Types of mergersTypes of mergers

Merger analysisMerger analysis

Role of investment bankersRole of investment bankers

LBOs, divestitures, and holding LBOs, divestitures, and holding companiescompanies

24MERGER AND ACQUISITION

Synergy: Synergy: Value of the whole exceeds Value of the whole exceeds sum of the parts. Could arise from:sum of the parts. Could arise from: Operating economiesOperating economies Financial economiesFinancial economies Differential management efficiencyDifferential management efficiency Taxes (use accumulated losses)Taxes (use accumulated losses)

What are some valid economicjustifications for mergers?

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Break-up valueBreak-up value: Assets would : Assets would be more valuable if broken up be more valuable if broken up and sold to other companies.and sold to other companies.

DiversificationDiversification

Purchase of assets at below Purchase of assets at below replacement costreplacement cost

Acquire other firms to increase Acquire other firms to increase size, thus making it more difficult size, thus making it more difficult to be acquiredto be acquired

What are some questionablereasons for mergers?

Five Largest Completed MergersFive Largest Completed Mergers(as of January 2002)(as of January 2002)

VALUEVALUE

BUYERBUYER TARGETTARGET (Billion)(Billion)

Vodafone AirTouchVodafone AirTouch MannesmanMannesman $161$161

PfizerPfizer Warner-LambertWarner-Lambert 116 116

America OnlineAmerica Online Time WarnerTime Warner 106 106

ExxonExxon MobilMobil 81 81

Glaxo WellcomeGlaxo Wellcome SmithKline BeechamSmithKline Beecham 74 74

Friendly mergerFriendly merger: : The merger is supported by the The merger is supported by the

managements of both firms.managements of both firms.

Differentiate between hostile and friendly mergers

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Hostile merger:Hostile merger: Target firm’s management Target firm’s management

resists the merger.resists the merger. Acquirer must go directly to the Acquirer must go directly to the

target firm’s stockholders, try to target firm’s stockholders, try to get 51% to tender their shares.get 51% to tender their shares.

Often, mergers that start out Often, mergers that start out hostile end up as friendly, when hostile end up as friendly, when offer price is raised.offer price is raised.

Access to new markets and Access to new markets and technologiestechnologies

Multiple parties share risks and Multiple parties share risks and expensesexpenses

Rivals can often work together Rivals can often work together harmoniouslyharmoniously

Antitrust laws can shelter Antitrust laws can shelter cooperative R&D activitiescooperative R&D activities

Reasons why alliances can make more sense than acquisitions

Reason for APVReason for APV

Often in a merger the capital Often in a merger the capital structure changes rapidly over the structure changes rapidly over the first several years.first several years.

This causes the WACC to change This causes the WACC to change from year to year.from year to year.

It is hard to incorporate year-to-year It is hard to incorporate year-to-year changes in WACC in the corporate changes in WACC in the corporate valuation model.valuation model.

The APV ModelThe APV Model

Value of firm if it had no debtValue of firm if it had no debt+ + Value of tax savings due to debtValue of tax savings due to debt= Value of operations= Value of operations

First term is called the First term is called the unlevered value unlevered value of the firmof the firm. The second term is . The second term is called the value of the called the value of the interest tax interest tax shieldshield. .

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APV ModelAPV Model

Unlevered value of firm = PV of FCFs Unlevered value of firm = PV of FCFs discounted at unlevered cost of discounted at unlevered cost of equity, requity, rsUsU..

Value of interest tax shield = PV of Value of interest tax shield = PV of interest tax savings at unlevered interest tax savings at unlevered cost of equity. Interest tax savings = cost of equity. Interest tax savings =

Interest(tax rate) = TSInterest(tax rate) = TStt . .

Note to APVNote to APV

APV is the best model to use when APV is the best model to use when the capital structure is changing.the capital structure is changing.

The Corporate Valuation model is The Corporate Valuation model is easier than APV to use when the easier than APV to use when the capital structure is constant—such as capital structure is constant—such as at the horizon.at the horizon.

Steps in APV ValuationSteps in APV Valuation

1.1. Project FCFProject FCFtt ,TS ,TStt , horizon growth rate, , horizon growth rate, and horizon capital structure.and horizon capital structure.

2.2. Calculate the unlevered cost of equity, Calculate the unlevered cost of equity, rrsUsU..

3.3. Calculate WACC at horizon.Calculate WACC at horizon.4.4. Calculate horizon value using constant Calculate horizon value using constant

growth corporate valuation model.growth corporate valuation model.

