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26-2
Topics in Chapter
Types of mergers Merger analysis Role of investment bankers LBOs, divestitures, and holding
companies
26-3
Economic Justifications for Mergers
Synergy = Value of the whole exceeds sum of the parts Operating economies Financial economies Differential management efficiency Taxes (use accumulated losses)
Break-up value = Assets more valuable broken up and sold
26-4
QuestionableReasons for Mergers
Diversification Purchase of assets below
replacement cost Acquire other firms to increase
size, thus making it more difficult to be acquired
26-5
Merger Types
Horizontal Vertical Congeneric
Related but not same industry Conglomerate
Unrelated enterprises
26-7
Friendly & Hostile Mergers Friendly merger:
Supported by management of both firms Hostile merger:
Target firm’s management resists the merger
Acquirer must go directly to the target firm’s stockholders – “tender offer” - try to get 51% to tender their shares.
Often, mergers that start out hostile end up as friendly, when offer price is raised
26-8
Merger Analysis
DCF Analysis Corporate Valuation (Ch 11) Adjusted Present Value Method (Ch
26.7) Equity Residual Model (Ch 26.8)
= Free Cash Flow to Equity Method
Market Multiples Analysis Provides a “benchmark”
26-9
The APV Model
Value of firm if it had no debt+ Value of tax savings due to
debt= Value of operations
First term = unlevered value of the firmSecond term = value of the interest tax
shield
26-10
The APV Model
TDVV UL (15-7)
(16-4)
(26-1)
1tt
sU
tUOP )R1(
FCFVV
1tt
sU
tTS )r1(
TSV
(15-1)
(26-2)
(26-3)
26-11
APV Model
VU = Unlevered value of firm
= PV of FCFs discounted at unlevered cost of equity, rsU
VTS = Value of interest tax shield
= PV of interest tax savings discounted at unlevered cost of equity, rsU
Interest tax savings = Interest * (tax rate) = TSt
26-12
APV vs. Corporate Valuation
Best model when capital structure is changing Merger often causes capital structure
changes over the first several years Causes WACC to change from year to year Hard to incorporate year-to-year WACC
changes in the corporate valuation model Corporate Valuation (i.e., discount FCF at
WACC) = easier than APV when capital structure is constant
26-13
Steps in APV Valuation
1. Calculate unlevered cost of equity, rsU
2. Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter.
ddsLssU
dsUsUsL
rwrwr
)SD)(T1)(rr(rr
(16-6)
(26-4)
(26-5)
26-14
Steps in APV Valuation
3. Project horizon growth rate, g Calculate horizon value of unlevered
firm using constant growth formula and FCFN
Calculate horizon value of tax shields using constant growth formula and TSN
gr
)g1(FCF
gr
FCFHV
sUsU
1NN,U
gr
)g1(TS
gr
TSHV
sUsU
1NN,TS
(26-7)
(26-8)
26-15
Steps in APV Valuation
4. Calculate Value of Operations Calculate unlevered value of firm as PV
of unlevered horizon value and FCFt
Calculate value of tax shields as PV of tax shield horizon value and TSt
N
1tN
sU
N,U
tU,s
tU )r1(
HV
)r1(
FCFV
N
1tN
sU
N,TS
tU,s
tTS )r1(
HV
)r1(
TSV
(26-9)
(26-10)
26-16
Steps in APV Valuation4. Calculate Value of Operations
Calculate Vop as sum of unlevered value and tax shield value
5. Find total value of the firm
TSUOP VVV (26-11)
shares #SP
debt of Value
assets operating-non of Value
F
Fop
opTSU
VS
VV
VVV
26-17
The FCFE Approach FCFE = Free Cash Flow to Equity
Cash flow available for distribution to common shareholders
debt issued newly payments principal
- expenseinterest tax-After
FCFFCFE
debt in changenet shield taxinterest
capital operating in investmentNet
NIFCFE
(26-12)
26-18
FCFE Approach Value of Equity =
Assuming constant growth:
1tt
sL
tFCFE )r1(
FCFEV
gr
)g1(FCFE
gr
FCFEHV
sLsL
1NN,FCFE
N
1tN
sL
N,FCFE
tsL
tFCFE )r1(
HV
)r1(
FCFEV
(26-13)
(26-14)
(26-15)
assets operating-Non FCFEVS (26-16)
