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Financial Modeling Basics
Financial models are widely used in a variety of business applications from financial reporting to capital budgeting to valuing and structuring mergers and acquisitions. The purpose of this chapter from my book Mergers, Acquisitions, and Other Restructuring Basics, 8th Edition, is to discuss the basics of applying financial modeling methods to firm valuation and to assist the reader in understanding the power (and limitations) of models in analyzing real world situations. The model discussed in this chapter is relatively simple consisting of four Microsoft Excel worksheets and is applied to the valuation of a single firm.
Inside Mergers and Acquisitions: The Role of Financial Models in Executive Decision Making
Equity markets often move quickly to express investor sentiment. Personal computer and printer behemoth Hewlett-Packard (HP) had just announced its agreement to buy Electronic Data Systems (EDS) for $13.9 billion in an all-cash deal in May 2008. Investors demonstrated their dismay with the decision by driving down HP’s share price 11% in a single day.
The source of investor displeasure was the magnitude of the 33% premium paid for EDS, a systems integration, consulting, and services firm. In a meeting arranged to respond to questions about the deal, HP’s chief executive Mark Hurd found himself barraged by concerns about how the firm intended to recover the sizeable premium it had paid for EDS.
The CEO had been a Wall Street darling since he had assumed his position 3 years earlier. Under his direction, the firm’s profits rose sharply as it successfully cut costs while growing revenue and integrating several acquisitions. Asked how HP expected to generate substantial synergies by combining two very different organizations, Mr. Hurd indicated that the firm and its advisors had done “double-digit thousands of hours” in due diligence and financial modeling and that they were satisfied that the cost synergies were there.
In an effort to demonstrate how conservative they had been, the CEO indicated that potential revenue synergies had not even been included in their financial models. However, he was convinced that there were significant upside revenue opportunities. He argued that by testing alternative scenarios reflecting a myriad of outcomes that he was confident that the likelihood of earning competitive financial returns on the investment was high.
When Hewlett-Packard bought E.D.S., it said E.D.S. would give it a way to compete with IBM in the services’ business, and the firm noted that the combined revenue of HP and EDS would be $38 billion. Four years later, HP had services revenue of just $35.9 billion, mostly in low margin outsourcing deals. Reflecting the extent of their overpayment for EDS, HP announced in August 2012 that it would take an accounting charge of $8 billion related to its EDS acquisition 4 years earlier. The write down amounted to a staggering 58% of what the firm had paid for EDS.
What went wrong? Was it due to poor planning, a bad strategy, or poor execution? Probably each had a role. Could financial models have helped to prevent this disaster? Yes and no. Models are attempts by their builders to approximate reality. Once built, they represent high-speed calculators. The reliability of their output is dependent on the extent to which they accurately represent the underlying dynamics of the businesses that have been modeled and the credibility of the assumptions that drive their cash flow projections. In the final analysis, models are an important tool supplementing but not replacing executive judgment.
If you liked this chapter, you may be interested in others from the book Mergers, Acquisitions, and Other Restructuring Basics, now in its Eight Edition, is the most current, comprehensive, and cutting-edge text on M&A and corporate restructuring available.
To access additional chapters, visit ScienceDirect. If you prefer a print or e-copy, visit the Elsevier Store. Apply discount code STC317 and receive up to 30% off the list price and free global shipping.
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