Corporate Finance Ⅰ:

Measuring and Promoting Value Creation

Professors Heitor Almeida and Stefan Zeume
Module 4: Mergers and Acquisitions, Risk, and Performance
Evaluation

Table of Contents
Module 4: Mergers and Acquisitions, Risk, and Performance Evaluation ................................. 1
Lesson 1-0 Module 4 Information ..................................................................................................... 2
Lesson 1-0.1: Objectives and Overview ............................................................................................................... 2

Lesson 1-1: Good and Bad Reasons to Engage in M&A Transactions ............................................... 10
Lesson 1-1.1: Good and Bad Reasons to Engage in M&A Transactions ............................................................. 10

Lesson 1-2: Synergy Valuation and Deal Pricing .............................................................................. 24

Lesson 1-2.1. Synergy Valuation and Deal Pricing ............................................................................................. 24

Lesson 1-3: Means of Payment and Stock Market Reaction to M&A Deals ...................................... 34
Lesson 1-3.1. Means of Payment and Stock Market Reaction to M&A Deals ................................................... 34

Lesson 1-4: Leveraged Buyouts ....................................................................................................... 50

Lesson 1-4.1. Leveraged Buyouts....................................................................................................................... 50

Lesson 1-5: Sensitivity Analysis....................................................................................................... 66

Lesson 1-5.1. Sensitivity Analysis ....................................................................................................................... 66

Lesson 1-6: Using Discount Rates to Incorporate Risk ..................................................................... 78

Lesson 1-6.1. Using Discount Rates to Incorporate Risk .................................................................................... 78

Lesson 1-7: Estimating the Required Return on Equity .................................................................... 86

Lesson 1-7.1. Estimating the Required Return on Equity .................................................................................. 86

Lesson 1-8: Finding Beta ................................................................................................................. 97

Lesson 1-8.1. Finding Beta ................................................................................................................................. 97

Lesson 1-9: Estimating the WACC ................................................................................................. 106

Lesson 1-9.1. Estimating the WACC ................................................................................................................. 106

Lesson 1-10: Performance Evaluation Economic Value-Added (EVA)............................................. 115

Lesson 1-10.1. Performance Evaluation: Economic Value-Added (EVA) ......................................................... 115

Lesson 1-11: Using EVA to Measure Performance of a Company’s Division ................................... 124
Lesson 1-11.1. Using EVA to Measure Performance........................................................................................ 124

Lesson 1-12 Module 4 Review ...................................................................................................... 136

Lesson 1-12.1: Module 4 Review ..................................................................................................................... 136

Lesson 1-13 Course Conclusion ..................................................................................................... 139

Lesson 1-13.1: Conclusion ............................................................................................................................... 139

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
Lesson 1-0 Module 4 Information

Lesson 1-0.1: Objectives and Overview

In this course, we'll be talking a lot about how to create shareholder wealth, right. In
particular, in Module 3, we discussed the concept of net present value and how we can
use net present value to measure the contribution of a new product to shareholder
wealth, okay. So, this we learned already, in this module, what we're going to talk about
is mergers and acquisitions, okay? Buying another company that has made that
valuable project is another way in which another company can create shareholder
value, right? So, you either make the cool product yourself, or you buy the other
company that has made that. And in some cases, you can actually create value by
selling, right? If you sell the company to another owner that values the company more
than you do, then you're also going to be creating value, so M&A is a very active
market. It's a way in which shareholders can actually make money. So, it's very
important for us to discuss that as well.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, one of our goals here is to discuss a few very important topics in M&A.
Unfortunately, we don't have time to talk about everything. We could definitely do an
entire class just on M&A. We don't have that much time, okay. So, what we're going to
do is focus on a few specific issues that I think are the most important for us to consider.
We're going to understand the key motivations for M&A. We're going to think about
valuations, how to value them. And then we're going to think about pricing, how to price
an M&A deal, okay? We're going to do mostly in thinking about deals between two
companies. Okay, and acquiring a target, but we're also going to talk about leveraged
buyouts.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Leveraged buyouts is a major form of M&A deal in recent years and as we're going to
learn, there is some specific facts about leveraged buyouts which make them different
from a merger between two companies, okay? So, we're going to talk about LBOs and
we're going to try to understand how LBOs can create shareholder value as well.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Okay, and then the other main topic we're going to discuss in Module 4 is uncertainty.
So far, for example, if you look at our examples in Module 3, we have been assuming
that we knew the forecasts. We always have the forecasts, we know what the schedules
are going to be and then we do the valuation. Okay? Of course, in the real world that's
unlikely to be the case. Every time you create something new, every time you create a
new product, every time you make an acquisition, there is going to be a lot of
uncertainty associated with that decision. So, we have to discuss the notion of
uncertainty and how we address uncertainty when valuing an investment. That's going
to be the other major topic we're going to talk about in this module, okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We're going to learn how to deal with uncertainty and how to incorporate that into our
evaluation. There are standard finance tools, there are standard techniques that we use
to deal with uncertainty and make sure that our evaluation takes that into account.

And finally, what you're going to learn is that you can use these tools, okay? These tools
that we have to measure uncertainty, we can actually use them to measure

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
performance. So that's going to be an interesting idea we're going to learn at the end.
Okay? We're going to be able to measure whether a project or division is generating
real economic value or not. And what you're going to learn is that the answer to this
question is directly related to the previous question that we made, how do we address,
how do we incorporate uncertainty into the evaluation. So that's going to be a very
interesting discussion that we're going have in this module as well.

In terms of specific objects, right, we're going to start with M&A. We're going to talk
about the concept of synergies, which is the most important idea in M&A. We're going to
think about how to value synergies, using NPV techniques. So that's going to use the
same net present value technique that you already learned. And then we're going to
think about how synergies determine the pricing of M&A deals, okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Then we're going to think about means of payment, right? Some mergers are paid with
cash, some mergers are paid with stock. We have to understand, what's the difference?
What does it mean to pay with stock? That's another topic we're going to be talking
about. Then we're going to talk a little bit about LBOs, specifically the specific
characteristics of leverage buyouts and how they can add value, okay? After we do that,
we're going to move and start talking about uncertainty, okay? So, we're going to learn
how to perform sensitivity analysis, how to incorporate sensitivity analysis into
investment decisions and then we're going to learn a very important concept in finance,
which is the idea of changing the discount rate to incorporate risk into the valuation.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, what we're going to learn is that the discount rate that we've been taking as given is
the key number that we're going to use to incorporate risk into the valuation. Okay? And
then we're going to learn how to estimate a discount rate for a real-world company using
the weighted average cost of capital formula. Okay? As we're going to learn, that's the
way in which we're going to estimate the discount rate when we are valuing a new
investment by a real-world company. Okay? And then we're going to use this WACC,
the weighted average cost of capital, to estimate economic value added, which is going
to be our measure of performance, so as I said before, our measure of performance is
going to directly linked to this formula that we're going to use to incorporate risk into the
valuation. So WACC and EVA are going to be very related concepts, as we're going to
learn in this module.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
Lesson 1-1: Good and Bad Reasons to Engage in M&A Transactions

Lesson 1-1.1: Good and Bad Reasons to Engage in M&A Transactions

Let us talk now about mergers and acquisitions, okay? And I want to start from what is
probably the most important concept that we're going to talk about, which is the concept
of synergy. The key idea is that a merger is not only going to add value if the two
companies are worth more together than they are apart, and the new thing that the
merger creates is what we are going to call synergy. Okay? So, the idea, I would like to
think of this idea as two plus two equal five. Right? Two plus two equal five meaning
that when you put company one and company two together, if both are worth two,
somehow when you add them, you create five, okay? The synergy in this example is
equal to one right. The one is the new thing that you create when you put the two
companies together and going back to what we learned in Module Three, the synergy is
going to be the NPV of the merger. Remember that the NPV is the value that is created
by a new investment. When a company makes a new investment, the net present value
is going to increase or decrease. Sometimes the NVP could be negative. The net
present value is going to chance shareholder value. So, if synergy is positive, then the
merger is going to add to shareholder value.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We are going to focus mostly on mergers between two companies. We're also going
talk about leveraged buyouts, but we can use the same logic to talk about other deals
that we're not going to have time to discuss much in this course, okay? The first one is
an asset sale. In some cases, a company may decide to buy just part of the other
company. So, for example, in 2012 Microsoft bought patents from America Online,
right? So rather than buying America Online as a whole, Microsoft decided to buy some
patents that America Online had produced in the past. The idea is that this transaction
only makes sense if the patents are worth more for Microsoft than America Online. And
mathematically you can express this idea as follows, right? Microsoft plus patents has to
be bigger than America Online plus patents. In that case the transaction creates value.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The other type of deal that is also very important in the real world but we're not going to
have time to discuss much in this course is the spinoff. Okay, so, what is a spinoff? A
spinoff in a situation when a firm separates into two different parts, usually it's two.
Okay? For example, in 2011, Kraft decided to split into two separate business. The first
one was called Mondelez which focused on Global Snacks, okay? And then the new
Kraft was going to focus only on North American grocery business so they split into
snacks and groceries, okay? When would such a deal make sense, when does a spinoff
create shareholder value, when the new Kraft plus Mondelez is worth more than the old
Kraft. So, you can see this is a very simple, but at the same time, very powerful idea
that allows us to really dig deep and think about M&A deals, okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So now what we need to think about is when is 2 + 2 = 5, right? So why would a merger
create value? The first argument we can think of is economies of scale, right? When two
companies merge they become bigger, right? That's what we called scale, right? And
when companies become bigger, they may be able to cut cost per units. They may be
able to produce goods at a cheaper price. Right? If you produce goods at a cheaper
price your profits are going to go up, right. An Economy of Scale could be as simple as
cutting the cost of management such as headquarters, okay. So, if you put two
companies together, suddenly, instead of two headquarters, you just need one. Right?
And that is going to reduce the overall cost of the company. Of course, the idea of
economy of scale could be more powerful than just cutting the cost of having two
headquarters instead of one. Okay, but this is the first reason why a merger could add
value. Right? The second one is industry consolidation. This is a very common reason,
a very common rationale for a merger. Right? This is the idea that a merger between
competitors in the same industry is going to increase market power. Right? If two
airlines merge, for example, they can coordinate routes, they can give more options to
consumers on one hand but on the other hand, they can cut routes that are repetitive,
they can cut routes that both airlines serve, and that may allow airlines to charge higher
prices. And these examples are more general every time two competitors merge, right?
They are going to gain market power and this is why this type of merger between
competitors is a merger that the regulators are always watching. Okay, when
competitors merge, it's very likely that the regulators are going to have a look at this to
make sure that the merger is not increasing monopoly too much. Right? Regulators are

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
concerned with consumers and other considerations. So, these mergers now watch
very closely, okay.