26-20
Valuation Examples Caldwell Inc’s acquisition of
Tutwiler Tutwiler
Market value of equity = $62.5 m Debt = $27 m Total market value = $89.5 m % Debt = 30.17% Cost of debt, rd = 9% 10 million shares outstanding
26-21
Tutwiler Acquisition
Tutwiler’s pre-merger beta = 1.20 Risk-free rate = 7% Market risk premium = 5%
CAPM rsL= 13%
%707.10WACC
%)13(6983.0%)9)(60.0(3017.0WACC
rwr)T1(wWACC sLsdd
26-22
Tutwiler Acquisition
Both firms = 40% tax rate Post-horizon g= 6% Caldwell will issue debt to maintain
constant capital structure: $6.2 m debt increase at merger
26-23
Projecting Post-Merger CFs
01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel A: Selected Items
1 Net Sales $105.0 $126.0 $151.0 $174.0 $191.0
2 Cost of goods sold 80.0 94.0 113.0 129.3 142.0
3 Selling & Admin expenses 10.0 12.0 13.0 15.0 16.0
4 Depreciation 8.0 8.0 9.0 9.0 10.0
5 EBIT 7.0 12.0 16.0 20.7 23.0
6 Interest Expense 3.0 3.2 3.5 3.7 3.9
7 Debt 33.2 35.8 38.7 41.1 43.6 46.2
8 Total Net Operating Capital 116.0 117.0 121.0 125.0 131.0 138.0
26-24
Post-Merger CF Projections01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel B Corporate Valuation CFs
9 NOPAT=EBIT(1-T) (T=40%) $4.2 $7.2 $9.6 $12.4 $13.8
10 Less net invest. In op cap 1.0 4.0 4.0 6.0 7.0
11 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Panel C: APV Model Cash Flows
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
13 Interst tax savings = INT(T) 1.2 1.28 1.4 1.48 1.56
Panel D: FCFE Model Cash Flows
14 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
15 Less A-T Interest=INT(1-T) 1.8 1.9 2.1 2.2 2.4
16 Plus Δdebt 6.2 2.6 2.9 2.5 2.5 2.6
17 FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $7.1
26-25
Tutwiler – Corporate Valuation
m1.83$27$1.110$
1.110$V
m1.153$06.01070/0
)06.1(800.6$HV
gWACC
)g1(FCF
gWACC
FCFHV
Operation
2014,OP
201420152014,OP
Equity of Value
(26-7)
26-26
Tutwiler: Corporate Valuation
Panel B Corporate Valuation CFs
9 NOPAT=EBIT(1-T) (T=40%) $4.2 $7.2 $9.6 $12.4 $13.8
10 Less net invest. In op cap 1.0 4.0 4.0 6.0 7.0
11 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon value $153.1
FCF $3.2 $3.2 $5.6 $6.4 $159.9
Present Value of FCF $110.1
Minus Value of current debt $27.0
Value of Equity $83.1
26-27
Tutwiler – APV Approach
%793.11r
%)9(3017.0%)13(6983.0r
rwrwr
sU
sU
ddsLssU
5)-(26
Estimate Tutwiler’s Unlevered Cost of Equity:
26-28
Tutwiler – APV Approach
Panel C: APV Model Cash Flows
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon Value of FCF $124.4
Total FCF $3.2 $3.2 $5.6 $6.4 $131.2
Value (Unlevered) $88.7
13 Interest tax savings = INT(T) 1.2 1.28 1.4 1.48 1.56
Horizon Value of tax savings $28.7
Total Tax Shield $1.2 $1.3 $1.4 $1.5 $30.3
Value(Tax Shield) $21.4
Total Value of Firm $110.1
Minus Value of current debt $27.0 r(sU) 11.793%
Value of Equity $83.1 g = 6%
26-29
Tutwiler – FCFE Model
m9.106$06.013.0
)06.1(06.7$HV
gr
)g1(FCFE
gr
FCFEHV
N,FCFE
sLsL
20152014,FCFE
(26-14)
26-30
Panel D: FCFE Model Cash Flows
14 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
15 Less A-T Interest=INT(1-T) 1.8 1.9 2.1 2.2 2.4
16 Plus Δdebt 6.2 2.6 2.9 2.5 2.5 2.6
17 FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $7.1
Horizon value of FCFE 106.9
Total FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $114.0
Value of FCFE $83.1
r(sL) 13.0%
g = 6%
Tutwiler – FCFE Model
26-31
Tutwiler Value Recap
Tutwiler is worth more as part of Caldwell than stand-alone
Current Value of Equity $62.5
Corporate Valuation $83.1
APV Approach $83.1
FCFE Model $83.1
TUTWILER Equity
26-32
The Bid PriceCaldwell’s Bid for Tutwiler
Caldwell will assume Tutwiler’s debt Added short-term debt for acquisition
Analysis shows Tutwiler worth $83.1m to Caldwell If Caldwell pays more Caldwell
value diluted How much should Caldwell offer?
