Mergers, LBOs,

Divestitures, and Holding

Companies
 Merger
• Growth of corporation occurs through
• Internal Expansion: growth
• Mergers
 Mergers

Mergers
• When two firms combine to
form a single company
• Growth of corporation occurs
• Internal Expansion: growth
• Mergers
Acquisitions
• Acquiring company initiates
action to takeover another
(target co)
 Mergers

Leverage Buyouts (LBO) Divestitures

• LBO occur, when a firm’s stock is
acquired by a small group of
investor, a highly leverage firm
rather than any other operating
company
• In Divestitures, a firm sell off
major division to other firm that
can better utilize the divest
assets.
 Mergers

Holding Company Primary motive of merger

• It is the form of organization, 1. Synergy
where is one corporation owns i. Operating Economies
the stock of one or more other ii. Financial Economies
companies iii. Tax Effect
iv. Differential Efficiency
v. Increased Market Power
 Primary motive of merger
1. Synergy
• Primary motive of merger is to increase the value of the combined enterprise
• E.g.: If Co A and B merge to form Co C and if C’s value exceeds than of A & B taken
together, then synergy is said to exist
• Synergistic effects can arise from five sources:
i. Operating Economies
ii. Financial Economies
iii. Tax Effect
iv. Differential Efficiency
v. Increased Market Power
 Primary motive of merger
1. Synergy
• Synergistic effects can arise from five sources:
i. Operating Economies:
• Economies of scale in management, marketing, production
ii. Financial Economies
• Lower transaction cost and better coverage by security analyst
iii. Tax Effect
• The combined firm pays less tax than two separate firms pay
iv. Differential Efficiency
• After the merger, management of one firm is more efficient and weaker firms assets will be
more productive
v. Increased Market Power
• Increased market power due to less competition
 Type of Mergers

Horizontal Merger Vertical Merger

• When one firm combines with • When a firm combines with one
another in the same line of of its customers or suppliers
business
 Type of Mergers

Congeneric or Concentric Conglomerate Merger

• It is a merger between unrelated
or somewhat related firms
• Newspaper merge with a TV
Channel
• Airlines co acquires a tourist
company
• It occurs when two extremely
unrelated firms combine
• Merger between the Walt Disney
Company and American
Broadcasting Company
 Hostile vs Friendly Takeover

Hostile Takeover Friendly Takeover

• It occurs when one corporation, • It occurs when one corporation
the acquiring corporation, attempts to takeover another
attempts to takeover another firm with the approval of target
corporation, the target firm.
corporation without the
agreement of target
corporation’s board of directors
 Merger Analysis
• Two questions must be answered by the acquiring company
1. How much would the target be worth after being incorporated into the
acquirer?
2. How much should the acquirer offer for the target?

• Following Discounted Cash Flow (DCF) approaches will be focused:

1. The Corporate Valuation Method
2. The Adjusted Present Value Method
3. The Equity Residual Method
 Example
• To illustrate the three valuation approaches,

• Consider Caldwell Inc., a large technology company, as it evaluates the

potential acquisition of Tutwiler Controls.

• Tutwiler currently has a $62.5 million market value of equity and $27 million
in debt, for a total market value of $89.5 million.
• Thus, Tutwiler’s capital structure consists of $27/($62.5 + $27) = 30.17% debt.
• Caldwell intends to finance the acquisition with this same proportion of debt and plans
to maintain this constant capital structure throughout the projection period and
thereafter.
 Example
• Tutwiler is a publicly traded company, and its market-determined pre-merger
beta was 1.2.

• Given a risk-free rate of 7% and a 5% market risk premium, the Capital Asset
Pricing Model produces a pre-merger required rate of return on equity, rsL, of
• rsL = 7% + 1.2*5% = 13%
 Example

• Tutwiler’s cost of debt is 9%.

• Its WACC is
• WACC = wdrd(1 – t) +wsrsL
= 0.3017*0.60*9% + 0.6983*13%
= 10.707%

• How much would Tutwiler be worth to Caldwell after the merger?

Caldwell Inc. evaluates the potential acquisition of Tutwiler. Tutwiler has $62.5 million of equity and $27 million of
debt. Growth rate is 6%, Tax rate is 40%, Risk-free rate is 7%, Risk Premium is 5% & Premerger Beta is 1.2. Evaluate
the acquisition based on the data given above and in table 21-3.
The Corporate Valuation Method
The Corporate Valuation Method
 The Corporate Valuation Method
• There are no non-operating assets,

• So, if Caldwell acquires Tutwiler, then

• the value of equity of Tutwiler = the value of Tutwiler’s operations – the value of
Tutwiler’s debt

=$110.1 − $27 = $83.1 million

 Valuation Using the APV Approach
• There are no non-operating assets,

• So, if Caldwell acquires Tutwiler, then

• the value of equity of Tutwiler = the value of Tutwiler’s operations – the value of
Tutwiler’s debt

=$110.1 − $27 = $83.1 million

The Adjusted Present Value Method
The Adjusted Present Value Method
The Adjusted Present Value Method
 Valuation Using the APV Approach
• rsL = rsU + (rsU − rd)*(D/S)
• Dividing D & S by (D+S) each
• Therefore,
• rsL = rsU + (rsU − rd)*[(D/(D+S)]/[S/(D+S)]
• As , wd = D/(D+S) & ws = S/(D+S)
• Therefore,
• rsL = rsU + (rsU − rd)*( wd /ws)
• Simplifying
• ws*rsL = ws*rsU + (rsU − rd)*wd
• ws*rsL = ws*rsU + wd*rsU − wd*rd
• ws*rsL + wd*rd = ws*rsU + wd*rsU
• ws*rsU + wd*rsU = ws*rsL + wd*rd
• (ws + wd)*rsU = ws*rsL + wd*rd
• As, (ws + wd) = 1
• rsU = ws*rsL + wd*rd
The Adjusted Present Value Method
The Adjusted Present Value Method
The Adjusted Present Value Method
The Adjusted Present Value Method
The Adjusted Present Value Method
The Adjusted Present Value Method
$ 88.7 million
21.4 million

$ 110.1 million
0.0 million

$ 110.1 million
27.0 million

$ 83.1 million
 THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH
• Free cash flow is the cash flow available for distribution to all investors.

• Free cash flow to equity (FCFE) is the cash flow available for distribution to common shareholders
 THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH
• Free cash flow is the cash flow available for distribution to all investors.

• Free cash flow to equity (FCFE) is the cash flow available for distribution to common shareholders
THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH
THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH
THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH
THE FREE CASH FLOW TO EQUITY
(FCFE) APPROACH

= $83.1 million + 0

= $83.1 million