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Chapter 9: Financial Modeling Basics:
Valuing the Target Firm
Answers to End of Chapter Discussion Questions
9.1 What is financial modeling? How is it helpful in analyzing a firm’s financial statements?
Answer: Financial modeling refers to the creation of a mathematical representation or model of the
financial and operational characteristics of a business. Applications involving financial modeling include
9.2 How is financial modeling applied to mergers and acquisitions?
Answer: Financial modeling helps the analyst understand the underlying relationships among a firm’s
financial statements, the key determinants of value creation, provides a useful means of assessing
9.3 What are the differences between GAAP based and Pro Forma financial statements?
Answer: U.S. public companies prepare their financial statements in accordance with generally accepted
accounting principles (GAAP). GAAP financial statements are those prepared in agreement with guidelines
9.4 What are value drivers and why are they important?
Answer: Value drivers are variables which exert the greatest impact on firm value and often include the
9.5 What does it mean to normalize historical financial data and why is this an important part of the financial
model building process?
Answer: To ensure that these historical relationships can be accurately defined, it is necessary to normalize
the data by removing nonrecurring changes and questionable accounting practices in order to identify
9.6 What are common size financial statements and how might they impact the financial model building
process?
Answer: Common-size financial statements are frequently used to uncover data irregularities. These
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
9.7 A firm’s financial statements are tightly linked such that an increase in a key variable on one statement will
impact the other financial statements. Assuming a firm’s gross margin (i.e., sales less cost of sales) is
positive and constant, describe how an increase in revenue will impact net income and in turn the other
financial statements? Assume the firm does not pay preferred dividends.
Answer: If a firm’s gross margin is positive and constant, an increase in revenue will increase net income,
unless offset by some other line item between gross margin and net income such as an increase in S,G&A
9.8 What is the appropriate number of years to project a firm’s financial statement?
Answer: The correct answer depends on the analyst’s confidence in her ability to forecast accurately and
the growth rate in future cash flows. In general, forecasting accuracy declines the further into the future the
9.9 What is the difference between a firm’s enterprise and equity values?
Answer: The former represents the value of the firm to all those supplying funds to the firm, while the
equity value represents the value of firm to common shareholders only. Target’s enterprise value is
9.10 Financial models normally are said to be in balance when total assets equal total liabilities plus
shareholders’ equity on the balance sheet. How are financial models often forced to balance automatically?
Answer: The mechanism in the model discussed in this chapter for forcing automatic balance is the use of a
revolving loan facility or line of credit. Such arrangements allow a firm to borrow up to a specific amount.
Practice Problems and Solutions
9.11 The purpose of this practice exercise is to illustrate how a change in an input cell impacts variables on other
financial statements. Using the Excel spreadsheet model in the file folder entitled Target Valuation Model
on the companion website accompanying this book (see the beginning of this chapter for website address),
note the values for 2018 of Target’s net income (Target IS Worksheet), cash balance and shareholders’
equity (Target’s BS Worksheet), and enterprise value and equity value (Target Valuation Worksheet).
On the Target’s Assumptions Worksheet, increase the growth rate from 7.5 to 8.5 percent in the yellow
input cell on the Sales Growth line for the year 2014. What are the new values in 2018 for net income, cash
balance, shareholders’ equity, enterprise value, and equity value following the increase in the growth rate
assumption in the base case by one percentage point? Explain why these variables increased (Hint: See
Figure 9.1)? When done, click the undo command or close the model but do not save the output to restore
the base case model results.
Answer: The increase in the revenue growth rate in the base case from 7.5 to 8.5 percentage points in 2014
increases the annual growth rate in the base case from 2014 to 2018 by one percentage point annually.
9.12 The purpose of this practice exercise is to underscore how small changes in terminal value assumptions
result in disproportionately large changes in firm value. Using the Excel spreadsheet model in the file
folder entitled Target Valuation Model found on the companion website to this book, locate the present
value of the Target’s enterprise and equity values on the Valuation Worksheet and write them down.