The third type of rational motive for a merger is the economy of vertical integration. So,
in some cases, the merger happens not between two competitors but between two firms
in different stages of production, okay? For example, recently. PepsiCo decided to buy
PepsiCo Bottling Company. They would choose to be a separate company that was
essentially doing bottling for PepsiCo. At one point, PepsiCo and PepsiCo Bottling
decided that they were going to become part of the same company. Essentially the idea
that bringing a major supplier in house in some situations, not in all situations but in
some situations is going to allow companies to produce at a lower cost and increase
profits. And finally, this is a rationale that is particularly important for private equity
deals, for leverage buyouts, which is to eliminate inefficiencies, okay, such as poor
management. Poor management is a good example. If a company is poorly managed,
right? If it has governance issues as we discussed in Module One, right? If the
management is not acting the interest of the shareholders, if the management is
stealing resources from the company. That company is going to be a good target for an
M&A deal. There is some value to be made just by coming in, buying the company, and
reorganizing the management. So, we're going to talk more about that when we discuss
private equity deals.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We also want to talk about some reasons for mergers that make less synergy, okay?
There are several arguments that are discussed in the press, that are discussed by
some practitioners that actually when you really dig deep and think about them, they
don't make that much sense, okay? The first one is cash, all right? The argument goes
as follows. So we know that companies hold cash, some companies actually hold a lot
of cash that we've been discussed in Module One, right? And cash earns very low
returns, right? So typically, cash is deposited in banks, right? Companies buy
treasuries. The interest rate on these instruments is variable. So, let's say that cash is
earning 1%, and if a company has a lot of cash, if a company has excess cash, it seems
that acquiring another company must have be of better use, right? Your cost of capital,
it seems like it's just 1%, right? So, you just have to generate a return greater than 1%
for this acquisition to make sense, right? The argument seems sensible, but when you
really think about it, it doesn't work.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

In fact, there is a very famous academic study by a guy called Jarrad Harford. It's an old
study, but which has been replicated and validated using more recent data. Which
shows that cash can create problems in the acquisition market. Cash-rich companies
are more likely to acquire, so having cash tempts companies and makes them more
likely to make acquisitions. What Harford finds is that these acquisitions were much
more likely to destroy shareholder value than acquisitions that were done by companies
with less cash. He actually estimates that cash-rich acquires destroyed seven cents in
value for each dollar of excess cash that they had. So, if you had one dollar of excess
cash, and you spend that in an acquisition, you ended up destroying seven cents. Just
by using that cash to acquire another company, okay, right?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

When you really think about this, you know why is that a bad idea, okay? What should
matter is whether the merger generates synergy, right? Going back to where we started
with, right? What matters is whether the merger is positive NPV or not. And if a merger
adds value, then company should be able to finance it. Even if you don't have cash to
pay for the merger, you can go to the market, you can issue a bond, you can issue
stock, if the merger is good enough, you're going to be able to add value. The lesson
here is that spending cash just because you have it is a recipe for disaster. I think we
know that when we think about our personal life. We know that sometimes when we
have too much cash we end up wasting it. It seems that the same thing happens with
companies. When they have too much cash in some cases they end up wasting it. An
M&A is a good candidate for that.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The other argument we're going to talk about is risk diversification. There are
companies around the world that have businesses in many unrelated industries. Those
companies are called conglomerates. Okay, for example, in the U.S. a very famous
company is called General Electric. General Electric makes aircraft engines, as we can
see there on that airplane. They also had a bank until recently. They make other
products. They are what we call diversified company, okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, let's think about their argument. Does that make sense? So, should a company buy
another company in a different industry, right? Like, say should a bank buy a company
that makes air craft engines to reduce risk, right? So, shareholders care about risks so if
you buy a company in a different industry, you might reduce risks for shareholders.
Does that argument make sense? The answer is no. Why? Because shareholders can
diversify risks on their own. If shareholders want to have stock bulk in a bank and in a
company that makes engines, they can go out in the market and buy the stock. They
don't need the company to do it for them. So, it's very unlikely that companies can
create value just by diversifying business like that.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

In fact, the current trend in the US and in other parts of the world as well is towards
focus. Conglomerates such as General Electric are actually being broken up. There is a
recent news article that talks about the fact that GE is actually retreating from finance,
okay? They are reorganizing the business and spinning off GE Capital, which is the
bank, okay? And focusing more on the manufacturing operation, and that's just an
example. It's a very general trend in the US, that companies are actually increasing
focus, rather than increasing conglomerate, okay? So perhaps companies finally
realized that diversifying risk for shareholders may not make that much sense, okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And finally, let's talk about earnings per share, okay? So here, there is going to be a
question for you, okay? So, let's have a look at this example here. Suppose that you
have two firms, two companies. Okay, and company A is going to acquire company B.
So here you have the earnings, the number of shares outstanding. So, pay attention
here. Earnings, so company A has earnings of 100, company B has earnings of 40, and
here you have the data for the merged firm, okay? So, here's what the third column tells
you what's going to happen after the two companies merged together, okay? So, let's
say this merger is stock finance. We're going to talk more about that later but,
essentially what this means is that, you know the new company is going to have a
number of shares but the new company is going to be the sum of the number of shares
for Firm A and the number of shares for Firm B. Okay, so the question I want to think
about using this data is, is this a value enhancing merger? Right? Are there synergies
here? Is this merger creating value for the shareholders of Firm A? Okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The answer is no. Look at this. This is a classic 2+2=4 case. If you look at the data, you
can see that earnings were 100 for Firm A. Earnings are 40 for Firm B. When you put
the two firms together, the profits are 140 so you're just adding the profits. It's as if the
firms are operating side by side, there is no gain, there is no synergy. Or at least it looks
like there is no synergy. What does happen, and this is what might have tricked some
people into thinking that this is a good merger, is that earnings per share is going up,
right? So, earnings go up to 140, the number of shares go up to 120 as we discussed,
so earnings per share is going up for the acquirer. Firm A is the acquirer here, so it
seems that Firm A can increase EPS by 17% just by acquiring firm B. What is going on?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

I like to think this as an averaging effect. It's a weighted averaging effect, okay? What's
happening here is that a company with low EPS is acquiring another company with high
EPS, okay? So, if a company with low EPS acquires another one with higher EPS is
going to go up because the EPS is going to become the average of the two companies.
Companies should not create value just by doing a transaction like that. This is another
example of why earnings per share is the wrong metric to look at, okay? And this
actually goes back to Module One when we talked about EPS. Remember there was a
recent yield that we talked about where EPS was going to go down but the deal was
well received by the market. The stock price went up, okay? In that case, as we
discussed, the market seems to be able to overlook the fact that EPS is decreasing, and
increase the market value of the acquirement the deal was announced, okay? So,
remember that M&As is another area where we have to be very careful about earnings
per share.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
Lesson 1-2: Synergy Valuation and Deal Pricing

Lesson 1-2.1. Synergy Valuation and Deal Pricing

What is the value of synergies? Okay, we just talked about the concept of synergies, but
to value, to price, to understand and emanate in the real world, we also need to place a
value on synergy, okay? We have to find the dollar value and what's you're going to
learn now, is that doing this is just doing an NPV calculation, okay? So, it's going to be
very familiar for you because it's exactly what we covered in Module 3, right. We learn
how to do an NPV calculation and that's the same thing we're going to do here to place
a value on synergies, okay. What we'll do is forecast cash flows from anticipated
synergies. So, you can think of those as the incremental cash flow from the merger. And
then we're going to compute the NPV of the synergies by discounting right? We're going
to discount the incremental cash flows using an appropriate discount rate. So, it's
exactly the way we've done NPV calculations in Module 3, right?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

What I want to do is to use a deal that happened in the past. It's a relatively old deal, but
it's a great one for us because we have a very detailed data on management's forecast
of synergies, which is the merger between Hewlett Packard and Compaq. So, these two
companies were in the computer business, okay? And what happened is that in that
year, HP decided to acquire Compaq, right? So, the merger was announced in
September 2001. And it was completed in 2002, and at the time of the merger, the
management gave a lot of details about where the synergies were going to come from.
So, we can use those numbers to try to figure out what is the NPV of the synergy in this
case.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Okay, so you have an article here that talks about this data, but what I've done is I
pulled it out for you and I'm describing it here. Okay? So, this is the data that we have,
so what management talked about doing that time was that there were going to be
major cost savings. Okay? As we just discussed. In some cases, mergers can allow
companies to reduce cost, okay. There are going to be major cost savings and
improved profitability as a result of that, okay. Specifically, management was projecting
a recurring annual pretax cost saving of $2.5 billion. Starting in mid 2004. That's very
common, right? It takes time for a merger to be completed. Companies have to be
reorganized, right? So, typically when management talks about synergy, what you'll see
is that they will give a company some time to realize those synergies. Okay? So, these
cost reductions, in the case of HP Compaq, were going to come from reductions in the
administrative costs, as we just discussed, administrative management cost is typically
a good source of synergism when there is a merger, but also through other sources like
R&D efficiency, marketing efficiency. The companies are going to become more
efficient, and hopefully reduce costs. Okay? But another very common effect of a
merger is the erosion of sales. Think about this. Those are two companies in the same
business. They used to be competitors, right? They are merging together. Some of the
sales are going to go, right? They sell similar products. It's natural to expect that sales
are going to go down a bit. In this case actually, the expectation was that there was
going to be a significant reduction of on sales of $4.1 billion, again, starting in 2004,
okay? So here you have the profit margin as well, which we're going to use to compute
the value of synergy. You have some other data here as well that we're going to use
later, okay? Discount rates, tax rates. And the rate of growth of the synergy.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, let's go back here, and think about how we're going to use these numbers. Okay?
So, we have the lost synergy here in 2004. Right? And then we have to figure out what
is the impact of this decreased revenue in the profits, okay? So, revenues are going to
go down by 4.1 billion. But think about this, this is coming from a decrease, from a
reduction in the sale of computers, right? So, the company's selling less. That mean that
costs are going to go down as well. Right. So, the impact on the bottom line is going to
be equal to the profit margin of 12%, times the decreasing revenue. So, this is the profit
margin, okay? So, what's going to happen in this case, is that profits are going to go
down by $0.5 billion, okay. And then we have the annual synergy, which starts in 2004
coming from the reduction in costs, right. That's $2.5 billion directly from the
management estimate. So, the total synergy cash flow is going to be 2.5 billion minus
0.5. So, the company's going to realize an annual cash flow of 2 billion starting in 2004,
okay?

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, the question now that I want you to work with is, what is the net present value of the
synergy? Okay. You have the cash flow. You know when the synergy starts. And
remember this is just a regular NPV problem, okay. And you should know how to work
this out. So, spend some time and try to figure out this problem on your own.

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 Corporate Finance Ⅰ:
Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
Okay, so let's solve this problem. Here you have the data that you need. The cost
savings, the reduction in revenue. Right? So, you have the annual synergy of 2 billion
starting in 2004. We are taxing it because it's a before tax value. Right? So, the after tax
synergy is 1.48 billion okay, but that only starts in 2004, right. So, what you need to do
to solve this problem is to apply the perpetuity formula, right. You have a cash flow of
1.48 billion, right. We're going to use the growing perpetuity formula. Okay. Which we
learned in Module 3 because this cash flow is going to continue growing into the future
at a 3% rate, right. The discount rate is 12%. So, you apply the growing perpetuity
formula and as we learned in Module 3, this value is going to come here to 2003, right.
If the cash flow starts in 2004 and you use the growing perpetuity formula then the value
is going to go to 2003. With that you can compute the NPV, right. So here you have the
solution for you, okay. You have the growing perpetuity here, okay, and then we are
discounting it back for two years right, because we have to bring it from 2003 to 2001.
Okay? So, what we end up with, is a net present value of the synergies that is equal to
$13 billion. Okay? So, what is the idea? The idea is that this merger between HP and
Compact, according to the management, was creating $13 billions of synergy. Okay?

How are you going to use that? As you're going to learn now, we are going to use the
valuation of the synergies to come up with the deal price, okay? What you learn is that
there is a very close link between the value of the synergies and the offer price that HP
can make to Compaq. Okay? So here is some more data for you. Okay? This is how
much the companies were worth. Before the deal was announced. HP's market value
was $45.8 billion, Compaq was $20.85 billion, you have stock prices and shares

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Professors Heitor Almeida and Stefan Zeume
outstanding as well. Okay, so the question is, how much should HP pay for Compaq?
Given the synergy, given the value of Compaq, how much should HP pay? Okay?

Think about what we learned, the value of the synergies is the total NPV of the deal,
right? In this case the deal was creating $13.1 billion in value, right? This NPV, this is
the total value, right? And now we have two companies, okay? This is the difference
between a new investment and an acquisition. This is the total NPV. The NPV has to be
divided between the acquirer and the target, right? So, let's think about that. What would
be the NPV for the target, right? The NPV for the target is just going to be the deal
premium, right? If the offer price is how much they get, right, so if you're a Compaq
shareholder you're going to get the price for your shares, minus your current value okay,
that's going to be our NPV. The NPV for the acquirer is going to be what? Is going to be
the synergy minus the deal premium, right. You're paying a premium for the target but
then you're going to get the synergy, right because you're buying this target company,
okay.

