0359 chapter 10 power point z

8/8/2019 0359 Chapter 10 Power Point z

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McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.1

Chapter 10

MERGERS AND ACQUISITIONS

Behavioral Corporate Finance

by Hersh Shefrin


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Learning Objectives

1.Explain why excessive optimism and

overconfidence lead the managers ofacquiring firms to overpay, therebyexperiencing the winners curse

2.Use the press coverage measure and

longholder measure to identifyexecutives who are prone to engage inacquisitions


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3.Explain why the managers of target firms whoare excessively optimistic, overconfident, andtrust market prices can destroy value for theirshareholders

4. Identify the manner in which being in thedomain of losses affects the decisions of

executives and board members in respect toacquisition activity


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Synergy

In theory, the shareholders of the

acquiring firm will capture this synergythrough the acquisition of the target, bypaying the current market value for thetarget.

Managers of the acquiring firm will onlygo forward with the acquisition if thevalue of the synergy is positive.


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Fungible Wealth

Stock or Cash

Since wealth is fungible and all assets

are priced correctly, the shareholders ofboth firms will be indifferent to thecombination of cash and equity used tofinance the acquisition.


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The Winner's Curse

When the winning bid in an auction

leads the winner to overpay, the winneris said to experience the winners curse.

Because overconfident managers suffer

from hubris, winners curse inacquisitions stemming fromoverconfidence is known as the hubrishypothesis.


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M&A

A study by KPMG International of the sevenhundred largest acquisitions during the period1996 through 1998 found that over halfdestroyed value.

Acquisition activity peaked at $1.8 trillion in2000, more than triple the level in the mid-

1990s. Between 1995 and 2000, the average

acquisition price in the U.S. rose 70%, to $470million.


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A Few Large Losses

Between 1991 and 2001, the shareholders of

acquiring firms lost $216

billion. A disproportionate share of these losses can

be traced to very large losses by a fewacquirers during the period 1998 through 2001.

Many of the large loss acquirers had beenactive acquirers prior to their large lossacquisitions, and the market values of theirfirms had been increasing.


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Behavioral Pitfalls:

Examples of Winners Curse

In 1991, AT&T purchased computer firm NCRfor $7.6 billion.

Robert Allen was the CEO of AT&T from 1988through 1995, and oversaw AT&Ts acquisitionof NCR.

The markets reaction to AT&Ts acquisitionannouncement was negative.

AT&T completed the deal, and its computeroperations subsequently lost $3 billion over thenext 3 years.


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Overconfidence

On announcing AT&Ts intention to

acquire NCR, Allen stated the following:I am absolutely confident that togetherAT&T and NCR will achieve a level ofgrowth and success that we could notachieve separately. Ours will be a futureof promises fulfilled.


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Viacom

In 1994 media firm Viacom agreed to

purchase Paramount for $9.2 billion. By all accounts, Viacom overpaid for

Paramount by $2 billion, despite ViacomCEO Sumner Redstones interests beingaligned with shareholders.

Redstone owned more than 75% ofViacoms cash flow and voting rights.


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Cisco Systems

In 1999 Cisco Systems made its largestacquisition.

It paid $6.9 billion in stock for Cerent, Corp.

A small networking firm that had yet to show a profit,was expecting to raise about $100 million in an IPO,and had fewer than 300 employees.

Cisco shareholders exchanged 3% of one ofthe worlds most valuable firms for a smallstartup that had yet to show a profit.


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Intel

In 2002, the market concluded that $10 billionof investments in the personal computerbusiness that Intel had made under its CEOCraig Barrett had generated little value.

The firms CFO Andy Bryant was quoted in

The Wall Street Journalas saying:I dont know of anything that we purchasedthat was worth what we paid for it.


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Optimistic, Overconfident

Executives

Excessively optimistic, overconfident

CEOs are1. described as such in the press, and

2. wait too long before exercising their

executive stock options.


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What the Evidence Shows Firms whose executives qualify as excessively

optimistic and overconfident through press

coverage and on the longholder measure are65% more likely to have completed anacquisition than firms whose executives do notso qualify.

This tendency is compounded when the firm isgenerating positive cash flow, but mitigatedwhen the board of directors has fewer than 12members.


