Appendix A. A BBREVIATIONS
Throughout this research, several expressions are abbreviated. Table A.1 provides a list of the abbreviations and their full descriptions.
Table A.1: Abbreviations
Abbreviation Expression
BoM Board of Management
capex Capital expenditures
COGS Cost of goods sold DCF Discounted cash flows E&Y Ernst & Young
EBIT Earnings before interest and taxes
EBITA Earnings before interest, taxes, and amortisation
EBITDA Earnings before interest, taxes, depreciation, and amortisation EBITDAR Earnings before interest, taxes, depreciation, amortisation and rent EPS Earnings per share
EV Enterprise value
FCF Free cash flows FMV Fair market value
GS Goldman Sachs
IFRS International financial reporting standards IQ Investigative question
IRR Internal rate of return
LBO Leveraged buy out
M&A Mergers & Acquisitions McKinsey McKinsey & Company
NOPLAT Net operating profit less adjusted taxes NPV Net present value
P/E Price to earnings P&L Profit & Loss account
PP&E Property, plant and equipment
PV Present value
R&D Research & development ROIC Return on invested capital
SG&A Selling, general and administrative expenses
TV Terminal value
WACC Weighted average cost of capital
Appendix B. M ERGERS & A CQUISITIONS PROCEDURES WITHIN TNT
Due to reasons of confidentiality, this appendix is not disclosed.
Appendix C. D ISCOUNTED CASH FLOW VALUATION
The valuation of a certain investment is based on the cash flows it generates. The discounted cash flow (DCF) method takes an approach of forecasting future cash flows and discounting them to attain their present value.
The present value of all future cash flows together represents the total value of an investment today. The DCF method is illustrated at the hand of the valuation of a company on a stand-alone basis, thus of the target firm in the situation preceding the acquisition.
Assume a company with a forecast Profit & Loss account (P&L) and balance sheet as presented in tables B.1 and B.2 respectively. In reality the P&L and balance sheet may contain several other items. For the purpose of simplicity, they are not regarded here. Forecasts are based on assumptions concerning growth, margins, investment requirements etc. Also, a certain capital structure is assumed. Valuation is based on market values.
Table B.1: Stand-alone Profit & Loss account of the target company
Actual Actual Forecast Forecast Forecast Forecast Forecast TV Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
Revenues (2% revenues growth) 290 299 305 311 317 324 330
COGS (60% of revenues) -175 -179 -183 -187 -190 -194 -198
SG&A -74 -78 -79 -81 -82 -84 -86
Personnel expenses (12% of revenues) -34 -36 -37 -37 -38 -39 -40
Other personnel expenses (0.5% of revenues) -2 -2 -2 -2 -2 -2 -2
Management fee (5% of revenues) -13 -13 -15 -16 -16 -16 -17
Housing expenses (5% of revenues) -13 -14 -15 -16 -16 -16 -17
Other operating expenses (3.5% of revenues) -10 -11 -11 -11 -11 -11 -12
EBITDA 41 42 43 44 44 45 46
Depreciation PP&E (20% of Net PP&E) -4 -5 -5 -6 -7 -7 -8
EBIT 37 37 38 38 38 38 39 39
Interest expense (5% of debt at beginning of year) 0 0 -1 -2 -1 -1 -1
Profit before tax 37 37 36 36 36 37 37
Income tax (30% tax rate) -11 -11 -11 -11 -11 -11 -11
Net income 26 26 25 25 26 26 26
Key to symbols:
COGS: Cost of goods sold EBITDA: Earnings before interest, taxes, depreciation and amortisation PP&E: Property, plant & equipment EBIT: Earnings before interest and taxes
SG&A: Selling, general, and administrative expenses
Table B.2: Stand-alone balance sheet of the target company
Actual Actual Forecast Forecast Forecast Forecast Forecast Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
Operating cash (3% of revenues) 7 8 9 9 10 10 10
Inventories (0.6% of revenues) 2 2 2 2 2 2 2
Trade receivables (13% of revenues) 35 36 40 40 41 42 43
Other current operating assets (1% of revenues) 3 3 3 3 3 3 3
Current assets 47 49 54 55 56 57 58
Net PP&E 23 25 29 33 36 38 40
Goodwill 6 6 6 6 6 6 6
Total assets 76 80 89 94 98 101 105
Trade payables (6% of revenues) 17 17 18 19 19 19 20
Other current operating liabilities (8% of revenues) 23 23 24 25 25 26 26
Current liabilities 40 40 43 44 44 45 46
Debt 27 30 31 29 27 24 20
Total equity 9 10 15 21 26 32 38
Total equity & liabilities 76 80 89 94 98 101 105
For valuation purposes, cash flows available to all investors are critical. Since a firm’s operations essentially create these cash flows, the DCF method focuses on the operating site of the P&L and the balance sheet. DCF valuation combines the P&L the balance sheet. A firm’s financial structure and items that are of non-operating nature (such as marketable securities or non-liquid investments, e.g. non-consolidated subsidiaries) have no impact on the value of a company. The cash flows generated throughout the forecast period are discounted to their present value. The sum of the present values represents the value of the target company today.
