1. Merger & Acquisition
Valuation: The Gap
Inc.
HEATHER O’CONNOR
2015
BUS 464-05
DELANEY LIM

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Contents
Introduction.................................................................................................................2
Target and Acquirer Background..................................................................................5
MACYS INC. ..............................................................................................................5
THE GAP INC.............................................................................................................6
Literature Review..........................................................................................................8
Synergies of Merger .....................................................................................................9
Target Valuation Analysis...........................................................................................11
DISCOUNTED CASH FLOWS (DCF) MODEL:................................................................11
PRO-FORMA ANALYSIS.........................................................................................11
WACC ANALYSIS TO ESTIMATE DISCOUNT RATE ...................................................13
COMPARABLE MULTIPLES:........................................................................................14
Synergies Valuation....................................................................................................16
Bid Range...................................................................................................................18
The Deal Offering.......................................................................................................19
Executive Summary ....................................................................................................21
Biliogrphy .........................................................................Error! Bookmark not defined.

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Introduction
When looking at the state of the merger and acquisition economy, the U.S. is
considered to be in the beginning stages of a merger wave. This meaning that in the
United States, merger and acquisition is heading towards the peak of heavy activity that
will eventually be followed by a lull in activity. In the last several years the percentage of
domestic merger and acquisition activity has increased extensively, by over 15 percent,
since the financial crisis of 2008. Deloitte, one of the largest financial consulting firms in
the United States, attributes this sudden increase to two major changes in the economy.
One major change came with the steady increase in economic activity that had occurred
as the U.S. economy has started to recover from the recession. This change can be
attributed to the Federal monetary policy that is known as quantitative easing. This
policy of quantitative easing is the process of keeping interest rates low so that
individuals and companies will borrow money to invest back into the economy. This
leads to the second major change, which is the increasing amount of cash flows that
companies are retaining that allows them to finance more deals and create growth for
their companies. In the last year, the impact of these changes has created over 52
percent growth in the total value of deals being announced on the international scale.
To fully understand the economy behind merger and acquisition, it is important to
understand the mechanics behind each theory and how a company will execute either
of them. The concept behind merger is that two companies will join to become one
company with single corporate governance. Mergers come in several forms that are
identified based on the industries of both the target and acquiring companies. The two
most popular types of merger are horizontal, which occurs between two companies
within the same industry, and vertical, which is between two companies in the same

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supply chain. The vertical merger style has become more popular in this merger period
as many companies are looking to diversify their portfolios by joining with other industry
participants to lower risk for their shareholders.
Acquisition, being another option for companies looking to expand, refers to the
process in which one company will buy out most, if not all, of the stock in another
company in order to assume ownership. With this process usually the target company
will consolidate with the acquiring company and the shareholders of that company will
be offered either shares in the new company or offered a cash payout. In the last few
years most companies are choosing to offer cash buyouts due to the large cash
holdings on their balance sheet. Acquisition comes two forms, hostile or friendly
takeover. In a hostile takeover, the acquiring company or an individual who represents
that company buys out enough shares of the target company in order to have voting
majority and control of it. For this process to be successful often times the acquiring
company must offer shareholders and managers hefty deals in either equity in the new
company or severance packages, often referred to as golden parachute. When dealing
with a friendly takeover, the process is less extensive as the target company is willing to
participate in the process with the acquiring company. This process usually ends with a
deal that rewards its shareholders with a premium for their shares.
With the promising future of the merger and acquisition economy, we will be
evaluating the potential merger or acquisition deal of our client company, Macy’s
Incorporated, with their identified target. After looking into the retail and distribution
industry, we have identified our client’s potential target company to be The Gap
Incorporated, a smaller and more focused retail company. In order to make the most

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successful recommendation for our client we will analyze the expediency, profitability,
and the deal that our client will present to their target. This analysis will be done through
the discounted cash flow model which consists of running pro-forma analysis and
WACC analysis. After doing so we will deliver the results in the form of a
recommendation for Macy’s Inc.

