4/11/2010

Chapter 21. Tool Kit for Mergers, LBOs, Divestitures, and Holding Companies

In theory, merger analysis is quite simple. The acquiring firm performs an analysis to value the target company. The acquiring firm then seeks to buy
the firm at preferably below that estimated value. Meanwhile, the target company would only want to accept the offer is the price exceeds its value if
operated independently. In practice, however, the process of merger analysis is much more involved and raises some difficult issues.

While many valuation techniques exist, we shall focus upon the discounted cash flow method. Regardless of the method used, it is crucial to
recognize that the target company typically will not continue to operate as a separate entity, but rather it becomes part of the acquiring firm's portfolio
of risky assets. This is significant because the operational changes that may occur will affect the value of the business and must be considered. In
addition, it is important to remember that the goal of merger evaluation is to value the target company's equity, because the business is acquired
from the company's owners, not its creditors. For that reason, our focus will be the value of equity, not total value.

ILLUSTRATION OF THE THREE VALUATION APPROACHES FOR A CONSTANT CAPITAL STRUCTURE (Section 21.9)

Problem Inputs
Long-term growth rate 6%
Tax rate 40%
Initial debt 27 million
Pre-merger value of Tutwiler's stock 63 million
Number of shares of Tutwiler stock 10 million
rRF 7.0%
Beta 1.2
RPM 5%
rd 9%
S (in millions) $62.50
D (in millions) $27.00

Tutwiler's Pre-Merger Cost of Equity and WACC

rSL = rRF + Beta * RPM

rSL = 7% + 1.2 * 5%
rSL = 13.00%

wd = D/(S+D) = 30.1676%

WACC = wdrd(1-T) + wSrSL

WACC = 1.63% + 9.08%
WACC = 10.7073%

Following are projections from the worksheet labeled "Web 21A."

Table 21-3: Projected Postmerger Cash Flows for the Tutwiler Subsidiary as of December 31 (Millions of Dollars)

1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15

Panel A: Selected Items from Projected
Financial Statementsa
. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
. Costs of goods sold 80.0 94.0 113.0 129.3 142.0
. Selling & admin. expense 10.0 12.0 13.0 15.0 16.0
. Depreciation 8.0 8.0 9.0 9.0 10.0
. EBIT 7.0 12.0 16.0 20.7 23.0
. Interest expenseb 3.0 3.2 3.5 3.7 3.9
. Debtc 33.2 35.8 38.7 41.1 43.6 46.2
. Total net operating capital 116.0 117.0 121.0 125.0 131.0 138.0

Panel B: Corporate Valuation Model Cash

Flows
. NOPAT = EBIT(1-T) 4.2 7.2 9.6 12.4 13.8
. Less net investment in operating capital 1.0 4.0 4.0 6.0 7.0
. Free cash flow 3.2 3.2 5.6 6.4 6.8

Panel C: APV Model Cash Flows

. Free cash flow 3.2 3.2 5.6 6.4 6.8
. Interest tax savings = Interest(T) 1.2 1.3 1.4 1.5 1.6

Panel D: FCFE Model Cash Flows

. Free cash flow 3.2 3.2 5.6 6.4 6.8
. Less A-T interest = Interest(1-T) 1.8 1.9 2.1 2.2 2.4
 . Plus change in debtd 6.2 2.6 2.9 2.5 2.5 2.6
. FCFE 6.2 4.0 4.1 6.0 6.7 7.1

Notes:

Rounded figures are presented here, but the full non-rounded values are used in all calculations. The tax rate is 40%.
a

b
Interest payments are based on Tutwiler’s existing debt, new debt to be issued to finance the acquisition, and additional
debt required to finance annual growth.

c
Debt is existing debt plus additional debt required to maintain a constant capital structure. Caldwell will increase
Tutwiler's debt by $6.2 million from $27 million to $33.2 million at the time of the acquisition in order to keep the capital
structure constant. This increase occurs because the post-merger synergies make Tutwiler more valuable to Caldwell
than it was on a stand-alone basis. Therefore, it can support more dollars of debt and still maintain the constant debt
ratio.
d
The increase in debt at the time of acquisition is a source of free cash flow to equity.