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Professors Heitor Almeida and Stefan Zeume

So here is a key relationship. For a deal to be positive NPV for the acquirer, the synergy
has to be bigger than the premium. So, the acquirer's going to pay a premium. You're
going to get the synergy. So, if the synergy's lower than the premium, the deal is going
to be negative NPV. Right? Even if the deal creates value, even if the deal reduces
cost, generates synergies, the acquirer has to make sure that you're not overpaying.
And notice that when we look at data, the average premium that is paid for public
targets is very high, approximately 30%. Okay? So, it has to be the case that M&A deals
have to generate large synergies to make sense, right.

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Professors Heitor Almeida and Stefan Zeume

Because you're paying on average 30% premium, so the value of the synergy has to be
very significant, otherwise the acquirer would not make money. Right? So, here's
another question for you. How much should HP offer to Compaq? Okay, given what we
just learned?

Here's the answer. Right. We came up with the value of synergies, this is what our

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evaluation allows us to do, is to figure out that the synergies were worth 13.1 billion.
Okay? So, then it must be the case that this premium that HP is going to pay for
Compaq has to be lower than the value of the synergy. Right? Compaq was worth $21
billion before that. Okay? So, the Compaq shareholders are not going to accept less
than $21 billion. It has to be more than that. Right, but it has to be lower than 20.9 plus
13.1, right. So, the maximum value that HP can pay for Compaq is that sum which in
these cases $34 billion, right. If HP pays more than that then you cannot generate value
for your shareholder. Right, of course, Compaq shareholders are going to be happy but
the shareholders of Hewlett Packard will not.

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Lesson 1-3: Means of Payment and Stock Market Reaction to M&A Deals

Lesson 1-3.1. Means of Payment and Stock Market Reaction to M&A Deals

Let's talk now about how to pay for a deal okay. We talked about synergies. We talked
about how to value synergies. And we talked about how to price a deal given the
synergy. But now what we're going to learn, is that acquirers can choose to pay either
cash or stock, okay? So, deals are not necessarily paid off with cash as in this picture,
sometimes what the target is going to get is stock in the merger company. So now what
we're going to figure out is what the key difference is.

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Professors Heitor Almeida and Stefan Zeume

Let's go back to HP-Compaq. Suppose that the final price is $27 we just figured out that
the price has to be between 21 and 34, given our evaluation of synergies. So, let's say
the price was $27. I'm going to show you in a second what the price actually was. Let's
say for now it's $27. Compaq had $1.7 billion outstanding approximately. So, if you do
the math, this is going to represent $16 a share. So, think about this. If you're paying
cash, you're going to pay $16 a share, what happens? HP takes cash out of its pocket,
okay. And gives to Compaq shareholders right. Compaq shareholders give their shares
to HP and they $16 in cash. Okay, so paying cash is extremely simple. We wouldn't
even need to be talking about it if there wasn't another way to pay for a deal.

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Professors Heitor Almeida and Stefan Zeume

So really the most interesting thing that we have to learn here is that in some cases
companies are paying with stock. How does this work? It's actually an issuance. It's a
stock issuance. What HP is going to do, is to issue new shares, okay, and gives the
shares to Compaq shareholders in exchange for Compaq shares. So, Compaq
disappears of course, right. Compaq is going to disappear. So, the shares of Compaq
disappear in exchange for the shares of Compaq, the shareholders of Compaq are
going to get shares of HP and of course HP is going to become the new merged firm
okay?

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

A key variable in a stock merger is what we think of, what we call the exchange ratio.
What is the exchange ratio? The exchange ratio is the number of shares of the acquire
that each target shareholder receives, so in this case it's the number of shares of
Hewlett Packard that each Compaq shareholder is going to receive. All right, that's how
HP is going to pay for the deal. What should be the exchange ratio then? What is the
exchange ratio?

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Professors Heitor Almeida and Stefan Zeume

Let's go back to our $16 number. Let's say that the final price is 27 billion, and let's say
then that HP is paying $16 a share, right. If you think about the math, for a compact
shareholder to get $16, and remember what you're going to get is you're going to get
HP stock. So, the exchange ratio, the number of shares that you're getting, times the
HP stock price has to equal $16. So, let's see how the math works. Notice that to do this
calculation, we have to make an assumption about the stock price. As we're going to
see next, and I think we've talked about this in the course already in Module One, the
stock market is going to react to the deal. But let's say that we use HP's pre-deal stock
price to do this calculation. We already learned that HP's pre-deal stock price was
$23.21. Okay, so, right. The way the math work here is that if you want to get $16 you
have to divide 16 by $23.21 right. And this is how you would compute the exchange
ratio.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

What does this mean? It means that if you want ten shares of Compaq, and then the
deal is financed with stock, you would receive 6.9 shares of HP. That's what the math
comes up to, okay. It's a 0.69 exchange rate. So, if own ten shares, if you own 100
shares of Compaq just to make the number round, you would receive 69 shares of
Hewlett-Packard, okay. This particular merger was financed, what actually happened to
be financed by stock so HP didn't use cash at all, okay. And the exchange ratio was
0.6325. So, it's not too far from what we computed, right? So, if a Compaq shareholder
had a thousand shares of Compaq, you got 632.5 shares, okay. And then of course
there are legal ways to deal with this decimal, okay. So that's how HP actually paid for
Compaq.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And here comes something really interesting. We saw this graph already in Module
One. What happened when HP announced that this deal, okay, the stock market
reacted immediately, right. On September 5th of 2001, the stock market reacted to this
deal, and actually what the market did is it sends HP's stock price down by 23 minus 18,
by $5 a share. Used to be $23. In the day it after it started trading after the deal was
announced, HP stock price went down to $18. So, the deal was very poorly received by
the market.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And remember, Compaq shareholders are paid in stock so what they're getting in stock,
so let's try to figure out how much was HP's offer worth following the market reaction.

Think about this, the actual value of the offer after the announcement was much lower,
right. Instead of 23, okay, you have 18 here. The exchange ratio is still the same, okay.
So what Compaq shareholders are getting is actually 11.4, right. Compaq's stock price

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Professors Heitor Almeida and Stefan Zeume
prior to the deal was 12.35. So, it really didn't make much sense, right at that point,
right? What should have happened to Compaq stock price after the deal was
announced? Compaq stock price should have gone down as well, right? Which is
exactly what happened. The deal was announced at this exchange ratio. The market
hated the deal so much that even the stock price of the target went down in this case,
okay? So, Compaq stock prize is also decreased. And the surprising thing in this deal is
that the Compaq management actually managed to convince the shareholders that the
market reaction was to be ignored, okay. So, the opposition to this deal actually came
from within Hewlett-Packard, rather than from Compaq shareholders.

And this is an example that we can generalize, okay. And we can think about, what
happens when mergers are announced. In the general, we have evidence about that in
the finest literature, okay. M&A deals are very interesting because they give us a
chance to look at how the market reacts, right. This is what we just did, we are thinking
about HP Compaq. There was a management forecast the synergies and all that. But
then the market is going to do its own calculation, right? And it's obvious that if the
merger is positive NPV for the acquirer as we already learned in this course then stock
prices, is stock prices should go up, right? If the merger is positive NPV for the target
Which in the case of Compaq it wasn't that clear right. Stock price of the target should
go up.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, let's see what happens on average okay. So, this is a graph that comes from a
famous research paper on M&A deals, okay. What it's showing is that the stock price
reaction of for, for target companies, okay? So, when a deal is announced this is what
happens on average to the stock price of a target, okay? Targets end up earning a
significant premium on average, right? So, when a deal is announced the stock price of
a target should zap by. Here you have a number between 15 and 20%, okay? So, stock
prices of targets are going up significantly. Notice also that there is a little bit of a trend
here before the deal is announced. Of course, what happens in the real world is that in
some cases there are rumors that ends up trickling to the market, so the target stock
price may end up reacting a little bit before the deal is announced. That's why this graph
starts a few days earlier. It's not just a three-day announcement return or a one-day
announcement return as we did with HP Compaq.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

What about acquirers? Acquirers actually is, what you see is a flat line on average
okay? So, the acquirer's stock price on average doesn't seem to increase when a new
M&A deal is announced, okay? Of course, that doesn't mean that all deals are zero
MPV.But on average that's what we find, okay? The bottom line is that what the
research seems to suggest is that on average merchants create value but most of the
value ends up going to the target firm okay? Fine, so remember our, our discussion
about synergies and premium, right? What this means is that mergers do generate
synergies, right, so targets get, a very high NPV if you want, right because their stock
price is going up by 20% on average but the acquirer ends up paying too much, okay.
So, all the premium goes to the target and none, none of the premium stays with the
acquirer on average, of course right. So that's what the evidence shows. So, the
negative reaction that happened to Hewlett-Packard is a little bit extreme, but there are
many deals that actually not successful for acquirers, at least in the short term.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Of course, that, the short-term stock price reaction may not be right as we discussed
already in the course. The market is trying to do these calculations, trying to figure out
what's going to happen in the future, right? Is this view going to add value or not. And
this is a very hard calculation to do, right? It's possible that the management was right
okay? Compaq management actually liked this deal they wanted to be acquired by HP.
They managed to convince the shareholders to go along. So, what can we do to try to
figure out? The first thing you might be thinking is that we can try to look at long term
stock price reaction instead of just looking at the short term how the market reacted
immediately to a deal.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Let's try to see what happens in the long term okay. We can certainly do that, this is
what you have here in this graph okay. So, the deal, this is 2001 here at the last corner.
So, that's when the deal was announced and here the blue line is HP. Okay, and then
you have two other companies to compare the stock prices to, actually, the red line is
an index. This is the S&P 500 index okay? And, here in the bottom, you have IBM okay.
If you read the management description of the HP-Compaq merger they were mostly
concerned with IBM and Dell. Those were the main competitors of HP at that time okay.
So, what do we see here? This is 2002, after 2007 okay it seems that HP actually did
pretty well. Right when you look at this, on the face of it, HP did significantly better than
the competitors. It seems that HP did pretty well in the years following the merger.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Of course, there is a problem with doing long term stock price reaction. It's very difficult
to find a good comparison right. What we would like to see is, suppose the deal had
never happened. Suppose HP had not acquired Compaq. What would have happened
to HP's stock price? But that will, this we will never know, okay. Right, so the only thing
we can do is to compare to competitors, compare to the market. In this case, it seems
that, at least there is no evidence that the merger was destroying value if we're looking
six, seven years ahead, okay?

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We can also do qualitative analysis to think about this deal, so here I have two articles
for you. The first one is from Fortune and the article was actually about the fact that the
deal was failing, okay. So, you can read here, buying Compaq has not paid off for HP
investors, not by a long shot, okay. Which seems to be a little bit inconsistent with the
stock price chart that you just saw.

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And we can also find an article that says the merger worked. This is the merger that
worked, HP and Compaq. And it was very, this article's talking precisely about the fact
that this deal was very poorly received by the market, but in the long term it ended up
creating shareholder value. The bottom line is that we never know. This is a big problem
with M&A research and trying to understand M&A in the real world is that it's very
difficult for outside observers and sometimes even for management to figure out if a
deal worked in the long term or not. So sometimes, in most cases you have to rely on
your intuition and you have to, you can of course observe the short-term market
reaction. But the long-term market reaction and this qualitative reaction to the deal is a
little bit harder to interpret.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
Lesson 1-4: Leveraged Buyouts

Lesson 1-4.1. Leveraged Buyouts

Let's talk now about leveraged buyouts. That's the second major type of M&A deal that
we're going to discuss in this course. The first thing we're going to think about is how is
a leveraged buyout different from a merger between two companies, right? There are
three specific facts about LBOs. The first one is that the payment is always in cash and
typically financed by debt issuance. So that's where the leverage in the name LBO
comes from. So, we saw in the HP-Compaq deal that we just analyzed, for example, HP
pays for the deal using stock; so, Compaq shareholders got stock. In an LBO, the target
shareholders are typically paid in cash, almost always. The second specific fact is that
it's a case when a public firm is usually taken private. What that means is that all the
shares outstanding of the target are bought out. That's where the buy-out in the name
comes from. The third specific fact is that the acquirer in this case is not another
company, is not a competitor, is not a company in a different stage of production, the
acquirer in this case is an investment company. It's a company that invests money
rather than produce something. In the case of leveraged buyouts, we call this
investment companies private equity firms.

