Company valuation and Merger Valuation

This report is a result of my own work which was an integral part of my full time MBA
program. Prior permission must be taken from the author before copying or
reproducing this work.

Author: Deepak Shrivastava (imdshrivastava@gmail.com) Page 1

Company Valuations and Merger
Assessment Report
Fossil Inc Joins Abercrombie & Fitch Co.


Contents
Introduction ............................................................................................................................................ 5
Risk Analysis ............................................................................................................................................ 7
Fossil Inc .............................................................................................................................................. 7
Abercrombie and Fitch Inc (ANF) ...................................................................................................... 10
Cost of Capital ....................................................................................................................................... 11
Fossil Inc ............................................................................................................................................ 11
Merged Entity ................................................................................................................................... 11
Stand alone valuation ........................................................................................................................... 13
Valuation of Fossil ............................................................................................................................. 13
Valuation of Abercrombie & Fitch Co ............................................................................................... 16
Valuation of Merged firm ................................................................................................................. 18
Value of merged firm including tax and costs .............................................................................. 19
Financing Options ................................................................................................................................. 20
Cash Financing .................................................................................................................................. 20
Share for Share offer ......................................................................................................................... 22
Conclusion ............................................................................................................................................. 23
References ............................................................................................................................................ 24
Appendix ............................................................................................................................................... 26


Figure 1: List of Beneficial Owner ............................................................ Error! Bookmark not defined.
Figure 2: List of Beneficial Owner ............................................................ Error! Bookmark not defined.
Figure 3: CEO Compensation breaks up................................................... Error! Bookmark not defined.
Figure 4: Beta values compared with market benchmark ...................................................................... 7
Figure 5: Calculated entities ................................................................................................................. 12
Figure 6: Free Cash Flow of Fossil Inc ................................................................................................... 13
Figure 7: Growth Rate calculation of Fossil Inc ..................................................................................... 14
Figure 8: Company Value calculation.................................................................................................... 14
Figure 9: Free Cash flow calculation of ANF ......................................................................................... 16
Figure 10: Growth Rate calculation for ANF ......................................................................................... 17
Figure 11: Firm Value calcualtions ........................................................................................................ 17
Figure 12: Free cash flow calculation of the merged firm .................................................................... 18
Figure 13: Firm value of merged entity................................................................................................. 18
Figure 14: Few Entities recalculated after debt structure change........................................................ 21
Figure 15: Income statement of FOSL. .................................................................................................. 26
Figure 16: Balance Sheet of FOSL.......................................................................................................... 26
Figure 17: Income statement of ANF .................................................................................................... 27
Figure 18: Balance sheet of ANF ........................................................................................................... 27


Introduction
The following report will determine the value of a possible merger between two US corporations i.e.
Fossil Inc (FOSL) and Abercrombie & Fitch Co. (ANF). The report will describe the associated risk of
both the companies and will evaluate individual companies using free cash flow method taking
various risks and cost involved. The report will also evaluate the value of the merged company and
later it will describe the possible financing options and their corresponding benefits and issues.

Fossil Inc

Fossil Inc is a well known brand in consumer fashion accessories industry and has multiple offerings
for Men and women. The company principle offerings involve fashion watches and jewellery,
handbags, small leather goods, belts, sunglasses, shoes, soft accessories and clothing. Company also
have diverse portfolio of branded and licenses products. Company uses various channels for
distribution including owned store, online retailing, and licensed store in 120 countries.

Company has a market capitalization of $ 8.46 billion and has shown 26% growth y-o-y basis.
Company also has shown an average growth of 30% growth in it net income. More details about can
be seen in Appendix.

Abercrombie & Fitch Co.

Abercrombie & Fitch Co. ("A&F"), is a known apparel retailer incorporated in Delaware in 1996. The
Company sells: casual sportswear apparel, including knit and woven shirts, graphic t-shirts, fleece,
jeans and woven pants, shorts, sweaters, and outerwear; personal care products; and accessories for
men, women and kids under the Abercrombie & Fitch, Abercrombie kids, and Hollister brands. The
Company also operates stores and direct-to-consumer operations offering bras, underwear,
personal care products, sleepwear and at-home products for women under the Gilly Hicks brand. As
of January 28, 2012, the Company operated 946 stores in the United States (“U.S.”) and 99 stores
outside of the U.S.

ANF has market cap of $4.5 billion and has shown a growth of 20% in sales y-o-y basis. The company
five average growth rates have been negative due its poor performance during recession. More
detail on company can be found in appendix.

