FINA 5512 VALUATION Case Study Ford Acquires Volvo’s Passenger Car Operations

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FINA 5512 VALUATION

Lecture 3

Applying Financial Modeling Techniques to Value and Structure Mergers and Acquisitions

Practice Problems and solutions:

1. An acquirer agrees to purchase a target firm in an exchange of shares. The acquiring

firm’s share price is $12 and the offer price for the target firm is $10. What is the implied share exchange ratio? What does the share exchange ratio mean?

Answer: $10/$12 = .83 Consequently, .83 acquirer shares must be issued for each target share purchased.

2. The acquirer’s current share price is $12 and its number of shares outstanding is

1,000,000. The offer price for the target firm is $15 in a share for share exchange. The target firm has 100,000 shares outstanding. The combined earnings of the two firms including synergy is $500,000. What is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + (100,000 x ($15 / $12)) = $.44

3. For question 22, assume that the purchase price consists of .5 acquirer shares and the balance in cash. Ignoring the cost associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + 100,000 x. 5) = $.48

4. For question 23, what is the postmerger ownership distribution?

Answer: Target company = (100,000 x .5) / (1,000,000 + 50,000) = 4.8% Acquiring company = 100 – .048 = .952

5. For question 22, assume the purchase price is an all cash offer. Ignoring the cost

associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000/1,000,000 = $.50

Case Study

Ford Acquires Volvo’s Passenger Car Operations

Background

By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing

mandates from regulators for new, cleaner engines and more safety measures added to

manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and

maintain market share in this highly competitive environment.

By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution

channels, entering new markets, reducing development and vehicle production costs, and

capturing premiums from niche markets. Volvo Cars is now part of Ford’s Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group,

operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures

required to develop new cars as overwhelming for a company its size.

Historical and Projected Data

The initial review of Volvo’s historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo’s cash flow is steadily trending

downward from its high in 1997. Table 1 displays a common-sized, normalized income

statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has

managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase

substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004

is the sharp increase in capital outlays during the forecast period. Ford’s acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform

sharing, access to wider distribution networks, and increased penetration in selected market

niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration.

Table 1. Volvo Common-Size Normalized Income Statement, Balance Sheet, and Cash-Flow Statement (Percentage of Net Sales) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Income Statement
Net Sales 1.000 Cost of Goods Sold .772 Operation Expense .167 Depreciation EBIT Interest on Debt Earnings Before Taxes Income Taxes Net Income .028		1.000 .738 .101 .034 .027 .050 .024 .004 .087	1.000 .749 .120 .033 .128 .023 .017 .018 .054	1.000 .777 .077 .033 .098 .022 .076 .022 .079	1.000 .757 .119 .034 .112 .021 .091 .012 .057	1.000 .757 .133 .029 .088 .015 .072 .015 .035	1.000 .757 .132 .038 .073 .023 .049 .014 .036	1.000 .757 .131 .038 .073 .023 .051 .014 .037	1.000 .757 .129 .039 .074 .022 .052 .015 .038	1.000 .757 .128 .040 .074 .021 .053 .015 .039	1.000 .757 .127 .040 .074 .021 .054 .015 .040	1.000 .757 .126 .041 .075 .020 .055 .015 .040	.042 .075 .020 .056 .016
Balance Sheet
Current Assets Current Liabilities Working Capital Total Assets Long-Term Debt Equity	.596 .036 1.21	.632 .400 .103 .889 .371 .244	.503 .283 .161 .809 .211 .278	.444 .298 .226 .905 .227 .299	.524 .304 .192 .889 .236 .371	.497 .350 .150 .906 .256 .329	.500 .350 .150 .880 .234 .321	.500 .350 .150 .858 .215 .316	.500 .350 .150 .839 .196 .312	.500 .350 .150 .822 .180 .309	.500 .350 .150 .808 .165 .308	.500 .350 .150 .795 .151 .307	.500 .307 .307
Selected Valuation Cash-Flow Items
EBIT (1 – t) Capital Expenditures .031 ∆ Working Capital .025 Free Cash Flow .047		.022 .027 .077 .079	.150 .033 .068 .053	.126 .053 .049 .059	.126 .054 .000 .088	.105 .061 .017 .087	.093 .069 .020 .044	.094 .078 .020 .036	.094 .088 .020 .027	.095 .099 .020 .017	.095 .096 .096 .112 .126 .020 .020 .005 (.008) to the Firm (FCFF)

