Megers & Acquisitions Three Areas of Study 1. Determining if a Merger creates value (then developing an offer price) 2. Evaluating M&A offers in the market place (your case analysis assignment) 3. M&A Strategies (biggest area of “talk”)

Megers & Acquisitions Three Areas of Study 1. Determining if a Merger creates value (then developing an offer price) 2. Evaluating M&A offers in the market place (your case analysis assignment) 3. M&A Strategies (biggest area of “talk”) Today - Cover both Part 1 & 3 via lecture Part 2 via example

Recent Mergers

Sensible Reasons for Mergers Economies of Scale A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units. $ $ $ Reduces costs

Sensible Reasons for Mergers Economies of Vertical Integration –Control over suppliers “may” reduce costs. –Over integration can cause the opposite effect.

Sensible Reasons for Mergers Economies of Vertical Integration –Control over suppliers “may” reduce costs. –Over integration can cause the opposite effect. Pre-integration (less efficient) Company S S S S S S S

Sensible Reasons for Mergers Economies of Vertical Integration –Control over suppliers “may” reduce costs. –Over integration can cause the opposite effect. Pre-integration (less efficient) Company S S S S S S S Post-integration (more efficient) Company S

Sensible Reasons for Mergers Combining Complementary Resources Merging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm. Firm A Firm B

Sensible Reasons for Mergers Combining Complementary Resources Merging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm. Firm A Firm B

Sensible Reasons for Mergers Mergers as a Use for Surplus Funds If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

Dubious Reasons for Mergers The Bootstrap Game

Dubious Reasons for Mergers Earnings per dollar invested (log scale) Now Time Muck & Slurry World Enterprises (before merger) World Enterprises (after merger)

Dubious Reasons for Mergers Diversification –Investors should not pay a premium for diversification since they can do it themselves.

M&A Q: Does M&A create Value? A: if PV AB > PV A + PV B Q: If M&A creates value, Why? A: Synergies -Admin -Dup services -lower COC

M&A Q: Does M&A create Value? A: if PV AB > PV A + PV B Q: If M&A creates value, Why? A: SynergiesTricks -Admin-excuse to change D/E -Dup services-diversification -lower COC

M&A Q: How Much Should A Firm Pay in a M&A?

M&A Q: How Much Should A Firm Pay in a M&A? A: Theory Gain = PV AB - (PV A + PV B ) A must pay B part of the gain

M&A Q: How Much Should A Firm Pay in a M&A? A: Theory Gain = PV AB - (PV A + PV B ) A must pay B part of the gain A: Reality A usually pays B all of the gain, plus more. Why?

M&A Q: How Much Should A Firm Pay in a M&A? A: Theory Gain = PV AB - (PV A + PV B ) A must pay B part of the gain A: Reality A usually pays B all of the gain, plus more. Why? Premium Paid by A = (Cash - MV B ) + (MV B - PV B )

M&A Type of Takeovers Hostile Friendly LBO Going Private Greenmail White Knight

Takeover Defenses White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor. Shark Repellent - Amendments to a company charter made to forestall takeover attempts. Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

M&A Who Usually Benefits from M&A? Shareholders of B Lawyers & Brokers Execs in A Who Usually Losses in M&A? Sharehpolders of A (overhead) Execs in B Employees

M&A Analysis Steps for M&A Market Analysis Briefly describe the financial & stretegic history of the company Determine pre-announcement value Describe M&A offer Determine merged value (examine synergies) Compare values, offer, & market prices Predict success of M&A Recommend a strategy for investors and shareholders Provide a summary analysis

Disney / Cap Cities Deal History - News, Annual Report, 10k, etc. (Library & My Web page) (use spreadsheets to present financial facts) (include appendix with actual copies of info) (reference your sources) (present both original & typed summary data) (remember to annualize data)

Announcement of Offer Disney offers to acquire Cap Cities/ABC. Disney will exchange each share of Cap Cities for one share of Disney plus $65 cash. Disney will issue $10bil in new debt to finance the deal. Disney / Cap Cities Deal

Fact Sheet Forecasted 14% growth rate Forecasted EPSx#New Shares **DisneyMarket Rd7.25%8.0 % EPS$ 2.50$ 2.33

EPS r e - g Discount Rates DisneyCC/ABCNew Firm r a 22.97%(M&M) r d 7.25% (given by market) r e 24.53%(given by perpetuity formula) Sh Pr = solve for r e Disney / Cap Cities Deal r A =r d (1-Tc)(D) + r e (E) (V) (V) r d = given

DisneyCC/ABCNew Firm r a 22.97%18.92% r d 7.25% 7.25% r e 24.53%19.31% EPS r e - g Discount Rates Sh Pr = solve for r e Disney / Cap Cities Deal r A =r d (1-Tc)(D) + r e (E) (V) (V) r d = given DisneyCC/ABCNew Firm r a 22.97%18.92% r d 7.25% 7.25% r e 24.53%19.31%

EPS r e - g Discount Rates Sh Pr = solve for r e Disney / Cap Cities Deal r A =r d (1-Tc)(D) + r e (E) (V) (V) r d = given DisneyCC/ABCNew Firm r a 22.97%18.92%14.80% r d 7.25% 7.25% 8.00% r e 24.53%19.31%17.97%

