Appendix 1.A. Interview planning

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Appendices part one:

Appendix 1.A. Interview planning

This appendix gives the interview planning for this thesis. Next to general information on the interviewees, their professions, the information objectives of the interviews and some miscellaneous information can be found in the table below.

Table 1.A. Interview planning

As can be seen above a variety of professionals with different backgrounds has been selected to interview. The relative “short” lines within A&Co gave me the opportunity to talk to people in the organisation that really were in the heat of fire concerning the topic of this thesis. To ensure a broad view, three external professionals were interviewed as well.

Appendix 1.B. Interview preparation

This appendix shows the topics dealt with at the semi-structured interviews. As a checklist during the interviews and to compare results a table such as presented in appendix 4.A. has been used. In this way a schematic overview could be obtained from the qualitative results.

The theoretical framework (section 1.5.) and research model (section 1.8.) were brought to the interviews too to illustrate this research. Sometimes figures from this thesis were used for discussion of the types of analysis.

Interview Planning Thesis Douwe

S l

28-Feb-2005 2004/2005

internal

date name profession information goal miscellaneous e-mail

25-11-'04 Andrew Ying investment banker >current A&Co methodology Supervisor at A&Co a.ying@A&Co.com

>experiences from banking practice Former: Credit Suisse First Boston 24-01-'05 Hans Ouwendijk CFO & COO A&Co >strategic assessment of target

>insight in takeover process

27-12-'04 Cami Hayduck MBA investment banker >current A&Co methodology cami_hayduk@B.com

>feedback on method

>experiences from banking practice Former: Credit Suisse First Boston

external

date name profession information goal miscellaneous e-mail

01-12-'04 ir. John Bleijdenstein MBA venture capitalist >comment on method Capital Partners B.V. (own company) johnb@bvpe.com

>strategical & financial factors from practice

22-11-'04 drs. Henk de Groot RC financial director >comment on method NDC Holding henk.de.groot@freeler.nl

& Controller >executive in a takeover context Former: Atos Origin

22-12-'04 drs. O.v/d Boogaard investment banker >comment on method NIB Capital, vice-president retail otto.van.den.boogaard

>strategical & financial factors and @nibcapital.com

techniques from practice

Former: West private equity (4 billion, London based, founding partner) head of B&Co's M&A- department

due to limited time available, focus is on strategic issues

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The interviews are presented by date. At the first interview all questions were written down 1 in a more detailed way as can be seen on the next pages. The questions and topics have not changed fundamentally. Below the topics that were discussed during the interviews are given.

Interview internal Hans Ouwendijk CFO & COO A&Co (24-01-‘05) A. explanation thesis; I. perspective & II. Method

Research objective: Provide the management of A&Co with a method to systematically value a potential takeover candidate in support of A&Co’s current growth strategy in Europe.

B. What are the A&Co’s demands for such a valuation-method?

• Management tool Æ usefulness

• Level of detail

• Format

• Output

• Speed

C. What is the current practice at A&Co?

• Target selection

• Sequence

• Target value determination?

D. What types of strategic analysis?

• How to judge targets?

E. What types of financial analysis?

• Comparable companies

• Comparable acquisitions

• interpretation

• assumptions

• ROIC??? Æ B&Codoes uses this F. What valuation sequence Æ Stages……..?

Interview internal Cami Hayduk – Head M&A B&Co (28-12-‘04)

“Own background & Explain thesis context”

Objective: Provide the management of A&Co with a method to systematically value a potential takeover candidate in support of A&Co’s current growth strategy in Europe.

2 main questions:

- method

- 2 case studies (test & calibrate method) 1. Cami’s background?

- education - working experience

Æ Main question interview: What is your experience regarding the following subjects?

2. What types of strategical analysis?

3. What types of financial analysis?

- Comparable companies - Comparable acquisitions - interpretation - assumptions - information sources 4. What valuation sequence Æ Stages……..?

- value determining variables 5. Method B&Co(similar as A&Co)

- EPS-impact - Financing issues - ROIC-impact???

- EBIT%-neutrality……..

6. Role B&Covs. A&Co in takeover context - investment banks - control

- compare with “current A&Co’s implicit method”

Interview external: Otto v/d Boogaard - NIB Capital (22-12-‘04) Explanation thesis; I. perspectives & II. sequence

1. Otto’s background?

- education

- current job description

- Comparable companies

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- Comparable acquisitions 2

- interpretation - assumptions - information sources 4. What valuation sequence Æ Stages……..?

- value determining variables

Interview external: John Bleijdenstein – BVPE (01-12- ’04) Explanation thesis; I. perspectives & II. sequence

1. John’s background?

- education - working experience

- Comparable companies - Comparable acquisitions - Interpretation - assumptions - information sources 4. What valuation sequence Æ Stages……..?

- value determining variables

Interview internal: Andrew Ying – A&Co (supervisor) (25-11-‘04) A. explanation thesis; I. perspective & II. Method

Research objective: Provide the management of A&Co with a method to systematically value a potential takeover candidate in support of A&Co’s current growth strategy in Europe.

B. What are the A&Co’s demands for such a valuation-method?

• Management tool Æ usefulness

• Level of detail

• Format

• Output

• Speed

C. What is the current practice at A&Co?

• Target selection

• Sequence

• Target value determination?

D. What types of strategic analysis?

E. What types of financial analysis?

F. What valuation sequence Æ Stages……..?

G. “Explain own ideas Æ Comments…..?

• additions

• errors

.

Interview external: Henk de Groot – NDC Holding (22-11-‘04) Explanation thesis; I. perspectives & II. sequence

A. What types of strategic analysis are performed?

• Strategic context:

a. “PEST&D”

b. Porter’s five forces

c. Competitive advantage (resource based…..),

d. Business system (from R&D and purchasing to service…..)