Mergers and acquisition can impact the corporate governance followed by companies and can
influence the decision. Hence it should also be taken into account while evaluating the merger and
acquisition. The companies with strong corporate governance faces less challenges related to


mergers or acquisition. This report will also describe the corporate governance followed by
companies and possible issues that can arise due to merger.


Risk Analysis
Fossil Inc
Any company holds 2 kinds of risk 1) financial risk and business risk. To calculate risk we should have
Betas

1) Levered Beta (βe): This is a measure of combine risk company has due to its operation (unique
risk) and financial obligations. This risk is generally reflected in the stock price of the company’s. This
is also referred as levered beta or equity beta. Fossil Inc has 1.376 as equity beta based on the 2
years market and Fossil return values.

Calculated Beta 1.38
Yahoo Beta 1.56
Figure 1: Beta values compared with market benchmark
Source: Complied by author using http://finance.yahoo.com/q/hp?s=FOSL+Historical+Prices [accessed 19th April 2012]
The beta is calculated using Company’s shares daily return which is calculated using following
equation:-

= I/V0 +(V1-V0)/V0 (Equation 1)

Where
I=Income received by investors in terms of dividend payout. = 0 (As Fossil Inc has not paid
any dividend to the investors in past 5 years)
V0= Value of stock at the start of the period
V1= Value of stock at the end of the period

Taking daily adjusted1 share close price of company from stock exchange, however this price should
also be adjusted with respect to the inflation rate. I have taken inflation into account while
calculating the market return.

Market daily return: Similarly market return is calculated using equation1.

Beta is defined as below

Equity Beta βe= Cov(Rc,Rs)/Var(Rs) (Equation 2)

Using this equation2 βe for Fossil is 1.376

Return on equity: This is calculated using Capital Asset Pricing Model (CAPM).

1
Adjusted with any stock splits or dividends


Re = Rm + β(Rm-Rf) (Equation3)

Rm = Market return.

Market return for the period of calculation is 12.67% which is nominal rate. Using fisher equation to
get real market return.

1+rNominal = (1+rReal) x (1+i) (Equation4)

i= average inflation rate for the period is 2.25%

Substituting the value we have Rm =10.19%

Rf = risk free rate. Assuming 52 weeks traded US Treasury bill rate which is 0.17%

βe= Beta =1.376

Re using Levered = 13.96%

2) Unlevered Beta (βa): - Business risk or unique risk or sometime called as diversifiable risk. This risk
is unique to the business by virtue of its operations. This is measured using Beta of assets or
unlevered Beta (βa). Debt is the main factor which introduces financial risk and if we remove the
debt from company than company is only exposed to its own business risk.

The equation for calculating unlevered beta =

βa = [βe + βd X (1-Tc)Dm/E] / [1+(1-Tc)Dm/E] (Equation5)

Where

βd = Beta of Debt (using CAPM equation2) = 0.29

Tc= Corporate tax rate = 35% (US registered company hence tax rate of US)

Dm = Market Value of debt (see below calculation)

2
CAPM = Rd = Rf +β(Rm-Rf)


Currently Fossil has a total debt of $15.24 million which is a mix of debts i.e. short term borrowing of
$9.009 million and long term borrowing $6.236 million. Below table show the details about the
debts.
Fossils Inc Weighted Cost of debt calculation
FOSL - Debts Amount ($m) Rate Weighted interest rate Maturity
Short Term 1 2.8 1.475 0.271068522 0.25
Short Term 2 6.2 4.75 1.932922027 0.25
Long Term 6.236 2 0.818587556 3
Total Debt 15.236 Rd= FOSL 3.022578104 1.35

Using the following formula for market value debt:
IE X 1-[1/(1+r)^t]/r + Db/(1+r)^t (Equation63)
Where IE = Interest expense
r= interest rate, t= maturity time in year, Db = book value of debt
Market Value of debt is = $17.76 million
Box 1: Market Value of debt calculation

E =market value of the equity = number of outstanding shares X share price.

Number of outstanding shares of Fossil Inc = 68370020

Share price as of 19th April = $129.92 per share

E = $8.88 billion

Inserting the values in equation5 we get βa=1.374

Corresponding Re (unlevered) = 13.94%

We currently see unlevered beta of Fossil is similar to the levered beta, which is common for a
company with less net debt. Hence we can deduce that company has more of business risk than
financial.

