Receivables Management and Factoring

Mergers & Acquisitions a primerDr Kousik GuhathakurtaIndian Institute of Management KozhikodeWhy Engage in Corporate Restructuring?Sales enhancement and operating economies*Improved managementInformation effectWealth transfersTax reasonsLeverage gainsHubris hypothesisManagements personal agenda

Sales Enhancement and Operating EconomiesSales enhancement can occur because of market share gain, technological advancements to the product table, and filling a gap in the product line.Operating economies can be achieved because of the elimination of duplicate facilities or operations and personnel.Synergy -- Economies realized in a merger where the performance of the combined firm exceeds that of its previously separate parts.Sales Enhancement and Operating EconomiesHorizontal merger: best chance for economiesVertical merger: may lead to economiesConglomerate merger: few operating economiesDivestiture: reverse synergy may occurEconomies of Scale -- The benefits of size in which the average unit cost falls as volume increases.Strategic Acquisitions Involving Common StockWhen the acquisition is done for common stock, a ratio of exchange, which denotes the relative weighting of the two companies with regard to certain key variables, results.A financial acquisition occurs when a buyout firm is motivated to purchase the company (usually to sell assets, cut costs, and manage the remainder more efficiently), but keeps it as a stand-alone entity.Strategic Acquisition -- Occurs when one company acquires another as part of its overall business strategy.Strategic Acquisitions Involving Common StockExample -- Company A will acquire Company B with shares of common stock.Present earnings$20,000,000$5,000,000Shares outstanding 5,000,000 2,000,000Earnings per share$4.00 $2.50Price per share$64.00 $30.00Price / earnings ratio 16 12Company A Company BStrategic Acquisitions Involving Common StockExample -- Company B has agreed on an offer of $35 in common stock of Company A.Total earnings$25,000,000Shares outstanding* 6,093,750Earnings per share$4.10Surviving Company AExchange ratio = $35 / $64 = .546875* New shares from exchange = .546875 x 2,000,000 = 1,093,750 Strategic Acquisitions Involving Common StockThe shareholders of Company A will experience an increase in earnings per share because of the acquisition [$4.10 post-merger EPS versus $4.00 pre-merger EPS].The shareholders of Company B will experience a decrease in earnings per share because of the acquisition [.546875 x $4.10 = $2.24 post-merger EPS versus $2.50 pre-merger EPS].Strategic Acquisitions Involving Common StockSurviving firm EPS will increase any time the P/E ratio paid for a firm is less than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio paid for Company B is $35/$2.50 = 14 versus pre-merger P/E ratio of 16 for Company A.]Strategic Acquisitions Involving Common StockExample -- Company B has agreed on an offer of $45 in common stock of Company A.Total earnings$25,000,000Shares outstanding* 6,406,250Earnings per share$3.90Surviving Company AExchange ratio = $45 / $64 = .703125* New shares from exchange = .703125 x 2,000,000 = 1,406,250 Strategic Acquisitions Involving Common StockThe shareholders of Company A will experience a decrease in earnings per share because of the acquisition [$3.90 post-merger EPS versus $4.00 pre-merger EPS].The shareholders of Company B will experience an increase in earnings per share because of the acquisition [.703125 x $4.10 = $2.88 post-merger EPS versus $2.50 pre-merger EPS].Strategic Acquisitions Involving Common StockSurviving firm EPS will decrease any time the P/E ratio paid for a firm is greater than the pre-merger P/E ratio of the firm doing the acquiring. [Note: P/E ratio paid for Company B is $45/$2.50 = 18 versus pre-merger P/E ratio of 16 for Company A.]What About Earnings Per Share (EPS)?Merger decisions should not be made without considering the long-term consequences.The possibility of future earnings growth may outweigh the immediate dilution of earnings.With themergerWithout themergerTime in the Future (years)Expected EPS ($)Initially, EPS is less with the merger.Eventually, EPS is greater with the merger.EqualMarket Value ImpactThe above formula is the ratio of exchange of market price.If the ratio is less than or nearly equal to 1, the shareholders of the acquired firm are not likely to have a monetary incentive to accept the merger offer from the acquiring firm.Market price per shareof the acquiring companyNumber of shares offered bythe acquiring company for eachshare of the acquired companyMarket price per share of the acquired companyXMarket Value ImpactExample -- Acquiring Company offers