plus:
Excess Cash 98.6
Net Deferred Tax Assets 73.1
Equals: Enterprise Value 3060.7
Less:
Capitalized Operating Leases 22.0
Equals: Equity Value 3038.7
Number of Shares 61.8
Equity Value Per Share 49.2
Explanatory Notes:
1A 40% marginal tax rate is used to reflect the full benefit of the 3PAR deferred tax assets to HP.
2Excludes 3PAR excess cash balances.
3Increases faster than depreciation through 2015 to support growth in 3PAR sales and matches depreciation through
the remainder of the forecast period.
4Cost of equity = 0.0265 + 1.21 (0.055), where 0.0265 is the 10 year Treasury bond at the time of the transacton, 1.21
is 3PAR’s beta, and 0.055 is the market premium. Note the WACC is the firm‘s cost of equity as 3PAR has no
long-term debt.
5The cost of equity for comparable firms.
6PV of annual operating lease expenses discounted at 7% the firm’s estimated cost of debt.
7Net Working Capital 17.5 27.85 34.19 47.87 67.02 90.47 117.62 147.02 176.43 202.89 223.18
Valuation Methodologies, Fairness Opinions, and
Verizon’s Buyout of Vodafone’s Share of Verizon Wireless
____________________________________________________________________________
Key Points
• Parties to transactions often employ investment bankers to provide opinions about whether a proposed purchase price is “fair” to
their shareholders.
25
• Alternative valuation methods often result in very different estimates of value, reflecting different assumptions about risk and the
amount and timing of future cash flows.
____________________________________________________________________________
Founded in 2000 as a joint venture of U.S.-based Verizon Communications Inc. and U.K.-based Vodafone, Verizon Wireless is the largest
wireless company in the United States. Verizon Communications owns 55% of the joint venture, with Vodafone holding the remainder.
The joint venture serves more than 101 million retail customers and operates more than 1,700 retail locations in the United States. For
strategic reasons, Verizon Communications agreed to pay $130 billion to purchase Vodafone’s 45% share of the JV on October 4, 2013.
Investment banks, J.P. Morgan and Morgan Stanley, were hired by Verizon Communications to certify that the $130 billion offered for
the Vodafone ownership position was reasonable. So–called “fairness opinions” represent third-party assertions about the suitability of
proposed deals. The two investment banks employed generally accepted valuation methods to arrive at their opinions as to the
appropriateness of the price to be paid to Vodafone.
A typical fairness opinion letter provides a range of “fair” prices, with the presumption that the actual deal price should fall within that
range. These valuation estimates were presented to the Verizon Communications board of directors with the usual caveats. That is, the
estimates of fair value should reflect an amalgam of the methods used. The investment banks also noted that in performing its analyses, it
considered industry performance, business conditions and other matters, and that the estimates of fair value are not necessarily indicative
of actual values or actual future results.
The two investment banks calculated that Vodafone’s equity interest was worth between $131 billion and $182 billion. These valuation
estimates were substantiated using a combination of discounted cash flow methods based on projected annual cash flows from 2013 to
2018 and further supported by using comparable company and breakup valuation methods. The full report to the Verizon board laid out
all the valuation methodologies employed and their key underlying assumptions. In rendering their opinion as to value of Vodafone’s
stake, the investment banks relied on publicly available financial forecasts of Verizon Wireless and discussed the past and present
operations and financial conditions and the prospects for Verizon and Verizon Wireless with Verizon senior management and other
industry experts.
Valuation Methodologies and Fairness Opinion Letters
____________________________________________________________________________________________________________
Key Points
Parties to transactions often employ investment bankers to provide opinions about whether a proposed purchase price is “fair” to their
shareholders.
Alternative valuation methods often result in very different estimates of value, reflecting different assumptions about risk and the amount
and timing of future cash flows.
____________________________________________________________________________________________________________
In July 2011, investment bank Goldman Sachs was hired by Immucor Inc., a manufacturer of blood-testing products, to certify that the
$27 price per common share offered by well-known buyout firm TPG was fair. These “fairness opinions” represent third-party assertions
about the suitability of proposed deals. Goldman assessed Immuncor’s fair value by applying discounted cash flow (DCF) analysis to the
firm’s projected after–tax cash flows between 2012 and 2015 and by comparing it to “similar” publicly traded firms and to recent
comparable deals. The analysis involved judgments about differences in financial and operating characteristics affecting the trading
values of the firms to which Immucor was compared.
A typical fairness opinion letter provides a range of “fair” prices, with the presumption that the actual deal price should fall within that
range. These valuation estimates were presented to Immuncor’s board of directors with the usual caveats, that is, the estimates of fair
value should reflect an amalgam of the methods used. Goldman also noted that in performing its analyses, it considered industry
performance, business conditions, and other matters, many of which are beyond the control of Immucor and that the estimates of fair
value are not necessarily indicative of actual values or actual future results.