3
DePamphilis 2010, pp263


Abercrombie and Fitch Inc (ANF)
Using above equations we calculate:

1. Levered Beta (βe): 1.365; Yahoo finance value = 1.97

Return on equity: Levered Beta = 13.85%,

2. Unlevered beta (βa):

βd = Beta of Debt (Using CAPM Equation) = 0.22

Tc= Coporate tax rate = 35% (US registered company hence tax rate of US)

Dm = see below calculation

Currently Fossil has a total debt of $57.85 million which is a long term borrowing. With a average
interest rate as 2.4% with a maturity of 5 years.
Using the formula for market value debt: i.e. equation 6.
Where IE = 3.577 million, r= 2.4 , t= 5, Vbd = $57.85 million
Market Value of debt is Vmd = $68.048 million

Box 2: Market value of Debt calculation

E= number of outstanding shares X share price. => 84723859 x $48.4 (as of 19th April 2012) = $4.09
billion

Inserting the values in equation5 we get βa=1.353

Return on equity (unlevered) =13.85%

Similar to FOSL, ANF unlevered beta is approximately same as levered beta. However this as this firm
has high net debt hence the difference between equity beta and unlevered beta is higher than Fossil.
Risk profile of this company shows more financial risk than Fossil Inc.


Cost of Capital
Formula for cost of capital or weighted average cost of capital (WACC) is:

WACC = (E/V) X Re + (Dm/T) X Rd (1-Tc)+(P/V)Rp (Equation7)

Where

P = value of preferred stocks

V = D+E+P

Re = return on equity, Rd = return on debt, Rp = return on preferred stocks.

Tc = Corporate tax = 35%

Fossil Inc
Return on Debt:

Fossil Inc only has bank debts which are not publicly traded and the weighted average cost of debt is
3.02% (see the calculation in Box 1).

Company has not issued any preferred stock to the investor hence the P and Rp will be 0 in this case.

E=$8.88 billion, Dm = $17.74 million,

WACC (Levered) = 13.93% and

WACC (unlevered) = 13.92%

Abercrombie & Fitch

The values for ANF are:-

Rd= 2.4% (Only long term debt no Bonds or traded debt), Rp = 0 (No preferred stocks were offered)

E= $4.08 billion, Dm = $57.85 million, P = 0 (No preferred stocks were offered).

WACC (levered) = 13.65% and WACC unlevered = 13.5%

Merged Entity
For cost of capital of merged entity let us.

Step 1: Calculate Unlevered Beta or Asset beta of merged company using following equation


βa(FOSL + ANF) =

E(FOSL)/(E(FOSL)+E(ANF)) x βd(FOSL) + E(ANF)/ (E(FOSL)+E(ANF)) x βd(ANF)

Substituting the values we get

βa(FOSL + ANF) = 1.36, this value shows combine business risk of both the firms.

Step 2: Calculate R(FOSL +ANF) using CAPM equation3.

R(FOSL +ANF) = 13.87% (Unlevered)

Step 3: Calculate Return on Debt (FOSL+ANF)

Weighted average Cost of Debt =2.52%

Step 4: Equity Beta:

As the capital structure has changed so the risk associated with firm. Hence we will calculate the
Beta for equity.

We already have the Asset beta of merged firm = 1.36

Using Return of debt value in CAPM equation we have Beta of debt of merged firm = 0.235

Re-levering the beta using following equation.

βe = βa + (Dm/E) x (βa- βd) x (1-Tc)

We get equity beta of merged firm = 1.37 (Levered Beta)

Step 5: Cost of Capital (WACC) using equation7

WACC (Unlevered) = 13.80%, WACC (Levered) = 13.85%

Summary of the values calculated are shown in below figure.

Entities FOSL ANF Merged Firm
Cost of Capital (U) 13.921 13.530 13.800
Cost of Capital (L) 13.935 13.651 13.850
Return on Equity (U) 13.945 13.730 13.880
Return on Equity (L) 13.959 13.852 13.930
Return on Debt 3.023 2.400 2.530
Equity Beta 1.376 1.365 1.373
Asset Beta 1.375 1.353 1.368
Debt Beta 0.285 0.223 0.235

Figure 2: Calculated entities


Stand alone valuation
In order to get the merged value of the company, we have to first value individual firms using free
cash flow method.

Valuation of Fossil
Fossil Inc is a growing company with a annual growth rate of 16% (Based on 5 years of trend) in sales
and 29% growth in Net Income (Based on 5 year trend). The forecasted free cash flow of fossil is
shown below. The complete calculation can be found in excel provided with report.

