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CHAPTER 26

Mergers, LBOs, Divestitures,

and Holding Companies

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Topics in Chapter Types of mergers

Merger analysis

Role of investment bankers

LBOs, divestitures, and holdingcompanies

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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

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Questionable

Reasons for Mergers Diversification

Purchase of assets below replacementcost

Acquire other firms to increase size,thus making it more difficult to be

acquired

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Merger Types Horizontal

Vertical

Congeneric

Related but not same industry

Conglomerate

Unrelated enterprises

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Five Largest Completed Mergers

(as of December, 2007)

TABLE 26-1

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Friendly & Hostile Mergers Friendly merger:

Supported by management of both firms

Hostile merger: Target firms management resists the merger

Acquirer must go directly to the target firmsstockholderstender offer - 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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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

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The APV ModelValue of firm if it had no debt

+ Value of tax savings due to debt

= Value of operations

First term = unlevered value of the firm

Second term = value of the interest tax shield

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The APV ModelTDVV UL

(15-7)

(16-4)

(26-1)

1tt

sU

t

UOP)R1(

FCFVV

1tt

sU

t

TS)r1(

TSV

(15-1)

(26-2)

(26-3)

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APV ModelVU = 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

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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 inthe corporate valuation model

Corporate Valuation (i.e., discount FCF atWACC) = easier than APV when capitalstructure is constant

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Steps in APV Valuation1. Calculate unlevered cost of equity, rsU

2. Project FCFt,TStuntil company is at its

target capital structure for one year andis expected to grow at a constant ratethereafter.

ddsLssU

dsUsUsL

rwrwr

)S

D)(T1)(rr(rr

(16-6)

(26-4)

(26-5)

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Steps in APV Valuation3. Project horizon growth rate, g

Calculate horizon value of unlevered firm

using constant growth formula and FCFN

Calculate horizon value of tax shields usingconstant growth formula and TSN

gr

)g1(FCF

gr

FCFHV

sUsU

1N

N,U

gr

)g1(TS

gr

TSHV

sUsU

1N

N,TS

(26-7)

(26-8)

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Steps in APV Valuation4. 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 taxshield horizon value and TSt

N

1tN

sU

N,U

t

U,s

t

U)r1(

HV

)r1(

FCFV

N

1tN

sU

N,TS

t

U,s

t

TS)r1(

HV

)r1(

TSV

(26-9)

(26-10)

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Steps in APV Valuation

4. Calculate Value of Operations Calculate Vopas sum of unlevered value and tax

shield value

5. Find total value of the firm

TSUOP VVV (26-11)

shares#SP

debtofValue

assetsoperating-nonofValue

F

Fop

opTSU

VS

VV

VVV

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The FCFE Approach

FCFE = Free Cash Flow to Equity

Cash flow available for distribution to commonshareholders

debtissuednewlypaymentsprincipal

-expenseinteresttax-After

FCFFCFE

debtinchangenetshieldtaxinterest

capitaloperatingininvestmentNetNIFCFE

(26-12)

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TABLE 26-2

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Valuation Examples

Caldwell Incs 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

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Tutwiler Acquisition

Tutwilers pre-merger beta = 1.20

Risk-free rate = 7%

Market risk premium = 5%

CAPM rsL= 13%

%707.10WACC

%)13(6983.0%)9)(60.0(3017.0WACCrwr)T1(wWACC sLsdd

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Tutwiler Acquisition

Both firms = 40% tax rate

Post-horizon g= 6%

Caldwell will issue debt to maintainconstant capital structure:

$6.2 m debt increase at merger

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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 94.0 113.0 129.3 142.03 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

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Post-Merger CF Projections

01/01/10 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 debt 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

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TutwilerCorporate 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

20142015

2014,OP

EquityofValue

(26-7)

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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 7.011 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

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TutwilerAPV Approach

%793.11r

%)9(3017.0%)13(6983.0r

rwrwr

sU

sU

ddsLssU

5)-(26

Estimate Tutwilers Unlevered Cost of Equity:

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TutwilerAPV 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 $131.2Value (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%

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TutwilerFCFE Model

m9.106$06.013.0

)06.1(06.7$HV

gr

)g1(FCFE

gr

FCFEHV

N,FCFE

sLsL

2015

2014,FCFE

(26-14)

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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 debt 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%

TutwilerFCFE Model

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Tutwiler Value Recap

Tutwiler is worth more as part ofCaldwell than stand-alone

Current Value of Equity $62.5

Corporate Valuation $83.1

APV Approach $83.1

FCFE Model $83.1

TUTWILER Equity

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The Bid PriceCaldwells Bid for Tutwiler

Caldwell will assume Tutwilers debt

Added short-term debt for acquisition

Analysis shows Tutwiler worth $83.1mto Caldwell

If Caldwell pays more Caldwell value

diluted How much should Caldwell offer?