The Importance of Distinguishing Between Operating and Nonoperating Assets
In 2006, Verizon Communications and MCI Inc. executives completed a deal in which MCI shareholders received $6.7 billion for 100%
of MCI stock. Verizon’s management argued that the deal cost their shareholders only $5.3 billion in Verizon stock, with MCI having
agreed to pay its shareholders a special dividend of $1.4 billion contingent on their approval of the transaction. The $1.4 billion special
dividend reduced MCI’s cash in excess of what was required to meet its normal operating cash requirements.
To understand the actual purchase price, it is necessary to distinguish between operating and nonoperating assets. Without the special
dividend, the $1.4 billion in cash would have transferred automatically to Verizon as a result of the purchase of MCI’s stock. Verizon
would have had to increase its purchase price by an equivalent amount to reflect the face value of this nonoperating cash asset.
Consequently, the purchase price would have been $6.7 billion. With the special dividend, the excess cash transferred to Verizon was
reduced by $1.4 billion, and the purchase price was $5.3 billion.
In fact, the alleged price reduction was no price reduction at all. It simply reflected Verizon’s shareholders receiving $1.4 billion less in
net acquired assets. Moreover, since the $1.4 billion represents excess cash that would have been reinvested in MCI or paid out to
shareholders anyway, the MCI shareholders were simply getting the cash earlier than they may have otherwise.
The Hunt for Elusive Synergy—@Home Acquires Excite
Background Information
Prior to @Home Network’s merger with Excite for $6.7 billion, Excite’s market value was about $3.5 billion. The new company
combined the search engine capabilities of one of the best-known brands (at that time) on the Internet, Excite, with @Home’s agreements
with 21 cable companies worldwide. @Home gains access to the nearly 17 million households that are regular users of Excite. At the
time, this transaction constituted the largest merger of Internet companies ever. At the time of the transaction, the combined firms, called
Excite @Home, displayed a P/E ratio in excess of 260 based on the consensus earnings estimate of $0.21 per share. The firm’s market
value was $18.8 billion, 270 times sales. Investors had great expectations for the future performance of the combined firms, despite their
lackluster profit performance since their inception. @Home provided interactive services to home and business users over its proprietary
network, telephone company circuits, and through the cable companies’ infrastructure. Subscribers paid $39.95 per month for the service.
Assumptions
• Excite is properly valued immediately prior to announcement of the transaction.
• Annual customer service costs equal $50 per customer.
• Annual customer revenue in the form of @Home access charges and ancillary services equals $500 per customer. This assumes that
declining access charges in this highly competitive environment will be offset by increases in revenue from the sale of ancillary
services.
• None of the current Excite user households are current @Home customers.
• New @Home customers acquired through Excite remain @Home customers in perpetuity.
• @Home converts immediately 2 percent or 340,000 of the current 17 million Excite user households.
• @Home’s cost of capital is 20 percent during the growth period and drops to 10 percent during the slower, sustainable growth period;
its combined federal and state tax rate is 40 percent.
• Capital spending equals depreciation; current assets equal current liabilities.
• FCFF from synergy increases by 15 percent annually for the next 10 years and 5 percent thereafter. Its cost of capital after the high–
growth period drops to 10 percent.
• The maximum purchase price @Home should pay for Excite equals Excite’s current market price plus the synergy that results from the
merger of the two businesses.
Discussion Questions
1. Use discounted cash flow (DCF) methods to determine if @Home overpaid for Excite.
2. What other assumptions might you consider in addition to those identified in the case study?
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3. What are the limitations of the discounted cash flow method employed in this case?
1. Did @Home overpay for Excite?
2. What other assumptions might you consider?
3. What are the limitations of the valuation methodology employed in this case?
Creating a Global Luxury Hotel Chain
Fairmont Hotels & Resorts Inc. announced on January 30, 2006, that it had agreed to be acquired by Kingdom Hotels and Colony Capital
in an all-cash transaction valued at $45 per share. The transaction is valued at $3.9 billion, including assumed debt. The purchase price
represents a 28% premium over Fairmont’s closing price on November 4, 2005, the last day of trading when Kingdom and Colony
expressed interest in Fairmont. The combination of Fairmont and Kingdom will create a luxury global hotel chain with 120 hotels in 24
countries. Discounted cash-flow analyses, including estimated synergies and terminal value, value the firm at $43.10 per share. The net
asset value of Fairmont’s real estate is believed to be $46.70 per share.
Discussion Questions:
1. Is it reasonable to assume that the acquirer could actually be getting the operation for “free,” since the value of the real estate per share
is worth more than the purchase price per share? Explain your answer.
2. Assume the acquirer divests all of Fairmont’s hotels and real estate properties but continues to manage the hotels and properties under
long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the acquirer? Explain
your answer.
Answers to Case Study Questions:
1. Is it reasonable to assume that the acquirer could actually be getting the operation for “free,” since the value of the real estate per
share is worth more than the purchase price per share? Explain your answer.
2. Assume the acquirer divests all of Fairmont’s hotels and real estate properties but continues to manage the hotels and properties
under long-term management contracts. How would you estimate the net present value of the acquisition of Fairmont to the
acquirer? Explain your answer.