• Cultural context:

(Inter)national, Professional & Organizational variables (like tight vs. loose control)

• Business idea; feedback loop --> which societal needs and distinctive competences??

• Value driver analysis: WACC, Investment (w.c. & fixed), Margin, Tax rate, Growth (& duration of growth) B. What types of financial analysis are used?

• Multiples (P/E, EBIT(DA), sales etc.)

• Discounted Cash Flow (including APV)

Cash flows: FCF (NOPLAT etc.), Discount rate: CAPM, APT, M/B, Size etc. & Continuing value

• EVA; explicitly more than cost of capital --> profitable growth

• Real options; qualitative uses --> event and decision tree

a. Flexibility; time, volatility, interest rate, underlying security value (), strike (or investment) price C. What is the sequence in which different value determinig variables of the target are analysed and why?

- Acquiring firm characteristics Æ target requirements - Target firm characteristics Æ stand alone value - Value of target opportunities

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- Synergy value 3

- Integration costs

Appendix 1.C. Important formulas

P/E-ratio:

Copeland et al, 2000, p. 66

P/E-ratioA = ((1 – g )/ ROICNEW ) / (RA – g)

Sales-ratio:

Fernandez, 2004

Price / Sales = Price / Earnings * Earnings / Sales Multiples in general:

EBIT(DA) or FCF or sales or earnings * Y

Where: Y is a certain number obtained from comparison

Annuity:

Grinblatt & Titman, 2002, p. 319 PV = CF * (1 / r – 1 / (1 + r)^T)

Perpetuity:

Grinblatt & Titman, 2002, p. 317 CF

PV =

r

Discounted cash flow (basic formula):

CF₁ + CF₂ + ….. + CF_N + V_cont VA =

(1 + r)¹ (1 + r)² (1 + r)^N (1 + r)^{N + 1}

Free cash flow:

Copeland et al, 2000, p. 168

FCF = EBITA – EBITA * Tax rate – ∆ Working Capital – ∆ Assets (net) - ∆ goodwill or: FCF = NOPLAT – net investment = NOPLAT * (1 - b)

Equity cash flow (CF_E) = FCF minus interest and principal payments plus new debt.

Debt cash flow (CFD) = all payments and receipts from and to debt holders.

Return on invested capital:

Copeland et al, 2000, p. 165 ROIC = NOPLAT / Invested Capital Invested Capital:

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4

Invested capital (including goodwill) = Operating current assets + property, plant & equipment + net other operating assets - non-interest-bearing current liabilities + goodwill

Weighted average cost of capital:

WACC = (E/V) * R_E+ (P/V) * R_P + (D/V) * (1 - T_C) * R_D

Where: RE = Return on ordinary equity R_P = Return on preferred stocks R_D = Return on debt

T_C = Effective tax rate (Fernandez, 2004)

E = market value of equity

D = market value of debt

P = market value of preferred stock V = total market value (E + D + P)

Capital Asset Pricing Model (CAPM):

Grinblatt & Titman, 2002, p. 153

cov. (R_E, R_M) R_E = R_F + β_E * (R_M - R_F) + ε and: β_E =

var. (R_M)

Dividend discount model (DDM):

V_A = Div₁ / (R_E – g) or: R_E = g + (Div₁ / V_A)

Plowback-ratio:

g = b * ROIC_NEW or: b = g / ROIC_NEW

Continuing value:

NOPLAT_N+1 * (1 – b) or: FCF_N+1 Vcont =

WACC – g WACC – g

Where: NOPLAT_N+1 = NOPLAT one year after the explicit forecasting period

Adjusted present value:

UA = D + E – T_C* D or: E = UA + T_C* D - D

Unlevering beta & WACC from unlevered return:

β_E = β_U * (1 + (1 - T_C) * (D / E)) and: WACC = R_U - (D / V) * T_C* R_D

Formulas to derive EP for one period N are:

EP_N = Capital * (ROIC – WACC) = NOPLAT – (Capital * WACC)

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5

Black and Scholes Formula:

Grinblatt & Titman, 2002, p. 257 S0N(d1) – PV(K)N(d 1 - σ√T)

Appendix 2.A. Macro environmental factors

This appendix describes the factors for macro environmental analysis. It complements the description in subsection 2.2.1.

Political issues that need to be analysed are legislation regarding taxes, anti-trust and labour (unions). Also the general philosophy about government involvement (US vs. EU) and education can be crucial factors.

General economical variables such as inflation, interest, trade and budget deficits or surpluses and personal and business saving rates define general profitability potential to some extent. Furthermore new innovative technology reshapes the world every now and then. Communication technology is the latest example of this factor. Some political issues that are crucial here are policies regarding R&D and education.

Demographical changes in population size and age structure influence a company’s environment directly. New industries are born serving the “baby boom”, because of ageing populations in the Western world for example. Recently the ethnic mix in societies has become an interesting factor as well. Also societal developments such as cultural shifts, employee attitudes and the amount of women in the workforce can change industry dynamics (Hitt et al, 2001, p. 51).

Appendix 2.B. Industry structure

This appendix details the relevant factors for analysis of the industry structure, which were introduced in subsection 2.2.1. It also shows an integrating figure for macro-environmental factors and industry structure. External shocks are ranked higher as they are an underlying force for all other forces. Therefore they are situated in a darker box than the other forces.

Figure 2.B. on the next page presents an overview of these factors.

The first factor that determines industry structure is the intensity of rivalry between existing competitors. Diversity of competitors, growth rates, (over)capacity, switching and exit barriers, brand identities and the stage in the product life-cycle are all elements that can be analysed to get a better picture of this factor (De Wit & Meyer, 1998, p. 347).