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Professors Heitor Almeida and Stefan Zeume

So, this is a structure of a private equity partnership, a typical structure. You have the
private equity firm that is managed by the general partner. The general partner is going
to be the people who are actually managing the companies and then you have the
limited partners that are providing capital to the private equity fund and then the private
equity fund is going to have a portfolio of investments.

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Professors Heitor Almeida and Stefan Zeume

Just listing the main characteristics of the private equity partnership here. So, we have
the general partners? Those are the people who identify investments and manage
them, and then we have the people who provide capital so that's going to be equity
capital. There's going to be investments made by the limited partners in this company
and then what the general partners do is to use this equity capital to go out, buy
companies, and try to make money. Of course, the general partners are going to make
money as well and the way that this happens is through this 2/20 fee structure. The
general partners keep 2% of the invested capital and 20% of profits. What that means is
that, for example, if the limited partners provide a billion dollars of equity to the private
equity fund, the general partners get to keep 2% of that billion annually as a fee just to
manage the fund. So of course, there are big dollars involved here, and then the profits,
this 20% of profits, that happens when the private equity fund has a successful deal,
creates value, the general partners keep 20% of the profit.

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Professors Heitor Almeida and Stefan Zeume

So that's how the partnership is organized and when you look at the world these days,
there are many famous well-known companies that are managed by private equity
funds. That's why it's important for us to talk about leveraged buyout. Companies like
Dell, the computer company, Budweiser that makes beer have gone through LBOs very
recently and are now managed by private equity firms. So, these are companies that
now are private, you're not going to find data on stock prices for this companies and
they happen to be managed by these private equity partnerships.

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Professors Heitor Almeida and Stefan Zeume

So, let's actually give an example of the leveraged buyout of Dell. So that's how a
leveraged buyout will work in terms of the numbers. Prior to the announcement in
January of 2013, Dell was trading at $11 a share. If you know something about Dell, you
will know that Dell was actually founded by a guy called Michael Dell who was the
founder and he's still the CEO of the company, he's still the manager of the company. At
that time, he owned 15% of the company's share, right? He had a very large ownership
of Dell even before the leveraged buyout happened. The total equity value of the
company was $19.3 billion and debt was seven billion. So that was the capital structure
of the company right before the leveraged buyout was announced.

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Professors Heitor Almeida and Stefan Zeume

Then Michael Dell came with this proposal together with Silver Lake, which is the
private equity fund involved in this deal, to buy out all the outstanding shares other than
Michael's. So, Michael was going to keep, he was going to remain as the manager and
owner of the company but all the other shareholders were going to be bought out at a
25% premium. So, the offer was $13.65 to the other shareholders. We can do the math
here, right? Dell had 1.757 billion shares outstanding so if you check this, financing this
deal required $20.4 billion because they only had to repurchase 85% of the shares,
right? You have 1.75 billion shares outstanding and you are making an offer of 13.65 so
that requires them to raise $24 billion. So, every time a leveraged buyout happens,
raising the capital is a big issue and these are big dollars, and remember, the private
equity fund cannot use stock to pay for this deal, they are usually private so there's no
stock to use.

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So how does the private equity fund finance the deal with the debt issuance? That's the
leveraging, the leverage buyout name. In this case, there was a new debt issuance of
$15 billion that was provided by banks and an interesting fact in these LBO is that
Microsoft actually helped provide some of the financing as well. So, Microsoft invested
in the debt that helped finance this deal. So, they raised $15 million of debt and then
Michael Dell also put in some of his own cash. At that time, if you read about this deal,
Michael Dell was being questioned about, is this really a good deal for shareholders? Is
this going to work? So, one way that he solved this problem is by paying with his own
pocket. So, put your money where your mouth is, right? He actually took $750 million to
pay for this deal. Silver Lake also put cash, of course, that's the equity, remember this
private equity, Silver Lake has equity that comes from the limited partners. They
invested $1.4 billion in this deal and then the balance was funded with the company's
own cash.

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This is the analysis of how the company's financial structure changed with the leveraged
buyout. So here you have a simplified balance sheet that has debt, equity, and assets
both pre-leveraged buyout and post-leveraged buyout. As you saw in the data, before
the leveraged buyout, Dell had seven billion dollars in the debt and $19.3 billion in
equity. So, using this simplified balance sheet, you just add debt and equity to get to
assets. So that means Dell has $26.3 billion in assets before the leveraged buyout
happened. What happens after the leverage buyout, the first thing to notice is that there
is a significant increase in debt. So, debt is going to go from 7 to 22 because the
company is issuing an additional $15 billion in debt to finance the leverage buyout so
that the private equity fund is issuing an additional $15 billion of debt that Dell is actually
responsible to pay after the leverage buyout that is supported by the assets of Dell. So,
this is added here to the balance sheet. So that is going from 7 to 22. What else is going
to happen? Notice that there is a premium so as the example tells you, the private
equity fund and Michael Dell are paying a premium of 25% on the equity. That means
that the value of the asset has to go up by that amount. They are revaluing the company
by paying this premium. It's a premium over the equity. So, the way to add that to the
Assets is to recalculate the Asset value adding this premium, which is 25% times 19.3,
the pre-LBO equity value. So, 26.3 plus this premium comes out to $31 billion. So that
should be the post LBO. It's an estimate of the post leveraged buyout asset value of
Dell. What that means then, is that if you have tallied $31 billion in assets and $22
billion in debt, then you're going to have an equity value of $9 billion. Notice then that
there is a significant increase in leverage. So, if you compute the leverage here of the
company as we learned in Module 1, you'll see that leverage is going to go up a lot. It

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Professors Heitor Almeida and Stefan Zeume
goes up from around 30% to about 70%, even with this added premium. The other issue
to note is that the equity went down significantly in dollar value. But this new equity is
owned only by Michael Dell and Silver Lake. So, you've bought out all the shareholders.
You repurchase all the shares that were trading in the market. All the remaining equity
is now owned by Michael Dell and Silver Lake.

So, we come to a very important question in the discussion of leveraged buyouts. So, if
you think about the example we just talked about. What we saw is that the asset value
is increasing. For some reason, the enterprise value of Dell is going up, the company's
becoming more valuable, almost 20%. If you think that this is strange, it actually is not.
There is a lot of research in corporate finance that says that that's pretty common. The
average premium paid to target shareholders during the period of 1973-2006 is
approximately 37% for a private equity deal. So, the median is 32. So, it's very common
to see premium of 20% to 30% etc. So that's standard in a leveraged buyout. One way
to think about this is the existing shareholders are really not going to sell their shares. If
the private equity fund cannot pay a significant premium very similar to a M&A deal. But
here's the question. Where is this value gain coming from? Are there synergies in
leverage buyouts? Just like we discussed in mergers and acquisitions or is there
something else going on. So, here's a question for you to think about.

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The answer is maybe. Why? Notice that here there's no acquire. That is the interesting
fact about leveraged buyout. The acquire is an investment companies, it's a private
equity fund. Okay, so many of the rationales that we discussed do not exist for a
leveraged buyout. So, increase in market power, vertical integration are going to be
hard to achieve, because the acquirer is not in the same business. The acquirer is just
an investment company, just an investment fund. So how can we have two plus two
equals five? How can we have two plus two equals five?

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Professors Heitor Almeida and Stefan Zeume

These are the usual reasons that are cited. So, if you ask a private equity funds, if you
read the literature, those are the reasons why we believe leveraged buyouts may add
shareholder value. Since there are no synergies in a real synergy between two
companies. It has to come from some kind of restructuring. So, you either, did the
private equity fund either has to increase efficiency in the short-term. So, increase the
operational performance of the firm by cutting costs a lot. So, we cannot rely on
economies of scale, for example, so you have to go there and really restructure this
firm, and cut costs. Or else you can try to engage in a longer-term restructuring. A major
change in strategy that might make sense in the long-term, but maybe difficult to do
under the scrutiny of public markets. So, if you read about Dell leveraged buyout, that's
actually the reason that was given to this particular deal, is that Dell wanted to engage
in long-term restructuring to move away from just selling computers and engage in a
different long-term strategy. But that would be difficult to do if you have to report
earnings to public markets on a quarterly basis. So that is actually the particular specific
rationale for this specific buyout. Then finally, the other reason why leveraged buyouts
may add value is because in some cases the acquirer may be able to buy cheap assets.
Here it's interesting to think about Warren Buffett, which, if you think about Berkshire
Hathaway which is Warren Buffett's company, it's a very famous investment company in
the US. They work a little bit like a private equity fund. Not all deals are financed by
leverage, but really what Warren Buffett does is to find companies to buy. In many
cases, it’s not even change anything with the management. So, in order for Berkshire
Hathaway to make money, you have to buy undervalued assets. So, buying cheap
assets is another way that private equity funds can make money.

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Because private equity relies on all this restructuring, a very important question that has
been discussed recently, is whether private equity is actually good for the economy or
not. When you look at the evidence, what you see is that cutting costs in many cases is
actually equivalent to firing people. So, it looks like when you look at employment and
private equity, it looks like employment goes down a lot when companies are acquired
by private equity funds. There’re usually layoffs. As part of this restructuring to increase
short-term profits, there is usually significant amount of layout.

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So, there is a very interesting recent article that looked at this issue. By these authors
here the bottom from the University of Chicago. What they tried to measure is, what
happens to employment following leveraged buyouts using US data. So, this article
uses data from the US. What you can see here, the blue line is the employment
trajectory for companies that are acquired by private equity firms. So, you can see that
employment was going up, date zero here is the date of the leverage buyout. What
happens is that there is a significant decline in employment. But the interesting thing
that this article did, is to build what we think of as a control group. Try to think of a
similar company that looked similar to companies that were acquired by private equity,
but which did not go through a leverage buyout acquisition. What you see in this chart is
that employment also went down for those companies. So, the bottom line really, when
you think about this is that employment does go down for companies that are acquired
by private equity. But maybe they would have gone down anyway. Okay? It's the
characteristic of the companies that are acquired by private equity that explains the
drop-in employment and not necessarily the acquisition itself.

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The other fact that is paper found, is that this following employment is partly
compensated by job growth in new establishments. So, there is also these long-term
restructuring aspects to leverage buyouts. So, what they find is that if you look at a
longer term like two or three years, you'll see that private equity funds also create new
establishments, and then end up hiring people as well. The total net effect is a small
decline. It is a less than 1% decline in employment relative to this control firms. So, the
bottom line of this article is this idea that perhaps private equity is not that bad for
employment. We may have been exaggerating this argument a little bit.

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Finally, let's go back to the Dell leverage buyout. When we studied HP-Compaq, we
tried to look at stock prices. What happened to HP stock prices in the years following
the deal? Unfortunately, we cannot do this for Dell. Why? Because the company's
private now. So, if you go to Yahoo Finance and try to find data on the stock price of
Dell, the data's going to stop in 2013 because the company's private. The company is
not trading in stock markets anymore.

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So, the only thing we can do here, is to look at the qualitative evidence. Here so far, the
qualitative evidence seems to be quite positive. So, this is a recent article that I found
which is based on data that we cannot verify. But what the article claims is that Dell and
Silver Lake already made a value gain of 90% only a year after the leverage buyout.
Due to increase in cash flows, due to increase in performance, they actually made a
bunch already. So that particular leveraged buyouts seems to be working well for the
company.

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Lesson 1-5: Sensitivity Analysis

Lesson 1-5.1. Sensitivity Analysis

In this lesson, we're going to talk about how to deal with uncertainty. We're going to
start talking about how we deal with uncertainty in corporate finance. When we conduct
valuation, we've done some examples already of net present value, IRR, M&A
synergies, etc. Our baseline case is always representing the average, the expected
value. It's your best gift. This is true for all the parameters, sales costs, and discount
rates, etc., and it's also going to be true for the final valuation. But of course, there is
going to be uncertainty about the parameters. For example, if the company is investing
in a new project, you don't know for sure how much sales this project is going to
generate.