5.5. Calculate VCalculate Vopsops as PV of FCF as PV of FCFtt, TS, TStt and and horizon value, all discounted at rhorizon value, all discounted at rsUsU..

Net salesNet sales $60.0$60.0 $90.0$90.0$112.5$112.5$127.5$127.5Cost of goods sold (60%)Cost of goods sold (60%) 36.0 36.0 54.0 54.0 67.5 67.5 76.5 76.5Selling/admin. expensesSelling/admin. expenses 4.5 4.5 6.0 6.0 7.5 7.5 9.0 9.0EBITEBIT 19.519.5 30.030.0 37.537.5 42.042.0Taxes on EBIT (40%)Taxes on EBIT (40%) 7.8 7.8 12.0 12.0 15.0 15.0 16.8 16.8NOPATNOPAT 11.711.7 18.018.0 22.522.5 25.225.2Net RetentionsNet Retentions 0.0 0.0 7.5 7.5 6.0 6.0 4.5 4.5Free Cash FlowFree Cash Flow 11.711.7 10.510.5 16.516.5 20.720.7

APV Valuation Analysis (In Millions)

2004 2005 2006 2007 Free Cash Flows after Merger Occurs

Interest Tax Savings after Interest Tax Savings after MergerMerger

Interest expenseInterest expense 5.0 5.0 6.56.5 6.56.5 7.07.0

Interest tax savingsInterest tax savings 2.02.0 2.62.6 2.62.6 2.82.8

Interest tax savings are calculated as Interest tax savings are calculated as

interest(T). T = 40%interest(T). T = 40%

2004 2005 2006 2007

What are the net retentions?What are the net retentions?

Recall that firms must reinvest in Recall that firms must reinvest in order to replace worn out assets and order to replace worn out assets and grow.grow.

Net retentions = gross retentions – Net retentions = gross retentions – depreciation.depreciation.

After acquisition, the free cash flows After acquisition, the free cash flows belong to the remaining debtholders in belong to the remaining debtholders in the target and the various investors in the the target and the various investors in the acquiring firm: their debtholders, acquiring firm: their debtholders, stockholders, and others such as stockholders, and others such as preferred stockholders. preferred stockholders.

These cash flows can be redeployed These cash flows can be redeployed within the acquiring firm.within the acquiring firm.

Conceptually, what is the appropriate discount rate to apply to the

target’s cash flows?

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Free cash flow is the cash flow that Free cash flow is the cash flow that would occur if the firm had no would occur if the firm had no debt, so it should be discounted at debt, so it should be discounted at the the unlevered cost of equity.unlevered cost of equity.

The interest tax shields are also The interest tax shields are also discounted at the unlevered cost of discounted at the unlevered cost of equity.equity.

Note: Comparison of APV with Note: Comparison of APV with Corporate Valuation ModelCorporate Valuation Model

APV discounts FCF at rAPV discounts FCF at rsUsU and adds in and adds in present value of the tax shields—the value present value of the tax shields—the value of the tax savings are incorporated of the tax savings are incorporated explicitly.explicitly.

Corp. Val. Model discounts FCF at WACC, Corp. Val. Model discounts FCF at WACC, which has a (1-T) factor to account for the which has a (1-T) factor to account for the value of the tax shield.value of the tax shield.

Both models give same answer IF carefully Both models give same answer IF carefully done. BUT it is difficult to apply the Corp. done. BUT it is difficult to apply the Corp. Val. Model when WACC is changing from Val. Model when WACC is changing from year-to-year.year-to-year.

Discount rate for Horizon ValueDiscount rate for Horizon Value

At the horizon the capital structure is At the horizon the capital structure is constant, so the corporate valuation constant, so the corporate valuation model can be used, so discount FCFs model can be used, so discount FCFs at WACC.at WACC.

Discount Rate Calculations

rsL = rRF + (rM - rRF)bTarget

= 7% + (4%)1.3 = 12.2%

rsU = wdrd + wsrsL

= 0.20(9%) + 0.80(12.2%) = 11.56%

WACC = wd(1-T)rd + wsrsL

=0.20(0.60)9% + 0.80(12.2%)

= 10.84%

Horizon valueHorizon value = =

==

= $453.3 million.= $453.3 million.

Horizon, or Continuing, Value

g WACC

g))(1(FCF2007

06.01084.0

)06.1(7.20$

What Is the value of the Target Firm’s What Is the value of the Target Firm’s operations to the Acquiring Firm? operations to the Acquiring Firm?

