Chapter 21 Mergers & Divestitures Types of Mergers Merger Analysis Role of Investment Bankers Corporate Alliances Private Equity Investments and Divestitures What is a merger? Why do firms merge? Organic vs merger

What are some good reasons for mergers? Synergy: value of the whole exceeds sum of the parts. Could arise from: Operating economies Financial economies Differential management efficiency Increased market power Break-up value: assets would be more valuable if sold to some other company. Operating Economies: economies of scale in terms of management, marketing, production, or distribution Financial Economies: lower transaction costs, lower interest rates Differential efficiency: the management of one firm is more efficient and is expected to better use the acquired firm’s assets Increased market power: reduced competition

What are some questionable reasons for mergers? Diversification Purchase of assets at below replacement cost Managers’ Personal Incentives More power Higher salaries Get bigger using debt-financed mergers to help fight off takeovers (defensive mergers) What is the benefit of diversification when the shareholders can diversify at lower costs? Diversified firms are worth less than the sum of their parts 2nd point: Buying another oil company is cheaper than exploring for oil. Steel companies find it cheaper to buy other steel companies that build steel mils

Types of Mergers Horizontal: A Combination of two firms that produce the same type of good or service Vertical: A combination of a firm & one of its suppliers or customers Congeneric: A merger of firms in the same industry but with no customer or supplier relationship Conglomerate: A merger of companies in totally different industries

What is the difference between a “friendly” and a “hostile” merger? Friendly merger :The merger is supported by the managements of both firms. Hostile merger: Target firm’s management resists the merger Acquirer must go directly to the target firm’s stockholders and try to get 51% to tender their shares. Often, mergers that start out hostile end up as friendly when offer price is raised. Acquirer: the buying company Target: the bought company Set price or range of prices 2) terms of payment (cash, stock, combination) 3) reach out to management Examples from Kuwait

Merger Analysis: Post-Merger Cash Flow Statements 2009 2010 2011 2012 Net sales $60.0 $90.0 $112.5 $127.5 - Cost of goods sold 36.0 54.0 67.5 76.5 - Selling/admin exp 4.5 6.0 7.5 9.0 - Interest expense 3.0 EBT 16.5 25.5 33.0 - Taxes 6.6 10.2 13.2 14.4 Net income 9.9 15.3 19.8 21.6 Retentions 0.0 Cash flow 7.8 13.8 17.1 In Merger analysis you find the value of the target and try to buy the target at or lower than its value The target should accept the bid if they believe the price is higher than their value Valuation just as we saw in chapter 9 a) discounted cash flow valuation 2) market multiples The analysis should take into account the target won’t operate as a separate entity and take into account the changes or synergies that would happen First step is to get the pro-forma cash flow statements. If a Financial Merger (the entities will not combine and no synergies) the cash flows are the same as expected for the firm. If an operating merger (synergies are expected) the forecasting of cash flow would be more difficult.

Why is interest expense included in the analysis? Debt associated with a merger is more complex than the single issue of new debt associated with a normal capital project. Acquiring firms often assume the debt of the target firm, so old debt at different coupon rates is often part of the deal. The acquisition is often financed partially by debt. If the subsidiary is to grow in the future, new debt will have to be issued over time to support the expansion. Equity Residual Method: Value the residual cash flows that go to the shareholders Another method could be the Firm Valuation of chapter 9

Why are earnings retentions deducted in the analysis? If the subsidiary is to grow, not all income may be assumed by the parent firm. Like any other company, the subsidiary must reinvest some its earnings to sustain growth.

What is the appropriate discount rate to apply to the target’s cash flows? Estimated cash flows are residuals which belong to the acquirer’s shareholders. They are riskier than the typical capital budgeting cash flows. Because fixed interest charges are deducted, this increases the volatility of the residual cash flows. Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC.

Discounting the Target’s Cash Flows The cash flows reflect the target’s business risk, not the acquiring company’s. However, the merger will affect the target’s leverage and tax rate, hence its financial risk.

Calculating Terminal Value Find the appropriate discount rate Determine terminal value

Net Cash Flow Stream Value of target firm 2009 2010 2011 2012 Annual cash flow $9.9 $7.8 $13.8 $ 17.1 Terminal value 221.0 Net cash flow $238.1 Value of target firm Enter CFs in calculator CFLO register, and enter I/YR = 14.2%. Solve for NPV = $163.9 million Just with capital budgeting decisions, sensitivity analysis and scenario analysis should be done Talk about Market Multiples valuation

Would another acquiring company obtain the same value? No. The input estimates would be different, and different synergies would lead to different cash flow forecasts. Also, a different financing mix or tax rate would change the discount rate.

The Target Firm Has 10 Million Shares Outstanding at a Price of $9 The Target Firm Has 10 Million Shares Outstanding at a Price of $9.00 per Share What should the offering price be? The acquirer estimates the maximum price they would be willing to pay by dividing the target’s value by its number of shares: Offering range is between $9 and $16.39 per share.

Making the Offer The offer could range from $9 to $16.39 per share. At $9 all the merger benefits would go to the acquirer’s shareholders. At $16.39, all value added would go to the target’s shareholders. Acquiring and target firms must decide how much wealth they are willing to forego.

Shareholder Wealth in a Merger Shareholders’ Wealth Acquirer Target Bargaining Range Price Paid for Target $9.00 $16.39 0 5 10 15 20 The bargaining range represents the expected synergies If there were no synergies, what would be the maximum price to pay? The greater the synergies, the more likely the merger will happen Dividing the synergistic benefits is important Where would the price fall? The method of payment, the negotiation skills, the bargaining position of each firm

Shareholder Wealth Nothing magic about crossover price from the graph. Actual price would be determined by bargaining. Higher if target is in better bargaining position, lower if acquirer is. If target is good fit for many acquirers, other firms will come in, price will be bid up. If not, could be close to $9.

Shareholder Wealth Acquirer might want to make high “preemptive” bid to ward off other bidders, or make a low bid and then plan to increase it. It all depends upon its strategy. Do target’s managers have 51% of stock and want to remain in control? What kind of personal deal will target’s managers get?

Do mergers really create value? The evidence strongly suggests: 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, because of competitive bids. Acquiring firms not much.

Functions of Investment Bankers in Mergers Arranging mergers Assisting in defensive tactics Establishing a fair value Financing mergers Risk arbitrage Find firms with excess cash that might want to merger. Companies that might be willing to be bought. Firms that might be attractive to others. Help firms that are looking for targets. Target firms that don’t want to be bought. Change by the by-laws to block the merger Convince the target firm’s shareholder the price is too low Repurchase the price in the hopes of increasing it Getting a White Knight Getting a White Squire Taking a Poison Pill (economic suicide). Borrow on terms that state all debt should be repaid if the firm is acquired. Selling the firm’s assets at bargain prices. Granting golden parachutes

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