VALUATION USING THE CORPORATE VALUE MODEL

In this scenario the capital structure is expected to remain constant and so the Corporate Valuation Model can be applied easily. Recall from Chapter
13 that in order to perform a valuation using the Corporate Valuation Model you discount projected free cash flows at the WACC to obtain the value of
operations.

First, calculate the horizon value at the end of the forecast period, assuming constant growth in FCF.

HV = FCF 2014 * (1 + g) ÷ (WACC - g)

HV = 6.8000 * 1.060 ÷ 10.707% - 0.06
HV = $153.13

Cash flows for the corporate valuation model

12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
FCF 3.20 3.20 5.60 6.42 6.80
Horizon value 153.1
Total CF (FCF and Horizon value) 3.2 3.2 5.6 6.4 159.9
WACC = 10.707%

The current value of operations is equal to the present value of the horizon value and the FCFs during the forecast period:
V Op = $110.07

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is $110.07 million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the value of Tutwiler's debt.

VEquity = V Op - Debt
VEquity = $110.1 - $ 27.00
VEquity = $83.07

Since Caldwell only has to pay $62.5 million for the equity, it is a good deal for Caldwell.

VALUATION USING THE ADJUSTED PRESENT VALUE MODEL

First, estimate Tutwiler's unlevered cost of equity

rU = wS rL + wd rd
rU = 0.698 0.13 + 0.302 0.09
rU = 11.793%

First, calculate Tutwiler's horizon value if it were unlevered:

HVU = FCF 2015 * (1 + g) ÷ (rU - g)
HVU = 6.8 * 1.060 ÷ 0.11793 - 0.06
HVU = $124.42

Second, calculate the horizon value of Tutwiler's tax shields:

HVTS = TS 2015 * (1 + g) ÷ (rU - g)
HVTS = 1.5689 * 1.060 ÷ 0.1179 - 0.06
HVTS = $28.71

Note: If we add these together, we get the same answer as the horizon value of the entire company using the corporate valuation model.
 Total HV 2015 = HVU 2015 + HVTS 2015
Total HV 2015 = 124.4 + 28.705
Total HV 2015 = $153.13

Cash flows for the value of unlevered operations

12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
FCF 3.2 3.2 5.6 6.4 6.8
Horizon value of FCF at rSU 124.4
Total CF (FCF and horizon value) 3.2 3.2 5.6 6.4 131.2
Discount rate for FCF = rSU 11.79%

Unlevered V Ops = $88.69

Cash flows for the value of tax shield

12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
Interest tax savings = Interest(T) 1.2 1.3 1.4 1.5 1.57
Horizon value of interest tax shield at rSU 28.7
Total CF (Tax savings and horizon value) 1.2 1.3 1.4 1.5 30.3
Discount rate for FCF = rSU 11.79%

V TS = $21.38

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is the sum of the unlevered value $110.07 million
of operations and the value of the tax shield:
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.

VEquity = V Ops - Debt

VEquity = $110.1 - $ 27.00
VEquity = $83.07

Since Caldwell only has to pay $62.5 million for the equity, it is a good deal for Caldwell. Note that these are the same figures we obtained using the
Corporate Valuation Model.

VALUATION USING THE FCFE MODEL

FCFE model horizon value calculation

HVFCFE = FCFE2015 * (1 + g) ÷ (rL - g)
HVFCFE = 7.0615 * 1.060 ÷ 0.1300 - 0.06
HVFCFE = $106.93

Cash flows for the FCFE model

1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
FCFE 6.21 4.00 4.13 5.96 6.67 7.06
Horizon Value $106.93
Total CF (FCFE and horizon value) 6.21 4.00 4.13 5.96 6.67 113.99
Discount rate for FCFE = rSL 13.00%

S= Value of equity = $83.07

Note that the first FCFE, $6.2 million, comes from the additional debt Tutwiler will issue on January 1 after the merger. This additional debt
will be issued to keep Tutwiler's capital structure at the current 30.17% debt, and will keep Tutwiler's cost of equity constant at 13%.
Tutwiler can support this $6.2 million in additional debt because it is worth more as a subsidiary of Caldwell than it was worth alone. If
Tutwiler did not issue this additional debt, then it would have less than 30.17% debt, and so its cost of equity would not be 13% and the
FCFE model would give the wrong answer for the value of the equity.