Bargaining power of buyers and suppliers are the second and third factors that shape the profitability of an industry. Elements that can be analysed to get an integrated overview are relative concentrations, volumes, mutual dependencies, switching costs, price sensitivity, quality requirements and the availability of substitutes.

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The threat of new entrants is the fourth factor and can be analysed by looking at current 6 economies of scale, brand identities, switching costs, capital requirements, legal issues, differentiation potential and all kinds of cost advantages of current competitors versus new entrants. It defines the likeliness that new companies enter a market and thereby reduce industry profitability.

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Figure 2.B. External analysis (based on: Porter (1985) & Copeland et al, 2000, p. 237) 7

Finally the threat of substitutes is an important limiting factor as well. A different product may serve the same buyer needs. “What if…-analysis”, extending product definitions and scenario-analysis can be useful to get a better picture of possible substitutes¹.

Appendix 2.C. Business system

The business system described in subsection 2.2.2. is further outlined in this appendix.

Figure 2.C. on the next page presents an overview. Also some “fashion-specific” issues are described.

“Filling in” the business system reveals differences between competitors. Building on different constellations of the factors below leads to different competences, cost structures and strategies. Relevant factors have been chosen for A&Co’s internal environment. An integrated approach can highlight the company’s core cross-functional processes (Copeland et al, 2000, p. 239). In “fashion retail” speed is key. An effective supply chain (i.e. business system) backing this is crucial. Quickly changing collections (fast fashion) generate traffic, speed up the buying-decision, shorten lead-times between order and arrival of goods² and they change supplier preferences³. Nowadays fast fashion is an important part of the “retail mix”, which exists of: store layout and atmosphere, understanding of modern customers,

1 A recent example of the potential danger of substitutes is the competition between high velocity trains and low-cost airlines in Europe. Billions of investments in infrastructure may turn out to be useless, because nobody could imagine the low cost business model of companies like Easyjet and Ryanair.

2 Zara for instance claims to change its collections in France 22 times a year.

3 Because of long shipping times, producers located in Eastern and Central Europe become more interesting versus their cheaper Chinese counterparts. In practice for normal fashion Chinese suppliers are used and for

“fashionable” goods faster European suppliers are used.

• Current competitors

• Competition rivalry Æ

Industry structure

Threats of Substitutes Bargaining power of

suppliers Bargaining power of

buyers External shocks:

• Political

• Economical

• Societal

• Technological

• Demographical

Threats of New Entrants

Performance:

• Individual competitors

• Industry

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tailoring fashion for different markets⁴, more fashionability and finally a strongly 8 communicated brand (Barry, 2004).

Figure 2.C. Business System (adapted from: Copeland et al, 2000, p. 238)

Brands create recognition, simplifying the decision-making process. It also makes someone part of a certain group (Tongeren, van, 2004). Considering the fact that A&Co is a brand – a way of life, an experience -, some additional information about retail branding is needed. A

“retail brand” differs from a “product brand”, because the physical shop is the visible,

“traffic-generating” platform for the entire formula. The shops show consumers the brand values and consumers can identify themselves with that (Tongeren, van, 2004). The marketing-box in the case of A&Co should at least include an analysis of these features.

Appendix 2.D. Competitive advantage

In addition to subsection 2.2.3. this appendix gives the criteria for a sustainable competitive advantage as well as some important definitions regarding this subject.

Resources, that can be tangible and intangible, are the inputs into a company’s production process. Finances, human resources and raw materials are all examples of a firm’s resources. Capabilities are the company’s ability to purposely bundle that resources to achieve goals. If a capability satisfies the criteria of sustainable advantage it becomes a core competence. Therefore all core competences are capabilities, but not all capabilities

4 Italians simply have different preferences for fashion than Germans for example.

Product design and R & D

Procurement

Manufacturing

& operations

Factors:

- Costs - Brands - Retail mix - Pricing/quality - # of collections - Promotion - Packaging Factors:

- Costs - Quality - Lead time

- IT

Factors:

- Costs - Product attributes - Quality - Proprietary technology - Time to market

Factors:

- Costs - Access to resources - Outsourcing - Quality

Marketing

Sales and distribution

Factors:

- Costs - Service - Sales effectiveness - Channels - Transportation - IT

ANALYSIS

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are core competences. Core competences are the source of competitive advantage (Hitt et 9 al, 2001, p. 102).

Basically a core competence is what a company excels at over its competitors. Usually it is built on a set of core competences, which are to some extent unique. The combination of these core competences can be a competitive advantage in itself. To ensure future value sustainable competitive advantage must be built. There are four criteria of sustainable competitive advantage (Hitt et al, 2001, p. 102). If the company’s core competences fulfil these criteria, long term value can be created.

• Valuable; it exploits an environmental opportunity or neutralises a threat,

• Rare; few or none of the competition own the same capabilities,

• Costly to imitate; capabilities can not be developed easily and

• Non-substitutable; there are no easy strategic equivalents for the capability

Appendix 2.E. Scenario analysis

Following the discussion in subsection 2.2.4., this appendix further explains scenario analysis. First uncertainty and its role in strategy is dealt with. Then the influence of time and finally the differences between forecasting and a scenario approach are given.

Scenario planning and analysis distinguishes itself from more traditional approaches of strategic planning and forecasting by explicit acknowledgement of ambiguity and uncertainty. Forecasting shows the expert perspective on the relevant variables of some subject. GDP, spending patterns, demographics are all examples of variables used in forecasting. Unexpected, or unknown variables are left out of the discussion and the mental model is fixed in a way. Although it is a very important activity, it is crucial to be aware of the boundaries of forecasting the future. Traditional forecasting, which includes building a base case and varying key assumptions using probabilities, box in the future while a scenario analysis opens up thinking (Van der Heijden, 1996, p. 103).

