What approaches would you use to place a value on sun microsystems?

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19

Approved Logo 1 Sept 2013

Student Name and ID #

Tuleen Basrawi 1310186

Lara Hamza 1310042

Heba Bannoub 1320048

Course

Financial Policy

BNFN 4304

Section

1

Assignment #

Case 48: Sun Microsystems

Due Date

Instructor

Masood Aijazi

Executive Summary
Oracle is among the leading, legitimate database management system vendors including other related programming services. Oracle wants to acquire Sun Microsystems. Sun Microsystems deals with storage, hardware equipment, and offers various services at the enterprise level. If the acquisition succeeds then, the combination will be similar to Walmart but operating in the programming industry. The ultimate purpose of this report is to evaluate whether Sun Microsystems is a perfect match for Oracle and the best price to settle at. With regards to Sun Microsystems, Base-Case or Stand Alone and the expected synergies after acquisition were used to make valuations. Ways were devised to better value Sun Microsystem. First, debt and market capitalization were included to arrive at $6.20 billion enterprise value. In the second case, a multiple analysis focused on comparable companies was utilized. The objective was to establish the enterprise value estimated at $3.87 billion. Third, discounted cash flow method was used. The enterprise value was estimated at $4.53 billion as stand-alone which is around $8.95 billion. It is notable that the values from the various ways are different and is due to the assumptions.

Table of Contents Executive Summary 3 Introduction 5 1. Is Sun Microsystems a good strategic fit for Oracle? Should Oracle acquire Sun Microsystems? 5 2. How much is Sun worth? What approaches would you use to place a value on Sun Microsystems? (Hint: Stand-Alone Value, Acquisition Price and Value with Synergies) 7 The Stand Alone and Value with Synergies methods for valuation using the WACC was calculated as follows: 8 Steps for WACC calculation are seen in the excel sheet: 9 3. Assuming a discounted cash flow valuation: 9 a. What rate of return should Oracle require on the acquisition? 10 b. What base-case cash flows do you forecast? 10 c. What is your estimate of terminal value? 11 d. What is the enterprise value of Sun Microsystems? What is the equity value? 12 4.Conduct a compare companies or multiples analysis to value Sun. What economic fundamentals are reflected in the multiples? 12 Multiples of Comparable Companies 13 Multiples Analysis 15 Economic Fundamentals 16 5. Identify the synergies and conduct a sensitivity analysis to estimate the effect of synergies on enterprise value. 16 The below table shows the sensitivity analysis for the two approaches: 20 Stand-Alone Sensitivity Analysis: 20 Synergy Value Sensitivity Analysis: 21 Summary of Results: 21 6. If a competing bidder appears, how high a price should Oracle be willing to offer? 22 Conclusion 23

Introduction
The computer industry is extremely competitive and the organizations are always searching for new way to evolve to be a step ahead of the competition at all times. In 2009, Oracle was planning to acquire Sun Microsystems. This acquisition would allow Oracle to further diversify their brand, customers and acquire various new platforms that would be added to their portfolio such as MySQL, Solaris and Java. Oracle originally placed an offer of $9.50 per share price which is considerably higher than Sun Microsystem’s price that is $6.69. In addition to this, Oracle levered the company’s value with the acquisition of Sun Microsystems through complementing their system with hardware manufacturing. This will cut the production costs and make the company more efficient throughout all the value chain. The acquisition will pool Oracle’s leading position in the software area with Sun Microsystem’s proficiency in hardware and networking. Moreover, Oracle aimed to capitalize on Sun Microsystem’s decline by getting particular assets or the whole company at the deflated price. The main issue that Oracle needed to confront was to make an accurate valuation model to think of a reasonable price for Sun Microsystems share price. Additionally, Oracle had to ensure that acquiring Sun Microsystem would convey benefits and productivity to its operation.

1. Is Sun Microsystems a good strategic fit for Oracle? Should Oracle acquire Sun Microsystems?
Oracle’s finance position was better in 2009 unlike Sun Microsystems. Sun Microsystems poor finance position was attributed to steady market share loss in the hardware segment. To improve the revenues, Sun tried to leverage software systems by making the Java Solaris, and acquiring MySQL. However, the improved performance as a result of the leveraging was not long-term. The onset of the recent global finance crisis adversely affected their financial performance. The only option for the company was accepting an acquisition (Nicalao, 2012). Oracle would greatly benefit from the acquisition.

Even though Oracle and Sun are classified in the same industry, they deal with different products. Oracle manufactures software while Sun specializes in networking and hardware. The acquisition is therefore, vertical integration. As a result, Oracle will benefit from products diversification (Kumar, 2012). In 1997, Oracle used Solaris and Java language, Sun’s products. The competition between MySQL and Oracle database systems was indirect as they targeted different customers. Adding MySQL will thus, contribute to the portfolio of Oracle. The company will be able to attract the high-end clients and sell the software to them. Oracle could further add Sun’s strong position in the software industry in relation to Solaris systems, Java, and MySQL to its portfolio.

The technology industry began with hardware, software, peripherals and storage. Uncertain segments however, groped up following industrial development in the new millennium. The other businesses in the technology sector have been influenced by Apple’s store which enables the customers to purchase the needed software, hardware and peripherals from one store to reconsider their strategies in business development.

Sun is perfect match for Oracle. The acquisition will enable Oracle to achieve the vision of becoming a market leader in the technological sector by offering hardware and software components. The acquisition will also help to distribute high-quality products, reducing the customer set-up procedure.