to acquire Bought Company with shares of common stock at an exchange price of $40.Present earnings$20,000,000$6,000,000Shares outstanding 6,000,000 2,000,000Earnings per share$3.33 $3.00Price per share $60.00 $30.00Price / earnings ratio 18 10Acquiring BoughtCompany Company Market Value ImpactExchange ratio = $40 / $60 = .667Market price exchange ratio = $60 x .667 / $30 = 1.33Total earnings$26,000,000Shares outstanding* 7,333,333Earnings per share$3.55Price / earnings ratio 18Market price per share $63.90Surviving Company* New shares from exchange = .666667 x 2,000,000 = 1,333,333 Market Value ImpactNotice that both earnings per share and market price per share have risen because of the acquisition. This is known as bootstrapping.The market price per share = (P/E) x (Earnings).Therefore, the increase in the market price per share is a function of an expected increase in earnings per share and the P/E ratio NOT declining.The apparent increase in the market price is driven by the assumption that the P/E ratio will not change and that each dollar of earnings from the acquired firm will be priced the same as the acquiring firm before the acquisition (a P/E ratio of 18).Empirical Evidence on MergersTarget firms in a takeover receive an average premium of 30%.Evidence on buying firms is mixed. It is not clear that acquiring firm shareholders gain. Some mergers do have synergistic benefits.BuyingcompaniesSellingcompaniesTIME AROUND ANNOUNCEMENT(days)Announcement date0-+CUMULATIVE AVERAGEABNORMAL RETURN (%)Valuing SynergyThe key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable if combined with the bidding firm's resources. The specialized resource will vary depending upon the merger:In horizontal mergers: economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales. (Examples: Bank of America and Security Pacific, Chase and Chemical)In vertical integration: Primary source of synergy here comes from controlling the chain of production much more completely. In functional integration: When a firm with strengths in one functional area acquires another firm with strengths in a different functional area, the potential synergy gains arise from exploiting the strengths in these areas.19Valuing operating synergy(a) What form is the synergy expected to take? Will it reduce costs as a percentage of sales and increase profit margins (as is the case when there are economies of scale)? Will it increase future growth (as is the case when there is increased market power)? )(b) When can the synergy be reasonably expected to start affecting cashflows? (Will the gains from synergy show up instantaneously after the takeover? If it will take time, when can the gains be expected to start showing up? )20A procedure for valuing synergy(1) the firms involved in the merger are valued independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm. (2) the value of the combined firm, with no synergy, is obtained by adding the values obtained for each firm in the first step. (3) The effects of synergy are built into expected growth rates and cashflows, and the combined firm is re-valued with synergy. Value of Synergy = Value of the combined firm, with synergy - Value of the combined firm, without synergy21Synergy Effects in Valuation InputsIf synergy isValuation Inputs that will be affected areEconomies of ScaleOperating Margin of combined firm will be greater than the revenue-weighted operating margin of individual firms.Growth SynergyMore projects:Higher Reinvestment Rate (Retention)Better projects: Higher Return on Capital (ROE)Longer Growth PeriodAgain, these inputs will be estimated for the combined firm.22Valuing Synergy: Compaq and DigitalIn 1997, Compaq acquired Digital for $ 30 per share + 0.945 Compaq shares for every Digital share. ($ 53-60 per share) The acquisition was motivated by the belief that the combined firm would be able to find investment opportunities and compete better than the firms individually could. 23Background DataCompaqDigital: Opt MgdCurrent EBIT $ 2,987 million$ 522 millionCurrent Revenues$25,484 mil$13,046 milCapital Expenditures - Depreciation$ 184 million$ 14 (offset)Expected growth rate -next 5 years10%10%Expected growth rate after year 55%5%Debt /(Debt + Equity)10%20%After-tax cost of debt5%5.25%Beta for equity - next 5 years1.251.25Beta for equity - after year 51.001.0Working Capital/Revenues15%15%Tax rate is 36% for both companies24Valuing CompaqYearFCFFTerminal ValuePV1$1,518.19 $1,354.47 2$1,670.01 $1,329.24 3$1,837.01 $1,304.49 4$2,020.71 $1,280.19 5$2,222.78 $56,654.81 $33,278.53 Terminal Year$2,832.74 $38,546.91Value of Compaq = $ 38,547 million After year 5, capital expenditures will be 110% of depreciation.

