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Page 1

J.P. Morgan M&A Reference Manual

Copyright © 1997 Morgan Guaranty Trust Company of New York. All rights reserved. June 1998 82890cl6

J.P. Morgan M&A Reference Manual



This “M&A bible” is meant to serve as a training guide for
newcomers to M&A, as well as a technical reference manual for
experienced (and not so experienced) M&A practitioners. It
incorporates what a number of people in M&A believe to be
essential or useful basic knowledge to perform the tasks required
in the daily routine of the strategic advisory business.

As the financial, legal and tax environment in which the M&A
Group operates is forever changing, periodic updates of this
publication are intended. As such, any suggestions for
improvement would be appreciated. Please direct your comments
for improvement, but not your requests for copies of the book, to
Eileen Smith at (77)6-8305. An online version of the book is
available to Investment Banking professionals on the IB M&A
Research database in Lotus Notes or through IB Today.

The book is confidential, proprietary and the sole property of J.P.
Morgan and should not be passed along to colleagues outside of
Investment Banking or to people at competitor firms.

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J.P. Morgan M&A Reference Manual

Copyright © 1997 Morgan Guaranty Trust Company of New York. All rights reserved. June 1998 82890cl6

Contents

Valuation methodologies overview ............................................................... 1
Advantages and disadvantages ........................................................................ 1

Comparable company trading analysis ....................................................... 6
Selected trading statistics explained ................................................................ 8
Selected operating statistics explained ............................................................. 13
Typical data problems ...................................................................................... 17
Summary of inputs and outputs ....................................................................... 18

Comparable transactions analysis ................................................................ 20

Discounted Cash Flow (“DCF”) ................................................................... 23
Free Cash Flow (“FCF”) .................................................................................. 24
End-period convention ..................................................................................... 28
Mid-period convention (J.P. Morgan standard) ............................................... 29
Terminal value: two methods of forecasting.................................................... 31
Weighted average cost of capital (“WACC”) .................................................. 35
Mechanics of discounting cash flows .............................................................. 38

Investing in, acquiring or merging with another company ........................ 40
Overview .......................................................................................................... 40
Cost method ..................................................................................................... 43
Fair value method ............................................................................................ 43
Equity method .................................................................................................. 44
Purchase method .............................................................................................. 48
Pooling method ................................................................................................ 53
Other accounting methods for business combinations ..................................... 56
NB: These areas of accounting are highly technical. Consult with
team members regarding implementation. ....................................................... 56

M&A tax issues and considerations ............................................................. 57
I. Terminology ................................................................................................. 57
II. The five key tax questions to answer in most M&A
transactions ...................................................................................................... 58
III. Joint ventures ............................................................................................. 80
IV. Diagrams of selected M&A transaction structures .................................... 83

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J.P. Morgan M&A Reference Manual 67

Copyright © 1997 Morgan Guaranty Trust Company of New York. All rights reserved.n 82890cl6

gains recognized on an asset sale and $7 from its normal operations. Target
can use $9 of its NOLs in 1997; $9 is the sum of the $3 recognized on the
asset sale and the $6 ($100 x 6%) annual limitation. It is therefore taxed in
1998 on $1 ($10 - $9).

Note that if Acquiror acquires Target’s business by acquiring Target’s assets in a
taxable transaction (including an acquisition in which a section 338(h)(10)
election is made), Target’s NOLs stay with the selling legal entity, are available to
absorb any gain recognized on disposition of Target’s assets, and are not acquired
together with the business.

a. Special rules for (formerly) insolvent corporations. A Target that has
gone through a Chapter 11 proceeding would typically have negligible equity
value at the time a change of control occurs (generally, when the prior
creditors are awarded all or a majority of the equity in the Target). Its post-
change of control annual limitation would therefore be close to zero (other
than for built-in gains). In such a circumstance, the Target can elect –
assuming it is eligible – to take advantage of a special rule under which (i)
there is no annual limitation on the amount of NOLs that can be utilized but
(ii) the aggregate amount of NOLs is reduced by the interest accrued within
the three years prior to bankruptcy on any debt exchanged for stock.
Eligibility requires, among other things, that more than half the Target’s
equity be owned by (i) former lenders who held their debt for at least
eighteen months prior to the date of the Chapter 11 filing and/or (ii) by trade
creditors.