Historical Forecasted
Fossil, Inc. (FOSL) Amounts in USD Thousands 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue 1432984 1583242 1548093 2030690 2567302
Net income 123261 138097 144294 264890 307402 356586 413640 479823 556594 645649 748953
Depreciation 32796 37642 41334 40560 51925 58714.49 65463.23 72987.69 81377.02 90730.64 101159.4
Receviable 227481 205973 209784 263218 302467 327252.3 354068.7 383082.4 414473.7 448437.3 485184
Inventory 248448 291955 245714 371935 488983 592295.6 717436.1 869016.3 1052623 1275021 1544408
Payables 111015 91027 103591 122266 157883 174838.1 193614 214406.3 237431.4 262929.2 291165.2
Other Liabilities 32833 30306 29618 50779 56122 66224.21 78144.86 92211.29 108809.7 128396 151507.8
Net Fixed Assets 186042 207328 212367 217424 282050 314469.3 350615 390915.3 435847.7 485944.8 541800.2
Interest Expense 890 555 235 1119 2391 2630.1 2893.11 3182.421 3500.663 3850.729 4235.802
Change In Receviable NA -21508 3811 53434 39249 24785.33 26816.33 29013.77 31391.27 33963.59 36746.7
Change in Inventory NA 43507 -46241 126221 117048 103312.6 125140.5 151580.2 183606.2 222398.6 269387.1
Change in payables NA -19988 12564 18675 35617 16955.09 18775.91 20792.26 23025.14 25497.82 28236.03
Change in other liabilities NA -2527 -688 21161 5343 10102.21 11920.65 14066.42 16598.44 19586.24 23111.85
Change in NFA NA 21286 5039 5057 64626 32419.32 36145.65 40300.29 44932.48 50097.1 55855.34
Effective Coporate tax (percentage) 34.7 27.1 34.4 31.1 31.9 32 32 32 32 32 32
After tax interest expense NA 404.595 154.16 770.991 1628.271 1788.468 1967.315 2164.046 2380.451 2618.496 2880.346
FCF 115397.595 236425.16 119023 170306.3 263424.9 299823.4 340805.8 386848.4 438450.6 496127.9
Figure 3: Free Cash Flow of Fossil Inc
Source: Complied by author using Fossil Inc Annual Report 2011, 2010, 2009, 2008, 2007. Delaware/USA

Following assumption has been made while calculating cash flow:

1) In majority of cases except (net income and interest expense) the forecasted value is based
on the last 4 years growth rate.
2) Net Income growth figure was 29% based on 5 years trend. I have taken a conservative
figure of 16% to calculate the future net income.
3) Interest expanse growth rate was 98% as company has increased its debt in past 2 years. For
future I have taken a moderate of 10% growth in interest expense. Also the majority of debt
(approx 11 million out of 15 million) will be paid in 2012 and rest in next 5 years.
4) The future depreciation will increase in proportion (based on the average ratio of past
depreciation over net asset of 4 years) to the net asset.
5) The terminal value of the firm is calculating growing perpetuity formula. Here growth rate of
the firm is assumed to be 11% y-o-y basis. However the growth rate of sales is 16% based on
historical data.


6) The tax rate for FOSL for future is taken as 32% average rate of past 5 years.

The growth rate calculation is shown below.

Growth Figures 2008 2009 2010 2011
Depreciation/Net Fixed Assets 0.181558 0.194635 0.186548 0.184099
Average Depreciation/ NFA 0.18671
Growth Rate of Revenue 0.104857 -0.0222 0.311736 0.264251
Average Growth Rate 0.164661
Growth Rate of Income 0.120362 0.044874 0.835766 0.160489
Average Growth Rate 0.290373 Assuming 0.16
Growth Rate of Receviable -0.09455 0.018502 0.25471 0.149112
Growth Rate of Inventory 0.175115 -0.15838 0.513691 0.3147
Growth Rate of Payables -0.18005 0.138025 0.180276 0.291307
Growth Rate of Other Liabilities -0.07697 -0.0227 0.714464 0.105221
Growth Rate of Net Assets 0.114415 0.024304 0.023813 0.297235
Growth Rate of Interest Expense -0.3764 -0.57658 3.761702 1.136729
Figure 4: Growth Rate calculation of Fossil Inc

The weighted average cost of capital (unlevered) is used to determine the discount factor. Below
figure shows the calculated value.

WACC (Unlevered) 13.92
Discount Factor 0.88
PV Value with 2011-16 1321278.95
Value after 2016 (Using Growing Perpetuity) 16986948.54
PV value of firm after 2016 7771428.21
Enterprise vale 9092707.17 9092707167
Equity Value of the firm 9077462.17 9.07 billion
Figure 5: Company Value calculation

Fossil Inc values $9.092 billion and the equity value of the firm is (Enterprise value – net debt) i.e.
$9.077 billion. Currently market value the company is $7.88 billion (yahoo finance) as enterprise
value and this shows that company is little undervalued4.

Ratio of value of firm over outstanding share will give us expected share price.