Determining the Initial Offer Price

Volvo’s estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other

current bidders for the entire company and Volvo’s urgent need to fund future capital

expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999.Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per

share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo’s total common shares outstanding of 442 million.

Determining the Appropriate Financing Structure

Ford had $23 billion in cash and marketable securities on hand at the end of 1998. This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost

associated with this excess cash is equal to Ford’s cost of capital, which is estimated to be 11.5% —about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to

shareholder value, because the expected return including the effects of synergy exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a

potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo’s pretax earnings.

Case Study Questions and Answer:

1. What is the purpose of the common-size financial statements developed for Volvo (see Table 1)? What insights does this table provide about the historical trend in Volvo’s historical performance? Based on past performance, how realistic do you think the

projections are for 2000-2004?

Answer: The common size financial statements for Volvo reveal the historical

relationship between key operating variables and sales. They revealed the deterioration in the firm’s long-term operating efficiency and the subsequent decline in operating

margins and cash flow. The deterioration in cash flow underscored the inability of the

firm to fund future cash flows at a level necessary to remain competitive. The projections

appear somewhat optimistic in that they assume some acceleration in revenue,

improvement in operating expenses, and a significant improvement in asset turnover

rates. The escalating capital outlays necessary to introduce new cars causes cash flow to turn negative by 2004.

2. Ford anticipates substantial synergies from acquiring Volvo. What are these potential synergies? As a consultant hired to value Volvo, what additional information would you need to estimate the value of potential synergy from each of these areas?

Answer: By acquiring Volvo, Ford hoped to expand its global market share with a

This study source was d l adedrb r1 0 8t9 7f4f8e6 nfrgoma o r el e os.c r1e0n-2 0 2 t: 6p:0r5eGs c-0e5: Europe. Specifically,

Ford saw Volvo as a means of improving its product weakness in luxury sedans and

station wagons, gaining access to new distribution channels and markets, reducing

development and vehicle production costs, and gaining greater penetration into the

premium car market. To estimate the potential increase in luxury market penetration, it is necessary to know the potential size of each of Ford’s and Volvo’s targeted markets in

both dollars and units. In addition, it is necessary to know their current penetration in

those markets and an estimate of the probable lift to market share that might be achieved by introducing Ford products into predominately Volvo markets and vice versa. To

estimate cost savings, it is necessary to know Volvo’s approximate cost per vehicle and the likely savings per vehicle that might be achieved. These savings could come from

economies of scale in centralizing production and making uniform automotive platforms, as well as by introducing “best practices” across the companies.

3. How was the initial offer price determined according to this case study? Do you find the

logic underlying the initial offer price compelling? Explain your answer.

Answer: The initial offer price for Volvo was determined by adding about one-fourth of the projected net synergy generated from acquiring Volvo to its standalone value of $15 billion. The reasonableness of the resulting price of $15.25 billion was confirmed by using other valuation methods. When compared to the firm’s market value of $11.9

billion, this offer price represented an approximate 28% premium. This premium was consistent with what Ford had paid for Jaguar one year earlier.

4. What was the composition of the purchase price? Why was this composition selected

according to this case study?

Answer: The proposed purchase price was an all-cash offer. At the time, Ford’s cash balances were substantially in excess of its required working capital needs. By re-

deploying some portion of these excess cash balances into an investment offering a higher return than the prevailing rate on short-term securities, Ford was potentially enhancing shareholder value and making itself less attractive as a takeover target.