Some adjustments in the financial statements are required to separate operating items. The valuation is presented in table B.3.
Table B.3: Stand-alone valuation of the target company
Actual Actual Forecast Forecast Forecast Forecast Forecast TV Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
1 2 3 4 5
EBIT 37 37 38 38 38 38 39 39
Taxes on EBIT -11 -11 -11.3 -11.3 -11 -11 -12 -12
NOPLAT 26 26 26 26 27 27 27 27
Depreciation & amortisation 5 6 7 7 8
Capex -9 -9 -10 -10 -10
Investment in working capital -3 0 0 0 0
Free cash flows 20 23 23 24 25 300
Discount rate (based on WACC of 9%) 0.92 0.84 0.77 0.71 0.65 0.65
Present value 18 19 18 17 16 195
Enterprise value 283
The valuation process is as follows:
1. Earnings before interest and taxes (EBIT) is taken from the P&L account. Taxes on EBIT are deducted to arrive at Net operating profit less adjusted taxes (NOPLAT). NOPLAT is thus a purely operating figure.
2. Depreciation and amortisation (P&L) are added back to NOPLAT, since they are non-cash items.
Remember that EBIT does not include depreciation and taxes, but must be used in step 1 for the correct calculation of taxes and the focus on operating items.
3. Capital expenditure (capex: the investment in fixed assets1) and Investment in working capital2 are subsequently deducted, as they represent actual cash flows. These items are obtained from the balance sheet. Free cash flows (FCF) are now computed. These are the cash flows from operations, available to all debt and equity holders, and thus the core of value creation.
4. Terminal value (TV) is then calculated. Under a steady-state assumption3, EBIT of the last year of the explicit forecast period is used, and again, taxes are deducted, resulting in NOPLAT. A steady-state formula is applied for the calculation of terminal value, dividing NOPLAT by the weighted average cost of capital (WACC).
5. All FCF and the terminal value are then discounted to achieve their present value. Since these cash flows are available to all investors, they must be discounted at the required rate of return of all investors: the WACC. In this example a WACC of 9% is assumed.
6. The sum of the present values is the total enterprise value, €283.
1 In this case example, capex is calculated as PP&Eprevious year – PP&Ecurrent year + depreciation.
2 Working capital is calculated as current assets minus current liabilities (Brealey et al. 2001). The investment in working capital is the change from one year to another.
3 A company reaches a steady state when its growth, margins, reinvestment rate and WACC are constant (Koller et al. 2005).
The entire process is illustrated in figure B.1, providing insight in the relationship between the various inputs of the DCF valuation.
Figure B.1: The DCF valuation process illustrated
Revenues
SG&A (-)
Taxes (-) EBIT COGS (-)
D&A (-) NOPLAT
D&A (+) Capex (-) Investment in WC (-)
FCF Discount
rate Present
value
Enterprise value WACC
Key to symbols:
From P&L
COGS: Cost of goods sold
SG&A: Selling, general & administrative expenses From balance sheet D&A: Depreciation & amortisation
WC: Working capital Results from DCF
As becomes apparent from this case example, the DCF method is highly dependent on the assumptions concerning the future. Different growth rates, profit margins or investment rates have great impact on the enterprise value. Also, the discount rate is a key input and must therefore be considered carefully. All in all, the DCF method enjoys great appeal. Once the assumptions are set, the process is relatively straightforward.
When considering which items generate cash flows, which items are of operating nature, and also considering the underlying assumptions with respect to the future carefully, the DCF method is considered to result in a rather accurate projection of today’s value of a certain investment.