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Cash Flow

When firms are financially constrained,

excessively optimistic, overconfidentexecutives choose not to go to thecapital markets in order to secure thefunds needed to conduct an acquisition.

Instead they act as if the marketundervalues the equity and/or risky debtissued by their firm.


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Behavioral Pitfalls:

Overconfident CEOs

The Wall Street Journalhas used both

optimistic and confident as adjectivesto describe Wayne Huizenga, thefounding CEO of BlockbusterEntertainment Group.

There are many CEOs for whom suchattribution has not been made, such as J.Willard Marriott, the CEO of MarriottInternational.


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During 14 years at the helm of Cook Data

Services, Wayne Huizenga conducted 6acquisitions.

During the 15 years Willard Marriott wasat the helm of Marriott International, hedid not conduct a single acquisition.


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Viacom and Blockbuster Shortly after overpaying for Paramount,

Viacom CEO Redstone merged Viacom with

Blockbuster. Redstone told the press that he was

confident about the Blockbuster deal andstated that Huizenga, Blockbuster's chairman,

is as turned on as I am today by what wehave wrought.

After the acquisition, Blockbuster turned outto be a major financial disappointment for

Viacom.


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Theory

Suppose that an acquiring firm is

considering the purchase of a targetfirm.

The market value of the acquiring firm

is $2 million and the market value of thetarget firm, is $1 million, where both arevalued as standalone firms.


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Synergy

Let there be $850,000 in synergy from

a merger of the two firms. Value of the combined firms is

$3,850,000

= $2,000,000 + $1,000,000 + $850,000


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Efficient Prices

Prices are efficient, meaning that themarket prices of the firms, both pre- andpost-merger, coincide with fundamentalvalues.

Information is symmetric, meaning that

the managers of both the acquiring firmand the target firm are equally wellinformed.


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Concept Preview Question

10.1

Put yourself in the position of themanager of the acquiring firm.

1. What is the maximum amount youshould be willing to pay to acquire thetarget firm?

2. If your firm is the only bidder, what isthe least amount you should expect topay in order to acquire the target firm?


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Acquire if Synergy > 0

If the acquirer is the only firm bidding forthe target firm, and all managers arerational, then the acquirer can obtain thetarget by paying a hair more than themarket value $1,000,000.

In this case, the acquirers managers willdo the shareholders of their firm aservice by acquiring the target as long asthe synergy value is greater than zero.


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APV

APV = -premium + synergy + financing

side effects In the example, the acquiring firm paid a

hair over the market value of theacquirer, and so the premium was ~0.

In general, the guiding principle is tomake the acquisition if APVu 0.


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Cash or Stock

The acquirer might offer the shareholders ofthe target firm a combination of cash andshares in the combined entity.

These shares represent some fraction of thevalue of the combined firm.

For example, the acquirer might offer thetargets shareholders $400,000 in cashtogether with $600,000 in shares of thecombined firm.


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Value

With a cash payout to the targets

shareholders, rather than to the targetitself, the value of the combined firmwould fall by $400,000, the value of thecash payout.

Therefore, the value of the combined firmwould fall to $3,450,000.


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How It Ends Up

The fraction of $3,450,000 that the acquireroffers the targets shareholders must equal

$600,000. The fraction offered must be 17.39%

= $600,000 / $3,450,000

In this case, the shareholders of the target

firm end up with $1,000,000 in value,($400,000 in cash and $600,000 in stock),while the shareholders of the acquiring firmend up with $2,850,000 (82.61% of

$3,450,000).


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Impact of Overconfidence

An overconfident manager will typically

overestimate the fundamental value ofboth the acquiring firms shares and theamount of synergy in the merger.

Therefore, an excessively optimistic,overconfident executive will typicallyoverpay for an acquisition.


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Extending the Example

Suppose that the acquiring firms managersbelieve that their firm is worth $1,000,000

more than the markets judgment of$2,000,000.

Suppose too that the acquiring firmsmanagers overestimate the amount of

synergy by an amount $100,000. How will the excessive optimism of the

acquiring firms managers impact the criterionthey use to decide whether or not to proceed

with the merger?


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Conflicting Concerns

1. The acquiring firms managers will worrythat because the target firms shareholdersdo not appreciate what the acquiring firmsmanagers perceive to be the true value ofthe acquirer, the target firms shareholderswill demand too large a share of the

combined entity. There may be little the acquiring managers can

do, except to accept that this will be part of theprice that they pay for acquiring the target.