SETTING THE BID PRICE (Section 21.10)

Analysis of the Tutwiler Acquisition with No Change in Capital Structure (Millions of Dollars)

Tutwiler as a Separate
Company Prior to the Tutwiler as a Subsidiary
Acquisition with No Change in Debt
Value of equity: $62.5 $83.1
Value of debt: $27.0 $27.0
Total value: $89.5 $110.1
Number of Tutwiler shares 10
Current Tutwiler price per share $6.25

Maximum amount Caldwell should pay for Tutwiler's equity:a $83.1

Maximum price Caldwell should pay for Tutwiler's stock per share:b $8.31

Minimum bid is Tutwiler's pre-merger stock price: $6.25

Maximum bid is Tutwiler's post-merger value to Caldwell: $8.31

Notes: a
Calculated as the total value as a subsidiary minus the amount of debt as a separate company.
b
Calculated as the maximum amount divided by the 10 million shares of Tutwiler stock.

Cash Offers

Tutwiler's stockholders would not accept less than their current price of $6.25 and Caldwell should not offer more than Tutwiler's post-
merger value of $8.31. The bid price should be somewhere in between. For example, Caldwell might offer $7.25 cash for each share of
Tutwiler stock.

Stock Offers

Tutwiler's stockholders would probably prefer a cash offer. To induce them to exchange their shares of stock for shares of stock in the
new post-merger company, to be called CaldwellTutwiler, they would probably require a higher price. For example, Caldwell might have to
offer $7.50 in new stock for each share of Tutwiler stock.

Analysis of a Stock Offer (Millions except per share data)

Price offered to Tutwiler's stockholders: $7.50

Number of outstanding Tutwiler shares: 10
Total value of post-merger CaldwellTutwiler that must be received by Tutwiler's stockholders: $75.00

Pre-merger stock price of Caldwell: $15.00

x Pre-merger number of outstanding shares of Caldwell: 20
Pre-merger value of Caldwell's equity: $300.00

+ Post-merger value of Tutwiler's equity to Caldwell: $83.07

Post-merger value of CaldwellTutwiler's equity: $383.07

Percent of equity that must be owned by Tutwiler's former shareholders

Post-merger value owned by Tutwiler's former shareholders: $75.00
¸ Post-merger value of CaldwellTutwiler's equity: $383.07
% of equity due to Tutwiler's former shareholders 19.58%

Number of new shares that must be owned by Tutwiler's former shareholders

nNew = Percent equity due to Tutwilers' former shareholders
nNew + nOld

Solving:
nNew = [ Percent x nOld ] / [ 1 - Percent ] = 4.87
+ Total shares before the merger: 20
Total shares after the merger 24.87

Post-merger value of CaldwellTutwiler's equity: $383.07

¸ Total shares after the merger 24.87
% of equity due to Tutwiler's former shareholders $15.40

Total value owned by Tutwiler's former shareholders = $75.00

Exchange ratio = #shares received by target shareholders in post-merger firm = 0.487

# shares given up by target shareholder in target firm

VALUING THE TARGET WITH A CHANGE IN CAPITAL STRUCTURE (Section 21.11)

Tutwiler currently has equity worth $62.5 million and debt of $27 million, giving it a capital structure financed with about 30 percent debt: $27 / ($62.5
+ $27.0) = 0.30 = 30 percent. If Caldwell decides to increase Tutwiler’s capital structure to about 50 percent after the acquisition, it will affect the
analysis by changing the interest tax shields during the projection period and also in the horizon value.
Tutwiler currently has equity worth $62.5 million and debt of $27 million, giving it a capital structure financed with about 30 percent debt: $27 / ($62.5
+ $27.0) = 0.30 = 30 percent. If Caldwell decides to increase Tutwiler’s capital structure to about 50 percent after the acquisition, it will affect the
analysis by changing the interest tax shields during the projection period and also in the horizon value.

Since the proportion of debt is not constant throughout the projection period, the Corporate Valuation Model and the Dividend Growth Model will give
incorrect values if a constant WACC or cost of equity is used. Rather than adjust the discount rate from period to period to reflect a changing
proportion of debt, it is much easier to use the APV model in which the tax shields from the debt are discounted separately.