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Target and Acquirer Background
MACYS INC.
Our client, Macy’s, was first acquired by the Federated Department Stores Inc. in
1994 which eventually it became known as it is today, as Macy’s Inc. Today they are in
the retail and department store sub-industry within the retail and distribution industry.
They encompass the Macy’s and Bloomingdales brands which are considered two of
the largest brands in the “omnichannel retailer” market. Along with the two major brands
they comprise several other large brands and control subsidiaries located in both the
U.S. and Hong Kong which allows them to serve various major geographic regions in
the United States. They operate over 825 retail stores throughout the United States,
Guam, and Puerto Rico and have a strong online presence in their home furnishing and
clothing retail departments. They also employ over 172 thousand people at the retail
and corporate level.
Macys Inc. sells merchandise in many different departments including men’s,
women’s, and children’s clothing and shoes, cosmetics, home furnishings, and other
consumer products. As with the department store style of company, Macy’s sells other
brands under a vendor style contract that allows them to price the merchandise at a
premium or discount at their discretion. This allows them to bring many brands into their
stores that grant them the ability to reach many markets of consumers.
With headquarters located in New York, New York, their top level management is
guided by their CEO, Terry Lundgren, and CFO, Karen Hoguet. There in New York,
Macy’s trades on the New York Stock exchange under the ticker M with a current stock
price of $68. Overall Macy’s Inc. holds third in market capitalization in its industry at

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about $23 billion dollars, behind Wal-Mart Stores Inc. and Target Corp. Over the last
few years Macy’s has grown increasingly competitive with revenues of $28 billion. The
graph below shows the profitability trend of Macy’s Inc.as it has steadily increased over
the last three years after recovering from the financial crisis of 2008. It has also
continuously beaten its industry in the last five years.
THE GAP INC.
Our target company is The Gap Incorporated. They started in 1969 as a jean
retailer store that has grown over the last forty six years into one of the largest
corporations in the family clothing stores sub-industry within the retail and distribution
industry. Within this corporation they possess six major brands in the retail market
including: Gap, Old Navy, Banana Republic, Piperlime, Athleta, and INTERMIX. With
these brands The Gap Inc. operates over 3500 stores and franchises located in North
America, South America, Europe, and Asia as well as individual websites for each
brand under its ownership. They manage all of these stores along with their
approximately 141 thousand employees out of their corporate headquarters in San
Francisco.
The Gap and its brands sell merchandise in the family apparel, accessories, and
personal care products. Each store sells these products under its own brand name and

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each brand specializes in certain apparel or accessories for a smaller market within The
Gap Inc.’s market. Both Gap and Old Navy appeal to the family apparel and
accessories market while Athleta is focused in women’s athletic apparel. They also
reach the smaller and more sophisticated market with boutique style stores for their
INTERMIX and Piperlime brands. Overall the Gap is able to reach multiple apparel
niche markets through its brand distinction.
The Gap is overseen by their CEO Arthur Peck and Executive Vice President
Michelle Banks along with four other executive members. From San Francisco, the
executives manage the trading of The Gap’s stock on the New York Stock Exchange
under the ticker GPS with a current stock price of $41.15. Overall The Gap Inc. is set
second to its competitors, only behind TJX Companies, in market capitalization at
approximately $17 billion. With its large market capitalization, they also hold competitive
in its industry for revenues of around $16 million. Principally, The Gap Inc. continuously
beats the market by producing returns above the industry average.

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Literature Review
In our analysis of the feasibility, profitability, and deal for the merger or
acquisition of our client, Macy’s Inc., with their target company, The Gap Inc. we used
multiple sources to refer to the theory of merger and acquisition. Several texts that we
used covered the methods of valuating both companies to determine the success of a
potential merger or acquisition. One major text used when implementing the valuation
methods of comparable data, discounted cash flows, and pro-forma analysis is
Fundamentals of Corporate Finance by Berk, DeMarzo, and Harford. This textbook
gives in depth instructions on how to perform these methods of analysis along with their
relevance to our final recommendation for our client. To support our questions on how
to perform some of the calculations needed for the analysis we used sites such as
Investopedia.com and YouTube.com videos. When finding information on deal pricing
and merger and acquisition trends, we used journal articles that dealt on topics such as
the current merger market, deal making in the acquisition economy, and
merger/acquisition pricing methods.

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Synergies of Merger
Since the financial crisis of 2008 the United States Economy has been in repair
and has finally started to recover in the last three years as the Fed has put in place the
monetary policy of quantitative easing. With this policy many American companies are
seeing large cash holdings on their balance sheet or taking on “cheap” debt and are
looking to reinvest in the growth of their companies. Our client is looking to do exactly
that and is going to do so through the merging or acquiring of the smaller retail
company, The Gap Inc. Both companies, although in different sub-industries, are in the
retail and distribution industry which allows us to assume that we would be analyzing a
horizontal strategy. Horizontal strategy refers to two companies participating in a deal
that are in the same industry. This strategy can be beneficial to both Macy’s Inc. and
The Gap Inc. because becoming one company allows them to acquire a higher market
share and have more control over the market that they are in.
Through the potential merger or acquisition of The Gap Inc. by Macy’s Inc., the
target is able to acquire economies of scale to conceivably lower its costs of production
or other supply chain activities. When referring to economies of scale, it is simply the
cost benefits that occur when the size, or “scale”, of a company is increased through
growth acquiring actions. Since our client has larger market capitalization, they can
afford to produce at larger levels than their target company and therefore the target
receives this cost benefit. Another synergy seen through this possible merger or
acquisition is that the target company is spread across multiple niche markets that our
client does not belong to. This will allow for a wider audience and greater potential for
profit increase as Macy’s will be able to appeal to the lower income markets as well as

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specialized markets with The Gap’s Athleta brand and smaller upscale markets with
INTERMIX and Piperlime brands.