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Dilution Cost

Specifically, if the target firms

shareholders receive the fraction17.39% of the combined entity, thenthe acquiring firms managersperceive them to be receiving anadditional $191,290 that isunwarranted.

Call this amount dilution cost.


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Second Concern

2. The acquiring firms managers need to

decide whether the amount of synergythat they perceive in the merger willjustify the price to be paid.


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Behavioral APV

Components of behavioral APV are:

premium

synergy

financing side effects including dilution cost

APV = -premium + synergy + financing side

effects including dilution cost In general, the guiding principle is to make the

acquisition if APVu 0.


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The Point

In formal, terms the acquiring firmsoverconfident managers will go through thesame kind of logic as their rationalcounterparts.

However, instead of pursuing the merger as

long as the true synergy value is positive, theywill pursue the merger as long as theperceived synergy ($950,000) exceeds thedilution cost ($191,304).


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When Cash is Preferred

Rational managers of an acquiring firm do notcare about how payment is divided between

cash and stock. Overconfident managers who represent the

interests of the acquiring firms shareholderswill care.

By paying in cash, the acquiring firmsmanagers perceive no dilution cost, whereaswhen they pay in stock they do perceive thereto be a dilution cost.


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Inefficient Prices and

Overvalued Acquirer

Suppose managers of the acquiring firm

perceive their firm to be overvalued. In this case, the pecking order needs to

be reversed.

Now, the manager of the acquiring firmwould want to purchase the target firmusing overvalued equity in its own firm,rather than cash.


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Overconfident Acquirer and

Overconfident Target If the target firms managers are

overconfident, they will be prone to overvaluetheir firm relative to the market.

In this case, they may require a premiumabove the market value before being willing

to accept the acquiring firms bid. As will be seen in the examples below,

premiums are common and sometimes verylarge.


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Asymmetric Information

A firm worth $2 million consider acquiring atarget firm whose market value is $1 million.

Suppose that in confidential discussions, themanagers of the potential acquirer learn thatthe target firm has developed a newtechnology whose value is not reflected in its

current $1 million market capitalization. The acquirer also learns that the new

technology would be the only basis for thevalue of the combined firms to exceed $3

million.


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Value of Technology

The target firm managers have done a

careful analysis to assess how muchthe new technology is worth.

They have shared some informationwith the managers of the acquiring firm,enough for the latter to estimate that thevalue of the new technology is$850,000.


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Partial Disclosure

Because the target managers have onlyengaged in partial disclosure, the acquiringfirms managers have established a valuerange centered on $850,000.

The low end of the value range is $0

The high end of the value range is $1.7 million

Any value in this range is as likely as any other


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Concept Preview Question

10.2 The acquiring firms managers typically make

value based decisions in a risk neutral

manner. Risk neutral means that they do not require a

risk premium.

Put yourself in the position of a manager in

the acquiring firm. What is the maximum price you would pay to

acquire the target firm?


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The Point

Because the target firm will only accept

offers in which the acquiring firmoverpays, the acquiring firm should offerno more than $1 million.

That is the lesson of the example:assume the worst when the other party isbetter informed.


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Images From

AOL Time Warner


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Goal

The goal of merging of AOL and TimeWarner was to create a distributionchannel whereby Time Warners mediaproducts would be delivered to millions ofconsumers via Internet broadband.

Time Warner brought media products anda television cable network to thecombination.


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Valuation

The merger of AOL and Time Warner

occurred at the height of the technologystock bubble.

Notably, the markets judgment of theoverall merger was favorable, with theshareholders of Time Warner benefitingat the expense of the shareholders ofAOL.


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On the day of the announcement, the

value of the combined companies roseby 11%, or $27.5 billion.

However, Time Warner stock increasedby 39% ($32 billion) while AOL stockdeclined by 2.7% ($4.5 billion).


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Bubble Prices

In January 2000, the market capitalization ofAOL was $185.3 billion, over twice as large as

the $83.7 billion market capitalization of TimeWarner.

A similar statement applies to P/E, whereearnings are measured as EBITDA, earnings

before taxes, interest, depreciation andamortization.

With the peak of the bubble not two monthsaway, was AOL overvalued at the time?