New Target % debt in the post-horizon period 50%

New interest rate on debt 9.50%

The Impact on Cash Flows to Caldwell

With more debt, the interest payments will be higher than those shown previously. Although this does not affect free cash flow or the unlevered cost
of equity, it does affect the interest tax shield during the 5 years of explicit projections and thereafter. Also, the long run WACC will be different under
a 50% debt level than it was under a 30% debt level. Note that the beauty of the APV method is that it is easy to incorporate different assumptions
about financing.

1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15

. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
. Costs of goods sold 80.0 94.0 113.0 129.3 142.0
. Selling & admin. expense 10.0 12.0 13.0 15.0 16.0
. Depreciation 8.0 8.0 9.0 9.0 10.0
. EBIT 7.0 12.0 16.0 20.7 23.0
. NOPAT = EBIT(1-T) 4.2 7.2 9.6 12.4 13.8
. Less net investment in operating capital 1.0 4.0 4.0 6.0 7.0
. Free cash flow 3.2 3.2 5.6 6.4 6.8

. Debt 52.63 63.16 73.68 78.95 87.33 This last debt level is consistent with the a
. Interesta 5.000 6.000 7.000 7.500 8.296 The last interest payment is cons
. Interest tax savings 2.000 2.400 2.800 3.000 3.319
Note: a
Interest is calculated at the higher rate and on the higher level of debt

New Horizon Value Calculation

First, calculate Tutwiler's horizon value if it were unlevered.

HVU = FCF 2015 * (1 + g) ÷ (rU - g)
HVU = 6.8 * 1.060 ÷ 0.1179 - 0.06
HVU = $124.42

Second, calculate the horizon value of Tutwiler's tax shields under the different financing plan:
HVTS = TS 2015 * (1 + g) ÷ (rU - g)
HVTS = 3.319 * 1.060 ÷ 0.1179 - 0.06
HVTS = $60.72 This is bigger than before because there will be more debt, and the interest rate is higher.

Third, write out the cash flows and calculate their present values:

APV Cash Flows 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15

Free cash flow 3.2 3.2 5.6 6.4 6.80
Horizon value of FCF 124.4
FCF and their horizon value 3.2 3.2 5.6 6.4 131.2
Discount rate = rSU 11.79%

UnleveredVOps = $88.7

12/31/11 12/31/12 12/31/13 12/31/14 12/31/15

Interest tax savings 2.0 2.4 2.8 3.0 3.319
Horizon value of interest tax shields 60.72
TS and their horizon value 2.0 2.4 2.8 3.0 64.04
Discount rate = rSU 11.79%

V TS = $44.3

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is $133.0 million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.

VEquity = V Ops - Debt

VEquity = $133.0 - $27.00
VEquity = $106.0

So with 30% debt, the value of Tutwiler's equity to Caldwell is $83.1

So with 50% debt, the value of Tutwiler's equity to Caldwell is $106.0
Difference $22.9
FINANCIAL REPORTING FOR MERGERS (Section 21.11)

Analysis of the Tutwiler Acquisition with a Change in Capital Structure

(Millions of Dollars)
Tutwiler as a Separate Tutwiler as a
Company Prior to the Tutwiler as a Subsidiary Subsidiary with a
Acquisition with No Change in Debt 50% Debt Ratio
 Tutwiler as a Separate Tutwiler as a
Company Prior to the Tutwiler as a Subsidiary Subsidiary with a
Acquisition with No Change in Debt 50% Debt Ratio
Value of equity: $62.5 $83.1 $106.0
Value of debt: $27.0 $27.0 $27.0
Total value: $89.5 $110.1 $133.0

Maximum amount Caldwell should pay for Tutwiler's

equity:a $83.1 $106.0

Number of Tutwiler shares 10

Current Tutwiler price per share $6.25
Maximum price per share Caldwell should pay for
Tutwiler's equity:b $8.31 $10.60

Notes: a
Calculated as the total value as a subsidiary minus the amount of debt as a separate company.
b
Calculated as the maximum amount divided by the 10 million shares of Tutwiler stock.