4
Keep is mind we have calculated the enterprise value with a conservative growth rate.


No outstanding shares = 68370020; Equity Value = $9.07 billion hence share price is $132.77, this is
approximately similar to the share price as of 19th April 2012 i.e. $129.9.


Valuation of Abercrombie & Fitch Co
With similar approach the FCF of ANF is shown below

Historical Forecast
Abercrombie and Fitch, Inc. (ANF) Amounts in USD Thousands 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue 3699656.00 3484058.00 2928626.00 3468777.00 4158058.00 4330048.08 4509152.20 4695664.62 4889891.77 5092152.75 5302779.87
Net income 475697.00 272255.00 254.00 150283.00 127658.00 153189.60 183827.52 220593.02 264711.63 317653.95 381184.75
Depreciation 183716.00 225334.00 238752.00 229153.00 232956.00 225536.74 227792.11 230070.03 232370.73 234694.43 237041.38
Receviable 53801.00 53110.00 90865.00 74777.00 89350.00 100072.00 112080.64 125530.32 140593.95 157465.23 176361.06
Inventory 333153.00 372422.00 310645.00 385857.00 569818.00 665386.00 776982.36 907295.29 1059463.87 1237153.67 1444645.02
Payables 108437.00 92814.00 110212.00 137235.00 211368.00 236732.16 265140.02 296956.82 332591.64 372502.64 417202.95
Other Liabilities 434676.00 356983.00 339160.00 415129.00 493985.00 516866.70 540808.30 565858.89 592069.83 619494.89 648190.29
Net Fixed Assets 1318291.00 1398655.00 1244019.00 1154759.00 1197271.00 1209243.71 1221336.15 1233549.51 1245885.00 1258343.85 1270927.29
Interest Expense -18827.00 -11328.00 -1598.00 3362.00 3577.00 3805.75 4049.13 4308.07 4583.57 4876.69 5188.55
Change In Receviable -691.00 37755.00 -16088.00 14573.00 10722.00 12008.64 13449.68 15063.64 16871.27 18895.83
Change in Inventory 39269.00 -61777.00 75212.00 183961.00 95568.00 111596.35 130312.93 152168.59 177689.80 207491.35
Change in payables -15623.00 17398.00 27023.00 74133.00 25364.16 28407.86 31816.80 35634.82 39911.00 44700.32
Change in other liabilities -77693.00 -17823.00 75969.00 78856.00 22881.70 23941.60 25050.59 26210.95 27425.05 28695.40
Change in NFA 80364.00 -154636.00 -89260.00 42512.00 11972.71 12092.44 12213.36 12335.50 12458.85 12583.44
Effective Coporate tax (percentage) 37.40 39.50 33.90 34.30 32.00 35.00 35.00 35.00 35.00 35.00 35.00
After tax interest expense -6853.44 -1056.28 2208.83 2432.36 2473.74 2631.93 2800.24 2979.32 3169.85 3372.56
FCF 433863.56 451828.72 362834.83 117277.36 265419.82 283020.39 304253.54 329917.83 360984.25 398632.98
Figure 6: Free Cash flow calculation of ANF

Following assumption were made while calculating the FCF for ANF

1) Average Net income growth rate of last 4 years was very high i.e. 147% due very high
fluctuation in the sales in during recession (2008-2009). Hence I have taken a rate of 20%.
2) Interest expense growth rate of company is assumed as per last year (i.e. 2011) as company
has long term loan for next 5 years.
3) Depreciation is again adjusted in similar fashion as of Fossil.
4) I have assumed a moderate of growth for account receivables, payables, and net assets. (see
assume rates below).
5) Terminal value of the company is calculate using growing perpetuity with a growth rate of
5% as average sales growth of company is 4.1% y-o-y basis.
6) Tax rate is assumed to be 35%.


Growth Figures 2008 2009 2010 2011
Depreciation/Net Fixed Assets 0.161 0.192 0.198 0.195
Average Depreciation/ NFA 0.187
Growth Rate of Revenue -0.058 -0.159 0.184 0.199
Growth Rate of Income -0.428 -0.999 590.665 -0.151
Growth Rate of Receviable -0.013 0.711 -0.177 0.195
Growth Rate of Inventory 0.118 -0.166 0.242 0.477
Average Growth Rate 0.168 0.168
Growth Rate of Payables -0.144 0.187 0.245 0.540
Growth Rate of Other Liabilities -0.179 -0.050 0.224 0.190
Growth Rate of Net Assets 0.061 -0.111 -0.072 0.037
Average Growth Rate -0.021 Assuming 0.010
Growth Rate of Interest Expense -0.398 -0.859 -3.104 0.064
Average Growth Rate -1.074 Assuming 0.064
Figure 7: Growth Rate calculation for ANF

The WACC unlevered is used to calculate the discount factor. Below are the calculations.