Increase the terminal value growth rate assumption by one percentage point and reduce the discount rate by
one percentage point. How does this impact the firm’s enterprise and equity value? Explain how this might
happen (Hint: Consider the definition of the constant growth valuation model.) Click the undo command to
eliminate changes to the base case model or close model but do not save the results.
END OF CHAPTER CASE STUDY
Life Technologies Undertakes a Strategic Review
Discussion Questions:
Use the Microsoft Excel model in a file folder entitled Life Tech Undertakes Strategic Review Financial Model on
the companion site to this book to address the following questions. The model already contains data and an estimate
of Life Tech’s enterprise and equity valuations based on this data and a set of assumptions about the planning period
spanning 2014 through 2018, as well as the years beyond. In answering the following questions, assume the
1. Note the enterprise and equity valuations for Life Technology in the Excel spreadsheet model entitled Life
Tech Undertakes Strategic Review on the companion website accompanying this book. View this as the
base case. The CEO Greg Lucier asks his chief financial officer (CFO) to determine the impact of
plausible assumption changes on the firm’s valuation. The CFO asks you as a financial analyst to estimate
the impact of a change in the firm’s revenue growth rate and cost of sales as a percent of sales. On the
Target Assumptions Worksheet, make the following changes and note their impact on Life Tech’s
enterprise and equity values on the Valuation Worksheet:
a. Increase the sales growth rate in 2014 by two percentage points
b. Retaining the assumption change made in (a), decrease the cost of sales as a percent of sales by
two percentage points in 2014
What is Life Tech’s enterprise and equity value resulting from these changes? How do they compare to the
base case? Briefly explain why each of these changes affects firm value. Do not undo the results of your
changes to the model’s base case.
Answer: The base case enterprise and equity valuation estimates are $10,853.9 billion and $9,068.5 billion
respectively. If we increase the sales growth rate by two percentage point in 2014 from 5.5 percent to 7.5
2. Using the model results from question (1), the CFO believes that in addition to an increase in the sales
growth rate and an improving cost position, Life Tech could employ its assets more effectively by better
managing its receivables and inventory. Specifically, the CFO directs you as a financial analyst to make the
following changes to days sales in receivables and days in inventory. On the Target Assumptions
Worksheet, make the following changes and note their impact on Life Tech’s enterprise and equity values
on the Valuation Worksheet:
a. Reduce receivables days by ten days starting in 2014
b. Reduce inventory days by ten days starting 2014
What is Life Tech’s enterprise and equity value resulting from these changes? How do they compare to the
results in question one? Briefly explain why each of these changes affects firm value. Do not undo the
changes to the model you have made.
Answer: If we reduce days in receivables by 10 days in 2014, the enterprise and equity values become
$13,545.1 billion and $11.759.7 billion, respectively. In addition, if we reduce days in inventory by ten
3. Given the results of the model from questions (1) and (2), assume Mr. Lucier and the Life Tech board
raised their target debt to equity ratio from 30 percent to 60 percent to reduce their weighted average cost of
capital. Such a reduction would make projects that would not have been undertaken at a higher cost of
capital attractive. Recalculate the firm’s weighted average cost of capital assuming that none of the
assumptions about the cost of capital made in the base case have changed, with the exception of the levered
beta. (Hint: The levered beta needs to be unlevered and then relevered to reflect the new debt to equity
ratio). Without undoing the assumption changes made in questions (1) and (2), use your new estimate of the
firm’s WACC during the planning period to calculate Life Tech’s enterprise and equity values given on the
Valuation Worksheet. Briefly explain why the change in the debt to equity ratio affected firm value.
Answer: The WACC and cost of equity before the increase in Life Tech’s target debt to equity ratio from
.30 to .60 are 9.8% and 11.9%, respectively. Unlever the firm’s current levered beta of 1.7 as follows:
βu = βl / (1+ (1-.4) x (D/E) = 1.70 / (1+ .6 x .30) = 1.44
4. Based on your answers to questions 1, 2, and 3, what do you believe are the most important value drivers
for Life Tech based on their impact on the firm’s enterprise and equity values? List these variables in
descending order in terms of their impact on increasing the magnitude of Life Tech’s enterprise and equity
values.
