Corporate Finance MLI28C060 Merger and Acquisition: How these are undertaken and the implications of takeovers (corporate discipline) Lecture 11 Monday 24 October 2016
Definition of Merger, Acquisition and Takeover
A Classification Scheme Financial analysts typically classify acquisitions into three types: Horizontal acquisition: when the acquirer and the target are in the same industry. Vertical acquisition: when the acquirer and the target are at different stages of the production process; example: an airline company acquiring a travel agency. Conglomerate acquisition: the acquirer and the target are not related to each other.
A Note on Takeovers Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another. Takeover can occur by acquisition, proxy contests, and going-private transactions. In a proxy contest, a group of shareholders attempts to gain controlling seats on the board of directors by voting in new directors. A proxy authorizes the proxy holder to vote on all matters in a shareholders’ meeting.
Source of Synergy from Acquisitions Revenue Enhancement Cost Reduction Including replacing ineffective managers. Tax Gains Net Operating Losses Unused Debt Capacity The Cost of Capital Economies of Scale in Underwriting.
Mergers and Acquisitions as Part of FDI
Entry Strategies and Ownership Structures DEVELOPED MARKETS North America Western Europe Japan Australia and New Zealand 0 20 40 60 80 100 % OF RESPONDENTS Adapted from Figure 9–1: Preferred Strategies for Global Expansion
Entry Strategies and Ownership Structures EMERGING MARKETS 20 40 60 80 100 % OF RESPONDENTS Adapted from Figure 9–1: Preferred Strategies for Global Expansion
Implications of these on corporate valuation
The NPV of a Merger Typically, a firm would use NPV analysis when making acquisitions. The analysis is straightforward with a cash offer, but gets complicated when the consideration is stock.
The NPV of a Merger: Cash NPV of merger to acquirer = Synergy – Premium Premium = Price paid for B - VB NPV of merger to acquirer = Synergy - Premium
The NPV of a Merger: Common Stock The analysis gets muddied up because we need to consider the post-merger value of those shares we’re giving away.
The three legal forms of acquisition are Merger and consolidation Acquisition of stock Acquisition of assets M&A requires an understanding of complicated tax and accounting rules. The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities.
Economic Gains and Distribution of Gains OH-Fut-Op 04/11/2017 copywrite
Economic Gains and Distribution of Gains OH-Fut-Op 04/11/2017 Economic Gains and Distribution of Gains 1) Economic Gains 2) Distribution of Gains - cash offer - cash offer and underpriced 3) Distribution of Gains - share offer copywrite
Economic Gains Gains from a merger OH-Fut-Op 04/11/2017 Economic Gains Gains from a merger Are the 2 firms worth more together than apart? Assume current share prices correctly reflect each firm’s ‘stand alone’ value Let PVA = PA x NA = $200 x 1m = $200m (reflects PV of FCF) PVB = $50m and assume PVAB = $275 copywrite
Economic Gains GainAB = PVAB - (PVA + PVB) - transactions costs OH-Fut-Op 04/11/2017 Economic Gains GainAB = PVAB - (PVA + PVB) - transactions costs $25 = 275 - (200 + 50) - 0 The difficulty is in assessing PVAB Major difficulties in using NPV to assess the gains (‘synergies’) is because of lack of data on FUTURE performance of A+B, at the time of the takeover Friendly takeover - more data may be available on value of A+B Hostile takeover - much less data available on possible synergies Scenario/sensitivity analysis will be used to estimate PVAB copywrite
Distribution of Gains: Cash Offer OH-Fut-Op 04/11/2017 Distribution of Gains: Cash Offer Target ‘Correctly’ Priced in the market ‘A’ takeover of ‘B’: Gain for B= Cost for A CostA = (cash paid - PVB ) = 65 - 50 = $15m This is the ‘bid premium’ This is a gain to B’s shareholders Gain for A’s shareholders GainA = GainAB - CostA = 25 - 15 = $10m Return to B’s shareholders = 15/50 = 30% Return to A’s shareholders = 10/200 = 5% copywrite
Distribution of Gains: Cash Offer OH-Fut-Op 04/11/2017 Distribution of Gains: Cash Offer Note: If GainAB had been 10 (rather than 25) then A’s shareholders would loose from the merger: GainA = GainAB - CostA = 10 - 15 = -$5m and PA would fall on announcement of merger terms copywrite
