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Valuation: Mergers, Buyouts and Restructuring, 2nd Edition


Praise for Valuation for Mergers, Buyouts, and Restructuring

“Enrique Arzac has provided an excellent analytical framework for the LBO business.”—William T. Comfort, Chairman, Citigroup Venture Capital

“Enrique Arzac has created a masterpiece—his work combines the theoretical with the practical. He has created an invaluable reference guide that is thoughtful, complete and very user friendly. He provides insight into the theory behind core valuation, LBO’s, and options pricing, which creates the foundation for mergers, buyouts and restructuring. In addition to the theoretical, he provides practical insight into deal structuring and deal dynamics. His work should be standard material for all incoming associates.”—James P. McVeigh, Managing Director, Corporate & Investment Banking, Banc of America Securities

“This first-rate book of applied financial theory provides the tools for financial institutions and capital market participants seeking a methodology for comparing, contrasting, and evaluating investment opportunities and options. By incorporating over 30 years of research, teaching, and practical experience, Professor Arzac has created a text that us not only timely, but timeless in its usefulness to anyone interested in learning the applications of financial theory for the best and most useful allocation of the scarcest economic resource in the world—capital.”—William W. Priest, Co-Managing Partner, Steinberg, Priest and Sloane Capital Management and Former Chairman and CEO of Credit Suisse Asset Management

“There are two important aspects in graduate business education. The first is acquiring a thorough understanding of the theories of modern finance and the second is acquiring an appreciation for how these theories can be applied to important decisions. Enrique Arzac has taken on this task and made it a successful venture for readers of this book. Unlike other texts on valuation, he explains the reasons for the process and sequence that he recommends rather than just providing the ingredients and the recipe without explanation. This is a welcome addition to the literature in applied corporate finance.”—Joel M. Stern, Managing Partner, Stern, Stewart & Co.

Enrique R. Arzac is Professor of Finance and Economics at the Columbia University Graduate School of Business, Director of the Merger, Buyouts, and Restructuring program for executives at Columbia Business School, and Co-Director of the Merger and Acquisitions program for executives at London Business School. He is the author of many academic articles in financial economics and has been consultant to corporations and financial institutions in North and South America and Europe. He is a director of the Adams Express Company, Petroleum and Resources Corporation and Credit Suisse Asset Management funds.
Part One: The Tools of Valuation.