WACC (Unlevered) 13.53
Discount Factor 0.88
PV Value with 2011-16 1168550.07
Value after 2016 (Using Growing Perpetuity) 4673088.60
PV value of firm after 2016 2182383.60
Enterprise vale 3350933.67
Equity Value of the firm 3293082.67 3.29 billion
Figure 8: Firm Value calcualtions

The market benchmark for this firm is $3.78 billion (yahoo finance). The firm currently looks
overvalued which is also shown in the share price with it current outstanding shares the estimated
share price should be $38.87 per share, where as it was traded on 19th April 2012 at $48.24.


Valuation of Merged firm
For merged firm we will simply add the cash flow of both the firm and will calculate the total value.

Current Forecast
Amount in $ thousands 2011 2012 2013 2014 2015 2016 2017
FCF FOSL 170306.3 263424.9 299823.4 340805.8 386848.4 438450.6 496127.9
FCF ANF 117277.4 265419.8 283020.4 304253.5 329917.8 360984.3 398633
Total Cash 287583.6 528844.8 582843.8 645059.4 716766.2 799434.9 894760.9
Figure 9: Free cash flow calculation of the merged firm

Terminal value is calculated assuming a moderate growth rate of 9%. This rate is assumed
considering Fossil contribution in the merged firm hence growth is more adjusted toward Fossil
growth rate of 11% rather than 5% of Abercrombie and Fitch.

Using the WACC (Unlevered) = 13.80% calculated earlier we can see the total value of the firm.

Dis Fac 0.878762114
NPV 2486491.29
Value after 2016 growing Perpetuity 18654687.43
PV after 2016 8590450.23
Enterprise value 11076941.52 11.08 billion
Equity Value 10991132.89 10.99 billion
Figure 10: Firm value of merged entity

The merged firm will have total of $85.08 million of total debt (combined market value of both firm)
and similarly merged firm will have total equity of $12.97 billion. The D/E ratio of this firm will be
0.0066 which more the individual firms D/E ratio.


Value of merged firm including tax and costs
Every firm enjoys some benefit due to its debt i.e. tax benefits and it also bear a cost i.e. bankruptcy
cost. Let us see how much benefit or cost this firm will have after this merger. This is calculation is
also important for the deciding the future capital structure.

Hence overall firm value can be seen as:

Firm Value = Value of Firm (unlevered) + Tax benefit (due to debt) – bankruptcy cost (due to debt
financing)

Tax Shield (Benefit):

Currently the merged firm has total of $73.10 million of debt (book value) and has tax rate 35%. The
combined interest expense of firm is $5.968 million ($2.391 million from FOSL and $3.577million
ANF)

Hence the tax shield is => 5.968 *0.35 = $2.09 million,

Bankruptcy Cost:

Debt also brings a risk of default or also known as Bankruptcy cost. This bankruptcy cost has 2
components:

1) Default cost: This is a combination of direct and indirect cost. I will assume this to be constant
with respect to the debt level (as this will remain same even if the debt will increase). Let us assume
it to be 6.5 %( average costs)5

2) Probability of default: This is directly related to the debt level the company has. There is no
information on the companies (FOSL & ANF) default probability as their debts are not publicly
traded. However at this stage I will take default probability rate of a competitor in this industry i.e
The Ralph Lauren Corporation (RL), as the probability rate i.e. 0.144% (A3 rate by Moody’s).

Expected Bankruptcy cost will be = 0.065 x 11.07 x 0.00144 = $1.04 million

Overall Value of firm = $11076 (m) + $2.09 (m) - $1.04 (m) = $11078 million

5
Direct Cost: Legal and Administrative only 1% of market value 7 year prior (Warner 1977); Indirect costs: 12%
of market value 3 years prior (Altman1984)


Financing Options
Looking at the share price and individual valuation of the companies and future growth of each
company I propose that Fossil Inc should buy Abercrombie & Fitch Co. A merger is more suitable for
the companies having same level of enterprise value. Currently in the merged entity Fossil has more
stake than Abercrombie & Fitch Co.

From business point of view both companies operates in same sector but Fossil operates in fashion
accessories and watches where as Abercrombie operates in apparel. Fossil recently trying to move
into the clothing business and buying Abercrombie will give it lot of advantage like established brand
value, supply chain network, experience management etc. This could be very promising business
diversification opportunity for Fossil.

Now let us consider possible financing options which Fossil have to finance this deal.

a) Cash financing:
a. Raising cash by debt (Bank Loan)
b. Raising cash by issuing shares in secondary market
b) Share for share offer.