(In Millions)(In Millions)

2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 453.3Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $476.8

VOps = + + +

= $344.4 million.

$13.7 (1.1156)1

$13.1 (1.1156)2

$19.1 (1.1156)3

$476.8 (1.1156)4

What is the value of the Target’s equity?What is the value of the Target’s equity?

The Target has $55 million in debt.The Target has $55 million in debt.

Vops – debt = equityVops – debt = equity 344.4 million – 55 million = $289.4 344.4 million – 55 million = $289.4

million = equity value of target to the million = equity value of target to the acquirer.acquirer.

No. The cash flow estimates would No. The cash flow estimates would be different, both due to be different, both due to forecasting inaccuracies and to forecasting inaccuracies and to differential synergies.differential synergies.

Further, a different beta estimate, Further, a different beta estimate, financing mix, or tax rate would financing mix, or tax rate would change the discount rate.change the discount rate.

Would another potential acquirer obtain the same value?

Assume the target company has 20 million shares outstanding. The stock last traded at $11 per share,

which reflects the target’s value on a stand-alone basis. How much should

the acquiring firm offer?

Estimate of target’s value = $289.4 millionEstimate of target’s value = $289.4 million

Target’s current value = Target’s current value = $220.0million$220.0million

Merger premium = Merger premium = $ 69.4 million$ 69.4 million

Presumably, the target’s value is increased by $69.4 million due to merger synergies, although realizing such synergies has been problematic in many mergers.

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The offer could range from The offer could range from $11 $11 to to $289.4/20 = $289.4/20 = $14.47 $14.47 per share.per share.

At At $11$11, all merger benefits would go to , all merger benefits would go to the acquiring firm’s shareholders.the acquiring firm’s shareholders.

At At $14.47$14.47, all value added would go to , all value added would go to the target firm’s shareholders.the target firm’s shareholders.

The graph on the next slide summarizes The graph on the next slide summarizes the situation.the situation.

0 5 10 15 20

Change in Shareholders’

Wealth

Acquirer Target

Bargaining Range = Synergy

Price Paid for Target

$11.00 $14.47

Points About GraphPoints About Graph

Nothing magic about crossover price.Nothing magic about crossover price.

Actual price would be determined by Actual price would be determined by bargaining. Higher if target is in better bargaining. Higher if target is in better bargaining position, lower if acquirer is.bargaining position, lower if acquirer is.

If target is good fit for many acquirers, If target is good fit for many acquirers, other firms will come in, price will be bid other firms will come in, price will be bid up. If not, could be close to $11.up. If not, could be close to $11.

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Acquirer might want to make high Acquirer might want to make high “preemptive” bid to ward off other “preemptive” bid to ward off other bidders, or low bid and then plan to bidders, or low bid and then plan to go up. Strategy is important.go up. Strategy is important.

Do target’s managers have 51% of Do target’s managers have 51% of stock and want to remain in control?stock and want to remain in control?

What kind of personal deal will What kind of personal deal will target’s managers get?target’s managers get?

What if the Acquirer intended to What if the Acquirer intended to increase the debt level in the Target increase the debt level in the Target to 40% with an interest rate of 10%?to 40% with an interest rate of 10%?

Free cash flows wouldn’t change

Assume interest payments in short term won’t change (if they did, it is easy to incorporate that difference)

Long term rsLwill change, so horizon WACC will change, so horizon value will change.

New WACC CalculationNew WACC Calculation

New rsL = rsU + (rsU – rd)(D/S)= 11.56% + (11.56% - 10%)(0.4/0.6) = 12.60%

New WACC = wdrd(1-T) + wsrsL

= 0.4(10%)(1-0.4) + 0.6(12.6%)= 9.96%

New Horizon Value CalculationNew Horizon Value Calculation

Horizon valueHorizon value = =

==

= $554.1 million.= $554.1 million.

g WACC

g))(1(FCF2007

06.01084.0

)06.1(7.20$

New VNew Vopsops and V and Vequityequity

2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 554.1Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $577.6

VOps = + + +

= $409.5 million.

$13.7 (1.1156)1

$13.1 (1.1156)2

$19.1 (1.1156)3

$577.6 (1.1156)4

New Equity ValueNew Equity Value

$409.5 million - 55 million = $354.5 $409.5 million - 55 million = $354.5 millionmillion

This is $65 million, or $3.25 per This is $65 million, or $3.25 per share more than if the horizon capital share more than if the horizon capital structure is 20% debt.structure is 20% debt.