26-33
Caldwell’s Bid for Tutwiler
Target’s Estimated value = $83.1 million
Target’s current value = $62.5 million
Merger premium = $20.6 million “Synergistic Benefits” = $20.6 million
Realizing synergies has been problematic in many mergers
26-34
Caldwell’s Bid
Offer range = $62.5m to $83.1m $62.5m → merger benefits
would go to the acquiring firm’s shareholders
$83.1m →all value added would go to the target firm’s shareholders
26-35
Bid Strategy Issues
High “preemptive” bid to ward off other bidders
Low bid and then plan to go up Do target’s managers have 51% of
stock and want to remain in control?
What kind of personal deal will target’s managers get?
26-36
Do mergers really create value?
According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management.
Target firm shareholders reap most of the benefits Final price close to full value Target management can always say no Competing bidders often push up prices
26-37
Acquisition with Permanent Change in Capital Structure
Tutwiler currently: $62.5m value of equity $27m debt = 30.17% debt
Caldwell’s plan Increase debt to 50% Maintain level from 2012 on New rate on debt = 9.5%
Tax shield, WACC and bid price will change
26-38
Change in Tax Shield
This last debt level is consistent with the assumed long-term capital structure
The last interest payment is consistent with the long-term capital structure
9. Debt 52.63 63.16 73.68 78.95 87.33
10. Interesta 5.000 6.000 7.000 7.500 8.29611. Interest tax savings 2.000 2.400 2.800 3.000 3.319
26-39
Effect on the Bid Price
New Horizon Value Calculation
First, calculate Tutwiler's horizon value if it were unlevered.
HVU = FCF 2014 * (1 + g) ÷ (rU - g)
HVU = 6.8 * 1.060 ÷ 0.1179 - 0.06
HVU = $124.42
Second, calculate the horizon value of Tutwiler's tax shields under new financing plan:
HVTS = TS 2014 * (1 + g) ÷ (rU - g)
HVTS = 3.319 * 1.060 ÷ 0.1179 - 0.06
HVTS = $60.72
Horizon value of Tax Shields is larger due to increased debt level.