The idea of strategy is based on at least some degree of predictability of the future.

Uncertainty thereby defines the degree of possible forecasting potential. Next to that the time frame used is very important. Even the most predictable variables become unpredictable when the timeframe is stretched far enough. Three classes of risk and uncertainty can be observed (Van der Heijden, 1996, p. 83):

• “Ordinary” risks; that can be estimated statistically by historic precedents like demo- graphical patterns. Estimation of risk on cancer is another example of this category.

• Structural uncertainties; that can be surfaced by looking at structures in trends and patterns like number and degree of natural disasters.

• Unknowables; which can never be predicted, although history tells us a lot of them have taken place⁵.

5An example of the category of unknowables are the 9-11 attacks.

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Scenario analysis can assist in assessing the structural uncertainties, because uncertainty 10 is placed explicitly on the management agenda. The most influential and uncertain external factors need to be taken into account to surface the company’s risk profile (Van der Heijden, 1996, p. 190). For management purposes “ordinary” risks can be assessed using the output of the statistical estimates. Below uncertainty is shown in relation to time. Through time the influence of predetermineds decreases. Therefore through time the extent to which strategy is useful decreases. The interpretation of this problem differs in literature though.

The purposes of forecasting and scenarios are rather different. Looking at figure 2.3., forecasting is useful in the short-term part, where the influence of predetermineds is substantial. Forecasting aims to predict the outcome of certain variables. This can be tested in retrospect. Scenario planning has its uses in the intermediate term where both predetermineds and structural uncertainty play their roles. Its aim is to create an understanding of the interaction of the risk factors. In the longer term unknowables dominate and any form of planning becomes difficult. Being aware of these limitations is very important.

Appendix 2.F. Balance sheet based methods

Differing balance sheet based values are given in this appendix as an extension of subsection 2.3.1. The book values are:

• Book value: a company’s book value is the equity value on its balance sheet. This can be restated as the difference between total assets and liabilities. This method is based on accounting criteria only (Fernandez, 2004).

• Adjusted book value: When adjustments to the pure accounting numbers from book value are made to reflect real market value, we are talking about adjusted book value.

Land can be worth much more than is stated in the balance sheet for example (Fernandez, 2004).

• Liquidation value: If the company is liquidated and the assets are sold to pay off debt obligations liquidation value is what remains. This is the minimum value of a company if the going-concern value is greater than its liquidation value (Fernandez, 2004).

Figure 2.E. uncertainty and time (Van der Heijden, 1996, p.

92)

uncertainty

predetermineds

short-term intermediate term

long-term Æ time

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• Substantial or replacement value: this is the net investment that needs to be made to 11 form a company with identical assets. This approach is not very realistic though, because some assets simply do not have to be replaced and thereby may be a source of competitive advantage (Copeland, 2000, p. 184).

Appendix 2.G. Income statement based methods

This appendix extends the description of the income statement based methods for valuation from subsection 2.3.2. Some additional issues with multiples are discussed here.

The best-known technique in this class is the price-earnings-ratio (P/E- ratio). The formula is given below (Fernandez, 2004):

P/E- ratio = Equity value / earnings or: Equity value = P/E- ratio * earnings

A different improved version of this formula is (Copeland et al, 2000, p. 66):

P/E-ratioA = ((1 – g )/ ROICNEW ) / (RA – g)

The second formula adds return on new investment (ROIC_NEW), growth rate (g) and the required return (RA) for risk-bearing relevant for company A to the simple version. They are both used to derive and compare firm values based on the assumption that the comparison firm has the same growth and risk-adjusted discount rate. Other assumptions regarding for example inflation, accounting treatment and return on investment need to be made to use the model. Clearly these assumptions tend to oversimplify most situations (Grinblatt & Titman, 2002, p. 444). The P/E- ratio is also a proxy for financial markets’

relative earnings growth expectations for the company. A high P/E- ratio is a sign of high expectations and high company value therefore (Sutton, 2000, p. 151).

A different, frequently used multiple is based on sales. Again this multiple is used as a check next to other methods. The price to sales-ratio can be further broken down in the P/E- ratio times the net margin on sales (Fernandez, 2004).

Price / Sales = Price / Earnings * Earnings / Sales

A metric that receives a lot of attention as well, is the earnings per share (EPS). Value is defined as a multiple of some form of earnings here. Share price is compared to earnings to derive this EPS-multiple. A debated issue is the EPS-effect on company value, which is being hyped in today’s’ financial news coverage. A rise or fall in EPS is no predictor of true economic value because of the timing of cash flows. It is important to bear in mind that a fall in profits now can be the result of crucial investments in resources that will drive future value and therefore create value for shareholders (Copeland et al, 2000, p.

73).

Appendix 2.H. Discounted cash flow methodology

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In this appendix discounted cash flow is explained. The determination of future cash 12 flows, the discount rate as well as the continuing value is explained in detail. This appendix is an extension of subsection 2.3.3.

Future cash flows

Future performance is driven basically by a company’s characteristics regarding industry structure and its competitive advantages and disadvantages. Different scenarios should be analysed by varying key variables. Section 2.2.4. has dealt with this subject in more detail.

The perspective on these variables should be translated into a future cash flow forecast.

Linking the different costs to their drivers creates a detailed forecast of cash flows. Direct operating costs can be expressed as a percentage of sales for example. An entire model can be built using relations like this resulting in forecasts of future balance sheets, cash flows and profit and loss statements (Maness & Zietlow, 2002, p. 431)⁶.

Because it is not possible to explicitly forecast cash flows for decades, the forecast can be divided in a detailed part for the first N years and a summary forecast of continuing value for the longer term (Copeland et al, 2000, p. 233). A few common measures for cash flow are given here.

