Http Hubcap.clemson.edu ~Kleinr 402 CHAPTER25

8/6/2019 Http Hubcap.clemson.edu ~Kleinr 402 CHAPTER25

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Finance 402 1

Recent Mergers

Reasons for Mergers

Types of Mergers Merger Analysis

Accounting for Mergers

Role of Investment Bankers

Corporate Alliances, LeveragedBuyouts, and Divestitures

Holding Companies

CHAPTER 25Mergers, LBOs, Divestitures, and

Holding Companies


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Finance 402 2

Mergers Announced in 2005Mergers Announced in 2005 America West and US Airways

$1.5 billion - Announced May 19, 2005

Lenovo Goup and IBM PC Division $1.25 billion Announced April 20th, 2005

Verizon and MCI $7.6 billion Announced March 29, 2005

Proctor and Gamble and Gillette $57 billion Announced March 28, 2005

IAC/Interactive and Ask Jeeves $1.9 billion Announced March 21, 2005

Met Life and Travelers Group

$11.5 billion Announced January 31, 2005


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Mergers Announced in 2004Mergers Announced in 2004

KMart and Sears Roebuck $11 billion Announced November 17, 2004

Wachovia and South Trust

$14.3 billion Announced June 21, 2004 May Company and Marshall Field

Purchased from Target (an Acquisition)

$3.24 billion Announced June 9, 2004

Wells Fargo and Strong Capital Management $400 million (estimated) Announced May 27, 2004

Marsh & McLennan Kroll, Inc $1.96 billion Announced May 18, 2004


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Finance 402 4

Mergers Announced in 2004Mergers Announced in 2004 --

ContinuedContinued Sun Trust and National Commerce

Financial

$6.98 billion Announced May 9, 2004

Cingular Wireless and AT & T Wireless

$47 billion Announced February 17, 2004

J P Morgan Chase and Bank One


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Finance 402 5

Mergers Announced in 2003Mergers Announced in 2003

St. Paul Companies and Travelers Property Casualty $16.5 billion

Announced November 17th, 2003

Bank of America and Fleet Boston $48 billion

Announced October 27, 2003

Manulife and John Hancock Financial Services $10.4 billion

Announced November 4, 2003

Anthem and Wellpoint $16.4 billion



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Finance 402 6

Mergers Announced in 2003Mergers Announced in 2003 --ContinuedContinued R.J. Reynolds and British American Tobacco PLC

$3 billion for U.S. units of British American Tobacco


Oracle and PeopleSoft $5.1 billion hostile takeover updated in 2004 to $9.2 billion

First Announced June 9, 2003

Manufactured Home and Chateau Communities $1.8 billion

May, 2003

Berkshire Hathaway and Clayton Homes $1.7 billion

April, 2003

Viacom and Comedy Central $1.2 billion

April, 2003


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Finance 402 7

Five Largest CompletedFive Largest Completed

MergersMergers

(as of January 2002)(as of January 2002)VALUE

BUYER TARGET (Billion)

Vodafone AirTouch Mannesman $161

Pfizer Warner-Lambert 116

America Online Time Warner 106

Exxon Mobil 81

Glaxo Wellcome SmithKline Beecham 74


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Finance 402 8

Foreign Acquisitions of U.S.Foreign Acquisitions of U.S.

FirmsF

irms Manulife and John Hancock Financial Services

Bridgestone and Firestone

Daimler Benz and Chrysler

HSBC Holdings and Household International

British Petroleum and Amoco, Sohio, andAtlantic Richfield

Ahold and Giant Food stores, Harris Teeter, andPrice Chopper

Michelin and B.F. Goodrich

Grand Metropolitan and Pillsbury

Thomson and G.E. Small Appliances


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Finance 402 9

Foreign Acquisitions and U.S.Foreign Acquisitions and U.S.

Firms

Firms -- ContinuedContinued

Credit Suisse and First Boston

Zurich Insurance and Scudder, Stevens

Bank of Tokyo-Mitsubishi and UnionBanCal Toronto Dominion Bank and Waterhouse Securities

Hong Kong and Shanghai Bank and Marine Midland

Matushita and MCA

Broken Hill Proprietary and Utah International (fromG. E.)