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There is an example that we used in Module 3 to talk about the project valuation so
what I'm doing here is I'm going back to that example and we're going to use it to show
how we can do sensitivity analysis which is one of the tools that we have to deal with
uncertainty. Here you have the example, it's 40 million initial investment. It is a machine
that costs 40 million, increases profits by nine million. The investment last for 10 years.
There is a tax rate, the salvage value, and the discount rate.

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What we're going to do first is we're going to go a little bit deeper into the forecast. This
is just a fictitious made-up example so what I'm doing is I'm really making up the
explanation here. The point that I want to emphasize is these forecasts reflect the
project's most likely scenario so it's our best guess. For example, the marketing
department may have forecasted revenues as what they expect the price to be, times
what they expect the additional sales to be.

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Let just to give an example here, say that the price is four dollars and the project is
going to generate 3,000 units, so that's how they generated the $12 million stock. Sorry,
three million units. Our unit here is million not thousand. In the production department,
they have forecasted costs in a similar way, the cost per unit times additional sales plus
the fixed cost. A project can have fixed cost as well, and that's how we got the three-
million-dollar annual cost.

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Here's the analysis that we've done, we've done these in Module 3. The full set of
assumptions including our tax calculation that we discussed in Module 3 as well. We got
an NPV, we got an IRR.

Notice that the value of sales that we used is the expected value. That's true in any
valuation you always use the best guess. But the production department, the sales

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department, may also be to tell you that there is a range. For example, suppose that
there is a 20% range that sales are going to be three million units, but there is also a
20% chance that sales are going to be one million, two million, four, or five?

One is the worst-case, five is the best, if all values are equally likely, then the average
value is three. That's why we're using three, we're not using one. You don't do NPV
using the worst case, you always do the NPV using the expected value.

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The role of sensitivity analysis is to allow us to calculate how sensitive the NPV is to
fluctuations in key parameters. For example, you can figure out how the NPV changes if
the sales change. If the sales are not equal to the average, what's going to happen to
the NPV? It's very easy to do it using the spreadsheet, is actually trivial. I set up the
spreadsheet in a way that you can directly use it. You just change a number right in the
Excel spreadsheet and you should be able to get the NPV.

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If sales are equal to one million, then the NPV is minus 16, if sales are equal to five then
the NPV is equal to 51. Of course, sales are lower the NPV goes down, sales are higher
the NPV increases.

Here's an example. I change the additional sales to one million units, and you can see
that in this case, the NPV is negative. Very simple stuff.

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The more important question is, how should you use it? You can do all these
calculations then what should you do about in particular? Should you reject the project,
because the NPV can be negative? Think about it. The answer, of course, is no.

Companies are all about risk-taking so with no uncertainty, with no risk, companies are
not going to be able to create value unless you have an arbitrage, unless you have $20

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bill lying on the floor. Every time a company creates value you are typically exposing
yourself to risk, you're exposing ourselves to uncertainty. What this means is the NPV
will always be negative under some assumptions.

The NPV of the project it still is $17.5 million so it's important to keep that in mind. The
NPV hasn't changed it, all we learned is the NPV can be negative, but this is almost like
an obvious conclusion.

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What can we use sensitivity analysis for? What is the role of sensitivity analysis? To be
honest, I don't think it's super important to do sensitivity analysis, but it can be useful.
For example, if sales are a particularly important variable as it is the case in our project,
the marketing department can do additional research to make sure that the three million
units is in fact a reasonable forecast. Your project is based on the assumption that you
are very likely to be able to generate three million units, then you can ask the marketing
department to do additional research to make sure that this is the case. It can also be
useful for planning purpose. For example, our spreadsheet can figure out what is the
minimum value of sales that is required for the project to create value.

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We have learned in the course that the project creates value only if NPV is positive so
you can use the spreadsheet to figure out what is the minimum value of sales that the
project needs to generate. In this case, you can calculate it as 1,965,000 units. You can
do this as using the spreadsheet, you can do it by trial and error, just change the units
until you get a zero NPV. Of course, these analyses can be useful for example, you can
ask your marketing department how confident are we that we're going to be able to
generate at least two million, and we're going to be able to sell at least two million units
of the product? That's a very specific question on the marketing department. Your
company may be able to have a good answer to that question.

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Lesson 1-6: Using Discount Rates to Incorporate Risk

Lesson 1-6.1. Using Discount Rates to Incorporate Risk

Let's talk about risk. We've done our sensitivity analysis. We know exactly how changes
in cashflows affect our NPV. We even laid down the risk in the sales of the company.
But in the end, we decided that NPV is still the same so we might sit here thinking that
risk really doesn't matter. I mean, where did it go? Does risk really not matter? Of
course, risk matters. Risk matters for the value of a project. We like safety. We want
projects to be safe. The higher the risk of the project, the lower its value. This idea has
to be true and now we will learn how to incorporate risk into valuation. The reason we
may have forgotten about risk is that it's hidden in the discount rate and we took the
discount rate as given so far. It's really the main reason why we haven't talked about
risk in this course. Heitor and I, we always just told you that the discount rate is 10%,
8%, 7%. Now, the key idea in finances is that the discount rate should reflect risk of the
project. The discount rate is the number that's going to capture the risk for us. This is
what we will talk about next.

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To understand the idea that discount rates capture risk, let's go back to Module 3. Let's
think about the internal rate of return again, the IRR. In Module 3, we learned that if the
IRR is bigger than the discount rate, then NPV is positive. You have to compare the IRR
of a project to the discount rate. What we're learning now is that the discount rate
captures risk so another way you can think about this is that the higher the risk of your
project, the riskier the project, the higher you need the IRR to be in order to accept the
project. To make a risky project positive NPV, you will need a high IRR, so that's a very
intuitive way for you to think about this. The riskier your project, the higher its IRR needs
to be to make a positive NPV.

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It turns out that measuring the risk of a project, measuring the risk of a company, even
measuring the risk of any investment is one of the key topics in finance. In fact, you may
have spent a lot of time in an investment course talking about this. What we will do in
the next couple of slides is to do a review so our course is self-contained and you know
how to incorporate risk into corporate finance valuation.

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But for a more in-depth discussion, I recommend you take the investment course. Let
me give you the bottom line first and you might remember seeing this in the investment
class. The way that we are going to measure risk for a project or a company is by using
the weighted average cost of capital formula, the WACC. If you haven't seen this, it's
going to sound funny and foreign. The WACC. If you've seen it, it's going to look
familiar. You might remember some of it. I'd still like to do this review anyway, even if
you took the investment class because I think it's useful to review the weighted average
cost of capital. As the name says it, the weighted average cost of capital is a weighted
average. You have the required return on debt. On the one hand, you multiply it by the
fraction of the value of the company that comes from debt. That fraction, that debt
overvalue, will use defined as debt plus equity. That's one side of your equation and
then you have the other side, the required return on equity multiplied by the fraction of
the value of the company that comes from equity so the E here on this slide, the E is
going to be the market value of equity. It's really just like a weighted average of these
two. Notice that the part where we deal with the debt is multiplied by one minus the
corporate tax rate. That's because interest payments are tax deductible. We will talk
about this later in the course, but for now, let's just use the formula the way you see it
there on the slide. In the next few slides, I would like to talk about an example and I'm
going to use an example that we have already seen.

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I want to use real-world data on PepsiCo in order to compute their WACC, the weighted
average cost of capital, for June 2022. We need to do this for a certain point of time
because as you just saw, the WACC depends on the value of the company so we have
to measure the market value of the company for a very specific point in time. But the
ideas are exactly the same. You can use the same principle, the same calculation, to
compute WACC anytime you like. Let's start with the required return on debt. The data
that we're going to use here can be found on Capital IQ. It's the data on capital structure
details for PepsiCo that contains information on the yield to maturity of PepsiCo bonds.
In this case, PepsiCo has issued bonds so debtholders now own these bonds, and what
bondholders get is the yield to maturity. They receive interest for holding the bonds, and
we call that yield to maturity. PepsiCo has issued many bonds, among them, some very
long-term bonds that mature in 2060. Those bonds have a yield of approximately 4%. It
turns out that the yield to maturity is just the expected return on the bond, the internal
rate of return, the IRR of the bond. You can think of the year to maturity on a bond as
the percentage return that an investor receives for holding the PepsiCo bond to
maturity. If you buy the bond today, and the bond does not default, you expect to make
4% a year. Default is an important vert here. The calculation only works if PepsiCo does
not go bankrupt. We won't have much time to discuss this in this course. But remember
that you can only approximate the required return on debt with the yield to maturity if the
company is far away from bankruptcy. For PepsiCo, that's probably a reasonable
assumption, if you asked me. But it might not be. You might have a company that is
really highly levered, that is approaching bankruptcy. Really what happens is that if a

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company goes bankrupt, if the bond defaults, you are not going to get 4%. The true
expected return for a company like that is lower than the yield to maturity.

Here's a question for you. We just figured out that the IRR of the long-term bond is 4%.
If you buy the 2060 PepsiCo bond, and hold it until maturity, your expected return is 4%.
Let me ask you about NPV, the Net Present Value. What's the NPV of buying the 2060
PepsiCo bond and holding it until maturity? The NPV should be zero. The zero NPV
idea, we discussed this in Module 3, will turn out to be very powerful. It's a very
important idea in finance. It might seem strange. I mean, why is NPV zero? We haven't
done any calculation. No calculations, no spreadsheets, no formulas. How do I know
NPV is zero? You might think there's a crystal ball hidden behind the camera while in
fact, I'm using a market equilibrium argument. Think about the formula. Suppose the
NPV of holding a PepsiCo bond was positive. If you had money, all you need to do is to
pick up a phone, call a trader, or go to your computer and buy a PepsiCo bond, buy
many PepsiCo bonds, as many as you like, you'd be making a lot of money. Or so you
think. In fact, everyone would be buying PepsiCo bonds. We know from basic
economics that if there is a lot of demand for a financial asset, the price should go up.

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But if the price of the PepsiCo bond goes up, your NPV will become zero. For a financial
asset, like a bond, an asset that everybody can buy and sell, NPV should be zero.That's
a very reasonable assumption.

You might wonder why we're going over this. Why is this an important idea? Well, we
will use this idea to estimate returns. That's why we spend time on it. This really is a

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very beautiful idea in finance. We just learned that zero NPV is a reasonable condition
for many markets. What this means, is that, well, remember Module 3, if the NPV is
zero, the expected return, should be the same as the discount rate, the required return.
If the PepsiCo bond NPV is zero, what this means is, that we can use the yield-to-
maturity to approximate the required return on that bond. The yield to maturity is just the
return that investors demand to invest in a PepsiCo bond. It's the required return. It's a
very useful idea because we can use that data to input in our evaluation and figure out
what the required return of that is. One last point here, I prefer to use the long-term yield
to maturity for corporate finance. Since we started this course, we've been pushing this
idea that corporate finance applications have a long horizon. We're always thinking
about the long term. My suggestion is that we always take the long-term required rate of
return. What this means for PepsiCo, is that we are going to use 4%, which is the yield
to maturity on the long-term bonds. Rather than use 2, 3, 4, 5, whatever years of
maturity, we're going to take the longest possible maturity that we have available. The
key takeaway from these last minutes is the zero NPV idea, and how we can use it to
estimate required returns using actual expected returns.

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Lesson 1-7: Estimating the Required Return on Equity

Lesson 1-7.1. Estimating the Required Return on Equity

Remember the WACC equation? We just talked about one of the inputs, the required
return on debt. Next, we will talk about the required return on equity.

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We just did the required return on debt and what we learned is that we can use the
yield-to-maturity to approximate the required return on debt at least as long as the
company is sufficiently far away from bankruptcy. That's the idea that we just learned.
The first thing to notice though, when we talk about the required return on equity is that
we won't be able to use the same idea here.