FINANCIAL REPORTING FOR MERGERS (Section 21.13)

Firm A will acquire Firm B. Current laws only allow for purchase accounting.

Table 21-4: Accounting for Mergers: A Acquires B

Purchase Accounting Postmerger: Firm A

Firm A Firm B $20 Paida $30 Paida $50 Paida Is price paid equal to NAV?
(1) (2) (3) (4) (5)
Current assets $50 $25 $75 $75 $80 c
Fixed assets 50 25 65 75 80 c
Goodwilld 0 0 0 0 10
Total assets $100 $50 $140 $150 $170

Debt $40 $20 $60 $60 $60

Common equity 60 30 80 80 110 f
Total claims $100 $50 $140 $140 $170
Notes:
a
The price paid is the net asset value, that is, total assets minus debt.
b
In column (3) we assume that Firm B's current and fixed assets are writen down from $25 to $15 before constructing the
consolidated balance sheet.
c
In column (4) we assume that Firm B's current and fixed assets are both increased to $30.
d
Goodwill refers to the excess paid for a firm above the apprised value of the physical assets purchased. Goodwill represents
payment both for intangibles such as patents and for "organization" value such as that associated with having an effective sales
force.
 Goodwill refers to the excess paid for a firm above the apprised value of the physical assets purchased. Goodwill represents
payment both for intangibles such as patents and for "organization" value such as that associated with having an effective sales
force.
e
In column (3), Firm B's common equity is reduced by $10 prior to consolidation to feflect the fixed asset write-off.
f
In column (5), Firm B's equity is increased to $50 to reflect the above-book purchase price.

Table 21-5 Income Statement Effects of Purchase Accounting

Firm A Firm B Purchase

(1) (2) (3)
Sales $100.0 $50.0 $150.0
Operating costs 72.0 36.0 109.0 a
Operating income $28.0 $14.0 $41.0
Interest (10%) 4.0 2.0 6.0
Taxable income $24.0 $12.0 $35.0
Taxes (40%) 9.6 4.8 14.0
Earnings after taxes $14.4 $7.2 $21.0
Goodwill write-off 0.0 0.0 0.0 b
Net income $14.4 $7.2 $21.0
EPSc $2.40 $2.40 $2.33
Notes:
a
Operating costs are $1 higher than they otherwise would be to reflect the higher reported costs (depreciation and cost of goods
sold) caused by the physical asset markup at the time of purchase.
b
Prior to 2001 goodwill was written off over its expected life. Now goodwill is subject to an annual "impairment" test. If its fair
market value has decreased during the year then goodwill is reduced, otherwise it is not.
c
Firm A had six shares and Firm B had three shares before the merger. A gives one new share for each of B's, so A has nine shares
outstanding after the merger.
 WEB EXTENSION 21A
PROJECTING CONSISTENT DEBT AND INTEREST EXPENSES

PROJECTING DEBT AND INTEREST EXPENSE FOR A CONSTANT CAPITAL STRUCTURE (Section 21A.1)

Since the capital structure is to remain constant, the easiest approach is to construct the debt levels using the corpor
valuation model. This is because the corporate valuation model does not require interest expense as an input for calc
value of the firm. So we can project firm value for each year, then use the target debt percentage to calculate a debt l
interest expense for each projected year.

INPUTS

Long-term growth rate 6%

Tax rate 40%
Initial debt on 12/31/10 $ 27.00
Pre-merger value of Tutwiler's stock $ 62.50
Target constant capital structure: wd = 30.17%
Cost of debt, rd, based on target constant capital structure 9.0%
Cost of equity, rs, based on target constant capital structure 13.0%

STEP 1: Project Operating Items and Calculate Free Cash Flow

We begin with the projected operating items on the financial statements. See Chapter 12 for a description of techniqu
forecasting operating items.