Free cash flow (FCF): Because accounting earnings and cash flow statements are based on accounting standards rather than economic value, FCF is the proper measure for future cash flow. Basically FCF is defined as cash flow from operations in an all equity financed-company (Grinblatt & Titman, 2002, p. 303). Different definitions can be found in current literature because the treatment of amortisation of goodwill differs for tax reasons. FCF in this thesis is (Copeland et al, 2000, p. 168):

FCF⁷ = EBITA – EBITA * Tax rate – ∆ Working Capital – ∆ Assets (net) – cash investment in goodwill

In practice minor adjustments regarding for example deferred payments or non-operating- cash flow are made. This is not described further here. Other measures of cash flow are Equity cash flow (CFE), which is FCF minus interest and principal payments plus new debt and Debt cash flow (CFD), which are all payments and receipts from and to debt holders. These measures should be combined with their own risk adjusted discount rates RE and RD to value the streams of cash flows.

Discount rate

As said above the cash flows need to be discounted at a rate that reflects opportunity costs for all providers of capital. To do this a weighted average of all these requirements is needed. This is called the weighted average cost of capital (WACC). The formula is given below (Copeland et al, 2000, p. 202):

6 Maness & Zietlow (2002) describe the use of gross profit margin-, receivables-, inventory- and payables-ratios to create a cash forecast. Fixed assets and financing needs can be analysed using this method as well. Appendix 6.L. presents a practical example of a financial model like this.

7or: FCF = NOPLAT – net investment = NOPLAT * (1 - b)

where: NOPLAT = net operating profit less adjusted taxes = EBITA – EBITA * Tax rate

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13 WACC = (E/V) * RE + (P/V) * RP + (D/V) * (1 - TC) * RD

Where: R_E = Return on ordinary equity R_P = Return on preferred stocks RD = Return on debt

TC = Effective tax rate (Fernandez, 2004) E = market value of equity

D = market value of debt

P = market value of preferred stock V = total market value (E + D + P)

Other forms of financing than ordinary equity and debt are observed in practice. They should be dealt with in the same way as preferred stocks above. Three different inputs need some attention: the required return on equity, the required return on non-equity and the weight of these sources of capital in the capital structure.

Weights: Taking current total market value of ordinary shares can derive the value of equity. Also taking the market value of the company’s outstanding debt by using current interest rates derives market value of debt. The same can be done for preferred stock or other forms of financing.

The formulas for valuation have a circularity problem. The outcome, equity value, is required as an input (E) for the WACC (Adsera, 2003). Next to that capital structure changes during the forecasting period. These problems are solved by applying a target capital structure (Copeland et al, 2000, p. 204). This is a simplification of organisational reality though.

Return on debt: The required return on debt is the current market opportunity cost of debt holders. When applied to bonds this means that yield to maturity should be used. A common error is to take historical interest rates as the cost of debt (Fernandez, 2004).

Return on other non-equity items such as preferred stock can be estimated by comparing dividend payments and their price. A very popular form of financing today is leasing.

Both operating and financial leases should be capitalised and treated as ordinary long- term debt. Their required rate of return is therefore the same as the opportunity costs of this form of financing (Copeland et al, 2000, p. 213).

Return on equity: Return on equity is difficult to measure, because it is not observable in the markets. Three techniques to derive this return are the capital asset pricing model (CAPM), the arbitrage pricing theory (APT) and the dividend discount model (DDM).

The first technique is the capital asset pricing model. The CAPM builds on the following three assumptions. Markets are frictionless, investors care only about the return and risk of their investments and investors conclude the same thing about risks and returns of investments (homogeneous beliefs). The CAPM specifies that expected return on equity is determined by (Grinblatt & Titman, 2002, p. 153):

cov. (R_E, R_M)

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RE = RF + βE * (RM - RF) + ε and: βE = 14

var. (RM)

Where: RF = Risk free investment; generally yield to maturity on 10 years government bonds is used as a proxy (Copeland et al, 2000, p. 216).

β_E = Beta is a measure of the covariance of the expected return on equity with a relevant expected market or industry return.

RM = Average return on relevant market or industry. This can be calculated for example by using the S&P 500 index.

ε = Risk residual (company specific factors) for the company

Beta can be derived by using published data of BARRA or Bloomberg for example, or by calculating it from historical returns. Considering it is a tool for comparison, it is important what entities are used as a proxy. It would not make much sense to compare a steel producer’s return with the computer industry average for example. Empirical research shows that apart from beta a company’s return is positively related to momentum and inversely related to size and market-to-book-ratio (Grinblatt & Titman, 2002, p. 166). The risk residual also can exist of illiquidity-, reliance on management- and other premiums (Swad, 1994). Adjustments for these effects need to be made sometimes. In general very high betas tend to overestimate company risk, while very low betas tend to underestimate risk. In an acquisition context the weighted average of the acquiring and target firm should be used when valuing the combined cash flows. When valuing a target firm, the risk (and beta) of the target firm’s assets and the cash flows resulting from it needs to be taken into account (Fernandez, 2004).

The market risk premium (MRP) is the spread between the expected market and risk free return (RM - RF). It is based on historical analysis of market performance and can be adjusted in several ways to reflect certain influences like survivorship bias. Survivorship bias reflects the fact that industry winners create an upward bias in historical returns, because bankrupt losers tend to disappear from their calculation (Brown, 1995). The MRP is a debated issue in current literature and practice. Higher MRP’s result in lower valuations or vice versa (Copeland et al, 2000, p. 217). In The Netherlands for example different, respected agencies use MRP’s varying from 3% to 6% (Hasic, 2003).