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The Key Questions

An opinion piece in Fortune magazinesuggests that AOL could not have been priced

at intrinsic value in January 2000. AOLs CEO was Steve Case, and Time

Warners CEO was Gerald Levin.

Did Steve Case knowingly purchase Time-

Warner with overvalued stock? And correspondingly, did Gerald Levin and

Time Warners shareholders trust marketprices?


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Steve Case

Case judged that dot-com stocks,including the stock of AOL, wereoverpriced, and that he sought to exploitthe overpricing.

Moreover, he expected that Internet

stocks would collapse in the not toodistant future, and sought to protect AOLshareholders by acquiring a more maturefirm.


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Case's Offer to Levin

Case eventually offered 45% of a

combined AOL Time Warner to TimeWarner shareholders.

Under the terms of the deal, GeraldLevin would be chief executive of AOLTime Warner, while Steve Case wouldbe its chairman.


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Gerald Levin

Gerald Levin trusted market prices.

During a press conference to announcethe mergerLevin stated:

Something profound is taking place. Ibelieve in the present valuations. Theirfuture cash flow is so significant, that ishow you justify it.


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Ted Turner

Ted Turner, the creator of CNN, was a

major shareholder in Time Warner. He owned 100 million shares that he

acquired through the sale of CNN to TimeWarner three years before, and held anoperating role overseeing his formerholdings.


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Initial Reaction

Turner first opposed the merger of AOL andTime Warner, asking:

Why should I give up stock in a $25 billioncompany for shares of this little p----antcompany?


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Reversal Under Pressure

I had the honor and privilege of signing apiece of paper that irrevocably cast avote of my 100 million shares for thismerger.

I did it with as much or more excitement

and enthusiasm as I did on that nightwhen I first made love some forty-twoyears ago.


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Asset Writedown

In April 2002, AOL Time Warner wrotedown $54 billion in goodwill, a charge toits earnings that reflected the decline inthe value of the combined firm.

Looking back 12 months from the end of

the third quarter of2002, the operatingprofit for most of AOL Time Warnerbusinesses experienced positive growth.


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AOL

Publishing had grown by 26%, networks

had grown by 16

%, and the music hadgrown by 10%.

However, AOLs operating earnings fellby 30%.


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jectory

AOL

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W

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arket

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Jan2001-

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c2002

.

5

.

.

5

.

200.00

$250.00

$300.00

1/12/2001

2/12/2001

3/12/2001

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7/12/2001

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1/12/2002

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6/12/2002

7/12/2002

8/12/2002

9/12/2002

10/12/2002

11/12/2002

12/12/2002

ate

$ (Billi

ns)


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Hubris

The adjective hubris has frequently beenapplied to Steve Case in the press.

The New York Times did not paint a flatteringpicture of the executives at Time Warner,stating:

If Case was guilty of hubris, then the Time

Warner management team was guilty ofignorance and credulity, industry analysts andacademics say.


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Images from H-P

and Compaq


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H-P and Compaq

In May 2002, H-P acquired CompaqComputer in a takeover that featured

considerable drama. In 1999, H-P was involved in three broad

business segments:

1. enterprise computing and services for

businesses2. personal computers (PCs)

3. imaging and printing


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Board members and executives concurred thatthat H-Ps enterprise computing business was

losing the ability to respond effectively tochanging customer requirements, and thatregaining this ability required significant newinvestment.

They also concurred that H-Ps operatingmargin on PCs was at best breakeven,compared to a 7% margin for industry leaderDell Computer.


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View From Boardroom

Imaging and printing was the H-Ps mostprofitable business. Ink-jet and laser printers, and the steady revenue

stream from consumables produced 93% of totalimaging operating profits and 118% of overalloperating profits.

However, the board judged that remainingcompetitive in imaging and printing requiredcontinued investment for growth and tighterlinkages with enterprise informationtechnology.


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One of the H-P boards primary goalswas to acquire a firm that would enable itto confront industry leader IBM moreeffectively.

In 2001 IBM was gaining strength, as

was PC leader Dell Computer, whereasH-P was losing momentum.


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Domain ofLosses

H-P had missed its earnings target forthe fourth quarter of fiscal 2000, andsubsequently provided guidance forlower future earnings.

In this respect its managers were

operating in the domain of losses, atleast psychologically.


