CHAPTER 26

Mergers, LBOs, Divestitures, and Holding Companies

Topics in Chapter

Types of mergers Merger analysis Role of investment bankers LBOs, divestitures, and holding companies

26-2

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

26-3

Questionable Reasons for Mergers

Diversification Purchase of assets below replacement cost Acquire other firms to increase size, thus making it more difficult to be acquired

26-4

Merger Types

Horizontal Vertical Congeneric

Related but not same industry

Unrelated enterprises

Conglomerate

26-5

Five Largest Completed Mergers

(as of December, 2007)

TABLE 26-1
26-6

Friendly & Hostile Mergers

Friendly merger:

Supported by management of both firms Target firms management resists the merger Acquirer must go directly to the target firms 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
26-7

Hostile merger:

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
26-8

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 firm Second term = value of the interest tax shield

26-9

The APV Model

VL VU TD
VOP FCF t VU t t 1 ( 1 R sU )

(15-7)
(16-4) (26-1)

(15-1) (26-2)

VTS

TS t t t 1 ( 1 r sU )

(26-3)

26-10

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

26-11

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
26-12

Steps in APV Valuation

1. Calculate unlevered cost of equity, rsU
r sL r sU ( r sU rd )( 1 T )( D S ) r sU w s r sL w d rd
(16-2) (26-4)

(26-5)

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.
26-13

Steps in APV Valuation

3.

Project horizon growth rate, g

Calculate horizon value of unlevered firm using constant growth formula and FCFN
HV U ,N FCF N 1 FCF ( 1 g ) r sU g r sU g
(26-7)

Calculate horizon value of tax shields using constant growth formula and TSN
TS N 1 TS ( 1 g ) HV TS ,N r sU g r sU g
(26-8)
26-14

Steps in APV Valuation

4. Calculate Value of Operations

Calculate unlevered value of firm as PV of unlevered horizon value and FCFt

HVU ,N FCFt VU t ( 1 rsU ) N t 1 ( 1 rs ,U )
N

(26-9)

Calculate value of tax shields as PV of tax shield horizon value and TSt
VTS HVTS ,N TSt t ( 1 rsU ) N t 1 ( 1 r s ,U )
N

(26-10)

26-15

Steps in APV Valuation

4. Calculate Value of Operations

Calculate Vop as sum of unlevered value and tax shield value

VOP VU VTS
5.

(26-11)

Find total value of the firm

VU VTS Vop Vop Value of non - operating assets VF S VF Value of debt PS # shares
26-16

The FCFE Approach

FCFE = Free Cash Flow to Equity

Cash flow available for distribution to common

shareholders

FCFE FCF After - tax interest expense principal payments newly issued debt
(26-12)

FCFE NI Net investment in operating capital interest tax shield net change in debt

26-17

FCFE Approach

Value of Equity = VFCFE FCFE t ( 1 r )t Assuming constant growth:

t 1 sL

(26-13)

FCFE N 1 FCFE ( 1 g ) HV FCFE ,N r sL g r sL g

VFCFE HV FCFE,N FCFE t t ( 1 rsL ) N t 1 ( 1 rsL )
N

(26-14)

(26-15)

S VFCFE Non - operating assets

(26-16)

26-18

TABLE 26-2

26-19

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
26-20

Tutwiler Acquisition

Tutwilers pre-merger beta = 1.20 Risk-free rate = 7% Market risk premium = 5%

CAPM rsL= 13%

WACC w d ( 1 T )rd w s rsL WACC 0.3017( 0.60 )( 9%) 0.6983( 13%) WACC 10.707%
26-21

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

26-22

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 2 3 4 5 6 7 8 Net Sales Cost of goods sold Selling & Admin expenses Depreciation EBIT Interest Expense Debt Total Net Operating Capital 33.2 116.0 $105.0 80.0 10.0 8.0 7.0 3.0 35.8 117.0 $126.0 94.0 12.0 8.0 12.0 3.2 38.7 121.0 $151.0 113.0 13.0 9.0 16.0 3.5 41.1 125.0 $174.0 129.3 15.0 9.0 20.7 3.7 43.6 131.0 $191.0 142.0 16.0 10.0 23.0 3.9 46.2 138.0