3. Foreign operations; foreign tax credits. If a significant portion of the Target’s
operations are outside the United States, the effective tax rate of Target going
forward may be impacted in a number of ways. First, it is likely that non-US tax
considerations, non-US tax rules and the US tax rules governing taxation of
foreign source income must be factored into that portion of the acquisition.
Second, the non-US portion of the business will be subject to foreign tax rates and
rules which are almost certain to be different than US tax rates and rules. The
degree to which the differences between the US and foreign tax regimes affects
the overall effective tax rate of Target’s business will depend on factors which are
beyond the scope of this discussion. For a discussion of some of those factors
(and for a summary of the rules governing the US taxation of foreign source
income and the impact of those rules on the ability of a US parent to effectively
deduct interest expense) see the May 1994 memo on “Foreign Tax Credits.”1


1 The memo can be found on the JPM Intranet under IB Analysis Policy Memos, “M&A Tax
Issues and Considerations.”

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Copyright © 1997 Morgan Guaranty Trust Company of New York. All rights reserved.n 82890cl6

4. Alternative minimum tax (“AMT”). Some corporations, especially those in
capital-intensive and natural resource extraction industries, are subject to the
AMT. A US corporation’s Federal income tax liability is the greater of 35% of its
“regular taxable income” (RTI) or 20% of its “alternative minimum taxable
income” (AMTI). To calculate AMTI, a corporation starts with RTI and adds
“preference items.” In general, a “preference item” is (1) a deduction (such as
“accelerated depreciation”) which may be taken for regular tax purposes but not
for AMT purposes or (2) an item of income (such as income on municipal bonds)
which may be excluded for regular tax purposes but not for AMT purposes.

Example. In year 1, US Corp has $100 of RTI and $200 of AMTI. Its
regular tax liability is $35 ($100 x 35%) and its AMT liability is $40 ($200 x
20%). Since its AMT liability is greater than its regular tax liability, it is
subject to the AMT.

A corporation subject to the AMT gets a credit to the extent that its AMT
liability exceeds its regular tax liability. Thus, US Corp in the above example
gets a credit of $5 (the excess of $40 over $35). This credit can be used in a
future year to offset its regular tax liability, but only to the extent that its regular
tax liability in that future year exceeds its AMT liability in that year. The net
effect of the credit is that (at least in theory) a US corporation will, in the long
run, never have a tax liability greater than 35% of its RTI. Of course, the long
run is a very long time; for many corporations it may be years before they flip
out of AMT and can use their AMT credits.

Example. In year 2, US Corp (from the previous example) has $100 of RTI
and $100 of AMTI. Its regular tax liability is $35 and its AMT liability is
$20. It is therefore not subject to the AMT and it gets a credit of $5 carried
forward from year 1. Its net tax liability for year 2 is therefore $30. Looking
at year 1 and year 2 together, US Corp had RTI of $200 ($100 in each of year
1 and 2) and a tax liability of $70 ($40 in year 1 and $30 in year 2). Not
coincidentally, $70 is 35% of $200. In other words, US Corp’s tax liability –
looking at years 1 and 2 together – is 35% of its RTI over that period even
though it was subject to the AMT in year 1.

E. Is there any other tax-efficient way to sell the business?
We noted in the answer to question B that a seller may be able to defer recognition
of taxable gain on the sale of a business by taking back equity in the buyer. This
section describes seven structures a seller can use to dispose of some or all of a
business while deferring all or some of its gain; some of the structures are variations
on the theme outlined in question B and others are unrelated to that theme. In each
structure, a substantial portion of the seller’s consideration may – depending on the
particular facts – consist of cash. Each transaction has significant limitations and

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82890cl6

Appendix G: JPM credit ratio guidelines and

definitions

Please visit the Corporate Risk Management website for most recent version of JPM
credit ratio guidelines and definitions.



http://crmg.ny.jpmorgan.com/Ratio_Guidelines2.html

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J.P. Morgan M&A Reference Manual



Copyright © 1997 Morgan Guaranty Trust Company of New York. All rights reserved.n 82890cl6

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