UBS and Paine Webber

Bertelsmann and Napster


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Finance 402 10

Synergy: Value of the combined firmexceeds the sum of the values of the firms

taken separately. Arises from:Operating economies

Financial economies

Differential management efficiencyTax Effects (possibly use accumulated

losses)(More...)

Which of the reasons that have beenproposed as justification for mergers

are economically justifiable?


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Finance 402 11

Increased Market Power: Due to reducedcompetition

Corporate Focus

World Wide Competition (Globalization) Acquire Technological Skills


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Finance 402 12

Break

Break--up Valueup Value

Break-up value: A companys assets would

be more valuable if sold to and then

operated by some other company or spun

off.


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Finance 402 13

Diversification Stockholders can achieve diversification at

lower cost than firms

Transfers wealth from stockholders to debtholders

No synergistic effects

Purchase of assets at below replacement

cost(more)

What are some questionablereasons for mergers?


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Finance 402 14

What are some questionableWhat are some questionablereasons for mergers?reasons for mergers? --

continuedcontinued Retention of control

Acquire other firms to increase size, thusmaking it more difficult to be acquired

Managers personal incentives


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Finance 402 15

Types of MergersT

ypes of Mergers Horizontal

First Union and Wachovia

Vertical DuPont and Conoco

Congeric - Related Enterprises

Duke Power and Pan Energy Conglomerate

Mobil Oil and Montgomery Ward


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Finance 402 16

Friendly merger:

Management of one firm (acquirer)agrees to buy another firm (target).

This merger is supported by the

management of both firms.

Differentiate between

hostile and friendly mergers


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Finance 402 17

Hostile merger:

Target firms management resists themerger.

Acquirer must go directly to the targetfirms stockholders, try to get 51% totender their shares.

Often, mergers that start out hostile end upas friendly, when the offer price is raised.

Tender offerProxy fights


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Finance 402 18

Merger RegulationMerger Regulation -- TheThe

Williams Act of 1968Williams Act of 1968 Acquirers must disclose their currentholdings within 10 days of amassing 5% of

companys stock

Acquirers must disclose source of funds to

be used in the acquisition

Target firms SH must be allowed at least

20 days to tender their shares

If the acquiring firm increases the offer

price, all SH who tendered must receive the

higher price.


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Finance 402 19

M & A TermsM & A Terms

Poison Put

Poison Pill

White Knight

Shark Repellent

Greenmail

Golden ParachuteSuper Majority

ESOP


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Finance 402 20

Reason for Adjusted PresentReason for Adjusted Present

Value (APV) Merger AnalysisValue (APV) Merger Analysis Often in a merger the capital structure

changes rapidly over the first several years.

This causes the WACC to change from year

to year.

It is hard to incorporate year-to-year

changes in WACC in the corporatevaluation model.


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Finance 402 21

The Adjusted Present ValueThe Adjusted Present Value

(APV) Model(APV) ModelValue of firm if it had no debt

+ Value of tax savings due to debt

= Value of operations

First term is called the unlevered value of thefirm. The second term is called the value of

the interest tax shield.(More...)


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Finance 402 22

APV ModelAPV ModelUnlevered value of firm = PV of FCFs

discounted at unlevered cost of equity, rsU.

Value of interest tax shield = PV of interest

tax savings at unlevered cost of equity.

Interest tax savings =

Interest(tax rate) = TSt .


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Finance 402 23

Note to APV

Note to APV

APV is the best model to use when the

capital structure is changing.

The Corporate Valuation model is easier

than APV to use when the capital structure

is constantsuch as at the horizon.


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Finance 402 24

Steps in APV ValuationSteps in APV Valuation1. Project FCFt , TSt , horizon growth rate,

and horizon capital structure.

2. Calculate the unlevered cost of equity, rsU.3. Calculate WACC at horizon.

4. Calculate horizon value using constant

growth corporate valuation model.5. Calculate Vops as PV of FCFt, TSt and

horizon value, all discounted at rsU.