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Target Valuation Analysis
DISCOUNTED CASH FLOWS (DCF) MODEL:
To properly analyze the target company for our client we are going to perform
several types of valuation to make the best decision. The most reliable of these
methods of valuation is the discounted cash flow model. This model assesses the
attractiveness of an investment based on the present value of future cash flows. It
entails running multiple models including pro-forma analysis which is used to project
future figures to better analyze the future of The Gap Inc. We will also calculate WACC,
which is the weighted average cost of capital that gives us the average cost of financing
either from debt or equity.
PRO-FORMA ANALYSIS
Pro-forma analysis is a useful tool to forecast future financial statement and
financing needs for a company. We used the percentage of sales method to forecast
the stream of sales for the next five years (2015-2019). By dividing each item on the
balance sheet and income statement by sales, we were able to find the relationship
between sales and each item. As the company grows in terms of revenues, we
expected other operational units of the company to also grow proportionally. Starting in
2014 at $16,148,000, our total revenue is expected to grow 3.8%, based on the
analyst’s estimate from Yahoo! Finance. Based on the net new financing, we had to
make revisions in order to balance out the asset and liability amounts to zero. Since The
Gap had generated more cash than it planned to consume, the company needs to
decide what to do with it. It can build up extra cash reserves, pay down some of its debt,
distribute the excess as dividends, or repurchase shares. We decided to balance out
the amounts by applying payments to debt. If liabilities were less than assets, new

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financing is needed and The Gap would need to reduce dividends, borrow, or issue new
equity to fund the shortfall.

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WACC ANALYSIS TO ESTIMATE DISCOUNT RATE
Using regression analysis, we estimated the raw CAPM beta. Through Yahoo! Finance
we were able to calculate the average monthly returns over the past 20 years using
historical stock price. We made a scatter plot of the past 60 month stock returns vs.
market returns. Our estimated beta was 1.28, which was the slope of the regression.
After the adjustment, the beta was 1.18. A beta over 1 generally means that the asset is
volatile and tends to move up and down with the market. Therefore, we conclude that
The Gap is 18 percent more volatile than the market which makes it a riskier
investment.

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COMPARABLE MULTIPLES:
In order to evaluate where our target company was in comparison to its closest industry
rivals we looked into another form of company valuation that uses rivals firms data to
find out how close the target firm is from them. Valuation is a method of estimating the
value of an asset by comparing it to the values assessed by the market for similar or
comparable assets. The multiple used to value our company was EV/EBITDA. We first
built our sample using Damodaran's financial data. We included companies in the
following industries to create a larger sample size: retail- soft lines, retail- hard lines,
and apparel. After several trial and error attempts, we finally came to the conclusion that
we would use the following variables to create our full regression model: expected
growth in revenue (next 5 years), 3 year regression beta, payout ratio, ROE, dividends,
ROC, ROIC, and dividend yield. This combination of variables resulted in the highest R-
squared (47%) However, about half of the variables had p-values that were less than
10%. With the reduced model, we only included the variables that were less than 10%.
Our R-squared decreased to 46% so we felt that our estimated equation was accurate
enough, but could have been better if we spent more time finding better variables.

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Synergies Valuation
The discounted cash flow method is a key valuation tool in M&A. This analysis
determines a company’s current value according to its estimated future cash flows.
Although it is sometimes seen to not be accurate in the future it allows us to properly
account for the value at the current time for this deal. Forecasted free cash flows are
discounted to a present value using the company’s WACC which is its required return
on the company and in this case can be used by us to determine the practicability of this
growth opportunity found in The Gap Inc. We calculated our WACC to be 10.23%,
which is relatively low meaning that our target is of low risk. Using the FCFs we
calculated in our pro-forma, we were able to calculate the present value of our terminal
value, which was $92,490,122,000. The terminal value is the value of the company at
the end of the projected 5 years. Therefore, we believe that the Gap will be a good
investment as it consistently has high value that will be beneficial to Macy’s.