Cash Financing
Cash availability:

Currently Fossil has $253 million of cash and its equivalent also it has unused credit facilities of total
of $600million approximately from various bank source. This cash might be required by Fossil for its
day to day hence cannot be used for financing.

Raising cash by Debt: Debt financing brings couple of simultaneous effects.

1) It changes the financial risk profile of company i.e. D/E, which will have an effect on β of
equity. This is will increase the Return on equity i.e. the investors will get the benefit.
2) Debt financing will raise the Tax shield offered to the company and will add the value of the
firm. This will have a circular effect on Bankruptcy cost (as it will increase the default cost).
3) Rise in debt level will also increase the probability of default factor, which will increase the
bankruptcy cost of the firm, this together with the increase in the default cost will pose a
negative effect on the firm’s value.

The below example explains the above stated points.


For example if Fossil raise $3.0 billion as debt (considering interest rate of debt remains the same)
and finance the deal6 then βe of combined firm will change from 1.37 to 1.757 and the
corresponding return on equity will increase from 13.92% to 17.92%. Below figure shows the change
in the values.

Beta Unlevered 1.367765333
Old D/E 0.006616078
New D/E 0.225436001
Equity Beta Old 1.372634949
Equity Beta New 1.67610888
Return Equity Old 13.92564297
Return Equity New 17.13222187
Figure 11: Few Entities recalculated after debt structure change

This will also increase the tax shield8 of the company from $2.08 to $83.5 million. And will also give
rise to bankruptcy cost from $1 million to $7.2 million9.

In this case we have seen that firm value has also increased from $11.07 billion to $11.15 billion.

With debt financing we have see 2 benefits 1) Increase in shareholder return 2) Increase in firm
value. Expert of corporate governance argues that top management will tend to finance the deal
using debt as this will benefit them (short term gain).

Raising cash by Equity:

The cash can also be raised by issuing shares to stock market. Fossil has 100,000,000 common shares
but has issued so far 68,370,020. In order to raise it can issue the remaining share either as right
issue. This approach has following advantage:-

1) As company is already listed in the share market it is easy access to gain long term finance
and it is the cheapest option to raise fund.
2) The right issue is offered to the existing share holders and over a discount on current market
price (to adjust for any market price change) at a pro-rata basis i.e. 1 share for every 2
shares. In past 2 years Fossil share price has shown a growth of 130% hence its shares at
discounted price will be accepted by the shareholder.

6
Assuming the enterprise value not the premium value on top of enterprise.
7
Beta is calculated by unlevering and than relevering it.
8
Assuming the rate of interest remains the same as before 2011 calculated as = Interest Expense
(FOSL+ANF)/Debt value(FOSL+ANF)
9
Assumed double of default rate of THE GAP (.51%, having $1.6 billion as debt with Baa3 rating Moody’s).


Current Price $129.9 right issue offered price10 = $110.415 hence company will be able to raise $3.5
billion.

Share for Share offer
Fossil also have an option to exchange share for share to share holders of Abercrombie and Fitch.
This option has few advantages

a. The shareholders of Abercrombie will still have equity interest in the Fossil Inc.
b. Shareholder of ANF will not incur any brokerage cost of reinvesting in other firm.
c. The growth rate of Fossil in far better than the current performance of ANF. Etc.

However the biggest disadvantage if this approach is that company has to pay a lot of premium to
ANF shareholders which make this deal more costly. There is also a threat of devaluation of share
price soon after the bid is finalized making take over more costly.

As we have already seen that entire deal cannot be financed by single approach hence I will propose
to finance the deal by mixed finance i.e. cashed raise by debt, right issue and share for share offer. In
this majority of deal must be financed by share-for-share offer and rest by debt and right issue.

The loss to share holder due to expected decline in share price caused because of issuing right issues
or giving share for share can be offset by raising the debt which will raise the return on shareholder
equity. Hence mix financing will be the best option to finance this deal.

10
Right issue price is assumed to be 15% discount on market price


Conclusion

We have seen various risks associated with each FOSL and ANF and we have seen that ANF has more
risk than FOSL. We have also seen the impact of these risks (Financial and Business) on cost of
capital. After valuing both the firms first separately and then as a merged entity, we have seen that
Fossil is undervalued and Abercrombie is a overvalued firm. Looking the business benefits associated
with this merger I have recommended acquisition rather than merger. This merger should be
financed using all three options to balance the risk and benefit to shareholder wealth. The strong
corporate governance already employed by companies will help in offsetting any kind of agency cost
or agency issues.