 FINA 5512 VALUATION

Lecture 3

Applying Financial Modeling Techniques to Value and Structure Mergers and Acquisitions

Practice Problems and solutions:

1. An acquirer agrees to purchase a target firm in an exchange of shares. The acquiring

firm’s share price is $12 and the offer price for the target firm is $10. What is the implied share exchange ratio? What does the share exchange ratio mean?

Answer: $10/$12 = .83 Consequently, .83 acquirer shares must be issued for each target share purchased.

2. The acquirer’s current share price is $12 and its number of shares outstanding is

1,000,000. The offer price for the target firm is $15 in a share for share exchange. The target firm has 100,000 shares outstanding. The combined earnings of the two firms including synergy is $500,000. What is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + (100,000 x ($15 / $12)) = $.44

3. For question 22, assume that the purchase price consists of .5 acquirer shares and the balance in cash. Ignoring the cost associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + 100,000 x. 5) = $.48

4. For question 23, what is the postmerger ownership distribution?

Answer: Target company = (100,000 x .5) / (1,000,000 + 50,000) = 4.8% Acquiring company = 100 – .048 = .952

5. For question 22, assume the purchase price is an all cash offer. Ignoring the cost

associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000/1,000,000 = $.50

Case Study

Ford Acquires Volvo’s Passenger Car Operations

Background

By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing

mandates from regulators for new, cleaner engines and more safety measures added to

manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and

maintain market share in this highly competitive environment.

By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution

channels, entering new markets, reducing development and vehicle production costs, and

capturing premiums from niche markets. Volvo Cars is now part of Ford’s Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group,

operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures

required to develop new cars as overwhelming for a company its size.

Historical and Projected Data

The initial review of Volvo’s historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo’s cash flow is steadily trending

downward from its high in 1997. Table 1 displays a common-sized, normalized income

statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has

managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase

substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004

is the sharp increase in capital outlays during the forecast period. Ford’s acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform

sharing, access to wider distribution networks, and increased penetration in selected market

niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration.

Table 1. Volvo Common-Size Normalized Income Statement, Balance Sheet, and Cash-Flow Statement (Percentage of Net Sales) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Income Statement
Net Sales 1.000 Cost of Goods Sold .772 Operation Expense .167 Depreciation EBIT Interest on Debt Earnings Before Taxes Income Taxes Net Income .028		1.000 .738 .101 .034 .027 .050 .024 .004 .087	1.000 .749 .120 .033 .128 .023 .017 .018 .054	1.000 .777 .077 .033 .098 .022 .076 .022 .079	1.000 .757 .119 .034 .112 .021 .091 .012 .057	1.000 .757 .133 .029 .088 .015 .072 .015 .035	1.000 .757 .132 .038 .073 .023 .049 .014 .036	1.000 .757 .131 .038 .073 .023 .051 .014 .037	1.000 .757 .129 .039 .074 .022 .052 .015 .038	1.000 .757 .128 .040 .074 .021 .053 .015 .039	1.000 .757 .127 .040 .074 .021 .054 .015 .040	1.000 .757 .126 .041 .075 .020 .055 .015 .040	.042 .075 .020 .056 .016
Balance Sheet
Current Assets Current Liabilities Working Capital Total Assets Long-Term Debt Equity	.596 .036 1.21	.632 .400 .103 .889 .371 .244	.503 .283 .161 .809 .211 .278	.444 .298 .226 .905 .227 .299	.524 .304 .192 .889 .236 .371	.497 .350 .150 .906 .256 .329	.500 .350 .150 .880 .234 .321	.500 .350 .150 .858 .215 .316	.500 .350 .150 .839 .196 .312	.500 .350 .150 .822 .180 .309	.500 .350 .150 .808 .165 .308	.500 .350 .150 .795 .151 .307	.500 .307 .307
Selected Valuation Cash-Flow Items
EBIT (1 – t) Capital Expenditures .031 ∆ Working Capital .025 Free Cash Flow .047		.022 .027 .077 .079	.150 .033 .068 .053	.126 .053 .049 .059	.126 .054 .000 .088	.105 .061 .017 .087	.093 .069 .020 .044	.094 .078 .020 .036	.094 .088 .020 .027	.095 .099 .020 .017	.095 .096 .096 .112 .126 .020 .020 .005 (.008) to the Firm (FCFF)