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Caldwells Bid for Tutwiler

Targets Estimated value= $83.1 million

Targets current value = $62.5 million

Merger premium = $20.6 million

Synergistic Benefits =$20.6 million

Realizing synergies has been problematicin many mergers

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Caldwells Bid

Offer range = $62.5m to $83.1m

$62.5m merger benefits would

go to the acquiring firmsshareholders

$83.1m allvalue added would go

to the target firms shareholders

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Bid Strategy Issues

High preemptive bid to ward off otherbidders

Low bid and then plan to go up

Do targets managers have 51% ofstock and want to remain in control?

What kind of personal deal will targetsmanagers get?

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Do mergers really create value?

According to empirical evidence,acquisitions do create value as a result of

economies of scale, other synergies, and/orbetter management.

Target firm shareholders reap most of thebenefits

Final price close to full value

Target management can always say no

Competing bidders often push up prices

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Acquisition with PermanentChange in Capital Structure

Tutwiler currently: $62.5m value of equity

$27m debt = 30.17% debt Caldwells plan

Increase debt to 50%

Maintain level from 2012 on New rate on debt = 9.5%

Tax shield, WACC and bid price will change

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Change in Tax Shield

This last debt level is consistent with the assumedlong-term capital structure

The last interest payment is consistent with the long-term capitalstructure

9. Debt 52.63 63.16 73.68 78.95 87.33

10. Interesta

5.000 6.000 7.000 7.500 8.296

11. Interest tax savings 2.000 2.400 2.800 3.000 3.319

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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 $131.2Value (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

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Recap: Value of Tutwiler Equity

Total Per ShCurrent Value of Equity $62.5 $6.25

Original Merger Value $83.1 $8.31

APV Approach Revised $106.0 $10.60

TUTWILER Equity

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Merger Payment

Cash

Shares in acquiring firm

Debt of the acquiring firm

Combination

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Bid StructureEffects

Capital structure of post-merger firm

Tax treatment of shareholders

Ability of target shareholders tobenefit from post merger gains

Federal & state regulations applied to

acquiring firm

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Tax ConsequencesShareholders

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

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Non-taxable Offer

Payment = primarily stock

IRS views as an exchange

Target shareholder pay no taxes attime of merger

Taxed at time of stock sale

Preferred by shareholders

Tax ConsequencesShareholders

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Tax ConsequencesFirms

Non-taxable offer

Simple merger of balance sheets

Continue depreciating targets assets aspreviously

Taxable offerdepends on offer type

Offer for targets assets Offer for targets stock

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Taxable Offer for Targets assets

Acquirer pays gain on offerasset value

Acquirer records targets assets atappraised value

Depreciation based on new valuation

Goodwill = offer new valuationAmortized over 15 years/straight line

Tax ConsequencesFirms

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Taxable Offer for Targets Stock

2 Choices of tax treatment

1. Record acquired assets at book valueand continue depreciating on currentschedule

2. Record acquired assets at appraisedvalue and generate goodwill

Tax ConsequencesFirms

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Figure26-1

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Purchase Accounting

Purchase:

Assets of acquired firm are written up or

down to reflect purchase price relative tonet asset value

Goodwill often created

An asset on the balance sheet

Common equity account increased tobalance assets and claims

Table 26-4

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Table 26 4

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Income Statement Effects

Table 26-5

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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

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The Role of Investment Bankers

Arranging mergers

Identifying targets

Developing defensive tactics

Establishing a fair value

Financing mergers

Arbitrage operations

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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

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Poison Pills

Any technique used to discouragehostile takeovers

Borrowing on terms that requireimmediate repayment if acquired

Selling desirable assets at low prices

Granting lucrative golden parachutesAllowing current shareholders to buy

shares at reduced prices

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Risk Arbitrage

Arbitrageurs or arbs

Speculation in likely takeovertargets

Insider trading scandals

Ivan Boesky

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Who Wins?

Takeovers increase the wealth oftarget firm shareholders

Benefit to acquiring firm debatableEvent Studies Target stock price

30% for hostile tender offers

20% for friendly mergers

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Alliances versus Acquisitions

Access to new markets and technologies

Multiple parties share risks and expenses

Rivals can often work togetherharmoniously

Antitrust laws can shelter cooperative

R&D activities

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Leveraged Buyout (LB0)

Small group of investors buys allpublicly 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

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Advantages and Disadvantages ofGoing 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

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Types of Divestitures

Sale of entire subsidiary to another firm

Spin-off

Spinning off a corporate subsidiary bygiving the stock to existing shareholders

Carve-out

Selling a minority interest in a subsidiary

Outright liquidation of assets

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Motivation for Divestitures

Subsidiary worth more to buyer thanwhen operated by current owner

Settle antitrust issues Subsidiarys value increased operated

independently

Change strategic direction Shed money losers

Get needed cash when distressed

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d d d f

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Advantages and Disadvantages ofHolding Companies

Advantages:

Control with fractional ownership

Isolation of risks

Disadvantages:

Partial multiple taxation

Ease of enforced dissolution