The second technique to derive the cost of equity is the arbitrage pricing theory (APT). The APT is a variation of the CAPM. It is basically the same formula with more factors and factor dependencies (or factor betas) than the single one from the CAPM. Five factors are usually used. Normally a company’s historical covariance to long and short-term inflation, the real interest rate, GDP and default risk is measured. Intuitively this sounds better, because it accounts for the fact that different companies have different dependencies to important environmental factors, which should be reflected in the discount rate. Empirical research also points out that theoretically APT is a better approach than the CAPM.

However individual dependencies are hard to measure (Grinblatt & Titman, 2002, p. 185).

The final way to derive return on equity is to use the dividend discount model (DDM).

Based on the continuing growth perpetuity formula⁸, this model predicts R_E by using the

8 This formula can be found in appendix 1.C.

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growth rate and next year’s dividends divided by total value. Total value is measured by 15 using the company’s market capitalisation. Compared to the CAPM and APT this model requires fewer inputs. The DDM therefore is a further simplification of reality and is used in practice as a check next to more sophisticated measures. Assumptions are that the company’s earnings and dividends grow at a constant rate and that financial markets’

growth forecasts are used. It can also be calculated on a per share basis. The formulas are given below (Grinblatt & Titman, 2002, p. 388).

VA = Div1 / (RE – g) or: RE = g + (Div1 / VA )

An important input for the DDM and PER is the growth rate. Apart from using economy and industry predictions another approach is using the plowback ratio (b) and the expected marginal return on investment (Grinblatt & Titman, 2002, p. 389). The plowback ratio is the amount of earnings that is retained within the company for investment. The preferred formula is given below (Grinblatt & Titman, 2002, p. 389):

g = b * ROICNEW or: b = g / ROICNEW

Also evaluating long-term goals for management on which their compensation depends, can provide interesting insights (Fernandez, 2004).

Continuing value

After the explicit forecasting period a different approach to forecasting is recommended.

Assumptions need to be made to derive the continuing value (Vcont ) of the company.

Using the same principles on which the DDM is based, the following formula is recommended. The advantage of this formula is that it surfaces underlying economic value drivers (Copeland et al, 2000, p. 269):

Vcont = (NOPLATN+1 * (1 – b)) / (WACC – g) = FCFN+1 / (WACC – g)

Where: NOPLATN+1 = NOPLAT one year after the explicit forecasting period Variables that need to be estimated or calculated are NOPLAT, free cash flow, WACC, growth rate, incremental ROIC and the investment rate. A different way of estimating continuing value is using an EBIT(DA)-multiple, based on comparable industry data (Liu et al, 2002). Simply extrapolating the last year’s figures is not a careful way of estimating these variables and it can lead to serious overvaluation of the continuing value.

Scepticism pays in estimating continuing value. This should not mechanically result in assumptions such as ROICNEW = WACC though. A careful analysis of competitive dynamics and industry structure is needed for this. Section 2.2 described these techniques in more detail.

Appendix 2.I. Adjusted present value

This appendix shows the adjusted present value method. It is an extension of subsection 2.3.4. The adjusted present value model (APV) is a variation on the discounted cash flow model given above. Building on the work of Modigliani & Miller in the ‘50s and ‘60s it breaks up company value to its sources. First value from unlevered operations is measured. Then the value resulting from the company’s tax shield coming from interest

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payments is added to that. Finally the value of a company’s debt obligations, including 16 bankruptcy costs, is deducted from that value to derive total company value (Grinblatt &

Titman, 2002, p. 468). In summary:

UA = D + E – T_C* D or: E = UA + T_C* D - D

In general the same formulas apply to APV-calculation as for the techniques above. The unlevered assets introduce the return on unlevered assets (RU). This is the same as the return on an all-equity financed firm. Important formulas are (Grinblatt & Titman, 2002, p. 484):

β_E = β_U * (1 + (1 - T_C) * (D / E)) and: WACC = R_U - (D / V) * T_C* R_D

The assumption underlying these formulas is that the debt is static, perpetual and risk free. Of course in real life this is not a realistic situation and a dynamic approach to debt is often observed. If companies grow, they need to issue debt to maintain their target ratio for example. If the company valued uses and maintains a target debt to equity ratio, the formula to unlever beta reduces to a no-tax situation so “T_C” would be zero (Grinblatt &

Titman, 2002, p. 484). Unlevering betas is important to be able to compare different companies with different capital structures.

Appendix 2.J. Real options theory

In this appendix real options theory is further explained to support subsection 2.3.6. First classical option theory is quickly reviewed and then the applicability is dealt with.

Classical options theory linked the value of options to buy (call) or sell (put) a security at a specified price to the underlying security. The Black and Scholes-formula, using the no- arbitrage-principle is widely known⁹. This formula states that option price is related as specified below to a rise in the following variables. Differences between so-called American and European options are ignored here for simplicity.

Table 2.J. Option price reactions (Grinblatt & Titman, 2002, p. 287)

These variables can be applied to real asset valuation as well. If an Oilrig can operate profitably when oil prices rise above certain levels, having the strategic option to build this oilrig (ignoring building time) can be seen as a call option. Extending the available time to wait for the right oil price raises the value. A higher oil price at the valuation moment and higher volatility in price movements do this as well. Finally an interest increase decreases present value of future investment cost and therefore increases value.

9 Black and Scholes Formula: S0N(d1) – PV(K)N(d 1 - σ√T) (Grinblatt & Titman, 2002, p. 257)

Variable value going up: Option price reaction (call): Option price reaction (put):

Investment cost (strike price) down up

Value of underlying security up down

Time (T) up up/mixed

Volatility (risk; s) up up

Risk free rate (RF) up down

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17 Examples of real options can be to expand a project if predictions and market conditions

work out well, or to downsize (or terminate) a project when it fails to meet certain targets, or to defer investment - stall investment until conditions are more profitable. Finally an option is to stage investment.