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Bid Range
Now that the target firm has been properly valued we are able to make a bid that is
appropriate for this possible growth investment for Macy’s. We first calculate our NPV to
be $27,982,847,180. This is the present value of our target company, The Gap Inc.
which means that our bid will need to be above this for the target to find value in the
deal. This number is then added to our terminal/synergies value of $92,490,122,561
which gives us the maximum bid that our client would offer; it totals $120,472,969,737.
This number represents the total value that Macy’s sees from the added benefits of
acquiring The Gap Inc. Typically, acquiring companies nearly always pay a substantial
premium on the market value of the companies they buy ranging from 10 percent when
the market for merger and acquisition is cold and up to 50 percent of the present value
of the company. This premium, sometimes referred to as the control premium, is the
difference between the offer price and the market price of the target and represents the
amount that the acquiring company is willing to pay over market value to have the
control amount of shares to control the target. Based on the current economy of merger
and acquisition in the United States, we recommend that our client pay a premium of 30
percent to make their initial bid to be approximately $33 billion which is conservative
considering the current market for these transactions. If our target does not choose to
accept the initial bid, we will recommend that our client increase their premium by 5
percent until their bid accepted or until they pull the offer for being overvalued. This
point of being overvalued occurs at the maximum bid range that was described earlier
to be slightly above $120 billion.

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The Deal Offering
Now that we have valued our target company and established a bid range for our
client to make an offer, a deal to make the offer with must be created. We will
recommend a leveraged buyout approach for our client due to several circumstances.
The first condition is that our client company has smaller cash holdings than most
companies are reporting in the current market. This may be due to a number of factors
including their recent dividend announcement or other reinvestment strategies that they
have implemented in the last several quarters. They also have also reported having
close to 10 percent of their cash holding in investments abroad which, according to
GAAP, are not reported on their financial statements. Another factor that leads us to this
recommendation that was mentioned earlier on in this proposal is the current Fed
monetary policy which has led to record low interest rates which are meant to
encourage borrowing. For our client this means that they could take on debt to cover the
bid for the target and pay it off with little interest earned. This current situation is
beneficial for our client to then implement our recommendation of leveraged buyout.
This strategy involves the acquiring the target company, in our case The Gap
Inc., using a substantial amount of debt to cover the costs of the acquisition and then
our client can use the assets of the target to cover the collateral on that debt. This
approach allows our client to receive a paramount deal on The Gap Inc. as it takes the
liability of the loan from their company and applies it to their acquiring company and it
will only be applied if the bid is accepted by the target. In the case of our client we will
be implementing this strategy as a friendly takeover which allows our client to offer a fair
price to the target company. Within this deal we recommend that our client keep The

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Gap’s brand level management while evaluating the efficiency due to their expertise in
the markets that their brands reach. As far as the top level management goes, we
recommend that they are offered a generous buyout or severance package that
consists of both a cash bonus for the severance and fair price for their voting rated
stock shares. For all of The Gap’s stockholders we advocate for cash offerings based
on the idea that our client can obtain cash “cheaply” in the current market and this route
will allow for easier management and possible increased value for Macy’s current
stockholders.
Overall our best endorsement is for leveraged buyout for Macy’s Inc. This
strategy will have the biggest reward with the lowest liability for our client as the liability
of borrowing will be placed on the target company. This also allows our client to offer a
generous cash buyout for stockholders to keep the acquisition friendly rather than
hostile while keeping costs low.

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Executive Summary
Our client company, Macy’s Inc., has come to us looking for a valuation of a
target company for possible merger or acquisition. They are looking at The Gap Inc. as
their potential target company based on their brand recognition that reaches several
niche markets that Macy’s does not have access to. Through a leveraged buyout
acquisition we are hoping that our client will be able to get the best deal on the majority
voting rights of The Gap Inc. which will allow them to take over and evaluate
management of brand segments and put into place a successful system. To
accommodate the stockholders of The Gap Inc., we recommended to our client a cash
offering to buy out the stock of the target company with starting bid premium of 30
percent which allows for a greater than average return for the target stockholders.
Inclusively this deal also offers the lowest liability for our client by using the target’s
assets as collateral for the loan that Macy’s will take out to cover the acquisition costs.
By implementing this plan Macy’s will be receiving the synergies of increased market
share which allow it to have greater control over its industry. This acquisition will
facilitate our client’s entry into new into new markets that it currently cannot meet
including: low income market with The Gap’s brand, Old Navy, and niche markets such
as women’s specialized athletic wear with Athleta and classic professional wear that is
offered at Banana Republic. From this analysis that we have prepared for our client they
have expected bid offers ready to offer to their target for simple execution of this
strategy that we believe to be the most successful.

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