Projected Operating Items (Millions of dollars)

Items necessary to calculate NOPAT

1/1/11 12/31/11 12/31/12
Net sales $ 105.0 $ 126.0
Costs of goods sold 80.0 94.0
Selling & admin. expense 10.0 12.0
Depreciation 8.0 8.0
EBIT 7.0 12.0

Items necessary to calculate total net operating capital

1/1/11 12/31/11 12/31/12
Operating current assets $ 11.0 $ 12.0 $ 13.0
Operating long term assets 110.0 112.0 116.0
Total operating assets 121.0 124.0 129.0
Operating current liabilities 5.0 7.0 8.0
Total net operating capital 116.0 117.0 121.0

FCF calculations
1/1/11 12/31/11 12/31/12
 NOPAT 4.2 7.2
Investment in net operating capital 1.0 4.0
Free cash flow 3.2 3.2
Growth in FCF 0%

STEP 2: Use the Target Capital Structure to Calculate the WACC

WACC = rs ws + rd(1-T)ws
WACC = 10.7073%

STEP 3: Calculate the Horizon Value of Operations

1/1/11 12/31/11 12/31/12

FCF (from Step 1) 3.2 3.2
Horizon value of FCF at WACC
The horizon value is calculated as FCF

STEP 4: Calculate the Value of Operations Each Year

At the horizon, the value of operations is equal to the horizon value. In each year prior to the horizo
of operations is the next year's value of operations and FCF discounted back one year at the WACC
value of operations one year before the horizon is (153.13 + 6.8)/(1 + WACC) = 144.5. This allows us
the value of operations each year, rather than only in the first year.

1/1/11 12/31/11 12/31/12

FCF (from Step 1) 3.20 3.20
Horizon value of FCF at WACC (from Step 3)

Value of operations using the corp valuation model = 110.07 118.66 128.16

STEP 5: USE THE ESTIMATED VALUE OF OPERATIONS AND THE TARGET CAPITAL STRUCTURE TO ESTIMATE THE
PROJECTED DEBT AND INTEREST EXPENSES

1/1/11 12/31/11 12/31/12

Value of operations from corp valuation model = 110.07 118.66 128.16
Target capital structure, wd = 30.168%
 Tutwiler's capital structure is assumed to be 30.168% debt, so each year projected debt is calculate
30.168% of the projected value of operations for that year. So 35.8 = 0.30168(118.7), and 38.7 = 0.30
1/1/11 12/31/11 12/31/12
Projected postmerger debt:
wdx (Projected Vop) = 33.2 35.8 38.7

We assume debt is added at the end of a year (for example, December 31, 2013). This means that th
the beginning of the next year (for example, January 1, 2014) is equal to the debt at the end of the p
year (for example, the debt on 12/31/2013 is the same as the debt on 1/1/2014). Because the debt fo
added only on the last day of the year, the interest expense each year is calculated as the level of d
beginning of the year mulitplied by the interest rate. And because the debt at the beginning of a yea
to the debt at the end of the previous year, the interest expense for a year is equal to the interest rat
multiplied by the cost of debt.

1/1/11 12/31/11 12/31/12

Debt for calculating interest expensea 33.2 35.8 38.7
Interest expense: Intt = rd Debtt-1 3.0 3.2

Note: Tutwiler currently has $27 million in debt. But im

after the acquisition, Caldwell will increase the debt lev
to maintain the target capital structure. The valuation w
based on the $27 million debt that Tutwiler currently h
that is how much Tutwiler will owe when the merger is
However, postmerger interest expense will be based o
million because that is how much debt will be in place
entire year.

Now that we have projected debt levels to be consistent with a constant target capital structure and the interest expen
consistent with these debt levels, we can complete the projected income statements.

Completed income statement

1/1/11 12/31/11 12/31/12
Net sales $ 105.0 $ 126.0
Costs of goods sold 80.0 94.0
Selling & admin. expense 10.0 12.0
Depreciation 8.0 8.0
EBIT 7.0 12.0
Interest expense 3.0 3.2
Profit before tax 4.0 8.8
Taxes 1.6 3.5
Net income 2.4 5.3

Completed asset side of balance sheet

1/1/11 12/31/11 12/31/12
Non-operating assets - - -
 Operating current assets 11.0 12.0 13.0
Operating long-term assets 110.0 112.0 116.0
Total assets 121.0 124.0 129.0

Summary of liabilities
1/1/11 12/31/11 12/31/12
Operating liabilities 5.0 7.0 8.0
Debta 33.2 35.8 38.7
Total liabilities 38.2 42.8 46.7

a
Debt will increase immediately to 33.2 million from 27 million in order to maintain the target capital s
This is because Tutwiler is worth more as a subsidiary of Caldwell than on a standalone basis--and
support more debt. Therefore the end of year debt in 2011 is 33.2 rather than 27. The difference, or
free cash flow to equity in 2011.

