Chapter 21 Mergers, LBOs, Divestitures, and Holding Companies

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

Merger & Acquisition (M&A) Acquisition & Divestment (A&D) Investment & Divestment (I&D)

Reasons for Mergers Synergy: Value of the whole exceeds sum of the parts. Could arise from: Operating economies Financial economies Differential management efficiency Taxes (use accumulated losses) Break-up value: Value of the individual parts of the firm if they are sold off separately. If it’s higher than current market value, the firm could be acquired then sold off in pieces to earn a profit. Diversification. Acquire other firms to increase size, thus making it more difficult to be acquired.

Why Buying an Asset or Business? Access to resources Proximity to market and infrastructure Buy or build growth strategies Achieve critical mass Enter new markets / increase market share Acquire technological know-how / intellectual property Complement existing business Diversify product or business portfolio Defence tactics/ elimination of competitors Benefit from synergies Long term investment Securing supply chain

Types of Mergers Horizontal Merger Vertical Merger Conglomerate Merger

Friendly vs Hostile Mergers 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 to tender offer their shares. Often, mergers that start out hostile end up as friendly, when offer price is raised.

Parties Involved

Acquisition Process

Target Valuation Approaches Market Multiple Analysis Corporate Valuation Model Equity Residual Model Adjusted Present Value (APV)

Market Multiple Model Using multiple ratio (P/E, P/CF, P/S, P/BV, etc) of industry average or comparable peer. Multiplying that ratio to estimated figures of target’s earnings/cash flow/sales/book value, etc. Easy to estimate but least accurate Provide a ballpark estimate

Corporate Valuation Model Forecasting Pro Forma Financial Statements, determining Free Cash Flow Determine Value of operations added with Value of nonoperating assets: Total Corporate Value Less value of debt & preferred stocks: value of common equity More suitable if WACC & capital structure is relatively stable

Equity Residual Model Also called Free Cash Flow to Equity (FCFE) model Estimate the value of equity as PV of projected FCF to equity, discounted at required return on equity. FCFE = cash flow available for shareholders after making debt related payment (interest & principal), adding debt in operating capital. More suitable if capital structure is relatively stable as change in capital structure may cause cost of equity to change.

Adjusted Present Value (APV) Often in a merger the capital structure changes rapidly over the first several years. This causes the WACC to change from year to year.

The APV Model Value of firm if it had no debt + Value of tax savings due to debt = Value of operations First term is called the unlevered value of the firm. The second term is called the value of the interest tax shield.

The APV Model Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity, rsU. Value of interest tax shield = PV of interest tax savings at unlevered cost of equity. Interest tax savings = (Interest) x (tax rate) = TSt = Tax Shield.

Note to APV APV is the best model to use when the capital structure is changing. The Corporate Valuation model is easier than APV to use when the capital structure is constant—such as at the horizon.

Steps in APV Valuation Project FCFt ,TSt , horizon growth rate, and horizon capital structure. Calculate the unlevered cost of equity, rsU. Calculate WACC at horizon. Calculate horizon value using constant growth corporate valuation model. Calculate Vops as PV of FCFt, TSt and horizon value, all discounted at rsU.

APV Valuation Analysis (In Millions) Projection of Free Cash Flows 2004 2005 2006 2007 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 EBIT 19.5 30.0 37.5 42.0 Taxes on EBIT (40%) 7.8 12.0 15.0 16.8 NOPAT 11.7 18.0 22.5 25.2 Plus Depreciation 0.0 3.0 4.0 5.0 Operating Cash Flow 11.7 21.0 26.5 30.2 Less Gross Inv. In Opr Capital 0.0 10.5 10.0 9.5 Free Cash Flow 11.7 10.5 16.5 20.7 7

Projection of Interest Tax Savings after Merger 2004 2005 2006 2007 Interest expense 5.0 6.5 6.5 7.0 Interest tax savings 2.0 2.6 2.6 2.8 Interest tax savings are calculated as Interest x Tax Rate. T = 40%

Discount Rate: Comparison of APV with Corporate Valuation Model APV discounts FCF at rsU and adds in present value of the tax shields—the value of the tax savings are incorporated explicitly. Corp. Val. Model discounts FCF at WACC, which has a (1-T) factor to account for the value of the tax shield.

Discount rate for Horizon Value At the horizon the capital structure is constant, so the corporate valuation model can be used, so discount FCFs at WACC.