1. A User's Guide.

1.1. Valuation of Stand-Alone Firms and Business Units.

1.1.1 Free Cash-flow Valuation.

1.1.2 Cost of Capital.

1.1.3 Valuation Multiples.

1.2. Economic Value Added.

1.3. Valuation with Changing Capital Structure.

1.4. Valuation in Developed and Emerging Markets.

1.5. Mergers and Acquisitions.

1.6. Deal Design and Special Offer Structures.

1.7. Leveraged Buyouts.

1.8. Recapitalization of Troubled Companies.

1.9. Asset Restructuring.

1.10. Real Options: Valuing Entry and Exit Options.

1.10.1 Financial Options.

1.11. Technical Notes and Problems.

1.12. Valuation Aids and DealModeler® Software.

2. Forecasting and Valuation of Free Cash Flows.

2.1. Free Cash Flows.

2.2. Building a Financial Model.

2.3. Enterprise Valuation.

2.4. Continuation Value.

2.4.1 Forecast Consistency.

2.4.2 Forecasting FCFT.

2.4.3 A Wrong Way to Forecast Continuation Value.

2.4.4 Sensitivity to Parameter Estimates.

2.4.5 Competitive Advantage Period.

2.4.6 EBITDA Multiples.

2.5. An Equivalent Approach: Valuing the Cash Flow to Equity.

2.5.1 Decomposition of Free Cash Flows: Cash Flows to Equity and Debt.

2.5.2 Equity Valuation.

2.5.3 Debt Valuation.

2.5.4 Financial Policy and Dividends.

2.6. Some Practical Aspects.

2.6.1 Choosing the Valuation Method.

2.6.2 Personal Taxes and Enterprise Value.

2.6.3 Enterprise Value in Tax-imputation Countries.

2.6.4 Balance Sheet Adjustments.

2.6.5 Cash and Marketable Securities.

2.6.6 Mid-year Discounting.

2.6.7 Dealing with Equity-linked and Other Securities in the Capital Structure.

2.6.8 Restructuring Expenses.

2.7. Analysis of Results: The Value of Franchise and Growth.

2.8 Summary.


3. The Equity Premium and the Cost of Capital.

3.1. Estimating the Cost of Capital.

3.2. The Cost of Equity.

3.2.1 The Capital Asset Pricing Model Approach.

3.2.2 Choosing the Riskless Rate.

3.2.3 Estimating the Equity Premium: Historical Analyses.

3.2.4 Time Varying Equity Premium.

3.2.5 Prospective Equity Premium.

3.3. The Cost of Equity of Large Capitalization Companies.

3.4. The Cost of Equity and Leverage.

3.5. Beyond the Capital Asset Pricing Model.

3.5.1 The Original CAPM.

3.5.2 The Fama-French Three-factor Model.

3.5.3 Arbitrage Pricing Theory.

3.5.4 Liquidity and Expected Returns.

3.6. The Cost of Equity of Small Capitalization Companies.

3.7. Estimating the Cost of Equity: A Detailed Example.

3.8. The Cost of Debt and Other Components of the Capital Structure.

3.8.1 Investment-grade Debt.

3.8.2 High-yield Debt and Preferred Stock.

3.8.3 Convertible Securities, Warrants, and Other Options.

3.9. Estimation of the Cost of Capital in Practice.

3.10. Summary.


4. Metrics and Multiples.

4.1. The Use of Multiples in Valuation.

4.2. Using Comparables: An Example.

4.3. Multiples and Continuation Value.

4.4. Relationships Among Valuation Multiples.

4.5. Adjusting Multiples for Leverage and Growth.

4.6. The Franchise Factor in Valuation Multiples.

4.7. Normalizing P/E Ratios by the Growth Rate.

4.8. Summary.


5. Economic Value Added.

5.1. Measuring Value Creation.

5.2. Relation to Free Cash-Flow Valuation.

5.3. A Detailed Example of EVA Valuation.

5.4. The Sources of Value: Franchise and Growth.

5.5. Economic Value-Added and Market Value.

5.6. Some Empirical Evidence.

5.7. Summary.


6. Valuation with Changing Capital Structure.

6.1. Leverage Changes and Enterprise Value.

6.2. Adjusted Present Value and The Value of the Tax Shield.

6.3. A Detailed Example of APV Valuation.

6.4. Valuing an Acquisition with Leverage Above Target.

6.5. Recursive WACC Valuation.

6.6. Compressed APV.

6.7. Uncertain Leverage: A Recursive APV Model.

6.8. Valuing Equity as an Option.

6.9. Summary.


7. Debt Capacity for Acquisition Financing.

7.1. Financial Interdependencies.

7.2. Financing Growth.

7.3. Growth via Acquisitions.

7.4. Sustainable Debt.

7.5. The Target Debt Ratio Assumed in WACC Valuation, Debt Capacity, and Interest Coverage.

7.6. Debt Capacity in Leveraged Buyouts and Recapitalizations.

7.7. The Debt Capacity Multiple in Practice.

7.8. Summary.


8. Valuing Entry and Exit Options.

8.1. Net Present Value and Options.

8.1.1 Accounting for Flexibility.

8.1.2 Option Pricing.

8.2. A Continuous-Time Model of Free Cash Flows.

8.3. Valuation in Discrete and Continuous Times.

8.4. Valuing a Going Concern in Continuous Time.

8.5. Valuing the Entry Option.

8.6. Entry and Exit Options.

8.7. Valuing Foothold and Growth Options.

8.7.1 Foothold Investment with an Expansion Option.

8.7.2 Valuing Foothold and Expansion Options.

8.8. Allowing for Uncertain Costs in Foothold Investments.

8.9. Sensitivity of DCF Values in the Presence of Real Options.

8.10. Summary.


Part Two: Mergers, Acquisitions, and Buyouts.