References
Abercrombie & Fitch Co. (2012) Annual Report 2011, Delware/USA





Abercrombie & Fitch 2011. Def 14A: Definitive proxy statements. Available from: :
http://services.corporate-
ir.net/SEC/Document.Service?id=P3VybD1odHRwOi8vaXIuaW50Lndlc3RsYXdidXNpbmVzcy5jb20vZG
9jdW1lbnQvdjEvMDAwMDk1MDEyMy0xMS0wNTA4NjUvZG9jL0FiZXJjcm9tYmllRml0Y2hDby5wZGYm
dHlwZT0yJmZuPUFiZXJjcm9tYmllRml0Y2hDby5wZGY= [Accessed on 19th April 2012]

Coinnews Media Group LLC (2012), US Inflation Calculator. Available from
http://www.usinflationcalculator.com/inflation/current-inflation-rates/ [Accessed 1st May2012]

Corina G., and Roxana S, (2011) Comparative Study on Corporate Governance. Economic Science
Series University of Oradea. JEL Classification G30, M10 (Online) Available from:
http://anale.steconomiceuoradea.ro/volume/2011/n2/095.pdf [Accessed on 25th April]

DePamphilis DM. (2010). Mergers, Acquisitions, and other restricting activites: An integrated
approach to process, tools, cases and solutions 5th Edition. London: Elsevier

Fossil Inc (2012) Annual Report 2011, Delware/USA





Fossil Inc 2012. Schedule 14A: Proxy statement pursuant to section 14(a). Available from :
http://www.fossil.com/attachments/en_US/financials/2011/2011_Proxy_Statement.pdf [Accessed
on 25th April, 2012]

Masulis RW., Wang C., and Xie F. (2007) Corporate Governance and Acquirer Returns. The Journal of
Finance Vol.LXII, No4.pp1851-1889.

Quiry P., Dallocchio M., Fur YL. and Salvi A.(2005) Corporate Finance: Theory and Practice 6th Edition.
England: John Wiley & Sons Ltd.

Taub, B. (2012) Capital Structure (II): Market frictions [Lecture Slide], BUSI49015 Corporate Finance,
Full time MBA Program 2011/2012, Durham Business School, Durham University, Durham UK.


TM1031 Exchange (2012) Tenant Credit Ratings – 2012 Q2 Available from:
http://www.tm1031exchange.com/tenant-credit-ratings.html [Accessed on 2nd May 2012]

US Department of The Treasury (2012) Resource Center: Daily Treasury Yield Curves Rates. Available
from: http://www.treasury.gov/resource-center/data-chart-center/interest-
rates/pages/textview.aspx?data=yield [Accessed on 25th April 2012]

Watson D. and Head A. (2004) Corporate Finance: Principles & Practices 3rd Edition. England: Pearson
Education limited.

Yahoo Finance (2012) Fossil Inc (FOSL) Available from:
http://finance.yahoo.com/q/ks?s=FOSL+Key+Statistics [Accessed on 20th April 2012]

Yahoo Finance (2012) Abercrombie & Fitch Co. (ANF) Available from:
http://finance.yahoo.com/q/ks?s=ANF+Key+Statistics [Accessed on 20th April 2012]


Appendix

Fossil financials

Figure 12: Income statement of FOSL.
Source: Adapted from Morning Star (2012) Fossil Inc. FOSL Available from: http://financials.morningstar.com/income-
statement/is.html?t=FOSL&region=USA&culture=en-us [Accessed on 19th April 2012]

Figure 13: Balance Sheet of FOSL
Source: Adapted from Morning Star (2012) Fossil Inc. FOSL Available from: http://financials.morningstar.com/income-
statement/is.html?t=FOSL&region=USA&culture=en-us [Accessed on 19th April 2012]


Abercrombie & Fitch Co. Financials

Figure 14: Income statement of ANF
Source: Adapted from Morning Star (2012) Abercrombie & Fitch Co ANF Available from: http://financials.morningstar.com/income-
statement/is.html?t=ANF&region=USA&culture=en-us [Accessed on 19th April 2012]

Figure 15: Balance sheet of ANF
Source: Adapted from Morning Star (2012) Abercrombie & Fitch Co ANF Available from: http://financials.morningstar.com/income-
statement/is.html?t=ANF&region=USA&culture=en-us [Accessed on 19th April 2012]


Company valuation and Merger Valuation

Empfohlen

Empfohlen

Weitere ähnliche Inhalte

Was ist angesagt?

Was ist angesagt? (20)

Ähnlich wie Company valuation and Merger Valuation

Ähnlich wie Company valuation and Merger Valuation (9)

Kürzlich hochgeladen

Kürzlich hochgeladen (20)

Company valuation and Merger Valuation