Determining the Initial Offer Price

Volvo’s estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other

current bidders for the entire company and Volvo’s urgent need to fund future capital

expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999.Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per

share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo’s total common shares outstanding of 442 million.

Determining the Appropriate Financing Structure

Ford had $23 billion in cash and marketable securities on hand at the end of 1998. This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost

associated with this excess cash is equal to Ford’s cost of capital, which is estimated to be 11.5% —about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to

shareholder value, because the expected return including the effects of synergy exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a

potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo’s pretax earnings.

Case Study Questions and Answer:

1. What is the purpose of the common-size financial statements developed for Volvo (see Table 1)? What insights does this table provide about the historical trend in Volvo’s historical performance? Based on past performance, how realistic do you think the

projections are for 2000-2004?

Answer: The common size financial statements for Volvo reveal the historical

relationship between key operating variables and sales. They revealed the deterioration in the firm’s long-term operating efficiency and the subsequent decline in operating

margins and cash flow. The deterioration in cash flow underscored the inability of the

firm to fund future cash flows at a level necessary to remain competitive. The projections

appear somewhat optimistic in that they assume some acceleration in revenue,

improvement in operating expenses, and a significant improvement in asset turnover

rates. The escalating capital outlays necessary to introduce new cars causes cash flow to turn negative by 2004.

2. Ford anticipates substantial synergies from acquiring Volvo. What are these potential synergies? As a consultant hired to value Volvo, what additional information would you need to estimate the value of potential synergy from each of these areas?

Answer: By acquiring Volvo, Ford hoped to expand its global market share with a

This study source was d l adedrb r1 0 8t9 7f4f8e6 nfrgoma o r el e os.c r1e0n-2 0 2 t: 6p:0r5eGs c-0e5: Europe. Specifically,

Ford saw Volvo as a means of improving its product weakness in luxury sedans and

station wagons, gaining access to new distribution channels and markets, reducing

development and vehicle production costs, and gaining greater penetration into the

premium car market. To estimate the potential increase in luxury market penetration, it is necessary to know the potential size of each of Ford’s and Volvo’s targeted markets in

both dollars and units. In addition, it is necessary to know their current penetration in

those markets and an estimate of the probable lift to market share that might be achieved by introducing Ford products into predominately Volvo markets and vice versa. To

estimate cost savings, it is necessary to know Volvo’s approximate cost per vehicle and the likely savings per vehicle that might be achieved. These savings could come from

economies of scale in centralizing production and making uniform automotive platforms, as well as by introducing “best practices” across the companies.

3. How was the initial offer price determined according to this case study? Do you find the

logic underlying the initial offer price compelling? Explain your answer.

Answer: The initial offer price for Volvo was determined by adding about one-fourth of the projected net synergy generated from acquiring Volvo to its standalone value of $15 billion. The reasonableness of the resulting price of $15.25 billion was confirmed by using other valuation methods. When compared to the firm’s market value of $11.9

billion, this offer price represented an approximate 28% premium. This premium was consistent with what Ford had paid for Jaguar one year earlier.

4. What was the composition of the purchase price? Why was this composition selected

according to this case study?

Answer: The proposed purchase price was an all-cash offer. At the time, Ford’s cash balances were substantially in excess of its required working capital needs. By re-

deploying some portion of these excess cash balances into an investment offering a higher return than the prevailing rate on short-term securities, Ford was potentially enhancing shareholder value and making itself less attractive as a takeover target.