26-40
Revised Value of Tutwiler
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon Value of FCF $124.4
Total FCF $3.2 $3.2 $5.6 $6.4 $131.2
Value (Unlevered) $88.7
13 Interest tax savings = INT(T) 2.0 2.4 2.8 3.0 3.3
Horizon Value of tax savings $60.7
Total Tax Shield $2.0 $2.4 $2.8 $3.0 $64.0
Value(Tax Shield) $44.3
Total Value of Firm $133.0
Minus Value of current debt $27.0 r(sU) 11.793%
Revised Value of Equity $106.0 g = 6%
Panel C: APV Model Cash Flows with Increased Debt
26-41
Recap: Value of Tutwiler Equity
Total Per Sh
Current Value of Equity $62.5 $6.25
Original Merger Value $83.1 $8.31
APV Approach Revised $106.0 $10.60
TUTWILER Equity
26-43
Bid Structure Effects
Capital structure of post-merger firm
Tax treatment of shareholders Ability of target shareholders to
benefit from post merger gains Federal & state regulations
applied to acquiring firm
26-44
Tax Consequences Shareholders
Taxable Offer Payment = primarily cash or bonds IRS views as a “sale” Target shareholders taxed on gain
Original purchase price vs. Offer price Taxed in year of merger
26-45
Non-taxable Offer Payment = primarily stock IRS views as an “exchange” Target shareholder pay no taxes
at time of merger Taxed at time of stock sale Preferred by shareholders
Tax Consequences Shareholders
26-46
Tax Consequences Firms
Non-taxable offer Simple merger of balance sheets Continue depreciating target’s assets
as previously Taxable offer – depends on offer
type Offer for target’s assets Offer for target’s stock
26-47
Taxable Offer for Target’s assets Acquirer pays gain on offer – asset
value Acquirer records target’s assets at
appraised value Depreciation based on new valuation
“Goodwill” = offer – new valuation Amortized over 15 years/straight line
Tax Consequences Firms
26-48
Taxable Offer for Target’s Stock 2 Choices of tax treatment
1. Record acquired assets at book value and continue depreciating on current
schedule2. Record acquired assets at appraised value and generate goodwill
Tax Consequences Firms
26-50
Purchase Accounting Purchase:
Assets of acquired firm are “written up or down” to reflect purchase price relative to net asset value
Goodwill often created An asset on the balance sheet
Common equity account increased to balance assets and claims
26-53
Goodwill Amortization
Goodwill amortization: No longer amortized over time for
shareholder reporting Still amortized for Federal Tax purposes
Goodwill subject to annual “impairment test” If fair market value has declined, then
goodwill is reduced
26-54
The Role of Investment Bankers
Arranging mergers Identifying targets
Developing defensive tactics Establishing a fair value Financing mergers Arbitrage operations
26-55
Defensive Tactics “Super Majority”
1/3 of Directors elected each year 75% approval for merger versus simple majority
Convince target price is too low Raising anti-trust issues Open market repurchase of stock to push price
up Finding a “White Knight” Finding a “White Squire” Taking a “Poison Pill” ESOP plans
26-56
Poison Pills
Any technique used to discourage hostile takeovers Borrowing on terms that require
immediate repayment if acquired Selling desirable assets at low prices Granting lucrative “golden
parachutes” Allowing current shareholders to buy
shares at reduced prices
26-57
Risk Arbitrage
“Arbitrageurs” or “arbs” Speculation in likely takeover
targets Insider trading scandals
Ivan Boesky
26-58
Who Wins?
Takeovers increase the wealth of target firm shareholders
Benefit to acquiring firm debatable
“Event Studies” – Target stock price 30% for hostile tender offers 20% for friendly mergers
26-59
Alliances versus Acquisitions
Access to new markets and technologies
Multiple parties share risks and expenses
Rivals can often work together harmoniously
Antitrust laws can shelter cooperative R&D activities
26-60
Leveraged Buyout (LB0)
Small group of investors buys all publicly held stock Takes the firm private Group usually includes management
Purchase often financed with large amounts of high-yield debt
Investors take firm public to “cash out”
26-61
Advantages and Disadvantages of Going Private
Advantages: Administrative cost savings Increased managerial incentives Increased managerial flexibility Increased shareholder participation
Disadvantages: Limited access to equity capital No way to capture return on
investment
26-62
Types of Divestitures
Sale of entire subsidiary to another firm “Spin-off”
Spinning off a corporate subsidiary by giving the stock to existing shareholders
“Carve-out” Selling a minority interest in a subsidiary
Outright liquidation of assets
26-63
Motivation for Divestitures
Subsidiary worth more to buyer than when operated by current owner
Settle antitrust issues Subsidiary’s value increased
operated independently Change strategic direction Shed money losers Get needed cash when distressed
26-64
Holding Companies
Corporation formed for sole purpose of owning the stocks of other companies
Typically, subsidiary companies: Issue their own debt Equity held by the holding company Holding company sells stock to
individual investors