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Finance 402 25

Net sales $60.0 $90.0 $112.5 $127.5

Cost of goods sold (60%) 36.0 54.0 67.5 76.5Selling/admin. expenses 4.5 6.0 7.5 9.0

EBIT 19.5 30.0 37.5 42.0

Taxes on EBIT (40%) 7.8 12.0 15.0 16.8

NOPAT 11.7 18.0 22.5 25.2Net Retentions 0.0 7.5 6.0 4.5

Free Cash Flow 11.7 10.5 16.5 20.7

APV Valuation Analysis (In Millions)

2004 2005 2006 2007

Free Cash Flows after Merger Occurs

From Mini Case in Chapter 25


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Finance 402 26

Interest Tax Savings afterInterest Tax Savings after

MergerMerger

Interest expense 5.0 6.5 6.5 7.0

Interest tax savings 2.0 2.6 2.6 2.8

Interest tax savings are calculated as

interest(T). T = 40%

2004 2005 2006 2007


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Finance 402 27

What are t

he net retentions?W

hat are t

he net retentions?

Recall that firms must reinvest in order to

replace worn out assets and grow.

Net retentions = gross retentions

depreciation.


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Finance 402 28

After acquisition, the free cash flows belongto the remaining debtholders in the target andthe various investors in the acquiring firm:their debtholders, stockholders, and others

such as preferred stockholders.

These cash flows can be redeployed withinthe acquiring firm.

Conceptually, what is the appropriate

discount rate to apply to thetargets cash flows?

(More...)


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Finance 402 29

Free cash flow is the cash flow that wouldoccur if the firm had no debt, so it should be

discounted at the unlevered cost of equity.

The interest tax shields are also discountedat the unlevered cost of equity.


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Note: Comparison of APV withNote: Comparison of APV with

Corporate Valuation ModelCorporate Valuation Model APV discounts FCF at rsU and adds in present

value of the tax shieldsthe value of the tax

savings are incorporated explicitly.

Corp. Val. Model discounts FCF at WACC, which

has a (1-T) factor to account for the value of the

tax shield.

Both models give same answer IF carefully done.

BUT it is difficult to apply the Corp. Val. Model

when WACC is changing from year-to-year.


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Finance 402 31

Discount rate for HorizonDiscount rate for Horizon

ValueValue At the horizon the capital structure is

constant, so the corporate valuation model

can be used, so discount FCFs at WACC.


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Finance 402 32

Discount Rate Calculations

rsL = rRF + (rM - rRF)bTarget= 7% + (4%)1.3 = 12.2%

rsU = wdrd + wsrsL

= 0.20(9%) + 0.80(12.2%) = 11.56%

WACC = wd(1-T)rd + wsrsL

=0.20(0.60)9% + 0.80(12.2%)

= 10.84%


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Finance 402 33

Horizon value =

=

= $453.3 million.

Horizon, or Continuing, Value

gWACC

g))(1(FCF2007

06.01084.0

)06.1(7.20$


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Finance 402 34

What Is the value of the TargetWhat Is the value of the Target

Firms operations to theFirms operations to the

Acquiring Firm? (In Millions)Acquiring Firm? (In Millions)

2004 2005 2006 2007

Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 453.3Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $476.8

VOps = + + +

= $344.4 million.

$13.7(1.1156)1

$13.1(1.1156)2

$19.1(1.1156)3

$476.8(1.1156)4


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Finance 402 35

What is the value of theWhat is the value of the

Targets equity?Targets equity?

The Target has $55 million in debt.

Vops debt = equity 344.4 million 55 million = $289.4 million

= equity value of target to the acquirer.


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Finance 402 36

No. The cash flow estimates would bedifferent, both due to forecasting

inaccuracies and to differential synergies.

Further, a different beta estimate,financing mix, or tax rate would change

the discount rate. Additionally, a different estimating

procedure could result in a differentdiscount rate.

Would another potential acquirer obtainthe same value?


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Finance 402 37

Estimate of targets value = $289.4 million

Targets current value = $220.0million

Merger premium = $ 69.4 million

Presumably, the targets value isincreased by $69.4 million due to

merger synergies, alth

ough

realizingsuch synergies has been problematicin many mergers.

(More...)


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Finance 402 38

Assume the target company has

20 million shares outstanding. Thestock last traded at $11 per share,

which reflects the targets value on astand-alone basis. How much should

the acquiring firm offer?


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Finance 402 39

The offer could range from $11 to $289.4/20 =$14.47per share.

At $11, all merger benefits would go to the

acquiring firms shareholders.