26-23

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 10 11 NOPAT=EBIT(1-T) (T=40%) Less net invest. In op cap Free Cash Flow $4.2 1.0 $3.2 $7.2 4.0 $3.2 $9.6 4.0 $5.6 $12.4 6.0 $6.4 $13.8 7.0 $6.8

Panel C: APV Model Cash Flows 12 13 Free Cash Flow Interst tax savings = INT(T) $3.2 1.2 $3.2 1.28 $5.6 1.4 $6.4 1.48 $6.8 1.56

Panel D: FCFE Model Cash Flows 14 15 16 17 Free Cash Flow Less A-T Interest=INT(1-T) Plus debt FCFE 6.2 $6.2 $3.2 1.8 2.6 $4.0 $3.2 1.9 2.9 $4.1 $5.6 2.1 2.5 $6.0 $6.4 2.2 2.5 $6.7 $6.8 2.4 2.6 $7.1

26-24

Tutwiler Corporate Valuation

FCF2015 FCF2014 ( 1 g ) HV OP ,2014 WACC g WACC g $6.800( 1.06 ) HV OP ,2014 $153.1m 0 / 1070 0.06 VOperation $110.1 Value of Equity $110.1 $27 $83.1m
26-25

Tutwiler: Corporate Valuation

Panel B Corporate Valuation CFs 9 10 11 NOPAT=EBIT(1-T) (T=40%) Less net invest. In op cap Free Cash Flow Horizon value FCF Present Value of FCF Minus Value of current debt Value of Equity $110.1 $27.0 $83.1 $3.2 $3.2 $5.6 $6.4 $4.2 1.0 $3.2 $7.2 4.0 $3.2 $9.6 4.0 $5.6 $12.4 6.0 $6.4 $13.8 7.0 $6.8 $153.1 $159.9

26-26

Tutwiler APV Approach

Estimate Tutwilers Unlevered Cost of Equity:
rsL w s rsL w d rd rsL 0.6983( 13%) 0.3017( 9%) rsL 11.793%

26-27

Tutwiler APV Approach

Panel C: APV Model Cash Flows 12 Free Cash Flow Horizon Value of FCF Total FCF Value (Unlevered) 13 Interest tax savings = INT(T) Horizon Value of tax savings Total Tax Shield Value(Tax Shield) Total Value of Firm Minus Value of current debt Value of Equity $21.4 $110.1 $27.0 $83.1 r(sU) g= 11.793% 6% $1.2 $1.3 $1.4 $1.5 $88.7 1.2 1.28 1.4 1.48 1.56 $28.7 $30.3 $3.2 $3.2 $5.6 $6.4 $3.2 $3.2 $5.6 $6.4 $6.8 $124.4 $131.2

26-28

Tutwiler FCFE Model

HV FCFE ,2014 FCFE 2015 FCFE ( 1 g ) rsL g rsL g

$7.06( 1.06 ) HV FCFE ,N $106.9 m 0.13 0.06

26-29

Tutwiler FCFE Model

Panel D: FCFE Model Cash Flows 14 15 16 17 Free Cash Flow Less A-T Interest=INT(1-T) Plus debt FCFE Horizon value of FCFE Total FCFE Value of FCFE $6.2 $83.1 r(sL) g= 13.0% 6% $4.0 $4.1 $6.0 $6.7 6.2 $6.2 $3.2 1.8 2.6 $4.0 $3.2 1.9 2.9 $4.1 $5.6 2.1 2.5 $6.0 $6.4 2.2 2.5 $6.7 $6.8 2.4 2.6 $7.1 106.9 $114.0

26-30

Tutwiler Value Recap

TUTWILER Equity Current Value of Equity Corporate Valuation APV Approach FCFE Model $62.5 $83.1 $83.1 $83.1

Tutwiler is worth more as part of Caldwell than stand-alone

26-31

The Bid Price

Caldwells Bid for Tutwiler

Caldwell will assume Tutwilers 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?

