Mergers, LBOs, Divestitures, CHAPTER 21 Mergers, LBOs, Divestitures, and Holding Companies Types of mergers Merger analysis Role of investment bankers Corporate alliances, LBOs, divestitures, and holding companies

Why do mergers occur? Synergy: Value of the whole exceeds sum of the parts. Could arise from: Operating economies Financial economies Differential management efficiency Increased market power Taxes (use accumulated losses)

Break-up value: Assets would be more valuable if sold to some other company.

What are some questionable reasons for mergers? Diversification Purchase of assets at below replacement cost Get bigger using debt-financed mergers to help fight off takeovers

Five Largest completed and proposed mergers, as of January 2000 Buyer America Online Vodafone AirTouch MCI WorldCom Exxon Bell Atlantic Target Time Warner Mannesmann Sprint Mobil GTE Value $160.0 billion 148.6 billion 128.9 billion 85.2 billion 85.0 billion

Differentiate between hostile and friendly mergers 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 try to get 51% to tender their shares. Often, mergers that start out hostile end up as friendly when offer price is raised.

Reasons why alliances can make more sense than 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

Merger Analysis (In Millions) Cash Flow Statements after Merger Occurs 2001 2002 2003 2004 Net sales $60.0 $90.0 $112.5 $127.5 Cost of goods sold (60%) 36.0 54.0 67.5 76.5 Selling/admin. expenses 4.5 6.0 7.5 9.0 Interest expense 3.0 4.5 4.5 6.0 EBT $16.5 $25.5 $ 33.0 $ 36.0 Taxes (40%) 6.6 10.2 13.2 14.4 Net income $ 9.9 $15.3 $ 19.8 $ 21.6 Retentions 0.0 7.5 6.0 4.5 Cash flow $ 9.9 $ 7.8 $ 13.8 $ 17.1

Conceptually, what is the appropriate discount rate to apply to target’s cash flows? Estimated cash flows are residuals which belong to 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. (More...)

Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC. 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.

Terminal Value Calculation 1. First, find the new discount rate: ks(Target) = kRF + (kM – kRF)bTarget = 9% + (4%)1.3 = 14.2%. 2. Terminal value = = = $221.0 million. (2004 Cash flow)(1 + g) ks – g $17.1(1.06) 0.142 – 0.06

Net Cash Flow Stream Used in Valuation Calculation (In Millions) 2001 2002 2003 2004 Annual cash flow $9.9 $7.8 $13.8 $ 17.1 Terminal value 221.0 Net cash flow $9.9 $7.8 $13.8 $238.1 $9.9 (1.142)1 $7.8 (1.142)2 $13.8 (1.142)3 $238.1 (1.142)4 Value = + + + = $163.9 million.

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.

Target firm has 10 million shares outstanding at a price P0 of $9 Target firm has 10 million shares outstanding at a price P0 of $9.00 per share. What should the offering price be? Value of Acquisition Shares Outstanding Maximum price = = = $16.39/share. Range = $9 to $16.39/share. $163.9 million 10 million

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. See graph on the next slide.

Change in Shareholders’ Wealth $9.00 $16.39 Price Paid for Target Acquirer Target $9.00 $16.39 Price Paid for Target 5 10 15 20 Bargaining Range = Synergy

Nothing magic about crossover price. Points About Graph Nothing magic about crossover price. 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. (More...)

Acquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. 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, i.e., move to right in merger graph (Slide 21-17), because of competitive bids.

Functions of Investment Bankers in Mergers Arranging mergers Assisting in defensive tactics Establishing a fair value Financing mergers Risk arbitrage