Dividend and shareholder equity calculation

Residual dividends are calculated. They are exactly the dividends needed to make the balance
sheets balance with zero notes payable and zero marketable securities, and debt consistent
with the assumed capital structure.

1/1/11 12/31/11 12/31/12

Net income 2.4 5.3
Dividends (repatriations to parent)a 6.2 4.0 4.1
Common stock 50.0 50.0 50.0
Retained earnings 32.8 31.2 32.3
Shareholder equity 82.8 81.2 82.3

Dividends in each year are equal to the FCFE. This is a "residual dividend model." At the beginning
debt will increase immediately to 33.2 million from 27 million in order to maintain the current capital
The difference, or 6.2, is a free cash flow to equity which we've listed as a dividend in 2011.

With these consistent financial statements we can use the APV, Corporate Valuation Model, or Free Cash Flow to Equ
for firm valuation and get the same answer for each model, as shown in the worksheep "Chapter." Note, though, that
above in which we projected actual debt levels and interest expenses are not required if we just use the Corporate Va
Model--so that is the preferred model to use when the capital structure isn't changing.

PROJECTING DEBT AND INTEREST EXPENSE FOR A NONCONSTANT CAPITAL STRUCTURE DURING THE FORECAS

If the debt ratio isn't constant until the end of the horizon period, then the APV is the easiest valuation model to use. H
important to calculate the interest expense at the end of the explicit forecast period in a manner that is consistent wit
structure that the firm will have in the post-horizon period. This worksheet shows how the projections for the debt lev
expense were calculated for the case in which Tutwiler's capital structure changes during the forecast period before b
the horizon.
Steps to project consistent debt levels and interest expense for the APV calculation:

1. Calculate the unlevered cost of equity based on the pre-merger costs of equity and debt and the pre-merger capita

2. Calculate the WACC that will persist at the horizon. This will be based on the projected long-term capital structure
3. Use the WACC and the projected FCF at the horizon to calculate the horizon value: Horizon Value = FCFHorizon(1+g)/
Note that this is the same horizon value calculation formula that is used in the Corporate Valuation Model. However,
will be different because the WACC reflects the new capital structure.
4. Calculate the last two years' levels of debt as the target long term percent of debt multiplied by the horizon value.
5. Calculate the last year's interest expense as the interest rate multiplied by the prior year's level of debt.

1. Calculate Tutwiler's unlevered cost of equity based on the pre-merger capital structure and cost of debt
Pre-merger:
Pre-merger value of stock S (in millions)
Pre-merger value of debt D (in millions)
Pre-merger percent of debt wd
Pre-merger cost of equity rL
Pre-merger cost of debt rd
Tax rate before and after merger will be the same T

From Equation 21-15, rL=rU + (rU -rD) (D/S). Solving for rU gives rU = wS rL + wd rd.

rSU = wS rL +
rSU = 0.698 0.13 +
rSU = 11.793%

2. Calculate levered cost of equity and WACC for the post-horizon period, based upon the pos-horizon capital structu
Post-horizon debt ration = wd = 50%
Post-horizon cost of debt = r d
= 9.50%

rSL = rU + ( rU
rSL = 0.1179 + 0.1179
rSL = 14.087%

WACC = wdrd(1-T) + wS rL
WACC = 2.85% + 7.04%
WACC = 9.893%
This WACC is lower than the WACC we obtained with 30% debt.