Flexibility resulting from these possibilities is difficult to assess in advance though (Grinblatt & Titman, 2002, p. 432). Options to alter the operating scale (expand or downsize), depending on how general economic and market conditions turn out, are very relevant to companies in the apparel industry (Trigeorgis, 1993). Depending on market conditions, roll-out speed of shop-openings can be increased or decreased. Next to that, acquisitions always contain growth options. Investments like these represent a possible access to new markets, new technologies and core competences. When there is much room for managerial flexibility and a high possibility of receiving new information during the course of a project, flexibility value can be substantial (Copeland et al, 2000, p. 402). The following steps are recommended to determine real options value (Copeland et al, 2000, p. 418).

1. Outline base case present value (no flexibility).

2. Model uncertainty using an event tree.

3. Identify and add strategic decisions (flexibility); create a decision tree.

4. By working backwards determine total value with flexibility.

Although precise estimates of the benefits may not be possible, a rough estimation can be useful as well (Grinblatt & Titman, 2002, p. 432).

An important determinant of real option value is the straight and observable cash flow- relation with a certain underlying variable, such as oil prices or other commodities. If this relation is not directly observable, quantitative estimates are quite difficult to make. An important application of real options analysis then, is the qualitative acknowledgments of strategic possibilities and their future impact on the investment. Though precise estimates of the benefits are not possible then, a rough estimation can be useful as well (Grinblatt &

Titman, 2002, p. 432).

Appendix 3.A. Cultural context

This appendix presents a a figure that summarises subsection 3.2.2.. Using the “scores”

of both firm’s, the cultural variables can be estimated using an ordinal scale.

The top-level culture is the (inter)national culture, which is the most important determinant of behaviour. The values that are gradually learned here generally are very strong. The second level is the professional background and culture. An example of this level of culture is the accountancy profession, which has (or should have!¹⁰) its own, strong, internalised ethics system. Finally the organisational level is dominated by daily

10 Recent scandals surrounding Enron, Ahold and Fannie Mae show a doubtful professional ethics system

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practices, which result from the “higher levels” and past organisational behaviour 18 (Hofstede, 1990).

Figure 3.A. Cultural context (based on: Hofstede, 1990)

The three levels described can be found in the figure above that shows the interrelations.

For consistency the levels are linked to the macro, meso and internal environment from subsection 2.2.5.

Appendix 3.B. Business idea

This appendix further describes the business idea presented in subsection 3.2.3. A figure is given below as well as some additional explanation. The elements of the business idea are shown schematically. The elements in boxes can be influenced by a company’s actions directly. The elements in circles result from these other elements, except for the

“societal needs”, which drives the entire feedback loop.

Distinctive competences erode over time through competitor actions, and changing customer values. A constant re-evaluation of the business idea and its fit with societal needs is crucial. Especially in large organisations business ideas tend to be taken for granted. Combined with the “old habit reinforcing power of success” it creates a ticking strategic time bomb (Van der Heijden, 1996, p. 79).

Figure 3.B. Business Idea (based on: Van der Heijden, 1996, p. 69)

Macro environment:

“Country culture; value systems”

Meso environment:

“Professional cultures”

Internal environment:

“Organisational culture;

daily practices”

Cultural picture of company X degree

of influence

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19

In subsection 2.2.4. it was noted that scenario analysis can lead to projects with a positive NPV against a wider set of future scenarios. Testing a company’s business idea against a set of differing future scenario’s can increase the robustness of the company’s business idea.

Two issues are crucial: the impact on the fulfilment of the societal needs and the defensibility of the company’s distinctive competences (Van der Heijden, 1996, p. 108). Uncertainty is explicitly on the management agenda using this approach.

Insights in the societal needs an organisation tries to fulfil is crucial when company characteristics are being analysed. Especially in the case of potential takeovers overlapping or complementary business ideas are relevant. A complementary set of distinctive competences or societal needs being fulfilled can be a source of value (increased future profitability!) and therefore justify a takeover.

Appendix 3.C. Value based management

In this appendix the three types of decisions that are used for value based management (VBM) are further described.

To summarise the relations between the decisions, value drivers and ultimately company value, the model below is given. It introduces the value tree, building on the quantitative techniques from section 2.2. Free cash flow discounting is the core valuation technique here (Martin & Petty, 2001, p. 50). On the left-hand side the ordinary day-to-day decisions are shown, grouped by the classes described on the previous page.

Theoretically every management decision can be classified using this tree. The tree can be extended to the left by inserting various day-to-day decisions. Examples of these are given as well. The level of detail increases when moving left. The aim is to point out the link between “ordinary” activities and shareholder value (Martin & Petty, 2001, p. 8).

Figure 3.C. Relation of day-to-day decisions and shareholder value

Evolving needs in society

Distinctive Competences

Sustainable competitive advantages

Value Resources

Environmental scanning by company

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20 Decision type: Value driver: “DCF driver”:

Company value:

Decisions regarding profit margin, tax rate and sales growth rate are classified as operating decisions. Examples of these decisions relate to product mix, promotion, pricing, service level, distribution etc. The elements of the business system of figure 2.C.

correspond with this type of decisions.

Decisions dealing with working capital and fixed capital are seen as investment decisions Capacity expansion, credit terms and inventory policy are issues in this class of decisions.

In the business system of figure 2.C. the decisions regarding the asset-structure (left-hand side of balance sheet) that enables the business system correspond with this class of decisions.

Decisions dealing with choices in debt and equity instruments, interest rate negotiations, target debt-to-equity ratio are all financing choices. Financing decisions result in a company’s cost of capital. This refers to the financing choices (right-hand side of the balance sheet) that are made to enable the asset structure, which in turn enables the business system in figure 2.C. Finally the duration of growth is an estimate of the time in which a certain project can earn certain returns (Rappaport, 1986). Although being an important value driver because of its quantitative influence this is not a management decision like the previous three classes.