Answer: As measured by the cumulative percentage increase over the base case valuation, the most
important value driver is the change in sales followed by the change in cost of sales, then change in capital
structure, and finally changes in receivables and inventories. Note that this ordering is dependent on the
magnitudes of the assumed changes in value drivers. Note also that the percent changes in enterprise and
equity values reflect the cumulative effects of previous changes made to value drivers.
Life Technology Value Drivers in Descending Order of Importance
Value Drivers
Enterprise Value
($Billions)
Pct. Change
Over Base
Case
Equity Value
($Billions)
Pct. Change
Over Base
Case
Base Case
10.853.9
9,068.5
Changes to Base Case
5. The base case valuation reflects a constant 57 percent gross margin throughout the planning period. Based
on the information given in the case study, do you believe that this is realistic? Why? Why not? How might
this assumption have biased the estimates of enterprise and equity valuation in your answers to questions
(1) to (4)? If they were biased, what would be the direction of the bias?
Answer: The assumption that the gross margin would be maintained at its historical percentage of 57
percent ignores the likely downward pressure on margins due to potentially lower selling prices and unit
Examination Questions and Answers
True/False Questions: Answer True or False to each of the following questions:
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 financial data of the target firm, it may be necessary to subtract large
increases in and add back large decreases in non-recurring expenses from operating profits. 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. 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
7. 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
8. If the target firm’s ratio of bad debt reserves as a percent of projected revenue is decreasing, the analyst
should be concerned that projected net revenues could be higher than would actually be realized due to
inadequate future reserves for probable uncollectable accounts.
True or False
9. 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
10. Common size financial statements are among the most commonly used tools to uncover data irregularities.
True or False
11. Complex models because of their greater sophistication are necessarily more accurate than simple models.
True or False
12. 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
13. 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
14. 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
15. Discrepancies between the way a firm records its financial statements and GAAP accounting standards are
common and should be ignored. True or False
16. Pro forma financial statements are simply another name for GAAP financial statements. True or False
17. Pro forma financial statements rarely deviate from those compiled in accordance with GAAP. True or
False
18. 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
19. 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
20. 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
21. 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
22. 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
23. Competitive dynamics simply refer to the factors within the industry that determine industry profitability
and cash flow. True or False
24. 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
25. 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
26. It is rarely useful to review more than one or two years of historical data for the acquiring or target firms.
True or False
27. 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
28. 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 sales to highlight significant
differences. True or False
29. 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
30. 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
31. 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
32. Financial modeling refers to the creation of a mathematical representation or model of the financial and
operational characteristics of a business. True or False
33. Financial modeling also provides a useful means of assessing alternative options and associated risks and
identifies how firm value is affected by different economic events. True or False
34. The income statement measures a firm’s financial performance at a specific point in time. True or False
35. A cash flow statement summarizes the firm’s cash inflows and outflows from operating, investing, and
financing activities during a specific time period. True or False
36. A financial model creates a set of projections about the future of a business in terms of the businesses’
income statement, balance sheet, and cash flow statement. Each statement is linked in such a way that
changing assumptions about one factor can result in changes only in the cash flow statement. True or False
37. Firms attempt to maintain minimum cash balances to meet short term working capital needs such as
payroll. Any cash from operating and investing activities in excess of that required to maintain the firm’s
desired minimum cash balance may be used to repay any outstanding debt. True or False
38. Circular references are a series of cell references in which the last cell reference refers to the first resulting
in a closed loop. True or False
39. Value drivers are variables which exert the greatest impact on firm value. True or False
40. Equal to the difference between sales and cost of sales as a percent of sales, gross margin per dollar of sales
is seldom used as a means of summarizing a firm’s ability to create value. True or False
41. If the factors affecting sales growth historically are expected to change in the future due to the introduction
of new products, total revenue growth may accelerate from its historical trend. In contrast, the emergence
of additional competitors in the future may limit revenue growth by eroding the firm’s market share and