Cash Offer: Target Underpriced OH-Fut-Op 04/11/2017 Cash Offer: Target Underpriced If PB << PVB : ie. B is underpriced Then (for a given bid premium) more of the gains go to A. ‘A’ can gain, even if there are no synergies (In this case there is not a gain for ‘society’, but a redistribution from B’s shareholders to A’s ) ~ but note that A could ‘realise’ this gain by simply buying B’s shares (and not merging) and merely waiting for the ‘market correction’ that increases B’s price. copywrite
Share Offer Assume A pays $65m for B (as with the cash offer) OH-Fut-Op 04/11/2017 Share Offer Assume A pays $65m for B (as with the cash offer) We also have PVAB = $275m, PVA = $200m, NA =1m and PA= $200 If B’s shareholders are to receive the equivalent of $65m then Number of (A’s) shares to be issued to B-shareholders NB = PVB / PA (before merger) = $65m /$200 = 0.325m This is announced BEFORE the actual merger takes place Cost of bid to A depends on the share price of the merged company AFTER the merger Assume Pay $65m for B We also have PVAB = $275m PVA = $200m so let NA =1m PA= $200 ) Number of shares issued to B-shareholders NB = PVB / PA (before merger) = $275m /$200 = 0.325m Apparent(incorrect cost) = Nb PA(before) - PVB = 0.325(200)-50 = $15m AFTER MERGER NAB = 1.5m hence PAB = PVAB/ NAB = $275/1.5 = $207.55 Cost to A is: CostA = (0.325/1.325) x 275 - $50m = 17.45m = z PVAB - PVB z= share of the merged firm held by B copywrite
Share Offer Apparent(but incorrect cost to A) OH-Fut-Op 04/11/2017 Share Offer Apparent(but incorrect cost to A) = 0.325 (200)-50 = $15m (as in ‘cash offer) = NB PA - PVB BUT correct’ cost of bid to A depends on the share price of the merged company AFTER the merger AFTER MERGER NAB = 1.325m hence PAB = PVAB/ NAB = $275/1.325 = $207.55 ‘True’ Cost to A of shares given to B’s shareholders: CostA = 0.325 x 207.55 - $50m = 17.45m Alternatively/equivalently Cost to A of shares given to B’s shareholders: CostA = (0.325/1.325) x $275m - $50m = 17.45m = z PVAB - PVB where z = share of the merged firm held by B copywrite
Cash versus Share Offer OH-Fut-Op 04/11/2017 Cash versus Share Offer CASH: cost to A of the merger is unaffected by the post-merger gains. SHARES Cost to A depends on the merger gains PVAB , which show up in the post merger price, PAB If cash is offered then the cost of the merger is unaffected by the post-merger gains. If shares are offered then the cost depends on the merger gains, which show up in the post merger price copywrite
Valuation and Rationalization of Mergers & Acquisitions
Definitions A merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company
Types of Mergers Horizontal Mergers - between competing companies Vertical Mergers - Between buyer-seller relation-ship companies Conglomerate Mergers - Neither competitors nor buyer-seller relationship
Motives and Determinants of Mergers Synergy Effect Operating Synergy Financial Synergy Diversification Economic Motives Horizontal Integration Vertical Integration Tax Motives
Equity Valuation Models Firm valuation in M&A Equity Valuation Models Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the balance sheet. Liquidation Value: the value that would be derived if the firm’s assets were liquidated. Replacement Cost: the replacement cost of its assets less its liabilities.
Firm valuation in M&A-2 Dividend Discount Models
Firm valuation in M&A-3 The Constant Growth DDM
Firm valuation in M&A-4 Price-Earnings Ratio
P/E ratio and Stock index value
Firm valuation in M&A-5 Cash Flow Valuation Models The Entity DCF Model : The entity DCF model values the value of a company as the value of a company’s operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity . Value of Operations: The value of operations equals the discounted value of expected future free cash flow. . Value of Debt . Value of Equity
Firm valuation in M&A-6 What Drives Cash Flow and Value? Fundamentally to increase its value a company must do one or more of the following: . Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital) . Increase the return on new capital investment . Increase its growth rate but only as long as the return on new capital exceeds WACC . Reduce its cost of capital.