26-32

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 problematic in many mergers
26-33

Caldwells Bid

Offer range = $62.5m to $83.1m $62.5m merger benefits would go to the acquiring firms shareholders $83.1m all value added would go to the target firms shareholders

26-34

Bid Strategy Issues

High preemptive bid to ward off other bidders Low bid and then plan to go up Do targets managers have 51% of stock and want to remain in control? What kind of personal deal will targets managers get?
26-35

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
26-36

Acquisition with Permanent Change in Capital Structure

Tutwiler currently:

$62.5m value of equity $27m debt = 30.17% debt Increase debt to 50% Maintain level from 2012 on New rate on debt = 9.5%

Caldwells plan

Tax shield, WACC and bid price will change

26-37

Change in Tax Shield

9. Debt
a

52.63

63.16 5.000 2.000

73.68 6.000 2.400

78.95 7.000 2.800

87.33 7.500 3.000 8.296 3.319

10. Interest 11. Interest tax savings

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

26-38

Effect on the Bid Price

New Horizon Value Calculation First, calculate Tutwiler's horizon value if it were unlevered. HVU = FCF 2014 * (1 + g) HVU = 6.8 * 1.060 HVU = $124.42

(rU 0.1179

g) 0.06

Second, calculate the horizon value of Tutwiler's tax shields under new financing plan: HVTS = TS 2014 * (1 + g) (rU HVTS = 3.319 * 1.060 0.1179 HVTS = $60.72

g) 0.06

Horizon value of Tax Shields is larger due to increased debt level.

26-39

Revised Value of Tutwiler

Panel C: APV Model Cash Flows with Increased Debt 12 Free Cash Flow Horizon Value of FCF Total FCF Value (Unlevered) 13 Interest tax savings = INT(T) Horizon Value of tax savings Total Tax Shield Value(Tax Shield) Total Value of Firm Minus Value of current debt Revised Value of Equity $44.3 $133.0 $27.0 $106.0 r(sU) g= 11.793% 6% $2.0 $2.4 $2.8 $3.0 $88.7 2.0 2.4 2.8 3.0 3.3 $60.7 $64.0 $3.2 $3.2 $5.6 $6.4 $3.2 $3.2 $5.6 $6.4 $6.8 $124.4 $131.2

26-40

Recap: Value of Tutwiler Equity

TUTWILER Equity Total Current Value of Equity Original Merger Value APV Approach Revised $62.5 $83.1 $106.0 Per Sh $6.25 $8.31 $10.60

26-41

Merger Payment

Cash Shares in acquiring firm Debt of the acquiring firm Combination

26-42

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

26-43

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

26-44

Tax Consequences
Shareholders

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

26-45

Tax Consequences
Firms

Non-taxable offer

Simple merger of balance sheets Continue depreciating targets assets as previously Offer for targets assets Offer for targets stock
26-46

Taxable offer depends on offer type

Tax Consequences
Firms

Taxable Offer for Targets assets

Acquirer pays gain on offer asset value Acquirer records targets assets at appraised value

Depreciation based on new valuation Amortized over 15 years/straight line

Goodwill = offer new valuation

26-47

Tax Consequences
Firms

Taxable Offer for Targets Stock

2 Choices of tax treatment 1. Record acquired assets at book value and continue depreciating on current schedule 2. Record acquired assets at appraised value and generate goodwill

26-48

Figure 26-1

26-49

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

26-50

Table 26-4

26-51

Income Statement Effects

Table 26-5

26-52

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

26-53

The Role of Investment Bankers

Arranging mergers

Identifying targets

Developing defensive tactics Establishing a fair value Financing mergers Arbitrage operations

26-54

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
26-55

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
26-56

Risk Arbitrage

Arbitrageurs or arbs Speculation in likely takeover targets Insider trading scandals

Ivan Boesky

26-57

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

26-58

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

26-59

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
26-60

Advantages and Disadvantages of Going Private

Advantages:

Administrative cost savings Increased managerial incentives Increased managerial flexibility Increased shareholder participation Limited access to equity capital No way to capture return on investment
26-61

Disadvantages:

Types of Divestitures

Sale of entire subsidiary to another firm Spin-off

Spinning off a corporate subsidiary by giving the stock to existing shareholders Selling a minority interest in a subsidiary

Carve-out

Outright liquidation of assets

26-62

Motivation for Divestitures

Subsidiary worth more to buyer than when operated by current owner Settle antitrust issues Subsidiarys value increased operated independently Change strategic direction Shed money losers Get needed cash when distressed
26-63

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
26-64

Advantages and Disadvantages of Holding Companies

Advantages:

Control with fractional ownership Isolation of risks Partial multiple taxation Ease of enforced dissolution

Disadvantages:

26-65