CHAPTER 26

Mergers, LBOs, Divestitures, and Holding

Companies

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

26-6

Five Largest Completed Mergers(as of December, 2007)

TABLE 26-1

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)

26-19

TABLE 26-2

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

26-42

Merger Payment

Cash Shares in acquiring firm Debt of the acquiring firm Combination

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

26-49

Figure 26-1

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

26-51

Table 26-4

26-52

Income Statement Effects

Table 26-5

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

26-65

Advantages and Disadvantages of Holding Companies

Advantages: Control with fractional ownership Isolation of risks

Disadvantages: Partial multiple taxation Ease of enforced dissolution