The added value is the value of the The added value is the value of the additional tax shield from the additional tax shield from the increased debt. increased debt.

According to empirical evidence, According to empirical evidence, acquisitions do create value as a result acquisitions do create value as a result of economies of scale, other synergies, of economies of scale, other synergies, and/or better management.and/or better management.

Shareholders of target firms reap most Shareholders of target firms reap most of the benefits, that is, the final price is of the benefits, that is, the final price is close to full value.close to full value. Target management can always say no.Target management can always say no. Competing bidders often push up prices.Competing bidders often push up prices.

Do mergers really create value?

Pooling of interests is GONE. Only Pooling of interests is GONE. Only purchase accounting may be used purchase accounting may be used now.now.

What method is used to account for for mergers?

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Purchase:Purchase: The assets of the acquired firm are The assets of the acquired firm are

“written up” to reflect purchase price if “written up” to reflect purchase price if it is greater than the net asset value.it is greater than the net asset value.

GoodwillGoodwill is often created, which is often created, which appears as an asset on the balance appears as an asset on the balance sheet.sheet.

Common equity account is increased Common equity account is increased to balance assets and claims.to balance assets and claims.

Goodwill AmortizationGoodwill Amortization

Goodwill is NO LONGER amortized Goodwill is NO LONGER amortized over time for shareholder reporting.over time for shareholder reporting.

Goodwill is subject to an annual Goodwill is subject to an annual “impairment test.” If its fair market “impairment test.” If its fair market value has declined, then goodwill is value has declined, then goodwill is reduced. Otherwise it is not.reduced. Otherwise it is not.

Goodwill is still amortized for Federal Goodwill is still amortized for Federal Tax purposes.Tax purposes.

Identifying targetsIdentifying targets Arranging mergersArranging mergers Developing defensive tacticsDeveloping defensive tactics Establishing a fair valueEstablishing a fair value Financing mergersFinancing mergers Arbitrage operationsArbitrage operations

What are some merger-related activities of investment bankers?

In an In an LBOLBO, a small group of , a small group of investors, normally including investors, normally including management, buys all of the management, buys all of the publicly held stock, and hence publicly held stock, and hence takes the firm privatetakes the firm private..

Purchase often financed with debt.Purchase often financed with debt. After operating privately for a After operating privately for a

number of years, investors take number of years, investors take the firm public to “cash out.” the firm public to “cash out.”

What is a leveraged buyout (LB0)?

Advantages:Advantages: Administrative cost savingsAdministrative cost savings Increased managerial incentivesIncreased managerial incentives Increased managerial flexibilityIncreased managerial flexibility Increased shareholder participationIncreased shareholder participation

Disadvantages:Disadvantages: Limited access to equity capitalLimited access to equity capital No way to capture return on investmentNo way to capture return on investment

What are are the advantages and disadvantages of going private?

Sale of an entire subsidiary to another Sale of an entire subsidiary to another firm.firm.

Spinning off Spinning off a corporate subsidiary by a corporate subsidiary by giving the stock to existing shareholders.giving the stock to existing shareholders.

Carving out Carving out a corporate subsidiary by a corporate subsidiary by selling a minority interest.selling a minority interest.

Outright liquidation of assets.Outright liquidation of assets.

What are the major types of divestitures?

Subsidiary worth more to buyer than Subsidiary worth more to buyer than when operated by current owner.when operated by current owner.

To settle antitrust issues.To settle antitrust issues. Subsidiary’s value increased if it Subsidiary’s value increased if it

operates independently.operates independently. To change strategic direction.To change strategic direction. To shed money losers.To shed money losers. To get needed cash when distressed.To get needed cash when distressed.

What motivates firms to divest assets?

A A holding company holding company is a corporation is a corporation formed for the sole purpose of owning formed for the sole purpose of owning the stocks of other companies.the stocks of other companies.

In a typical holding company, the In a typical holding company, the subsidiary companies issue their own subsidiary companies issue their own debt, but their equity is held by the debt, but their equity is held by the holding company, which, in turn, sells holding company, which, in turn, sells stock to individual investors.stock to individual investors.

What are holding companies?

Advantages:Advantages: Control with fractional ownership.Control with fractional ownership.

Isolation of risks.Isolation of risks.

Disadvantages:Disadvantages: Partial multiple taxation.Partial multiple taxation.

Ease of enforced dissolution.Ease of enforced dissolution.

What are the advantages and disadvantages of holding companies?