selling prices. True or False
42. Since above average profit growth is not sustainable indefinitely, cash flows for such firms should be
projected until they are expected to slow to the industry average. True or False
43. Enterprise value often is defined as the sum of the market value of a firm’s equity, preferred shares, debt,
and non-controlling interest less total cash and cash equivalents. True or False
44. Financial models normally are said to be in balance when total assets equal total liabilities minus
shareholders’ equity on the balance sheet. True or False
45. The 10k contains detailed income, balance sheet, and cash flow statements as well as numerous footnotes
explaining these financial statements. True or False
46. An increase in revenue growth, assuming it is profitable, will increase the firm’s equity value but not its
enterprise value assuming nothing else changes. True or False
47. A 10% reduction in the cost of sales as a percent of sales will have the same impact on a firm’s enterprise
and equity values as a 10% increase in revenue. True or False
48. The constant growth method of valuation often is used to estimate a firm’s terminal growth period value.
Small changes in the key underlying assumptions such as the terminal growth rate and the discount rate
used during the terminal period seldom have very large impacts on the firm’s enterprise and equity values.
Multiple Choice Questions
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 ensures 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 actual market prices from Target’s cost of sales
d. A and B only.
e. None of the above.
4. Real Cool 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
5. A target firm’s standalone value is best defined by which of the following statements:
a. What a business would be worth as part of another firm
b. What a business would be worth as a going concern following a takeover bid
c. What a business would be worth as a going concern in the absence of a takeover bid
d. What the target is worth after the closing date following a takeover
e. None of the above
6. Value drivers are best described by which of the following statements:
a. Variables which exert the greatest impact on firm value
b. Only involve revenue-related variables
c. Only involve cost-related variables
d. Refer to the weighted average cost of capital and cost of equity only
e. None of the above
7. Financial models are said to be in balance when
a. Net income is positive
b. Total assets equal total liabilities plus shareholders’ equity
c. Total assets equal total liabilities less shareholders’ equity
d. Cash flow is positive
e. None of the above
8. Which of the following is true of pro forma financial statements?
a. Pro forma statements purport to show what the combined firms would look adjusted for synergy
and the terms of the deal
b. Pro forma statements are the same as GAAP statements
c. Pro forma statements show what the combined firms would look excluding the effects of synergy
d. a and b only
e. None of the above
9. Financial modeling may be applied in which of the following situations:
a. Business valuation
b. Management decision making
c. Capital budgeting
d. Financial statement analysis
e. All of the above
10. The financial modeling process used to value a firm consists of a series of steps. These include which of the
following:
a. Analyzing the target firm’s historical statements to identify the primary determinants of cash flow.
b. Project three-to-five years (or more) of annual pro forma financial statements. This three-to-five
year period is called the planning period.
c. Estimating the present value projected pro forma cash flows during the planning period.
d. Estimating the terminal value.
e. All of the above
11. An increase in gross margin over time could indicate what about the firm:
a. It has been able to reduce its costs compared to sales
b. It has been able to raise prices
c. It has been able to achieve a combination of (a) and (b)
d. It was forced to lower its prices
e. a, b, or c
12. Which of the following future events could affect projections of a firm’s cash flow?
a. Introduction of new products by the firm
b. The emergence of products that are substitutes for the firm’s products
c. The emergence of additional competitors to the firm
d. Improvements in the firm’s productivity
e. All of the above
13. Common items found on a balance sheet include all of the following except for which of the following:’
a. Receivables
b Cost of sales
c. Inventory
d. Long-term debt
e. Payables
14. Common items found on an income statement include all of the following except for which of the
following:
a. Revenue
b. Retained earnings
c. Cost of sales
d. Sales, general and administrative expenses
e. Net income
15. Common items found on a cash flow statement include all of the following except for which of the
following:
a. Net income
b. Change in working capital
c. Principal repayments on outstanding debt
d. Retained earnings
e. The proceeds of asset sales
16. Changes in the key assumptions underlying the estimation of a firm’s terminal period valuation are likely to
have
a. A disproportionately large impact on the firm’s enterprise and equity values
b. A disproportionately small impact on the firm’s enterprise and equity values
c. A disproportionately large impact on the firm’s enterprise value but little impact on its equity
value
d. A disproportionately large impact on the firm’s equity value but little impact on its equity value
e. None of the above.