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We do not have a yield-to-maturity on equity. That's because equity really has no

promised cashflows unless it's preferred equity, which is really more like a bond. When
we hold equity, a share in a company, what we get is a residual cash flow. After the
company pays interest to bondholders, it may or may not pay dividends to equity
holders. There is no notion of promised cash flow, equity holders get whatever is left. Of
course, the hope is that after a company pays interest, there is something left. But in
some cases, there might be nothing left. The company becomes bankrupt. Anyway, the
point is that there is no notion of promised cash flows to equity which stops us from
estimating a yield-to-maturity. This concept for equities does not exist.

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What we're going to use to estimate the cost of equity is a very important model in
finance. We call it the capital asset pricing model, the CAPM or the C-A-P-M. This is a
model that you will study in great detail if you take the investment course. Here, we are
going to have a quick and intuitive discussion of how to apply the capital asset pricing
model to a corporate finance world. You will see the model on the slide. The model tells
us what the required return on equity is. One input is rF, the risk-free rate, which is the
yield- to-maturity on a government bond. We assume that the government is risk-free.
Why is this a reasonable assumption? Well, when the government is in trouble, it can
always use taxes. The government can always tax you and me, it can tax companies to
make sure that it has enough funds to repay the bond. This argument doesn't always
work. But if you're thinking about markets like the US, which are established, mature,
then it works. We will use the yield-to-maturity on bonds issued by the government, in
this case, the US government for the risk-free rate, rF. The other input we need in order
to use the CAPM is a risk premium. For a company, the risk premium is the company's
Beta times the market risk premium. We will talk about these in more detail in just a
moment.

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This might seem complicated at the moment, but we will try to simplify and build some
intuition. The most valuable thing in finance everywhere actually is intuition. Really what
you should take from your finance course is an intuition on how the CAPM works. Let's
build that intuition by simplifying things a little bit.

We do this by simply ignoring Beta for the moment, ignore Beta. As we're going to learn

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later, Beta captures the relationship between stock returns for the company and stock
returns for the market. Let's ignore it for now, let's just say it's one. It doesn't matter for
our formula on the slide. For now, the required return is really just the sum of two things,
the yield-to-maturity on the government bond plus the risk premium on the market.
That's going to give you directly the required return on equity.

We just have to estimate these two things. Let's start with the yield to maturity on
government bonds. I told you that we are going to use securities issued by the US
government, and here's the data for May 2022. It's another reason why we always have
to think about cost of capital for a given time period because yield-to-maturities are
going to change. The risk-free rate on the economy, the return that you get from buying
a government bond, that's going to vary overtime. In May 2022, it turned out that the 30-
year government bond was returning 2.99%. Let's make that 3%. As I said, my
recommendation is to always take the longest maturity. What I'm going to do here is use
3% as our risk-free rate for our calculation. All you have to do to get this number is open
a newspaper and get a table like the one on the slide or go to Yahoo Finance, Wall
Street Journal, you name it, any source you like.

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The market risk premium is a little bit more complicated. It's a huge topic in finance. So,
measuring the risk premium on the stock market, it's a topic of its own. It has already
given an overpriced to economists who studied this and discovered some of the most
important facts. It's one of the key objects that we study in economics, not just in finance
and economics more broadly. Here, we will try to keep it intuitive and practical. The
concept is that the risk premium on the stock market is the additional return that an
investor demands for putting their money into the stock market instead of putting it into
a government bond. The government bond will very likely give you that 3% return
unless something happens, something really unexpected. But we believe that won't
happen. But investing in the stock market is obviously more risky. The stock market can
give you a very high return or it can give you a very low return. We require a higher rate
of return when investing in the stock market. So how do we estimate that rate of return,
that market risk premium? Let's think about it. Going back to what we already
discussed, let's think about this question. What should be the net present value of
investing in the market?

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Suppose you take your money and put it in the stock market, what should be the NPV?
A reasonable guess is that the NPV should be close to zero. We can use the same
argument that we used before. If the NPV is positive, then a lot of people will start
buying stocks, the price of stocks might go up. If NPV is negative, it works the other way
around. People would sell stock prices would go down, stock returns, would go up.
Again, we can think of this as a market equilibrium story. But with the stock market, your
intuition is probably telling you that the NPV is not exactly zero. The bond is a simpler
asset. It's easier to value if the NPV deviates from zero. It's a very easy for participants
or investors or analysts to figure this out and to bring the bond market vector
equilibrium. For the stock market, it's a little bit more complicated. If the stock market
thinks for example there is a big crisis and the volt, stock prices will go down. People
naturally will be afraid. They might take the money out of the market instead of perhaps
investing more. Risk is going to complicate all this calculation. We're going to talk more
about this in just a second.

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For now, remember the idea we discussed. If the NPV is zero, we can use actual
returns. We can use realized returns to estimate required returns. That's the idea that
financial economists use when they look at historical data. Historical returns on the
stock market to measure expected future returns, to measure required returns.

Here, what you have is the average return on stocks and bonds between 1928 and

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2021. Treasury bonds, government bonds returned on average 4.84%. You can see
that this number is larger than the 3% yield that they are returning in May 2022.
Common stocks, the stock market on the other hand, returned close to 10%. What we
find from the historical analysis is that the risk premium, the difference between the
stock market and treasury bonds, is approximately 5.1%. Let's make that five 5% to
save some time and some ink.

Let's go back to the NPV equals zero idea. How can we use this 5% to estimate the risk
premium? The assumption we have to make to use the 5% is that the NPV of investing
in the stock market during that period was zero. If investors were on average getting a
zero NPV by putting their money into stocks, then 5% is exactly the compensation that
investors demand in order to put their money into the stock market. Again, we can take
realized returns and use them to estimate required returns. But as we just discussed,
this assumption is less likely to be reasonable for the stock market.

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Now comes the question for you. It should be simple to think about this. Suppose we
are doing this calculation in May 2022, what would be the expected return on the
market? How much do you expect the market to return next year? Suppose we are here
in May 2022, how much should the market return between June 2022 and May 2023?
Very simply, all you need to do is to add the 3% yield on the government bond to the
5% risk premium and you would get an 8% return so that's our zero NPV return. If
things go as we expect, the market should return 8%, and that should give investors
exactly zero NPV. That's why we can use that as the discount rate. It's our required
return. Notice that here in this formula, we are using 3%. You always start from the
current T-bond yield. Don't take the historical ones for bonds as we just learned, we
have great data on current yield to maturity. We know we have a good estimate of what
the bond is likely to return in the next 30 years. We should always use that instead of
historical bond yields, we take 3% plus our assumption for the risk premium and we get
8%. That's our estimate for future market returns if we do this in May 2022.

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Lesson 1-8: Finding Beta

Lesson 1-8.1. Finding Beta

Let's go back to the company to PepsiCo. Our original goal was to estimate the cost of
capital for PepsiCo. We figured out the required return on debt and we are in the
process of figuring out the required return on equity. We figured out the required return
on the market, but we need the required return for PepsiCo a company, okay? So, we
need to think about Beta and the CAPM formula. It's the same formula we just used for
the market except that now we have a Beta that might be different from one.

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So, let's find Beta. Again, this is a very important concept in finance that you talk about
in any investment course. But here's the key idea, the key idea is that Beta measures
the risk of the company. It's the idea to remember, high Beta means high risk. And in
the next few slides we will go through an example of how we estimate data using real
world data. If you think about Beta, what Beta is going to measure is how the stock
returns of the company correlate with the stock returns of the market. So, let me give
you an example, suppose the market goes down by 10% and PepsiCo goes down by
15%. Investors will dislike this a lot, okay? It's a time when they are losing money, since
the overall market goes down, all your investments are decreasing in value. Pepsi is
going down even more. So that means Pepsi is a very risky stock with Beta, greater
than one. So, in this case the PepsiCo stock return is an amplified version of the
fluctuations of the market returns. The other example also works. If Beta is less than
one, then that's a situation when PepsiCo does not fluctuate as much as the market.
Maybe if the market goes down by 10%, Pepsi goes down by 3%. In that case PepsiCo
is going to be less risky and Pepsi's Beta is below one. So, in a sense, Pepsi is
providing investors with a hatch. They are losing 10% on most of their investments, but
PepsiCo turns out to be a relatively safe investment.
So, this is the concept behind Beta. What I want to show you next is how we actually
estimate Beta for a company like PepsiCo. I'm going to use Beta for the period of 2012
to 2021 and then I'm going to show you a Beta that is computed by Capital IQ. I'm going
to do this for two different periods of time because when analysts compute Beta, they
typically use five years of monthly data. So, we want to have sufficient number of data
points to figure out how the stock moves with the market. At the same time, you

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perhaps don't want to use too many years in the past because the company can change
over time. So, the compromise in this case is to use five years of monthly data, okay?
You're going to have 60 data points.

Here's an example on the slide. This calculation is using a statistical analysis called a
regression but really, it's very intuitive. What the regression is measuring is the
relationship between PepsiCo stock returns and market returns, okay? On the left you
have all the data plotted, on the Y-axis, you have the PepsiCo returns, on the X-axis,
you have the return on the market which is proxied by the S&P 500 here. And just by
looking at this plot, what seems to be the case is that PepsiCo stock is not that highly
correlated with the market. If you look at these points, there are many cases here where
the market goes down by more than PepsiCo and there are cases where the market
goes up more than PepsiCo. What this means is that the Beta is likely below one.
The regression for those of you want to understand the regression is shown on the right.
These tables report outputs from a regression of PepsiCo stock returns on the market
return. There's lots of information here, but down at the bottom you will see the Beta, it's
0.467. This is indeed significantly below one. This is consistent with our visual
inspection that Pepsi returns do not move as much as the market.

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We can also do this for the later period of 2017 to 2021. If you look at the plot now, it
seems that the Beta increased. Pepsi it goes up a bit more with the market and down a
bit more with the market. Mind you, Beta is still below one, Pepsi still doesn't go up as
much as the market. Here the regressions will tell us that Beta is 0.609, up from 0.469.

So, here's the summary of our regression analysis. Remember that Beta is a statistical

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estimate, every time we do this, we are estimating a beta using statistics. For PepsiCo,
we came up with two different Beta. Of course, they refer to two different time periods,
but you have to remember that there's uncertainty in this estimate as well. If you look at
the regression more closely, they also spit out a confidence interval. In this case, for
Pepsi, we can be 95% sure that PepsiCo Beta ranges from 0.22 to 0.83. This is a wide
range but we are also 95% sure, okay? We are quite sure.

Before we use this Beta, let me show you the most recent beta, this comes right out of
Capital IQ, or Yahoo finance, okay? And they use similar data but they went all the way
to May 2022. As it turns out, Beta is such an important number for corporate finance
applications that the same sources that give you financial data, will also give you the
Beta, okay? They give you everything, balance sheets, accounting statements, cash
flow statements, market values, and Beta. Here you see that the Beta from capital like
you for May 2022 is 0.59. And unsurprisingly, it's pretty close to our estimate for 2017 to
2021. So which Beta should be used? We have three different estimates. Two of them
are 0.6 and one is a bit lower and we have the confidence intervals. For sure our data
suggests that PepsiCo has a fairly low Beta.

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So, remember our initial discussion, if Beta is below 1, the stock return of the company
is dampening the movement in the market. This is definitely the case for PepsiCo.
The estimates of data based on the most recent data, 0.6. So, I would suggest we use
0.6, what I also recommend doing in practice is to use a range of Betas. That's to
recognize the fact that Beta is a statistical estimate that we are very uncertain about the
true number. So, in this case we could use a Beta of 0.6, but we could also do some
sensitivity analysis, with Betas of 0.4, 0.5, 0.7, 0.8, okay, just to be sure. If you want to
be more sure, you can of course increase that range a bit.

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All right, so we have a risk-free rate of 3%, a market risk premium of 5% and a Beta of
0.6. It turns out that we now have everything we need for the CAPM. If you plug it all in,
we get 6%. That 6% is our required return on equity. That's the required return on
owning PepsiCo stock. And if you use a range, you're going to get a required return on
equity of 5 to 7%. And by the way, there is no correct way to pick that range, okay? I
just used the combination of our statistical analysis and common sense. So, use what
you get from the regressions together with some common sense to figure out what a
reasonable range for your Beta is, okay? In this case we come up with a range of 5% to
7% and that's our required return of equity.