9. Mergers and Acquisitions.

9.1. Value Creation and Mergers.

9.2. Legal Form of the Transaction and Tax Considerations.

9.3. Examples of Tax Consequences.

9.4. Tax-Free Reorganizations.

9.5. Merger Accounting.

9.6. Premiums and the Iron Law of M&A.

9.6.1 All-cash Offer.

9.6.2 Share Exchange.

9.6.3 Cash and Share Offer.

9.7. Break-Even Synergies.

9.8. Premiums and the Acquirer's Foothold.

9.9. Accretion-Dilution Analysis.

9.10. Free Cash-Flow Valuation: Total Versus Incremental Free Cash Flows.

9.11. Comprehensive Merger Example.

9.11.1 Terms of the Merger.

9.11.2 Building the Financial Model of the Merger.

9.11.3 Accretion-dilution Analysis.

9.11.4 Free Cash-flow Valuation.

9.11.5 Sensitivity and Scenario Analysis.

9.12. Summary.


10. Deal Making with Difference of Opinion.

10.1. Sources of Disagreement in Deal Making.

10.2. Risk Shifting.

10.3. Staged Financing.

10.4. Earnout Agreements.

10.5. Valuing Earnout Cash Flows.

10.6. Earnouts as Options on Future Cash Flows.

10.6.1 Earnouts with Thresholds.

10.6.2 Earnouts with Thresholds and Caps. 

10.6.3 Earnouts Based on Average Performance.

10.6.4 Valuing the Seller's Repurchase Option.

10.6.5 Valuing Multiyear Earnouts.

10.6.6 Earnouts Based upon Relative Performance.

10.7. Perpetual Earnouts and Class Shares with Threshold.

10.8 Summary.


11. Special Offer Structures: Price Guarantees and Collars.

11.1 Special Offer Structures.

11.1.1 Risk Arbitrage.

11.1.2 Guarantees.

11.2. Valuing Price Guarantees.

11.2.1 Commodity Price Guarantees.

11.3. Valuing Offers with Price Collars.

11.4. Additional Features in Price Collars.

11.4.1 Walk-away Rights.

11.4.2 Top-up Rights.

11.4.3 Fixed Exchange Ratio with Collar.

11.4.4 Weighted Average.

11.5 Summary.


12. Acquisitions in Developed and Emerging Markets.

12.1. The Global Capital Market.

12.2. Translating Foreign Currency Cash Flows.

12.3. The Cost of Capital in Developed Capital Markets.

12.4. Valuing Emerging-Market Companies.

12.4.1 Translating Free Cash Flows to the Acquirer’s Currency.

12.4.2 Value to the Acquirer.

12.4.3 Nominal and Real Cash Flows and the Cost of Capital.

12.4.4 Value to the Seller.

12.5. On the Nature of the Country Risk Premium.

12.6. Post-Emergence Systematic Risk.

12.7. Summary.


13. Leveraged Buyouts.

13.1. The Rationale for LBOs.

13.2. Financing LBOs.

13.3. Robust Financial Structures.

13.4. Computing the Returns to Investors.

13.5. Option Pricing of Warrant Kickers.

13.6. Debt Capacity and Affordable Price.

13.7. Returns to Investors and the Private-Equity Discount.

13.8. A Detailed LBO Example.

13.9. Mezzanine Financing.

13.10. APV Valuation.

13.11. Summary.


Part Three: Recapitalizations and Restructuring.

14. Recapitalization of Troubled Companies.

14.1. Dealing with Financial Distress.

14.2. Framework for Recapitalizations.

14.3. Out-Of-Court Workouts and Bankruptcy.

14.3.1 Out-of-court Workouts.

14.3.2 In-court Reorganization.

14.3.3 Prepackaged Bankruptcy.

14.3.4 Liquidation.

14.4. Accounting Treatment.

14.4.1 Troubled Debt Restructuring.

14.4.2 Asset Impairment.

14.4.3 Fresh-start Accounting.

14.5. Tax Considerations.

14.6. Valuing Recapitalization Securities.

14.6.1 The Southland LBO.

14.6.2 The Recapitalization Plans.

14.6.3 Valuing the New Debt Securities.

14.6.4 Valuing Equity.

14.6.5 Recovery.

14.7. Valuing Recapitalization Rights and Options.

14.8. Summary.


15. Asset Restructuring.

15.1. Asset Restructuring and the Value Gap.

15.2. Is There a Diversification Discount?

15.3. Share Repurchases.

15.4. Asset Disposition.

15.5. Tax and Accounting Treatment.

15.5.1 Private Sales, IPOs, and Carve-outs.

15.5.2 Spin-offs.

15.5.3 Tracking Stock.

15.6. Sum-of-the-Parts Valuation.

15.7. Headquarter Costs and Benefits.

15.8 Comprehensive Restructuring Analysis.

15.8.1 Sum-of-the-Parts Valuation: Multiples.

15.8.2 Sum-of-the-Parts Valuation: Free Cash Flows.

15.8.3 Valuing the Effect of Cost Reductions at Wendy's Stores.

15.8.4 Refranchising Wendy's Operated Restaurants.

15.8.5 Comparison of Restructuring Actions.

15.8.6 Monetizing Real Estate.

15.8.7 Share Repurchases.

15.8.8 Wendy's Restructuring Plan.

15.9. Summary.


Appendix A. Financial Options.

A.1 Financial Options in M & A Valuation.

A.2 European Calls and Puts and American Calls.

A.3 American Puts.

A.4 Warrant Pricing Model.

A.5 Asian Options.

A.6 Knockout (Barrier) Options.

A.7 The Put-Call Parity.

A.8 Stock Options Paying A Known Dividend Yield.

A.9 Dilution Adjustment in Warrant Valuation.


Appendix B. Valuation Aids Software.

Appendix C. Answers to Selected End-of-Chapter Problems.

Appendix D. Modeling Mergers and Buyouts with DealModeler™: User's Manual.

D.1 Brief Description of DealModeler.

D.1.1 Financial Modeling.

D.1.2 Inputs.

D.1.3 Addictions.

D.1.4 Printing Output.

D.1.5 Demo and Blank Copies.

D.2 Modeling Mergers and Acquisitions.

D.2.1 Setting Up the Financial Model for M&A Transactions.

D.2.2 Valuation.

D.2.3 Checking the Model.

D.2.4 Printing M&A Financials and Valuation Output.

D.2.5 Sensitivity and Scenario Analysis.

D.3 Modeling Leveraged Buyouts.

D.3.1 Setting Up the Financial Model for LBO Transactions.

D.3.2 IRR Valuation.

D.3.3 Checking the Model and Printing.

Technical Notes.