Modeling and Valuation

A pro forma financial statement is an estimated financial statement with restructuring effects. The pro forma financial statement includes the EPS, revenue, and free cash flow measures. The situational specifics and the type of restructuring will determine the process of creating the pro forma financial statement.

Financial Modeling Steps for Acquisitions

1. The acquirer’s and target’s financials are combined.
2. The financing effect of the transaction is included.
3. The lack of synergies or the effect of synergies and incompatibilities in forecasted costs and revenue is projected.
4. The divesture effect, either voluntary or involuntary, required by regulators for the approval of the acquisition is incorporated.
5. Adjustments for goodwill recognition and the book value increase of the target’s assets and liabilities to fair value are made.

Pro forma Weighted Average Cost of Capital

The weighted average cost of capital is used to estimate the required rate of return used to discount the pro forma free cash flow. The market value weighted average cost of capital of an issuer’s debt-equity and other capital is an issuer’s cost of capital.

Restructuring changes the weights of each type of capital, the cost of each capital type, and the capital structure. An example is an acquirer buying a target entirely with cash financed largely by debt. This will cause the capital structure to shift from equity to debt as debt increases, given that the price change is not material. It is more challenging to estimate the restructuring effect on the cost of equity and debt than to estimate changes in capital structure weights.

Restructuring changes the cost of capital by changing the factors that affect the cost of capital. Thus, it is common for an investment-grade issuer to structure transactions to reduce their weighted average cost of capital and maintain their investment-grade rating. Moving to a speculative grade credit rating will increase WACC.

Question

Which decisions will an investment grade issuer most likely make to avoid moving to a speculative grade rating following an acquisition?

1. Use a large proportion of stock.
2. Borrow from banks instead of issuing bonds.
3. Use a large proportion of cash.

Solution

The correct answer is A.

Using more equity in an acquisition will mean that less debt and cash will be used to finance the acquisition.

B is incorrect. Bond debt and bank debt have no material difference from credit.

C is incorrect. Using cash has the same effect on net debt as borrowing.

Reading 21: Corporate Restructuring

LOS 21 (d) Demonstrate how corporate restructurings affect an issuer’s EPS, net debt, EBITDA ratio, and weighted average cost of capital.