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So, let's try to understand all of this a little bit better through the following question. Let's
say we wait one year, and at the end of that year we see that the market was up 8%
and PepsiCo was up 7.5%. Market 8% Pepsi 7.5%, should PepsiCo investors be happy
or not?

Your first reaction might be no, okay? Investors should not be happy. The market

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returns 8%, PepsiCo only 7.5%. So, investors are losing money. Well, that would turn
out to be wrong. Remember, high risk, high return, okay?

We are pretty sure that PepsiCo's Beta is lower than one. So, PepsiCo doesn't have to
return 8% because PepsiCo is less risky than the market. That’s what we just learned.
Even taking that range into account, we just calculated a reasonable range for PepsiCo,
for its required return on equity. We calculated it should be between 5 and 7%. So, what
that means is that investors should be happy with 7.5%. The actual return of 7.5% is
higher than the required or expected return of 5 to 7% so the investors should be happy,
not sad.

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Lesson 1-9: Estimating the WACC

Lesson 1-9.1. Estimating the WACC

We have made a lot of progress so far. A few lessons ago I gave you the weighted
average cost of capital formula. The formula. And sure enough, we have estimated
almost all the variables that we need. The required return on debt is 4%. The required
return on equity is 6%. We also need taxes. But if you look at Module Two we were
doing a financial planning exercise for PepsiCo and we already figured out that 21% is a
reasonable estimate for the tax rate. There's one more set of numbers that we need. It's
the ratios that tell us how the company is financed.

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What we need to find out is how PepsiCo is financed. All we need to do is go back to
Model One and look at leverage ratios. I know it's very tempting to look at Pepsi's
balance sheet right here and right in this moment. But remember for leverage we use
the market value of equity. So be extra careful if you use standard data sources like
Morningstar, they might report a lot of data for you and before you know it you're using
lever leverage based on book values. So, you know you might be lazy and just google
leverage for your company of interest and you might even find a neat little pie chart like
this one. Pie charts help us think of the company as a pie and then we can figure out
who's eating that pie here, debt holders and equity holders are eating it. Okay. The
problem is that if you look at the underlying data which is also on this slide, it might be
that this pie chart is representing book value. The equity value here in the pie chart is 16
million and the debt value is 34 million. Okay. But when you look at it a little bit closer,
when you look at the small print you might realize that these are book values. The book
value of equity is a poor proxy for the value of equity because it ignores everything that
happens in the future. So, hands off the pie chart most of the value of equity for a
healthy company like Pepsi is going to be in the future and the book value completely
ignores that. We will fix this problem by using market values.

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So, let's just go back here to recap how we do this very quickly. We have here the data
on Pepsi's market value and it's that. So, our D is simply going to be 40 And our E is
going to be 240. So, V is going to be 40 plus 240, that's 280. Now leverages simply
14%. Okay 14% leverage. If D over V is 14% obviously E over V is going to be 86%.
That's just one minus 14%. So, it turns out once we have the required returns on debt
and equity the rest is easy to do. But I bet if you hadn't taken this class you would have
used book values to estimate this. So that's the point I really want to emphasize use
market values to calculate leverage ratios.

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Okay, on this slide, you see the entire calculation. For our best estimate of Beta the
work is 5.6%. What we are doing here is multiplying the cost of equity with the weight on
equity. That's one side and add to that, the cost of debt weighted by leverage,
accounting for one minus the tax rate. Before we talk about the interpretation of this
work, let me make one additional new point. It is very important to use market values.
Okay. I may have said that before, but it's important. Okay. And this example Pepsi's
market value of equity is greater than its book value of equity. If you use book value of
equity, you might get a much higher leverage than 14%. If you use a much higher
leverage you get a much lower WACC. That's because the return on debt is lower and
you put more weight on that. Okay, that's not what you want to do. You want. You don't
want to buy us down your cost of capital. If you do that. If you get too lower WACC, you
might underestimate your risk and you might take on negative NPV projects.

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Okay, that's the end of my rent. Use market values. The key takeaway is that our best
estimate of the weighted average cost of capital is 5.6%. These 5.6% are of course not
a magic number. We don't have a crystal ball. Okay, this output depends on all our
inputs. In particular. The WACC is very dependent on the Beta. If Beta goes up or down
the cost of capital for the company goes up or down.

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So, here's a little table for you. We were working with the range of 0.4, to 0.8 for Beta.
That range is going to imply a range of approximately 4.7% to 6.5% for the cost of
capital. If you want to be conservative and use 0.7 as a Beta, your cost of capital is 6%.
And in any practical application you do want to do a sensitivity analysis with varying
WACCs. Okay. It's simple. It should be relatively straightforward to do this and it's going
to help you a lot when you are using the WACC to value projects to do performance
evaluation and so on. Talking about projects. Let's actually talk about how we use the
WACC. So, here's a question for you.

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The WACC is the discount rate for the company. That was our starting point. We talked
about the fact that we are going to use the WACC to estimate the discount rate for the
company. So, the way to interpret it is that it's the required return on projects that have
risks similar to the company. So just to make it clear. So, we all understand how to use
the WACC, consider the following example.

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Suppose that PepsiCo is developing a new soda which will be similar to the company as
a whole. What is the minimum IRR are going back to Module Three? Think about IR like
what's the minimum IRR the PepsiCo would need to generate to make the soda a
positive NPV project? What is the required rate of return in this case?

The answer is WACC. The answer is that the IRR needs to be greater than 5.6%. The

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cool thing is that we can now actually estimate that number, the 5.6%. It's not falling
from the sky anymore. So, the 5.6% is the cost of capital. It's not a perfect estimate, like
all estimates we use when we do finance, we have to use statistical analysis, common
sense and so on. So, it's not a number we know for sure, but it's better than just
guessing. We now know that the back is not 10% that we know for sure. Okay, there is
a possible range for back 5.6% is a reasonable estimate. You could use 6% if you want
to be wrong on the conservative side.

So, if you want to use a higher Beta, so to speak. The bottom line goes back to Module
Three, we need this IRR to be greater than the discount rate. If the IRR of the soda
project is greater than the discount rate then NPV is positive. So, what this all means is
that for a new soda, for a project that looks like PepsiCo, all it needs to do is to generate
a return greater than 5.6%, and we are pretty sure that this new soda is going to be a
positive NPV project.

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Lesson 1-10: Performance Evaluation Economic Value-Added (EVA)

Lesson 1-10.1. Performance Evaluation: Economic Value-Added (EVA)

There is another important application of the WACC, our Weighted Average Cost of
Capital. Knowing the WACC allows us to measure performance. We can now try to
answer the following question. How do we measure whether a company or a division of
a company is generating sufficient profits? So, think about the following, suppose you
have invested say $1 million dollars into a project, how large would annual profits have
to be for this project to create value.

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Remember, for a project to create value the rate of return has to be greater than the
discount rate. And now we have an estimate for the discount rate, that comes from our
previous calculations. So, the answer has to be, that the minimum profit that the project
has to generate is the WACC times $1 million in this case. The WACC is a percentage
return, if you multiply that by a million, you will get a dollar value. This dollar value
should be a benchmark for the company. So, if it's PepsiCo, we just figured out that the
back is 5.6%. So, what you would do is you would multiply 5.6% times one million to
figure out the minimum amount of annual profit that PepsiCo project would need to
generate.

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The general concept that we are going to introduce here is called EVA economic value
added. Economic value added is just going to be profit minus WACC times the amount
of invested capital, either in a company or a division or a project. And now we go back
to Module One, where we talked about how to measure profits and how to measure
assets. A very important notion that we discussed back in Module One, was that if you
want to measure profits for the company as a whole, you should not use net income,
you have to use operating income. You have to use a measure of profits that is before
interest payments. In this course, the measure we are using is called an OPAT which is
Operating Profits minus Taxes.

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This is the measure we are using to calculate EVA, what EVA is going to give you is the
difference between actual operating profits after taxes and what should have been the
operating profits given a WACC, okay. So, the EVA in the end is going to measure
whether the company is generating real economic profits after accounting for the
required return, after accounting for the minimum profits that the company should
generate, okay.

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So, let me back up a little, why are we using this notion of operating assets. First of all,
the definition, what we mean by operating assets is the difference between book value
of assets and cash. Going back to Module One, think about the following. Why are we
using book values? We already saw the answer in this type of applications, when we
are measuring current profitability. What you want to do is you want to measure the
capital that is invested in the company at the moment right now, okay. You don't want to
include future profits in your measure of assets. So, you definitely do not want to use
market values in this case. If you're using market values really what you're doing is
comparing current profits to future profits. We do that when we calculate valuation
ratios, but not right now, not when we are trying to measure performance.

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So why are we excluding cash? We're excluding cash because cash is clearly not
invested in the business in most cases. Cash is invested in financial assets, typically in
treasury bonds or bank deposits. This is not money that is directly invested in the
business, so when computing EVA, it's generally good practice to remove cash and
short-term investments. There's the verge generally there because in some cases cash
might be in operating assets. In some cases, cash is required to run the business, you
can think of a supermarket for instance, that needs some cash to give change to
customers, okay. In that case cash is part of the business, it's invested in the business
but as this example shows for most real-world companies, cash is going to be invested
in financial assets. So, it should not be included in operating assets.

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So, let's go back to PepsiCo and try to figure out whether PepsiCo is generating enough
profit to cover its cost of capital. That's really the notion EVA, okay EVA. We estimate
the WACC at 5.6% and we have confidence that the ranges between 4.7 and 6.5%. So,
we can use our measure of WACC to measure EVA. All we need to do is measure
OPAT and operating assets.

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And you should know how to do this already, we did a lot of this stuff in Module One.
For OPAT we looked at the income statement. OPAT is just the difference between
operating income EBIT minus taxes, so OPAT for PepsiCo in 2021 was 9.7 billion.

Operating assets. Very easy as well. Just look at the balance sheet, take the total
assets and deduct cash. Our estimate here would be 86.4 billion. Our assumption when

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we do this calculation is that all the other current assets are invested in the business.
And if we go over the list for most of them, this is probably reasonable. Receivables we
learned in Module Two that receivables are an investment in the business. Net PP&E.
Goodwill, which if you know some accounting, you will know that Goodwill comes from
the effect of previous acquisitions on the balance sheet. Okay, so it looks like most of
these are actually invested in the business except for cash. Cash is definitely well most
likely to be invested in financial assets like bank deposits, treasury bonds and so on.
Before this, we can calculate EVA, which is reported here in this table. So, for each
estimate of the WACC we have an EVA. Remember we have a range of WACCs, but
you can tell that EVA is positive regardless of the cost of capital we use. Even if we take
our most conservative estimate, which is a high WACC of 6.5%. What we find is that
PepsiCo is generating approximately 4.1 billion of pure economic profit for the year
2021. So that's the difference between OPAC and the WACC multiplied by the
operating assets.

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Lesson 1-11: Using EVA to Measure Performance of a Company’s Division

Lesson 1-11.1. Using EVA to Measure Performance

We just learned how to estimate cost of capital and how to use cost of capital to figure
out whether a company is generating economic value or not. Doing this as useful and
not really hard. But here comes the problem. Most real-world companies are going to
have different divisions. Companies invest in more than one type of product. They might
be investing in many different products, that's true even for PepsiCo. Most of PepsiCo's
investments are related to soda soft drinks, but PepsiCo also has other food business.
The general point is that if a company has different divisions, the company-wide cost of
capital might not be the right discount rate for all of them. Remember our initial idea,
discount rates have to reflect the specific risk of each project. In this case, the discount
rates have to reflect the specific risk of each division. If the company has many
divisions, then all the halls break loose. Maybe the company by cost of capital is not
doing the right job for each and every one of these divisions. Now what I want to talk
about is how would we do it. If we have this problem, if the division is different from the
company, how can we do the EVA calculation?