FINA 5512 VALUATION

Lecture 3

Applying Financial Modeling Techniques to Value and Structure Mergers and Acquisitions

Practice Problems and solutions:

1. An acquirer agrees to purchase a target firm in an exchange of shares. The acquiring

firm’s share price is $12 and the offer price for the target firm is $10. What is the implied share exchange ratio? What does the share exchange ratio mean?

Answer: $10/$12 = .83 Consequently, .83 acquirer shares must be issued for each target share purchased.

2. The acquirer’s current share price is $12 and its number of shares outstanding is

1,000,000. The offer price for the target firm is $15 in a share for share exchange. The target firm has 100,000 shares outstanding. The combined earnings of the two firms including synergy is $500,000. What is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + (100,000 x ($15 / $12)) = $.44

3. For question 22, assume that the purchase price consists of .5 acquirer shares and the balance in cash. Ignoring the cost associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000 / (1,000,000 + 100,000 x. 5) = $.48

4. For question 23, what is the postmerger ownership distribution?

Answer: Target company = (100,000 x .5) / (1,000,000 + 50,000) = 4.8% Acquiring company = 100 – .048 = .952

5. For question 22, assume the purchase price is an all cash offer. Ignoring the cost

associated with financing the cash portion of the purchase price, what is the postmerger EPS of the combined firms?

Answer: $500,000/1,000,000 = $.50

Case Study

Ford Acquires Volvo’s Passenger Car Operations

Background

By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing

mandates from regulators for new, cleaner engines and more safety measures added to

manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and

maintain market share in this highly competitive environment.

By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution

channels, entering new markets, reducing development and vehicle production costs, and

capturing premiums from niche markets. Volvo Cars is now part of Ford’s Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group,

operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures

required to develop new cars as overwhelming for a company its size.

Historical and Projected Data

The initial review of Volvo’s historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo’s cash flow is steadily trending

downward from its high in 1997. Table 1 displays a common-sized, normalized income

statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has

managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase

substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004

is the sharp increase in capital outlays during the forecast period. Ford’s acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform

sharing, access to wider distribution networks, and increased penetration in selected market

niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration.

Table 1. Volvo Common-Size Normalized Income Statement, Balance Sheet, and Cash-Flow Statement (Percentage of Net Sales) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Income Statement
Net Sales 1.000 Cost of Goods Sold .772 Operation Expense .167 Depreciation EBIT Interest on Debt Earnings Before Taxes Income Taxes Net Income .028		1.000 .738 .101 .034 .027 .050 .024 .004 .087	1.000 .749 .120 .033 .128 .023 .017 .018 .054	1.000 .777 .077 .033 .098 .022 .076 .022 .079	1.000 .757 .119 .034 .112 .021 .091 .012 .057	1.000 .757 .133 .029 .088 .015 .072 .015 .035	1.000 .757 .132 .038 .073 .023 .049 .014 .036	1.000 .757 .131 .038 .073 .023 .051 .014 .037	1.000 .757 .129 .039 .074 .022 .052 .015 .038	1.000 .757 .128 .040 .074 .021 .053 .015 .039	1.000 .757 .127 .040 .074 .021 .054 .015 .040	1.000 .757 .126 .041 .075 .020 .055 .015 .040	.042 .075 .020 .056 .016
Balance Sheet
Current Assets Current Liabilities Working Capital Total Assets Long-Term Debt Equity	.596 .036 1.21	.632 .400 .103 .889 .371 .244	.503 .283 .161 .809 .211 .278	.444 .298 .226 .905 .227 .299	.524 .304 .192 .889 .236 .371	.497 .350 .150 .906 .256 .329	.500 .350 .150 .880 .234 .321	.500 .350 .150 .858 .215 .316	.500 .350 .150 .839 .196 .312	.500 .350 .150 .822 .180 .309	.500 .350 .150 .808 .165 .308	.500 .350 .150 .795 .151 .307	.500 .307 .307
Selected Valuation Cash-Flow Items
EBIT (1 – t) Capital Expenditures .031 ∆ Working Capital .025 Free Cash Flow .047		.022 .027 .077 .079	.150 .033 .068 .053	.126 .053 .049 .059	.126 .054 .000 .088	.105 .061 .017 .087	.093 .069 .020 .044	.094 .078 .020 .036	.094 .088 .020 .027	.095 .099 .020 .017	.095 .096 .096 .112 .126 .020 .020 .005 (.008) to the Firm (FCFF)

