Case Study-AW135

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1. Read the HP-Compaq case and answer the following questions

i) Calculate the present value of projected synergies from the merger. Use the information in Exhibit 9 for your calculations.

ii) The terms of the merger call for a tax-free exchange of 0.6325 shares of HP for each share of Compaq. Use your estimate of synergies in part (a) to calculate the implied premium being paid by HP to acquire Compaq. Use the stock prices and the number of shares outstanding of HP and Compaq on September 3, 2001, the day before the merger was announced, to perform this calculation.
iii) Set up a hedged merger arbitrage strategy to take advantage of the spread between the price of CPQ on September 4, 2001 and the offer price for each share of CPQ implied by the terms of the merger. What is the expected gross annualized return if the merger was completed on March 3, 2002. CPQ and HP were expected to pay dividends per share of 3 cents and 8 cents respectively, in September, December and March. Transaction costs to buy and sell shares is expected to be 5 cents a share.
iv) Calc Premium

Exhibit 9
-20- UVA-F-1450 Exhibit 9 THE MERGER OF HEWLETT-PACKARD AND COMPAQ (A): STRATEGY AND VALUATION Valuing Synergies The following description of HP’s synergies valuation is excerpted from pages 60 and 61 of the joint proxy statement/prospectus dated February 4, 2002. “[The] cost savings have a net present value of approximately $5–$9 per share of the combined company calculated by applying a range of price/earnings multiples to the estimated earnings per share impact of the cost savings in calendar year 2004 and discounting those amounts to the present. This analysis is based on the following assumptions.
• $2.5 billion of pretax cost savings in calendar year 2004; • A range of price/earnings multiples of 15×–25× which is supported by the average one-year forward price/earnings multiple for HP in the last year (20.8×) and the last three years (22.2×)
• A discount rate of 15% which is based on the weighted cost of equity of the combined company on a pro forma basis;
• An assumed effective tax rate of 26% for the combined company, which is based upon the weighted average of the effective tax rates of each HP and Compaq;
• Marginal pretax profit decline of approximately $500 million in calendar year 2004 resulting from estimated overall revenue loss for the combined company resulting from the merger in calendar year 2004 of approximately $4.1 billion (representing 4.5% of overall estimated revenue for calendar year 2004 of $92.8 billion or 4.9% of estimated revenue for the fiscal year 2003), which is based upon potential revenue loss in businesses of the combined company as follows
18% in home PCs; 11% in UNIX servers; 8% in business PCs; 7% in appliances; 6% in NT servers; and 5% in storage. We have assumed that our combined imaging and printing business will not experience material revenue losses as result of the merger because Compaq does not have an imaging and printing business.


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In addition, we have assumed that our combined service business will not experience material net revenue losses as a result of the merger
A weighted average contribution margin of 12%, which represents the marginal pretax profit decline resulting from revenue loss. We have assumed a weighted average contribution margin of 12%, reflecting an assumed contribution margin of 11% for the combined company’s Personal Systems business (which is expected to account for 66% of 2004 revenue loss) and 14% for the combined company’s Enterprise business (which is expected to account for 34% of 2004 revenue losses)
• Our estimate of the net present value of the cost savings resulting from the merger excludes both the cost savings expected to result from the merger in calendar years 2002 and 2003 and the expected non-recurring cash costs of achieving those cost savings (e.g. costs of integration) during those calendar years, as well as the pretax profit decline resulting from estimated revenue loss in calendar years 2002 and 2003.
Our estimate of the net present value of the cost savings resulting from the merger does not account for possible revenue increases resulting from the merger. Based upon the revenue loss assumption described above, and a weighted average contribution margin of 12%, the combined company would have to lose approximately $20.6 billion of overall revenue in calendar year 2004 as a result of the merger (i.e. more than five time the amount of our assumed revenue loss resulting from the merger) in order to completely offset our anticipated annual cost savings of $2.5 billion resulting from the merger.”
2. VANS is a privately owned manufacturer of light trailers that are sold to rental companies and individuals. Its sole owner, Mr. Benjamin Webster is presently considering a purchase offer from Prentice Works. The offer for the equity of VANS is as follows
i) A cash payment for $5 million due at closing.
ii) A 7.5% annual coupon five-year subordinated note issued by Prentice Works, for $7 million with principal payable at maturity.
v) An earnout agreement stipulating a payment to take effect at the end of the third year equal to one-half times third year EBITDA.
Prentice Works will assume VANS’s present net debt of $14.8 million. Furthermore, VANS will become a wholly owned subsidiary of Prentice and Mr. Webster will stay as its president with a three-year contract and competitive compensation, at the end of which he will retire.
The following additional information is available

– Prentice Works’ outstanding subordinated notes are presently priced to yield 10%.
– Mr. Webster believed that he could make VANS’s EBITDA grow at 11% per year during the following three years. Current EBITDA is $6 million.
– Small companies with characteristics similar to VANS have a WACC of about 14%.

a. What is the value of the 7.5% $7 million note offered by Prentice Works?
b. What is the value of the earnout agreement?
c. How much is Prentice Works offering for the enterprise (debt plus equity) of VANS? What is the initial EBITDA multiple offered by Prentice?
While Mr. Webster will take into account his salary as president of the subsidiary as well as the tax consequences of the transaction, you should ignore these matters in answering the above questions.
3. Consider the following alternative earnout for VANS’s Mr. Webster. The other components of the consideration stay the same. The earnout would pay 2.5 times the excess of third-year EBITDA over $6 million. The riskless interest rate is r=5%, and the likely range of VANS’s EBITDA growth is [-40%, 110%] (Hint: estimate volatility at one-sixith of this range). What is the value of the earnout and how much would Prentice Work pay for the enterprise?

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