At $14.47, all value added would go to the targetfirms shareholders.

The graph on the next slide summarizes thesituation.


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Finance 402 40

0 5 10 15 20

Change inShareholders

Wealth

Acquirer Target

Bargaining Range= Synergy

PricePaid forTarget

$11.00 $14.47


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Finance 402 41

Points About GraphPoints About Graph

Nothing magic about crossover price.

Actual price would be determined by

bargaining. 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 bid up. Ifnot, could be close to $11. Most of the timethe targets stockholders receive the vastmajority of the benefits. (More...)


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Finance 402 42

Acquirer might want to make highpreemptive bid to ward off other bidders,or low bid and then plan to go up. Strategy

is important.Do targets managers have 51% of stock

and want to remain in control?

What kind of personal deal will targetsmanagers get?


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What if the Acquirer intended toWhat if the Acquirer intended to

increase the debt level in theincrease the debt level in the

Target to 40% with an interestTarget to 40% with an interestrate of 10%?rate of 10%?

Free cash flows wouldnt changeAssume interest payments in short

term wont change (if they did, it iseasy to incorporate that difference)

Long term rsLwill change, so horizonWACC will change, so horizon valuewill change.


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New WACC Calculation

New WACC Calculation

New rsL = rsU + (rsU rd)(D/S)

= 11.56% + (11.56% - 10%)(0.4/0.6)= 12.60%

NewWACC = wdrd(1-T) + wsrsL= 0.4(10%)(1-0.4) + 0.6(12.6%)= 9.96%

All data are from the mini case.


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Finance 402 45

New Horizon ValueNew Horizon Value

CalculationCalculation

Horizon value =

=

= $554.1 million.

gWACC

g))(1(FCF2007

06.00996.0

)06.1(7.20$


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Finance 402 46

N

ew VN

ew Vopsops and Vand Vequityequity

2004 2005 2006 2007

Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 554.1Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $577.6

VOps = + + +

= $409.5 million.

$13.7(1.1156)1

$13.1(1.1156)2

$19.1(1.1156)3

$577.6(1.1156)4


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Finance 402 47

N

ew Equity ValueN

ew Equity Value $409.5 million - 55 million = $354.5

million

This is $65.1 million, or $3.26 per sharemore than if the horizon capital structure is20% debt.

The added value is the value of theadditional tax shield from the increaseddebt.


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Pooling of interests is GONE. Onlypurchase accounting may be used now.

What method is used to account for

for mergers?

(More...)


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Purchase:

The assets of the acquired firm are written up

to reflect purchase price if it is greater than the

net asset value.

Goodwill is often created, which appears as an

asset on the balance sheet.

Common equity account is increased to balance

assets and claims.


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Goodwill AmortizationGoodwill Amortization Goodwill is NO LONGER amortized over

time for shareholder reporting.

Goodwill is subject to an annual impairment

test. If its fair market value has declined,then goodwill is reduced. Otherwise it is not.

AOL Time Warner wrote down $54 billion ofgoodwill in 2002 because of impairment test.

Goodwill is still amortized for Federal Taxpurposes. Can amortize goodwill over 15 yearsusing straight-line method.


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Finance 402 51

Corporate CultureCorporate Culture

Should also consider factors other than cash

flows, such as Corporate Culture, marketing

philosophies, and personnel policies.

Merger talks often collapse because of social

issues and chemistry.

Who will run the combined company? What will be the name of the combined firm?

Where will the headquarters be located?


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Finance 402 52

Analysis for a TrueAnalysis for a True

ConsolidationConsolidation -- Merger of EqualsMerger of Equals Steps: Develop pro forma financial statements for the

consolidated corporation. Determine the

projected consolidated free cash flows availableto stockholders.

Estimate the new companys unlevered cost ofequity, and use that rate to discount the free

cash flows and interest tax shields of theconsolidated company.

Decide how to allocate the new companysstock between the two sets of old stockholders.


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Identify targets

Help arrange mergersNo parked stock

Develop defensive tactics

Value target companies

Help finance mergers

Invest in stocks of potential mergercandidates

Arbitrage operations

Trend is away from using investment

bankers, especially for smaller deals

What merger-related activities areundertaken by investment bankers?


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Finance 402 54

According to empirical evidence, acquisitions do

create value as a result of economies of scale, other

synergies, and/or better management.