Appendix D. W EIGHTED AVERAGE COST OF CAPITAL A company’s cost of capital
The weighted average cost of capital (WACC) is a measure for a company’s cost of capital. A company’s cost of capital is a weighted average of the rate of return required by all the debt and equity providers of a company.
It relates to market values, since it projects what debt holders and investors demand today; it is not a reflection of past returns. An adjustment for the taxes a firm saves when it borrows is incorporated in the calculation, as interest payments are deducted before taxes are calculated. Assume the balance sheet in table D.1. The company’s WACC is subsequently calculated with formula C.1.
Table C.1: Balance sheet (market values)
Assets Liabilities & Shareholders' Equity
Assets 100 Debt 20
Equity 80
100 100
Formula C.1: WACC (Source Brealey et al. 2001)
D E
(D+E) (D+E)
}
WACC = rd *
{ }
* (1-Tc) + re *{
Key to symbols:
D = Debt rd = required rate of return on debt Tc = corporate tax rate E = Equity re = required rate of return on equity
Assume a required rate of return on debt of 6% and on equity of 10% and a tax rate of 30%. The WACC is then 9%:
WACC = 6% * 20/100 * 0,70 + 10% * 80/100 = 8.8%
The WACC is thus based on the relative proportions of debt and equity and their required rates of return. If a company has any other securities, additional terms must be added to the formula, with the respective rates of return. The weight of debt and equity must be based on target capital structures.
The costs of debt and equity
For the determination of the cost of equity, the Capital Asset Pricing Model (CAPM) is commonly used. At the basis of CAPM lie three variables: the expected rate of return of a company’s stock, the risk free rate and the market risk premium. The rationale behind CAPM on the relationship between risk and return is that the risk premium which is expected on a security is equal to the beta of that security times the market risk premium (Brealey et al. 2001). A stock’s beta represents the sensitivity of that stock’s return to the market’s return. The market risk premium is the premium above the risk free rate which one receives on the market portfolio.
Translating this into a formula results in the formula C.2. The cost of debt is the required rate of return of all debt holders.
Formula C.2: CAPM formula (Source Brealey et al. 2001)
r = rf + β (rm – rf) Key to symbols:
r = required rate of return on equity rm = market rate of return β = stock’s beta rf = risk free rate rm – rf = market risk premium
Appendix E. L ETTER OF REQUEST
For the purpose of this research, several companies with knowledge and experience in the field of acquisitions were asked to give their opinion on the TNT hurdle rates, to provide insights in the approach they take and to share their knowledge in the topic of acquisition evaluation in general. The letter of request is presented below.
Dear Sir/ Madam,
Currently, I am working on the master thesis for my Economics study. I do this by means of a research project for TNT, Group Mergers & Acquisitions. The objective of the research is to create a dialogue among TNT senior management allowing them to reach agreement on the hurdle rates or benchmarks to be considered when assessing investment opportunities.
Group M&A developed a number of metrics that they find important when assessing a possible acquisition. My task is to evaluate these metrics and consider other possible benchmarks to reach a conclusion on which benchmarks are to be used and on the value that they should have. I do this through a literature study and through interviews with experts in the field. This is why I am writing to you. I would like to hear your point of view and experience on the use of certain benchmarks and hurdle rates when assessing an acquisition.
TNT has developed a perspective on the following points:
1. ROIC should exceed WACC within # years.
2. Cash (FCF) should be accretive within # years.
3. Earnings should be accretive within # years.
4. IRR should exceed x%.
5. Payback period should be within the forecast period.
6. Maximum payout of synergies.
7. Market-to-book value of the target’s assets.
8. Implied EV/EBITDA multiple in comparison to market/trading multiples.
9. Terminal value in comparison to total value.
I am very curious to hear your views on this matter.
Kind regards, Anne Kiers
Appendix F. I NTERVIEWS WITH EXPERTS
Following the request for feedback (appendix E), the following companies have provided a reaction, either in the form of a (telephone) interview or a response per email. The role of each of these experts in the acquisition process is also indicated.
• Akzo Nobel (acquirer),
• Ernst & Young (advisor: transaction services),
• Goldman Sachs (advisor: investment bank),
• ING (advisor: investment bank),
• JP Morgan (advisor: investment bank),
• Kempen & Co (advisor: investment bank),
• McKinsey & Company (advisor: consultant),
• Merrill Lynch (advisor: investment bank),
• Philips (acquirer), and
• Shell (acquirer).
Due to reasons of confidentiality, the interviews are not disclosed.