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On July 19, 2001, Fiorina raised themerger issue with the other eightmembers of H-Ps board.

Only three expressed interest. H-Pdirector Sam Ginn raised doubts about

becoming more deeply involved in thePC business.


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Responding to Ginn

Ginn pointed out that both H-Pscomputer business and Compaqs

computer business were not especiallyprofitable.

The consultants at McKinsey responded

to Ginn's concerns by saying that even asmall profit in PCs would translate into adecent return on invested capital.


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Responding to Dunn

Outside director Patricia Dunn took an outsideview.

Dunn was vice chair of Barclays GlobalInvestors, H-Ps third largest shareholder.

She noted that history has produced manyunsuccessful technology mergers and asked whatwould make the odds of this one any better?

The consultants at McKinsey responded by citing$2.5 billion a year in cost savings, which led her tofeel more positively about a possible combination.


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Three Questions

Posed by Fiorina1. Do you think the information-technology

industry needs to consolidate and, if so, is it

better to be a consolidator or a consolidatee?

2. How important is it to our strategic goals to beNo. 1 or No. 2 in our chief productcategories?

3. Can we achieve our strategic goals withoutsomething drastic?


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Behavioral Issues

Did Carly Fiorinas questions appeal tothe directors natural tendency to be

overconfident? Did she frame the issue for them in a

way that placed them in the domain of

losses? In speaking about drastic action, did she

induce them to be risk-seeking?


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Morning After

Directors slept on these questions.

Sam Ginn indicated that his main goalwas to compete with IBM, and thatmerging with Compaq would help.

Phil Condit, the then CEO of Boeing Co.

stated that although mergers are difficult,focused acquirers are able to make themsuccessful.


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Valuation Table

Syne rg ies

Im

ctof

Revenue Los s Net Sy nerg ies

After-T

x N etSyne rg ies

(

6% tax rate )

Futu re Value of Net

Syne rg ies at

x P/E

Present Valueof Net Sy nerg ies

at

x P/E

.5b n (

.5)bn $2 .

bn $1 .5b n $29.4b n $21.2bn


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Two years after the H-P/Compaq mergerclosed, the printing unit contributed 30% of

H-Ps revenue and 80% of its profit. Some analysts actually assessed H-Ps

printer business to be more valuable than thefirm as a whole.

Despite achieving the promised cost savings,the merger failed to improve the firmscompetitive position in its other businesses.


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Dismissal

In February 2005, The Wall Street Journalcharacterized H-Ps business services group

as second-tier, relative to industry leader IBM,and noted that its computer division was losingits battle against Dell.

That month, H-Ps board dismissed Carly

Fiorina as CEO of H-P, and namedindependent director Patricia Dunn asnonexecutive chair.


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Subsequent Scandal

H-P board member George Keyworth leaks tothe press about board discussions.

Carly Fiorina presses board to identify leaker. LOSS of trust on board domain of losses. Key issue for Patricia Dunn, who

Hires investigators who use unethical, illegal tactic,pretexting.

At instigation of Tom Perkins, Dunn and 4investigators are indicted by Bill Lockyer.

Charges against Dunn dropped for reasons ofpoor health.


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Summary

The more optimistic and overconfident areexecutives, the more they engage in

acquisitions, and the more they leave theirinvestors vulnerable to experiencing thewinners curse.

In situations where the market price of a firm

roughly measures its intrinsic value,excessively optimistic and overconfidentexecutives overestimate the synergy fromacquisitions, but believe their own firms to beundervalued.


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As a result, these executives favor paying fortarget firms using cash instead of stock.

Executives who are excessively optimistic andoverconfident according to press coverage andthe longholder criterion are especially prone toengage in acquisitions, and prefer to pay in

cash instead of stock. Moreover, they tend to discount the negative

market reaction to their acquisitionannouncements.


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Acquirers who always trust prices leavethemselves vulnerable to the winners curse

during times when investors are irrationallyexuberant about target firms. WorldComs acquisitions serve as an example.

Targets who always trust prices, and accept

payment in the form of the acquirers stockleave themselves vulnerable to sellersremorse, the flip side of the winners curse. Time Warner provides such an example.


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Managers who participate in acquisitionsoften do so when they perceivethemselves to be operating in the domainof losses.

H-Ps acquisition of Compaq illustrates this

phenomenon.

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