Mergers and Divestitures

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CHAPTER 21

Mergers and Divestitures

Types of mergers Merger analysis

Role of investment bankers Corporate alliances LBOs, divestitures, and

holding companies


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Why do mergers occur? Synergy: Value of the whole exceeds

sum of the parts. Could arise from:

Operating economies Financial economies

Differential management efficiency

Increased market power

Taxes (use accumulated losses)

Break-up value: Assets would be morevaluable if sold to some other company.


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questionable reasons for

mergers? Diversification

Purchase of assets at belowreplacement cost

Get bigger using debt-financedmergers to help fight off

takeovers


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What is the difference betweena friendly and a hostile

takeover? Friendly merger:

The merger is supported by the managements ofboth firms.

Hostile merger: Target firms management resists the merger.

Acquirer must go directly to the target firmsstockholders try to get 51% to tender their shares.

Often, mergers that start out hostile end up as

friendly when offer price is raised.


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Reasons why alliances can make

more sense than acquisitions Access to new markets and

technologies

Multiple parties share risks andexpenses

Rivals can often work together

harmoniously Antitrust laws can shelter

cooperative R&D activities


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Merger analysis:Post-merger cash flow

statements2003 2004 2005 2006

Net sales $60.0 $90.0 $112.5 $127.5

- Cost of goods sold 36.0 54.0 67.5 76.5

- Selling/admin. exp. 4.5 6.0 7.5 9.0- Interest expense 3.0 4.5 4.5 6.0

EBT 16.5 25.5 33.0 36.0

- Taxes 6.6 10.2 13.2 14.4

Net Income 9.9 15.3 19.8 21.6

Retentions 0.0 7.5 6.0 4.5

Cash flow 9.9 7.8 13.8 17.1


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What is the appropriate discountrate to apply to the targets cash

flows? Estimated cash flows are residuals which

belong to acquirers shareholders.

They are riskier than the typical capital

budgeting cash flows. Because fixed interestcharges are deducted, this increases thevolatility of the residual cash flows.

Because the cash flows are risky equity flows,they should be discounted using the cost ofequity rather than the WACC.


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Discounting the targets cash

flowsThe cash flows reflect the

targets business risk, not the

acquiring companys. However, the merger will affect

the targets leverage and taxrate, hence its financial risk.


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Calculating terminal value Find the appropriate discount rate

kS(Target) = kRF + (kM kRF )Target

= 9% + (4%)(1.3) = 14.2% Determine terminal value

TV2006 = CF2006 (1 + g) / (kS g)

= $17.1 (1.06) / (0.142 0.06)

=$221.0 million


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Net cash flow stream2003 2004 2005 2006

Annual cash flow $9.9 $7.8 $13.8 $ 17.1

Terminal value 221.0Net cash flow $9.9 $7.8 $13.8 $238.1

Value of target firm

Enter CFs in calculator CFLO register, and enter I/YR =14.2%. Solve for NPV = $163.9 million


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ou ano er acqu r ngcompany obtain the same

value? No. The input estimates would be

different, and different synergies

would lead to different cash flowforecasts.

Also, a different financing mix or taxrate would change the discount rate.


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outstanding at a price of $9.00 pershare. What should the offering

price be?The acquirer estimates the maximum pricethey would be willing to pay by dividing thetargets value by its number of shares:

Max price = Targets value / # of shares

= $163.9 million / 10 million

= $16.39

Offering range is between $9 and $16.39 pershare.


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Making the offerThe offer could range from $9 to

$16.39 per share.

At $9 all the merger benefits wouldgo to the acquirers shareholders. At $16.39, all value added would go

to the targets shareholders. Acquiring and target firms must

decide how much wealth they arewilling to forego.


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Shareholder wealth in a

mergerShareholders

Wealth

Acquirer Target

BargainingRange

Price Paidfor Target

$9.00 $16.39

0 5 10 15 20


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Shareholder wealth Nothing magic about crossover price from

the graph.

Actual price would be determined bybargaining. Higher if target is in betterbargaining position, lower if acquirer is.

If target is good fit for many acquirers,

other firms will come in, price will be bidup. If not, could be close to $9.


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Shareholder wealth Acquirer might want to make high

preemptive bid to ward off other

bidders, or low bid and then plan togo up. It all depends upon theirstrategy.

Do targets managers have 51% of

stock and want to remain in control? What kind of personal deal will

targets managers get?


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Do mergers really createvalue?

The evidence strongly suggests: Acquisitions do create value as a

result of economies of scale, othersynergies, and/or bettermanagement.

Shareholders of target firms reapmost of the benefits, because ofcompetitive bids.


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Functions of InvestmentBankers in Mergers

Arranging mergers Assisting in defensive tactics Establishing a fair value Financing mergers Risk arbitrage

Documents

Mergers and Divestitures