Acquiring Sun Microsystem will also create room for expansion. In fact, the acquisition justifies Oracle's strategy of improving via acquisition and integrating with other companies. Oracle is not new to acquisition strategy. The company has spent at least $30 billion acquiring companies since 2005 hence, familiar with acquisition concept. The company has the ability to study the intended company and perceive possible synergies. Basing on the benefits of the acquisition, Sun Microsystem is therefore considered the best proposal for Oracle.

2. How much is Sun worth? What approaches would you use to place a value on Sun Microsystems? (Hint: Stand-Alone Value, Acquisition Price and Value with Synergies)
It is prudent to choose the best approach for valuing Sun Microsystem before ascertaining its worth. The recommended approaches are stand-alone value, acquisition price, and value with synergies. Stand-alone is Sun’s present value without considering the synergy as a result of the acquisition. It is the excess money received by Sun’s shareholders. It is a way of valuing a firm before any merging or acquisition takes place (Brigham & Ehrhardt, 2013). The value is important to confirm where the target company is overvalued or undervalued by comparing it against the current share prices.

Second, Sun’s value after the acquisition must be calculated. The value helps to verify whether the acquisition was appropriate or not. The company’s value included in the deal will grow if the acquisition is established to be a perfect strategic decision. This is referred to as the synergy effect. The cost saving as well as the gain in revenue and efficiency that is attained when merging occurs is indicated via synergies (see Q.3.2, Q.3.3, Q.5.2, and Q.5.3 in spread sheet and question 5).

Comparative analysis or trading comps is another method of valuing Sun Microsystem. In comparative analysis, the competitors and peer businesses of same size and in same industry is assessed (Brigham & Ehrhardt, 2013). Acquisition price can also be used for valuation. The acquisition price value ranges between the values of stand-alone and synergies. The best way to figure out stand-alone and synergies values are by calculating the discounted cash flow (DCF) by employing multiples and perpetuity growth methods and finding the average of both. These methods however, have challenges. First, the DCF using the multiples method does not consider long-term growth or the econometrics of business. It is also difficult to identify comparable companies (Brigham & Ehrhardt, 2013). Second, the DCF using the perpetuity growth method appears inaccurate as the company assumes a certain growth rate will remain the same which is impossible.

The Stand Alone and Value with Synergies methods for valuation using the WACC was calculated as follows:
Weighted Average Cost of Capital (WACC) refers to cost of individual sources of capital when averaged. It is the minimum return rate from the invested capital (Brigham & Ehrhardt, 2013). The capital considered when calculating WACC is debt and equity. Returns greater than WACC must be generated to stay above the break-even point. Going below it, would create a deficit. WACC must be calculated for the landers and shareholders to able to approximate the returns that their investments might yield. The spreadsheet shows the steps for calculating WACC.

Steps for WACC calculation are seen in the excel sheet:
The formula: WACC = Wd x Rd x (1-T) + We x Re

Wd= weight of debt

Rd= cost of debt

We= weight of equity

Re= cost of equity

T= tax rate

To calculate WACC, the weight of debt in the capital structure must be calculated using: Debt/ (Debt + Market Capitalization)

(The numbers can be found in exhibit 9.

Then, a calculation of the weight of equity must be done by: 1-Wd or 1-%Debt

Furthermore, the corporate bond yield from Exhibit 10 is used for the BB+ ratings since in Exhibit 9 it was shown that the bond rating for Sun Microsystem is Ba1 (Moody’s), which is equivalent to BB+ (S&P).

Moreover, the cost of equity is calculated by using the Capital Asset Pricing Model: Rf + Beta x (Rm).

All using the following data: a market risk premium (MRP) of 6% (assumed) and the 10-year Treasury Yield as the risk-free rate (from Exhibit 10) of 2.82% and a Beta of 1.73 (the levered beta for Sun Microsystem found in Exhibit 9).

Finally, determining the WACC using the assumed tax rate of 35%, providing us with a WACC of 12.05%.

3. Assuming a discounted cash flow valuation:
The Discounted Cash Flow (DCF) Method is considered to the be the superior valuation techniques to use in case of mergers and acquisitions compared to the comparable company’s analysis (CCA) since it is considered to be forward looking and will consider time value of money. DCF in addition focuses on cash flows instead of profits, and reflects on other non-cash charges such as depreciation and amortization and also investment inflows and outflows.

a. What rate of return should Oracle require on the acquisition?
When there is a possibility of acquisition, the acquirer may plan to increase the level of debt or decrease it after the merger because at that moment of time the objectives of the target’s finances is not ideal. The WACC reflects the company’s business risk of the target. An intermediary for this can be acquired from the unlevered beta of the target association’s value or a normal unlevered beat for firm with comparable business risk. The targets premerger unlevered beat should then be re-levered to reflect what the acquirer expected to have as a post-merger capital structure. To un-lever a company’s expected beat, one should use the predominant tax rate and the debt to equity ratio (D/E) of the company which relates to the beta estimate. The equation is below; ßu =ßL/[1+(1– T)D/E

Then, using the unlevered beta to estimate or normalize the unlevered beta estimate if its utilizes numerous companies to appraise the unlevered beta and the to re-lever the beta to the new proposed debt to equity ratio. Using the below formula: ß'L =ßu[1+(1– T)D/E

The rate of return that Oracle should require on the acquisition is equal to the Sun Microsystem’s WACC which is equal to 12.05%.