Firm valuation in M&A-7 The Economic Profit Model: The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.
Steps in Valuation Analyzing Historical Performance
Steps in Valuation -2 Forecast Performance Evaluate the company’s strategic position, company’s competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC. Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance. Forecast income statement and balance sheet line items based on the scenarios. Check the forecast for reasonableness.
Steps in Valuation-3 Estimating The Cost Of Capital Develop Target Market Value Weights Estimate The Cost of Non-equity Financing Estimate The Cost Of Equity Financing
Steps in Valuation-4 Estimating The Cost Of Equity Financing CAPM . Determining the Risk-free Rate (10-year bond rate) . Determining The Market Risk premium 5 to 6 percent rate is used for the US companies . Estimating The Beta
Steps in Valuation-5 Estimating The Continuing Value Selecting an Appropriate Technique . Long explicit forecast approach . Growing free cash flow perpetuity formula . Economic profit technique
Steps in Valuation-6 Calculating and Interpreting Results Calculating And Testing The Results Interpreting The Results Within The Decision Context
Introduction to typical defenses against hostile takeover
Financing of Mergers CASH (TENDER) OFFER OH-Fut-Op 04/11/2017 Financing of Mergers CASH (TENDER) OFFER Source of cash can be provided by the acquirer undertaking a ‘rights issue’ or, by bank borrowing or, issuing debt (e.g. LBO) or by using retained profits (‘free cash flows’) - advantage to target shareholders is ‘precision’, and free to re-invest the cash in any other company - disadvantage is cash paid out may be treated as realised capital gain and taxed. - advantage for acquirer is that it retains total control of the new merged firm (ie no ‘dilution’ for its shareholders copywrite
Financing of Mergers SHARE OFFER OH-Fut-Op 04/11/2017 Financing of Mergers SHARE OFFER - advantage to target shareholders is that any capital gain on ‘new’ shares are not realised and hence not subject to immediate capital gains tax - advantage is target shareholder have (voting) shares in the new company -disadvantage to acquirer, if target (B) is overvalued by stock market or bid premium is ‘too high’ MIXED OFFERs ARE ALSO USED: Cash, shares, preference shares, share options copywrite
Defensive Tactics Target-firm managers frequently resist takeover attempts. It can start with press releases and mailings to shareholders that present management’s viewpoint and escalate to legal action. Management resistance may represent the pursuit of self interest at the expense of shareholders. Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.
The Control Block and The Corporate Charter If one individual or group owns 51-percent of a company’s stock, this control block makes a hostile takeover virtually impossible. Control blocks are typical in Canada, although they are the exception in the United States. The corporate charter establishes the conditions that allow a takeover. Target firms frequently amend corporate charters to make acquisitions more difficult. Examples Staggering the terms of the board of directors. Requiring a supermajority shareholder approval of an acquisition
Defence Tactics PAC MAN - mount a counter bid against the predator OH-Fut-Op 04/11/2017 Defence Tactics PAC MAN - mount a counter bid against the predator WHITE KNIGHT - arrange another bid from a friendly company POISON PILL - make bid costly (e.g. your shareholders can buy shares of new company at v. large discount. Rights issue to dilute predators holdings ) POISON PUT (in bond covenants) - bondholders of target can demand immediate repayment in full, if there is a change in ownership CROWN JEWELS - sell off bits the acquirer is most interested in copywrite
Defence Tactics GOLDEN PARACHUTES OH-Fut-Op 04/11/2017 Defence Tactics GOLDEN PARACHUTES - managers get massive payoff if they are taken over GREENMAIL - bribe your shareholders with promise of large future dividend payouts if they don’t sell their shares. - buy-up shares promised to the predator, at a premium. SHARK REPELLANTS - supermajority (80%) to approve merger - restricted voting rights (for shareholders who own more than x% of stock) staggered elections to the Board- more difficult to ‘capture’ the board so they recommend merger to their shareholders copywrite