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The example, I'm going to use is Altria, which is a conglomerate that produces mostly
tobacco. Most of their business is to sell cigarettes, smokeless tobacco, and cigars.
Mostly cigarettes really. That's the big business both in the US and abroad. But they
also have some other smaller divisions. In particular, they have a wine division.

We're going to talk about this wine division. This is the wine division of Altria. It makes

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wines in Washington state. The division is called Ste. Michelle Wine Estates. You might
have seen this before, especially if you live in the US. These wines are sold very
generally in supermarkets and all that, so you might have seen some of them. These
wines are made in Washington State and they are made by this company called Ste.
Michelle Wine Estates. Importantly, Ste. Michelle is a division of Altria, and Altria is
mostly a tobacco company.

What we want to do now is figure out whether Ste. Michelle generates economic profit.
Suppose we are Altria, we are the CFO and we have to figure out whether the wine
division, Ste. Michelle Wine Estates, is generating economic profit or not. How do we do
this? How do we compute EVA for the wine division? That's going to be our question.
The first thing we need is data on profits and assets, ideally separated by division, and
this data might be very hard to come by. Companies are not necessarily required to
report this data. Some of them do others don't. If you're inside the company, you might
get your hands on that information. In the case of Altria, they are reasonably nice. They
actually report data separately for their wine division. Note they have other divisions as
well, but we focus on the wine and the tobacco division in this case. It turns out the
Capital IQ has operating profits and revenues separately by division. In this case, I use
the revenue data to figure out assets of the tobacco and wine divisions. What we don't
have is cash separated by division. But it turns out that Altria doesn't hold that much
cash, so we're just going to assume that cash is equal to zero. Remember that in
general, you want to deduct cash from all assets to figure out operating assets. In this
case, we assume cash is zero. We can calculate OPAT, all we have to do a tax

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operating profits of the wine division of Altria as effective tax rate, which is 21%. Then
our OPAT would be $16.6 million. In 2021, the wine division of Altria generated 16.6
million in profits. The question that the CFO is trying to answer now is whether 16.6
million is a sufficient profit for the wine division or not. Does the division have to perform
better? Did the division manager perform well, and so on? Think about the following
that's really getting to the fundamental question we're trying to answer in this session.

We can get Beta for Altria. That's very easy. Just go to Capital IQ or do a regression.
You will find out that Altria doesn't have a very high Beta, similar to Pepsi. Altria's Beta
is 0.5. We can use the range and all that. The bottom line is that Altria will have a low
Beta. Now the question is this the right Beta to use? If you're trying to answer the
question we just post, which is to figure out the performance of the wine division, is that
the right Beta? Which risks is this Beta reflecting? The answer, put very simply, is that
0.5 is the tobacco Beta. How do we know? Well, most of this company is all about
tobacco. If you look at the market value of our Altria, is going to be driven mostly by
tobacco. If you look at the table that we just worked with, most of the assets, more than
95% are invested in tobacco. Most of the profits come from tobacco. Most of the equity
value is going to reflect tobacco. There's no guarantee that if you use 0.5, we're actually
going to be measuring the wine Beta.

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We need a wine Beta. That's really very important because we want to calculate EVA
for the wine division, and the wine division might be more or less risky than tobacco.
Say, we want to use EVA to determine, let's say, executive compensation. If the wine
division is doing great, then the manager of the wine division gets paid more, gets more
stock options. But to determine whether the manager of the wine division did well or not,
we need to compare the performance of the wine division to what we expect given the
risk of wine. We need the cost of capital for wine. Unfortunately, the wine division does
not trade separately in the stock market so we can't just use Capital IQ to get the Beta.
We cannot find the stock price for the wine division so we can't run regressions. We can
know everything about regressions, but it's useless in this case because we don't have
Beta.

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Turns out there are two approaches that we can use in corporate finance. One is to take
a range of similar companies and use an industry Beta. That's the Beta that is going to
be averaged out across many firms in a related industry. The second approach is called
the pure-play approach, where we try to find a similar company that is publicly traded.
Let me give you an example here for Ste Michelle, for Altria's wine division.

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We can start from the beverage Beta. A beverage Beta is definitely going to be better
than a tobacco Beta. Using this table on the slide, you will see that the alcoholic
beverage Beta using 21 companies is 0.82. That's a Beta that is closer to one than the
tobacco Beta of 0.5. We can also try a pure-play approach. We are looking for the wine
Beta. What we need to search for is a company that mostly makes wines. A company
whose main business is wine and ideally, that is publicly traded in the stock market.

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In this case, we are in luck. We can use a company called Constellation Brands. This
company produces wine all over the world, including the US, Australia, and so on. We
can get data for Constellation Brands. We can go to Capital IQ or Yahoo Finance or
Google and find the Beta. Turns out the Beta is around one, the Beta is 1.07 in this
case. Think about this. We almost used a tobacco Beta of 0.5, but it turns out that the
wine Beta could be 1.07.

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Once we plug that into our CAPM equation, we get a required return on equity of 8.3%.
Had we used a Beta of 0.5, our required return would be 5.5%. That's a big difference,
5.5% versus 8.35%. Just a couple of more data points here to compute the WACC to go
from [inaudible] to return equity to the WACC. We have to add the debt to value and the
cost of debt. But we can take those from Altria, from Capital IQ. Those are company-
wide values. Now, of course, there could be a difference in the cost of debt from the
wine division to the tobacco division, but it's less likely the case. As it turns out, Altria
doesn't have a lot of leverage anyway so it will not really matter that much for our
calculation. If we now apply the WACC formula, we are going to find the cost of capital
of 7.2%. Because of equity, the required return on equity is 8.35%, the cost of capital is
7.2%.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Now, we can go back and estimate EVA. We have the OPAT, we have the operating
assets, and we have a wine WACC of 7.2%. We get an EVA of minus 48.12 million.
What does this mean? It means that looking at that year in isolation, just the 2021, the
wine division did not generate sufficient economic profits. They did not generate
sufficient profits to justify the assets invested in them or to justify their high risk.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Let's go back to the tobacco Beta. Suppose we had used the 0.5 instead of the 1.07 for
the Beta? We would have ended up with a higher EVA. Essentially, we would be
underestimating the risk because Beta measures risk. Because we would be using a
low Beta, we'd end up with a lower WACC and we'd overestimated EVA. In this
example, it doesn't really matter, the wine division is simply too unprofitable and EVA
will always be negative, even with a tobacco Beta. But in real life, this might make a
very big difference, a difference for your bonus and the future of your company.

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Professors Heitor Almeida and Stefan Zeume

Let's conclude at this point. Suppose we have checked this calculation carefully and we
are certain that the wine division is, in fact, generating negative EVA? What does it
mean? Should we go ahead and restructure this division? Should we fire the manager,
sell off the division? What should Altria do? That's our questions. Well, in this case, we
have to be a little bit careful. When we measure EVA, we measure current profits. EVA
by definition tells you whether a company is generating economic profit in a given year
or not, in this case in 2021. What might be happening is that perhaps, the wine division
is expected to grow a lot and to generate higher profits in the future. Having negative
EVA today, doesn't really mean you have to sell off the wine division. What it means
though, is that you have to make sure the performance of the wine division is going to
pick up at some point. If that never happens, if EVA never turns positive, then at some
point, you may have to restructure. Essentially, this division is not creating economic
value. Maybe it will be creating economic value in the future. They just planted some
wine varieties, and it takes some time for them to mature, carry sufficient grapes,
generate profit or something has to be done. EVA provides very useful information for
the CFO that tells the CFO whether the division or a project is contributing economic
value or not. But it has to be interpreted with some care.

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Professors Heitor Almeida and Stefan Zeume
Lesson 1-12 Module 4 Review

Lesson 1-12.1: Module 4 Review

In the first part of this module, we talked about mergers and acquisitions. In particular
we talked about the concept of synergies, which is the right reason for companies to
engage in acquisitions, for companies to engage in M&A. We also learned how to
distinguish good reasons from bad reasons. So, we talked about several bad reasons
why companies sometimes engage in M&A, we learned how to recognize them and how
to avoid them, okay. We also learned how to calculate synergies using net present
value techniques. Calculating synergies is just another example of NPV that we also
used in Module Three to figure out the value of a new investor. Then we used our
synergies to determine the pricing of M&A deal. We learned how the pricing of a deal
and how much you pay for a target, is related to our evaluation of synergies.

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We then talked about the difference between stock financed mergers and cashed
financed mergers. We learned what stock financed means, right. And then we started
talking about the very important cash financed merger which is a leveraged buyout. All
right? We talked about the specific characteristics of a leveraged buyouts and how
leveraged buyouts can increase your holder value, okay? That was the first part of
Module Four. The second part of Module Four looked at uncertainty, right?

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Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We learned how to incorporate uncertainty and risk into our evaluation analysis, right?
First, we talked about sensitivity analysis, we learned how to do it and how to use it,
okay? And then we talked about the fundamental idea in finance that we can use
discount rate to incorporate risk into valuations. We talked about the weighted average
cost of capital. We talked about how to estimate it for a real-world company. And then
we used the weighted average cost of capital to estimate performance, to measure
performance, right. The way we did this is by estimating economic value added. We did
it both for a company as a whole and for the division of a company, okay? And finally,
we talked about how to use EVA for performance evaluation for compensation purposes
and to decide whether a decision should be restructured or not.

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Lesson 1-13 Course Conclusion

Lesson 1-13.1: Conclusion

In this course, we learned a lot about how companies make financial and investment
decisions. What I want to discuss now are the key concepts that you should remember
from the course. What are the key takeaways? The first one is this notion of shareholder
value. The driving principle for company financial decisions is that companies should
almost always make decisions that maximize the stock price. The word almost is of
course, because maximizing the stock price is not a perfect objective.

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There are conflicts, for example between shareholder value and social welfare that
companies needed to address. But the point is that Mac is thinking about the stock price
is better than other alternatives, such as maximizing current profits that could lead to
short-term use. The stock price is very important for corporate finance. We talked about
financial ratios. Accounting is very important for corporate finance as well. Accounting
statements are a book, and you have to learn how to read that language. Without that
language is very difficult to do finance. We use accounting statements to measure
fundamental concepts such as liquidity, leverage, profitability, sources, and uses of
cash. We learned how to do this and in how we avoid the most common pitfalls. We are
also learning how to write the book of corporate finance. We learned how to forecast
future financial statements. We learned how to use forecasts to project and manage a
company's long-term and short-term liquidity needs.

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Professors Heitor Almeida and Stefan Zeume

Then we talked about net present value. Net present value is the probably the most
important concept in corporate finance, which is this mathematical model that allows us
to measure the contribution of a new project or acquisition to value. If a decision
generates a positive NPV then the bottom line is, it will increase stock prices and it's
good for companies. They should take it, they should make that decision. We use this
principle to discuss investments, acquisitions, and the pricing of M&A deals.

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We talked about rates of return as well. IRRs are useful because they give you a
percentage rate of return. However, remember that in some cases we cannot compute
IRR. If you can, if it's valid to compute IRR, then you should remember that there is a
fundamental relationship. If the IRR is bigger than the discount rate, the NPV is positive.
Then we talked about real options. For some investment decisions like R&D, it's a bit
tricky to try to use a standard NPV model. You have to introduce a few tweaks. You're
still doing an NPV calculation, but with some tweaks like decision trees, etc., to allow
you to think about the net present value of R&D. We're learning how to use these
decision trees and how to mix them with NPV calculations.

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Then we talked about risk. We talked about how to incorporate finance. We measure
risk using discount rates, and we learn how to estimate a discount rate using the
weighted average cost of capital. The weighted average cost of capital can be used to
discount cash flows. It can also be used to measure the performance of investments.
We talked about EVA, how to measure the performance of the divisions of the company
itself. Remember, practice makes perfect. Even though now we're done with this
course, you should continue thinking about finance, reading the financial newspaper,
trying to apply what you learn in this course to real-world situations, and keep learning.
Learning is always important.

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