25Combined Firm ValuationThe Combined firm will have some economies of scale, allowing it to increase its current after-tax operating margin slightly. The dollar savings will be approximately $ 100 million.Current Operating Margin = (2987+522)/(25484+13046) = 9.11%New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years, because of operating synergies.The beta of the combined firm is computed in two steps:Digitals Unlevered Beta = 1.07; Compaqs Unlevered Beta=1.17Digitals Firm Value = 4.5; Compaqs Firm Value = 38.6Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16Combined Firms Debt/Equity Ratio = 13.64%New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98%26Combined Firm ValuationYearFCFFTerminal ValuePV1$1,726.65 $1,541.95 2$1,907.95 $1,521.59 3$2,108.28 $1,501.50 4$2,329.65 $1,481.68 5$2,574.26 $66,907.52 $39,463.87 Terminal Year$3,345.38 Value of Combined Firm= $ 45,511

27The Value of SynergyValue of Combined Firm wit Synergy= $45,511 millionValue of Compaq + Value of Digital= 38,547 + 4532 = $ 44,079 millionTotal Value of Synergy = $ 1,432 million28Digital: Valuation BlocksValue of Firm - Status Quo= $ 2,110 million+ Value of Control= $ 2,521 millionValue of Firm - Change of Control= $ 4,531 million + Value of Synergy= $ 1,432 millionTotal Value of Digital with Synergy= $ 5,963 million 29Estimating Offer Prices and Exchange RatiosThere are 146.789 million Digital shares outstanding, and Digital had $1,006 million in debt outstanding. Estimate that maximum price you would be willing to offer on this deal.

Assume that Compaq wanted to do an exchange offer, where it would exchange its shares for Digital shares. Assuming that Compaq stock is valued at $27 per share, what would be the exchange ratio?30Evaluating Compaqs OfferValue of Digital with Synergy =$5,963 mil - Value of Cash paid in deal = $ 30 * 146.789 mil shrs =$4,403 mil - Digitials Outstanding Debt (assumed by Compaq)$1,006 milRemaining Value $ 554 mil / number of Shares outstanding146.789= Remaining Value per Share$ 3.77Compaqs value per share at time of Exchange Offer$ 27Appropriate Exchange Ratio = 3.77/27 = 0.14 Compaq shares for every Digital shareActual Exchange Ratio = 0.945 Compaq shares/Digital Share

31Citicorp + Travelers = ?CiticorpTravelersCitigroupNet Income $ 3,591 $ 3,104 $ 6,695 BV of Equity $ 20,722 $ 20,736 $ 41,458 ROE17.33%14.97%16.15%Dividends $ 1,104 $ 587 $ 1,691 Payout Ratio30.74%18.91%25.27%Retention Ratio69.26%81.09%74.73%Expected growth12.00%12.14%12.07%Growth Period555Beta1.251.401.33Risk Premium4.00%4.00%4.00%MV of Equity (bil)8184165.00Cost of Equity11.00%11.60%11.31%Beta - stable1.001.001.00Growth-stable6.00%6.00%6.00%Payout-stable65.38%59.92%62.85%DDM $ 70,743 $ 53,464 $ 124,009 DDM/share 155.84 46.38

32The Right Exchange RatioBased upon these numbers, what exchange ratio would you agree to as a Citicorp stockholder?

The actual exchange ratio was 2.5 shares of Travelers for every share of Citicorp. As a Citicorp stockholder, do you think that this is a reasonable exchange ratio?33The Value of Synergy

34Chart281851628724255

Increase in Value of EquityChange in ROE of combined firmIncrease in Equity ValueIncrease in Value of Equity as ROE Increase

Sheet1CiticorpTravelersCitigroupNet Income$3,591$3,104$6,695BV of Equity$20,722$20,736$41,458ROE17.33%14.97%19.15%Dividends$1,104$587$1,691Payout Ratio30.74%18.91%25.27%Retention Ratio69.26%81.09%74.73%Expected growth12.00%12.14%14.31%Number of years of growth6$1,553Growth Period5557$5,12587713Beta1.251.401.33910320Risk Premium4.00%4.00%4.00%1012944MV of Equity (bil)8184165.00Cost of Equity11.00%11.60%11.31%ROEIncrease in Value of EquityBeta - stable1.001.001.00Increase by1%8185Growth-stable6.00%6.00%6.00%Increase by 2%16287Payout-stable65.38%59.92%68.67%Increase by 3%24255DDM$70,743$53,464$148,354DDM/share155.8446.38124009

Sheet1

Increase in Value of EquityChange in ROE of combined firmIncrease in Equity ValueIncrease in Value of Equity as ROE Increase

Sheet2

Sheet3