Shareholders of target firms reap most of the benefits,

that is, the final price is close to full value.

Target management can always say no.

Competing bidders often push up prices.

Do mergers really create value?


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Studies show stock price of target firms

increase by 30% in hostile tender offers,while in friendly tender offers, the

increase is 20%.


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MergerFailuresMergerFailures

61% of buyers destroyed their own

shareholders wealth

In April 2002, AOL Time Warner took a

$54 billion charge

17 out of the 21 winners in the merger

spring of 1998 were a bust for investorswho owned the shares


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Finance 402 57

Reasons for MergerFailureReasons for MergerFailure

Overpay by a sizeable premium

Overestimate likely cost savings and

synergies

Delay over integrating operations after

merger

Emphasis on cost-cutting, damaging thebusiness and losing key personnel


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OtherFailure ResultsOtherFailure Results

TYCO Paid $11.3 billion for CIT in June 2001 and completed

an IPO for $4.6 billion in July 2002 (loss of 6.7 billion)

WorldCom

AT&T Vivendi

Cisco Systems

Conseco

First Union Corp


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Finance 402 59

Joint Venture

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

Reasons why alliances can make more

sense than acquisitions


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Finance 402 60

Leveraged Buyout (LBO)Leveraged Buyout (LBO)

A small group of equity investors, usuallyincluding current management, acquires afirm in a transaction financed largely by

borrowing. They go private. Typically buy

publicly held stock. Can be a subsidiary of apublic company.

Purchase often financed mostly with debt.

After operating privately for a number ofyears, investors might take the firm public tocash out.

Very prevalent during the 1980s


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Leverage Buyout (LBO) ContinuedLeverage Buyout (LBO) Continued Between January 2002 and November 6, 2002,

LBOs were up 50% vs. the same period theprevious year to $20 billion. In the third quarter of2002, LBOs accounted for almost 10% of allmergers & acquisitions, their largest share since

1989. Nov. 19, 2002 Northrop Grumman Corp. sold

TRW Automotive Business to Blackstone for$4.73 Billion

April, 2003 Investor Group purchased AladdinResort & Casino for $500 million

Nov. 17, 2003 DuPont sold its Invista textilesunit to Koch Industries for $4.4 billion


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Finance 40262

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 How to exit an LBO

Go Public

Sell to another company

Another LBO

What are are the advantages anddisadvantages of going private?


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Types ofDivestituresTypes ofDivestitures

Sale of an entire subsidiary to another firm Target and Marshall Field

Spin-Off Spinning off a corporate subsidiary by giving stock

to existing shareholders AT&T and Lucent Technologies

Carve Out A minority interest in a corporate subsidiary is sold

to new shareholders, so the parent gains new equityfinancing yet retains control

Philip Morris and Kraft

Outright liquidation of assets

Woolworth


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Subsidiary worth more to buyer than whenoperated by current owner.

To settle antitrust issues. Subsidiarys value increased if it operates

independently.

To change strategic direction. To shed money losers.

To get needed cash when distressed.

What motivates firms to divest assets?


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Divestitures vs. AcquisitionsDivestitures vs. Acquisitions

Not the opposite side of a coin of anacquisition

Like selling a house, one purchaser at a time

Have to decide what it is worth to someoneelse

Typically an admission of failure

Hurts the Balance Sheet and benefits theIncome Statement

Risks and Returns are different


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Finance 40266

A holding company is a corporation formedfor the sole purpose of owning the stocks of

other companies.

In a typical holding company, the subsidiarycompanies issue their own debt, but their

equity is held by the holding company,which, in turn, sells stock to individualinvestors.

What are holding companies?


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Holding CompaniesHolding Companies --

Advantages andD

isadvantagesAdvantages andD

isadvantages Advantages

Control with

fractionalownership

Isolation of risks

(but often theparent is still

responsible)

Disadvantages

Partial Multiple

Taxation

Ease of enforced

dissolution


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ConclusionConclusion

Merger Trends

Reasons for Mergers

Types of Mergers Merger Analysis

Accounting for Mergers

Leveraged Buyouts

Divestitures Holding Companies

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Http Hubcap.clemson.edu ~Kleinr 402 CHAPTER25