1. Chapter 21 Mergers, LBOs, Divestitures, and Holding Companies

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

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

4. 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.

5. 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

6. Types of Mergers
Horizontal Merger
Vertical Merger
Conglomerate Merger

7. 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.

8. Parties Involved

9. Acquisition Process

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

11. 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

12. 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

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. APV Valuation Analysis (In Millions)
Projection of Free Cash Flows
Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%)
Selling/admin. expenses
EBIT
Taxes on EBIT (40%)
NOPAT
Plus Depreciation
Operating Cash Flow
Less Gross Inv. In Opr Capital
Free Cash Flow 7

20. Projection of Interest Tax Savings after Merger
Interest expense
Interest tax savings
Interest tax savings are calculated as
Interest x Tax Rate. T = 40%

21. 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.

22. 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.

23. 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%) (12.2%) = 11.56%
WACC = wd(1-T)rd + wsrsL
=0.20(0.60)9% (12.2%)
= 10.84%
Equation 17-15 10

24. Calculation of Horizon Value=
= $453.3 million.

25. Value of the Target Firm’s Operation
Free Cash Flow $11.7 $10.5 $16.5 $ 20.7
Horizon value
Interest tax shield
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

26. 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.

27. 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.

28. 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?

29. 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.

30. Change in Shareholders’ Wealth Acquirer Target $11.00 $14.47
$11.00
$14.47
Price Paid for Target
Bargaining Range = Synergy 15

31. 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?

32. Due Diligence

33. 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

34. 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

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

36. 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.

37. Accounting for Merger

38. 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.

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

40. Alliance, JV & Merger Example: Royal Dutch Shell

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

42. 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.

43. 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.”

44. 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

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

46. 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.

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