17. When changing financial model assumptions, which of the following is true?
a. Change more than one assumption at a time
b. Make large changes in assumptions
c. Change only one assumption at a time
d. Only change assumptions impacting the income statement
e. Only change assumptions impacting the balance sheet
18. Which of the following statements is true?
a. A 10% increase in sales has a smaller impact on cash flow than a 10% reduction in cost of sales.
b. A 10% increase in sales has the same impact on cash flow than a 10% reduction in cost of sales.
c. A 10% increase in sales has a larger impact on cash flow than a 10% reduction in cost of sales.
d. A 10% increase in sales has a smaller impact on after-tax profits than a 10% reduction in cost of
sales.
e. None of the above
Short Essay Examination Questions
VERIZON DISCOUNTS THE YAHOO PURCHASE PRICE
_____________________________________________________________________________
KEY POINTS:
• Financial models are used to project key components of the target firm's cash flow in order to establish a
baseline standalone valuation.
• Their accuracy is dependent on the quality and availability of data used to build the model and the
assumptions underlying projections.
• They assist in assessing the impact of unanticipated events which can erode (or improve) the baseline
valuation.
____________________________________________________________________________
Valuing the target's cash flow typically involves identifying the key determinants of cash flow, projecting pro forma
financial statements, and converting projected cash flows to a present value. This provides a baseline standalone
value for the target and theoretically represents the minimum price a buyer can expect to pay for the target.
Estimates of synergy plus the minimum price denotes the maximum value the acquirer should pay for the target. The
actual purchase price paid falls within this range and is determined by the relative negotiating leverage of buyer and
seller.
What happens when something occurs that could reduce significantly the baseline standalone value of the target
firm? M&A agreements of purchase and sale try to account for the unexpected by including so-called material
adverse change clauses. If triggered, such clauses allow the buyer to renegotiate the contract or to walk away from
the deal. Adverse changes could include events having a negative impact on the target's operating and financial
condition or the ability of the seller to close the deal. What follows is a discussion of a recent example of how such a
clause was used to compensate a buyer for the perceived reduction in the value of the target firm due to events not
revealed during due diligence.
Both firms were under considerable pressure to close the deal. The Yahoo board wanted to exit the firm's
internet assets so that it could focus on the eventual sale of its stake in Alibaba and Yahoo Japan. Verizon wanted to
gain control of Yahoo internet operations so that it could implement its digital media strategy to compete against
Facebook and Alphabet's Google in digital advertising. What was not known at the end of 2016 is the extent of the
potential damage to the value of Yahoo internet assets due to the data breaches.
Verizon's executives and board weighed the relative cost of acquiring damaged Yahoo assets compared to the
lost time in implementing its planned digital media strategy. The options were clear: walk away; wait to assess the
extent of the damage and negotiate a price reduction; or close the deal and merge Yahoo into AOL (which Verizon
acquired in 2015) and begin to build their digital media businesses. How could they measure the dollar cost of each
option?
Walking away from the purchase of the Yahoo assets would mean that Verizon would have to either find another
firm to acquire similar assets (and there weren’t any) or incur the cost of building similar assets. Closing
immediately ran the risk of acquiring assets which could come with substantial liabilities from consumer and SEC
THE UNRELENTING ALLURE OF THE "TRANSFORMATIVE" ACQUISITION --
MICROSOFT BUYS LINKEDIN IN ITS BIGGEST DEAL IN HISTORY
____________________________________________________________________
KEY POINTS: FINANCIAL MODELS
• Enable the rapid consideration of alternative scenarios by changing key assumptions underlying valuation,
deal structuring and financing issues,
• Help define the range of risks associated with an investment, but
• Sometimes aid and abet managers in crossing the fine line between "reimagining" how their business can
compete and hyperbole.