3. Calculate the horizon value based upon the post-horizon WACC

Assumed horizon growth rate g= 6%

We have projected free cash flows already:

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Free cash flow 3.2 3.2
Calculate Tutwiler's 2015 horizon value given its free cash flow, WACC and growth rate:

HV = FCF 2014 * (1 + g)
HV = 6.8000 * 1.060
HV = $185.14

4. Calculate the last two years' debt levels and the last year's interest expense:

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Free cash flow 3.2 3.2
Horizon Value
Value of operations
Debt anything anything anything
Interest Dt-1(rd) Dt-1(rd)

A SHORTCUT FOR THE APV

This example is based upon the nonconstant capital structure with 50% debt, but it could easily be applied to the con

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Free cash flow 3.2 3.2
Horizon value based upon WACC
Interest tax savings 2.0 2.4
Total CF 5.2 5.6

PV at unlevered cost of equity $133.00

EREST EXPENSES

URE (Section 21A.1)

t the debt levels using the corporate

erest expense as an input for calculating the
t percentage to calculate a debt level and

r 12 for a description of techniques used to

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$ 151.0 $ 174.0 $ 191.0
113.0 129.3 142.0
13.0 15.0 16.0
9.0 9.0 10.0
16.0 20.7 23.0

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$ 14.0 $ 16.0 $ 18.0
118.0 125.0 129.0
132.0 141.0 147.0
7.0 10.0 9.0
125.0 131.0 138.0

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 9.6 12.4 13.8
4.0 6.0 7.0
5.6 6.4 6.8
75% 15% 6%

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5.6 6.4 6.8
153.13
alue is calculated as FCF2015 (1+g)/(WACC - g)

e. In each year prior to the horizon, the value

unted back one year at the WACC. So the
+ WACC) = 144.5. This allows us to know

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5.60 6.42 6.80
153.13

136.29 144.46 153.13

L STRUCTURE TO ESTIMATE THE

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136.29 144.46 153.13
h year projected debt is calculated as
= 0.30168(118.7), and 38.7 = 0.30168(128.2).
12/31/13 12/31/14 12/31/15

41.1 43.6 46.2

ber 31, 2013). This means that the debt at

ual to the debt at the end of the previous
n 1/1/2014). Because the debt for a year is
ear is calculated as the level of debt at the
the debt at the beginning of a year is equal
a year is equal to the interest rate

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41.1 43.6 46.2
3.5 3.7 3.9

tly has $27 million in debt. But immediately

Caldwell will increase the debt level to $33.2
capital structure. The valuation will be
ion debt that Tutwiler currently has, because
wiler will owe when the merger is concluded.
interest expense will be based on the $33.2
s how much debt will be in place for the

al structure and the interest expense is

.

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$ 151.0 $ 174.0 $ 191.0
113.0 129.3 142.0
13.0 15.0 16.0
9.0 9.0 10.0
16.0 20.7 23.0
3.5 3.7 3.9
12.5 17.0 19.1
5.0 6.8 7.6
7.5 10.2 11.4

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- - -
 14.0 16.0 18.0
118.0 125.0 129.0
132.0 141.0 147.0

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7.0 10.0 9.0
41.1 43.6 46.2
48.1 53.6 55.2

der to maintain the target capital structure.

than on a standalone basis--and can
ather than 27. The difference, or 6.2, is a

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7.5 10.2 11.4
6.0 6.7 7.1
50.0 50.0 50.0
33.9 37.4 41.8
83.9 87.4 91.8

ividend model." At the beginning of 2011

der to maintain the current capital structure.
ed as a dividend in 2011.

Model, or Free Cash Flow to Equity model

ep "Chapter." Note, though, that the steps
d if we just use the Corporate Valuation
g.

RUCTURE DURING THE FORECAST PERIOD (Section 21A.2)

easiest valuation model to use. However, it is

n a manner that is consistent with the capital
w the projections for the debt level and interest
uring the forecast period before becoming stable at
d debt and the pre-merger capital structure.

ected long-term capital structure.

: Horizon Value = FCFHorizon(1+g)/(WACC - g).
orate Valuation Model. However, the answer

multiplied by the horizon value.

or year's level of debt.

cture and cost of debt

S (in millions) 62.50

D (in millions) 27.00
30.168%
13.0%
9%
40%

wd rd
0.302 0.09

on the pos-horizon capital structure and cost of debt.

- rD ) D/S
- 9.5% 1.00000

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5.6 6.4 6.8
 ÷ (WACC - g)
÷ 9.893% - 0.06

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5.6 6.4 6.8
$185.14
174.66 $185.14
anything 87.33 $92.57
Dt-1(rd) Dt-1(rd) 8.296

ould easily be applied to the constant case.

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5.6 6.42 6.8
185.14
2.8 3.0 3.3
8.4 9.4 195.3