MarketTheory DisneyCC/ABCNew Firm New Firm DisneyCC/ABCNew Firm New Firm V L bil15.30 bil52.60 bil NOI U g20%14% r EU V U Disney / Cap Cities Deal Derive data for the unlevered firm & Calculate the Theoretical New Firm Values GOAL

Value of the Firm (M&M) VL=VL= NOI u r EU - g + (Tax rate)debt Disney / Cap Cities Deal NOI u = EPS U x # of shares or NOI u = (EPS L x # of sh) + (debt)(r D )(1-Tax Rate) Solve for r EU VUVU

Disney / Cap Cities Deal NOI u = (EPS L x # of sh) + (debt)(r D )(1-Tax Rate) Disney NOI u = (2.60x.520) + (2.6)(.0725)(1-.34) = $1.47 bil CC/ABC NOI u = (5.10x.154) + (.5)(.0725)(1 -.34) = $.81 bil New Firm NOI u = (2.33x.674) + (13.1)(.08)(1 -.34) = $2.26 bil

VL=VL= NOI u r EU - g + (Tax rate)debt Disney / Cap Cities Deal Disney VL=VL= 1.47 r EU (.34) 2.6 Solve for r EU r EU = % VU=VU= = $ bil

VL=VL= NOI u r EU - g + (Tax rate)debt Disney / Cap Cities Deal CC/ABC VL=VL= 0.81 r EU (.34) 0.5 Solve for r EU r EU = % VU=VU= = $ bil

VL=VL= NOI u r EU - g + (Tax rate)debt Disney / Cap Cities Deal New Firm (market) VL=VL= 2.26 r EU (.34) 13.1 Solve for r EU r EU = % VU=VU= = $ bil

MarketTheory DisneyCC/ABCNew Firm New Firm DisneyCC/ABCNew Firm New Firm V L bil15.30 bil52.60 bil NOI U 1.47 bil0.81 bil2.26 bil 2.26 bil g20%14%17.87%-Avg based on NOI U r EU %19.35 %22.58 % V U bil15.14 bil47.98 bil Disney / Cap Cities Deal

New Firm (Theory) r EU = Weighted Avg of Disney & CC/ABC r EU r EU = x ( ) x ( ) ( ) ( ) r EU = % Disney / Cap Cities Deal

New Firm (Theory) r EU = Weighted Avg of Disney & CC/ABC r EU r EU = x ( ) x ( ) ( ) ( ) r EU = % g = Weighted Avg of Disney & CC/ABC g g = 20 x ( ) + 14 x ( ) ( ) ( ) g = % Disney / Cap Cities Deal

MarketTheory DisneyCC/ABCNew Firm New Firm DisneyCC/ABCNew Firm New Firm V L bil15.30 bil52.60 bil NOI U 1.47 bil0.81 bil2.26 bil 2.26 bil g20%14%17.87%18.02 % r EU %19.35 %22.58 %22.92 % V U bil15.14 bil47.98 bil Disney / Cap Cities Deal

New Firm (Theory) Disney / Cap Cities Deal VL=VL= NOI u r EU - g + (Tax rate)debt VL=VL= (.34) 13.1 V U = bil V L = $ bil

Disney / Cap Cities Deal MarketTheory DisneyCC/ABCNew Firm New Firm DisneyCC/ABCNew Firm New Firm V L bil15.30 bil52.60 bil50.58 bil NOI U 1.47 bil0.81 bil2.26 bil 2.26 bil g20%14%17.87%18.02 % r EU %19.35 %22.58 %22.92 % V U bil15.14 bil47.98 bil46.12 bil

Disney / Cap Cities Deal New Firm (Theory) V L = Debt Value = 13.1 Equity value = = $ bil Price per Share = /.674 = $55.60

Disney / Cap Cities Deal Comparative Equity Values ($ bil) DisneyCC/ABCNew Firm Market (pre)$29.8 $14.8 Market (post) M&M (pre) $29.8 $14.8 M&M (post)

Disney / Cap Cities Deal Comparative Equity Values ($ bil) DisneyCC/ABCNew Firm Market (pre)$29.8 $14.8 Market (post)$ M&M (pre) $29.8 $14.8 M&M (post)$ 37.48

Disney / Cap Cities Deal Comparative Equity Values ($ sh pr) DisneyCC/ABCNew Firm Market (pre)$57.63 $96.13 Market (post)$ M&M (pre) $57.63 $96.13 M&M (post)$ 55.60

Predicted Success of Offer Cap Cities Market Price = 116 1/4 Cap Cities Offer = 123 5/8 = (58 5/8 + 65) Offer will succeed Disney / Cap Cities Deal

Predicted Success of Offer Cap Cities Market Price = 116 1/4 Cap Cities Offer = 123 5/8 = (58 5/8 + 65) Offer will succeed Cap Cities Market Price = 116 1/4 (Theory) Value of Offer = = ( ) Offer should succeed Disney / Cap Cities Deal

Analysis Summary The market is accurately valuing the offer to Cap Cities/ABC at around 116 (123 is too high) While both firms were properly valued prior to the offer, Disney is now overvalued Cap Cities stockholders should take the offer and cash out at the inflated market value Disney stock holders should sell at the inflated price The market is over reacting to Disney’s offer by pushing up Disney’s stock price. The primary cause is probably an inflated opinion of Disney’s growth opportunities Disney / Cap Cities Deal