____________________________________________________________________________
The good news, bad news about financial models is that they can be used to evaluate a wide range of alternatives.
Generally, this capability is highly useful because it gives senior management a look into the future without having
to commit substantial resources to a bet on a highly uncertain outcome. But it is critical to remember that financial
models are in effect sophisticated high speed calculators that can lull management into a false sense of security. If
given a set of optimistic assumptions, we should not be surprised that we get a rosy outlook. This can be especially
seductive when management is frustrated with their inability to improve their firm's current operating performance
and boost its share price.
Enter the "transformational deal:" those intended to enable a company to fundamentally change the way it does
business. Often highly risky, they push the acquirer into new areas with which it is largely unfamiliar, requiring the
acquirer to climb rapidly a steep learning curve. In the tech sector, "transformational deals" often are precedent
setting, with little historical comparisons to assess likely future performance. They require management to place a
bet on new products still in the concept stage to be sold in markets that are often poorly understood or largely
undefined and requiring execution skills seldom found in large bureaucratic firms.
professional skills and accomplishments.
Arguably the deal was about gaining access to LinkedIn's data and user bases. Using this metric for valuing
businesses without significant earnings but with significant user growth rests on the premise that sustained user
growth will eventually result in future earnings. Facebook acquired Whatsapp (the popular messaging service) for
$21.8 billion in late 2014. Facebook paid about $48 per existing user ($21.8 billion/.45 billion users) for WhatsApp
versus about $33 per user ($1 billion/.30 billion users) for its earlier acquisition of Instagram. While these deals
were eye-popping at the time, Microsoft's acquisition of LinkedIn topped these transactions by paying almost $61
dollar per user for LinkedIn ($26.2 billion/.433 billion users). To be fair, Microsoft believed it was playing catch up
as the digital world moves away from the firm's traditional software business to cloud computing in which users rent
software accessible via the internet. Management may have viewed the price paid as justifiable as this acquisition
could ultimately "save" the firm.
The common thread between Microsoft and LinkedIn, Microsoft argues, is that both make most of their money
selling to professionals. Microsoft sees the deal conceptually as all about bringing together the professional cloud
and the professional network. It sees the acquisition as providing new revenue streams to shore up its aging
Windows operating system and Office software businesses by combining their capabilities with LinkedIn's user
supplied data.
While the potential may be large, any payoff requires skillful execution by Microsoft in implementing a coherent
strategy. Given what the firm paid for LinkedIn, the challenges to earning the firm's cost of capital are daunting.
Paying a 50 percent premium for a money losing business like LinkedIn should raise red flags. LinkedIn has
struggled to sustain its growth. Less than one year ago, its stock was trading 30% higher than the $196 per share
offered by Microsoft.
THE ROLE OF FINANCIAL MODELS
IN EXECUTIVE DECISION MAKING
____________________________________________________________________
KEY POINTS: FINANCIAL MODELS
• Address valuation, deal structuring, and financing issues.
• Enable the rapid consideration of alternative scenarios by changing key assumptions underlying these
issues.
• Help define the range of risks associated with an investment.
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Equity markets often move quickly to express investor sentiment. Personal computer and printer behemoth Hewlett-
Packard (HP) had just announced its agreement to buy Electronic Data Systems (EDS) for $13.9 billion in an all-
cash deal in May 2008. Investors demonstrated their dismay with the decision by driving down HP’s share price
11% in a single day.
The CEO had been a Wall Street darling since he had assumed his position three years earlier. Under his
direction, the firm's profits rose sharply as it successfully cut costs while growing revenue and integrating several
acquisitions. Asked how HP expected to generate substantial synergies by combining two very different
organizations, Mr. Hurd indicated that the firm and its advisors had done "double-digit thousands of hours" in due
diligence and financial modeling and that they were satisfied that the cost synergies were there.