Calculation of Discount Rates Assumptions: rRF = 7%; (rM - rRF) = 4%; bTarget = 1.3; rD = 9% Growth at Horizon, g = 6% Current Capital Structure (assumed to be returned at horizon): wd = 20%; ws = 80% rsL = rRF + (rM - rRF)bTarget = 7% + (4%)1.3 = 12.2% rsU = wdrd + wsrsL = 0.20(9%) + 0.80(12.2%) = 11.56% WACC = wd(1-T)rd + wsrsL =0.20(0.60)9% + 0.80(12.2%) = 10.84% Equation 17-15 10

Calculation of Horizon Value = = $453.3 million.

Value of the Target Firm’s Operation 2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7 Horizon value 453.3 Interest tax shield 2.0 2.6 2.6 2.8 Total $13.7 $13.1 $19.1 $476.8 $13.7 (1.1156)1 $13.1 (1.1156)2 $19.1 (1.1156)3 $476.8 (1.1156)4 VOps = + + + = $344.4 11

What is the value of the Target’s equity? The Target has $55 million in debt. Vops – debt = equity 344.4 million – 55 million = $289.4 million = equity value of target to the acquirer.

Would Another Potential Acquirer Obtain the Same Value? No. The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies. Further, a different beta estimate, financing mix, or other assumptions would change the discount rate.

Offer Price: Assumptions Assume the target company has 20 million shares outstanding. The stock last traded at $11 per share, which reflects the target’s value on a stand-alone basis. How much should the acquiring firm offer?

Offer Price: Calculation Estimate of target’s value = $289.4 million Target’s current value = $220.0million Merger premium = $ 69.4 million Presumably, the target’s value is increased by $69.4 million due to merger synergies The offer could range from $11 to $289.4/20 = $14.47 per share. At $11, all merger benefits would go to the acquiring firm’s shareholders. At $14.47, all value added would go to the target firm’s shareholders.

Change in Shareholders’ Wealth Acquirer Target $11.00 $14.47 $11.00 $14.47 Price Paid for Target 5 10 15 20 Bargaining Range = Synergy 15

Offer Price: Bargaining 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 $11. Acquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. Strategy is important. What kind of personal deal will target’s managers get?

Due Diligence

Due Diligence: Financial Review of past historical performance (generally the last 3 years) Review of key assets and liabilities Review of profitability Identification of hidden exposure (incl. tax exposure), commitments, contingencies and other unrecorded liabilities Review of transactions with related parties Identification of key Generally Accepted Accounting Principle differences (if required) Review of compliance matters and other relevant regulations

Due Diligence: Tax Review of status tax filing and payment and other tax compliance practices Identify potential tax exposure on major commercial arrangements Analysis of any outstanding dispute with the Tax Office Review of tax facilities, if any Review of material related party transactions and highlight potential transfer pricing issue

Sales & Purchase Agreement: Key Areas Timeline Consideration Condition Precedent Representation & Warranties Tax Matters Indemnification Book & Records Due Diligence

Accounting for Merger Purchase Accounting: The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value. Goodwill is often created, which appears as an asset on the balance sheet. Common equity account is increased to balance assets and claims.

Accounting for Merger

Goodwill Amortization Goodwill is no longer amortized over time for shareholder reporting. Goodwill is subject to an annual “impairment test.” If its fair market value has declined, then goodwill is reduced. Otherwise it is not.

Why alliances can make more sense than acquisitions Multiple parties share risks and expenses Rivals can often work together harmoniously Avoiding antitrust laws

Alliance, JV & Merger Example: Royal Dutch Shell

The Role of Investment Bankers Identifying targets Arranging mergers Developing defensive tactics Establishing a fair value Financing mergers

Reasons for Divestiture Subsidiary worth more to buyer than when operated by current owner. To settle antitrust issues. Subsidiary’s value increased if it operates independently. To change strategic direction. To shed money losers. To get needed cash when distressed.

Leveraged Buy Outs (LBOs) In an LBO, a small group of investors, normally including management, buys all of the publicly held stock, and hence takes the firm private. Purchase often financed with debt. After operating privately for a number of years, investors take the firm public to “cash out.”

Why Sell a Business or an Asset? A change in strategic focus An underperforming division A mature division with limited growth prospects Maximizing shareholder value A need for cash to finance other expansion opportunities The retirement of the owners Industry consolidation Liquidity issues Unable to expand without additional financial assistance Changing Technology

Potential Deal Issues Seller/Buyer’s Expectations Potential Tax Exposure Availability of Information & Time for Due Diligence Legal & Regulation Issues

Holding Companies A holding company is a corporation formed for the sole purpose of owning the stocks of other companies. In a typical holding company, the subsidiary companies issue their own debt, but their equity is held by the holding company, which, in turn, sells stock to individual investors.

Holding Companies: Advantages & Disadvantages Control with fractional ownership. Isolation of risks. Disadvantages: Partial multiple taxation. Ease of enforced dissolution.