Operating

Sales growth

Financing Investment

Profit margin

Free cash flow

Working capital requirements

Fixed capital investment

WACC Duration of

growth

Shareholder Value

Discount rate Tax rate

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Appendix 3.D. Target firm opportunity value; option grid

21

This appendix further describes ways to look for internal strategic options for the target firm. Next to that it deals with the strategic options grid.

Searching internal strategic options: Based on the analysis of the distinctive (core) competences described before, new growth opportunities can be clear. Opportunities can be classified under an inside-out-approach (organic growth; new markets) or an outside-in approach (joint ventures and acquisitions). A portfolio analysis reveals potential divestitures and also shows whether certain key competences are available to a certain company (inside-out) or need to be acquired (outside- in) (Van der Heijden, 1996, p. 223).

Strategic options grid: Easy comparison of options given a certain number of criteria is possible using this tool. The criteria used in the strategic option grid are not fixed. Of course given certain circumstances the criteria can be weighted to ensure the importance of certain factors in decision-making. Entire companies can be analysed as well using a grid like this. Strategic, financial and uncertainty issues are dealt with in this thesis.

Implementation and stakeholder issues are not dealt with in very much detail here. These belong to a different stage in the takeover process. Considering the fact that A&Co is fully owned by B&Co some stakeholder issues may be involved later in this thesis.

Table 3.D. Strategic option grid (based on: Grundy, 2004)

Above an example of a strategic option grid has been given including examples of project options. Scores can be added to this by using scores of one to four stars and than adding them all up for example. Four stars is “excellent” and one star is “poor”. Different ordinary scales can be used of course. The “defer-option” has been filled in as an example. Easy comparison of options given a certain number of criteria is possible using this tool. Different ordinary scales can be used of course.

Appendix 3.E. Synergy value

This appendix supports section 3.5. on synergy value. First integration approaches are dealt with. Then synergies are classified and finally some problems with synergies are outlined.

Criteria: option 1: expand option 2: defer option 3: cancel

Strategic attractiveness * * * *

Financial attractiveness *

Uncertainty and risk * *

Implementation difficulty *

Stakeholder acceptability * * *

Total Score: 11

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Integration approaches 22

A classification of acquisitions and integration approaches is dealt with in this part. Three types of acquisitions exist (Grinblatt & Titman, 2002, p. 694):

• Strategic acquisitions: two companies are more valuable combined than separate, because of combined operational value improvements.

• Financial acquisitions: no operating synergies involved. Leveraged Buyouts (LBO’s) and private equity fall under this category. Perceived poor management quality drives this type of acquisitions sometimes.

• Conglomerate acquisitions: this can be seen as diversifying risks. Often financial synergies exist with this type of acquisitions.

Below an overview of structures that define the degree of integration is given. This approach looks at the need for autonomy and degree of interdependence as determinants of the integration approach.

Figure 3.E. Integration approaches (Haspeslagh & Jemison, 1991)

A holding structure can be used when low interdependence (low synergy potential) and low autonomy are needed. The absorption structure is frequently observed in practice and can be used when there is not much need for autonomy and high strategic interdependence. This is a “classical” form of a takeover. The “symbiosis” form of integration is the most difficult form. Extra attention is needed, because the strategic and operational boundaries for the acquired company need to be clear while simultaneously leaving a certain degree of freedom to ensure adaptability. Finally “preservation” is a structure in which resources needed for the acquired company to run its business are provided. Daily management is left to the target’s management to ensure the required autonomy.

symbiosis absorption

holding preser-

vation

Need for autonomy Degree

of strategic interdependence

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The importance of synergies differs in the different integration approaches. In the 23

“absorption and symbiosis”-structure the realisation of operational synergies plays a much bigger role and should be on top of the management agenda. In the “holding and preservation”- structure operational synergies are less important. Financial synergies are significant though. Knowing the strategic rationale for the acquisition and the synergies sought is crucial therefore. The next subsection goes into more detail about different kinds of synergies.

Classification of synergies

This part deals with a classification of operational synergies and a retail application of this concept first. Then a different classification regarding ownership is described. The category operational synergies is further broken down into the following value creating classes (Campbell & Goold, 1998):

• Shared know-how: Skills and knowledge are shared and processes, products or geographic know-how are thereby improved

• Coordinated strategies: Strategy alignment can be very valuable. An example is dividing markets within a corporation by coordinating shop locations within a holding’s business units to make sure internal competition is minimised.

• Shared tangible resources: Asset utilisation rates can be improved when “fixed”

resources are combined. Using the same warehouse to increase usage rate is an example of this.

• Vertical integration: Negotiations and communication between supplier and customers are reduced thereby enabling smoother product flows, market access and reducing inventory costs for example.

• Pooled negotiation power: Improved negotiation power can lead to huge savings on production costs and higher prices, thereby clearly enhancing company value.

• New business creation: Combination of know-how and technologies can be used to develop new product-market combinations.

The category shared tangible resources is a very relevant one for A&Co. Logistics are essential for the business-process of a fashion retailer. Most synergies are likely to be sought in this area, because the front-end businesses (the brands and shop-formats) all need to be managed separately (Berry, 2004). Whether the same truck supplies A&Co and another retailer for efficiency-reasons or not can save a lot of money though. Number of distribution centres, volume of throughput, speed, automation, negotiating power to carriers; it are all potential sources of value creation in an acquisition context (Berry, 2004).

A different classification of synergies in the following classes can shed some light on the ownership issue (Pursche, 1988):

• Universal: available to almost every company; economies of scale and financial synergies often fall into this category.

• Endemic: only a few acquirers can benefit from these synergies; usually industry related economies of scope.