Determining the Initial Offer Price

Volvo’s estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other

current bidders for the entire company and Volvo’s urgent need to fund future capital

expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999.Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per

share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo’s total common shares outstanding of 442 million.

Determining the Appropriate Financing Structure

Ford had $23 billion in cash and marketable securities on hand at the end of 1998. This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost

associated with this excess cash is equal to Ford’s cost of capital, which is estimated to be 11.5% —about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to

shareholder value, because the expected return including the effects of synergy exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a

potential acquisition target. The acquisition is expected to increase Ford’s EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo’s pretax earnings.

Case Study Questions and Answer:

1. What is the purpose of the common-size financial statements developed for Volvo (see Table 1)? What insights does this table provide about the historical trend in Volvo’s historical performance? Based on past performance, how realistic do you think the

projections are for 2000-2004?

Answer: The common size financial statements for Volvo reveal the historical

relationship between key operating variables and sales. They revealed the deterioration in the firm’s long-term operating efficiency and the subsequent decline in operating

margins and cash flow. The deterioration in cash flow underscored the inability of the

firm to fund future cash flows at a level necessary to remain competitive. The projections

appear somewhat optimistic in that they assume some acceleration in revenue,

improvement in operating expenses, and a significant improvement in asset turnover

rates. The escalating capital outlays necessary to introduce new cars causes cash flow to turn negative by 2004.

2. Ford anticipates substantial synergies from acquiring Volvo. What are these potential synergies? As a consultant hired to value Volvo, what additional information would you need to estimate the value of potential synergy from each of these areas?

Answer: By acquiring Volvo, Ford hoped to expand its global market share with a

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Ford saw Volvo as a means of improving its product weakness in luxury sedans and

station wagons, gaining access to new distribution channels and markets, reducing

development and vehicle production costs, and gaining greater penetration into the

premium car market. To estimate the potential increase in luxury market penetration, it is necessary to know the potential size of each of Ford’s and Volvo’s targeted markets in

both dollars and units. In addition, it is necessary to know their current penetration in

those markets and an estimate of the probable lift to market share that might be achieved by introducing Ford products into predominately Volvo markets and vice versa. To

estimate cost savings, it is necessary to know Volvo’s approximate cost per vehicle and the likely savings per vehicle that might be achieved. These savings could come from

economies of scale in centralizing production and making uniform automotive platforms, as well as by introducing “best practices” across the companies.

3. How was the initial offer price determined according to this case study? Do you find the

logic underlying the initial offer price compelling? Explain your answer.

Answer: The initial offer price for Volvo was determined by adding about one-fourth of the projected net synergy generated from acquiring Volvo to its standalone value of $15 billion. The reasonableness of the resulting price of $15.25 billion was confirmed by using other valuation methods. When compared to the firm’s market value of $11.9

billion, this offer price represented an approximate 28% premium. This premium was consistent with what Ford had paid for Jaguar one year earlier.

4. What was the composition of the purchase price? Why was this composition selected

according to this case study?

Answer: The proposed purchase price was an all-cash offer. At the time, Ford’s cash balances were substantially in excess of its required working capital needs. By re-

deploying some portion of these excess cash balances into an investment offering a higher return than the prevailing rate on short-term securities, Ford was potentially enhancing shareholder value and making itself less attractive as a takeover target.