1. Mergers, LBOs, Divestitures, and Holding Companies
CHAPTER 26
Mergers, LBOs, Divestitures, and Holding Companies

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

3. Economic Justifications for Mergers
Synergy = Value of the whole exceeds sum of the parts
Operating economies
Financial economies
Differential management efficiency
Taxes (use accumulated losses)
Break-up value = Assets more valuable broken up and sold

4. Questionable Reasons for Mergers
Diversification
Purchase of assets below replacement cost
Acquire other firms to increase size, thus making it more difficult to be acquired

5. Merger Types Horizontal Vertical Congeneric Conglomerate
Related but not same industry
Conglomerate
Unrelated enterprises

6. Five Largest Completed Mergers (as of December, 2007)
TABLE 26-1

7. Friendly & Hostile Mergers
Friendly merger:
Supported by management of both firms
Hostile merger:
Target firm’s management resists the merger
Acquirer must go directly to the target firm’s stockholders – “tender offer” - try to get 51% to tender their shares.
Often, mergers that start out hostile end up as friendly, when offer price is raised

8. Merger Analysis DCF Analysis Market Multiples Analysis
Corporate Valuation (Ch 11)
Adjusted Present Value Method (Ch 26.7)
Equity Residual Model (Ch 26.8)
= Free Cash Flow to Equity Method
Market Multiples Analysis
Provides a “benchmark”

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

10. The APV Model
(15-7)
(16-4)
(26-1)
(15-1)
(26-2)
(26-3)

11. APV Model VU = Unlevered value of firm
= PV of FCFs discounted at unlevered cost of equity, rsU
VTS = Value of interest tax shield
= PV of interest tax savings discounted at unlevered cost of equity, rsU
Interest tax savings = Interest * (tax rate) = TSt

12. APV vs. Corporate Valuation
Best model when capital structure is changing
Merger often causes capital structure changes over the first several years
Causes WACC to change from year to year
Hard to incorporate year-to-year WACC changes in the corporate valuation model
Corporate Valuation (i.e., discount FCF at WACC) = easier than APV when capital structure is constant

13. Steps in APV Valuation Calculate unlevered cost of equity, rsU
Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter.
(16-6)
(26-4)
(26-5)

14. Steps in APV Valuation Project horizon growth rate, g
Calculate horizon value of unlevered firm using constant growth formula and FCFN
Calculate horizon value of tax shields using constant growth formula and TSN
(26-7)
(26-8)

15. Steps in APV Valuation Calculate Value of Operations
Calculate unlevered value of firm as PV of unlevered horizon value and FCFt
Calculate value of tax shields as PV of tax shield horizon value and TSt
(26-9)
(26-10)

16. Steps in APV Valuation Calculate Value of Operations
Calculate Vop as sum of unlevered value and tax shield value
Find total value of the firm
(26-11)

17. The FCFE Approach FCFE = Free Cash Flow to Equity
Cash flow available for distribution to common shareholders
(26-12)

18. FCFE Approach Value of Equity = Assuming constant growth: (26-13)
(26-14)
(26-15)
(26-16)

19. TABLE 26-2

20. Valuation Examples Caldwell Inc’s acquisition of Tutwiler Tutwiler
Market value of equity = $62.5 m
Debt = $27 m
Total market value = $89.5 m
% Debt = 30.17%
Cost of debt, rd = 9%
10 million shares outstanding

21. Tutwiler Acquisition Tutwiler’s pre-merger beta = 1.20
Risk-free rate = 7%
Market risk premium = 5%
CAPM rsL= 13%

22. Tutwiler Acquisition Both firms = 40% tax rate Post-horizon g= 6%
Caldwell will issue debt to maintain constant capital structure:
$6.2 m debt increase at merger

23. Projecting Post-Merger CFs

24. Post-Merger CF Projections

25. Tutwiler – Corporate Valuation
(26-7)

26. Tutwiler: Corporate Valuation

27. Tutwiler – APV Approach
Estimate Tutwiler’s Unlevered Cost of Equity:

28. Tutwiler – APV Approach

29. Tutwiler – FCFE Model
(26-14)

30. Tutwiler – FCFE Model

31. Tutwiler is worth more as part of Caldwell than stand-alone
Tutwiler Value Recap
Tutwiler is worth more as part of Caldwell than stand-alone

32. The Bid Price Caldwell’s Bid for Tutwiler
Caldwell will assume Tutwiler’s debt
Added short-term debt for acquisition
Analysis shows Tutwiler worth $83.1m to Caldwell
If Caldwell pays more Caldwell value diluted
How much should Caldwell offer?

33. Caldwell’s Bid for Tutwiler
Target’s Estimated value = $83.1 million
Target’s current value = $62.5 million
Merger premium = $20.6 million
 “Synergistic Benefits” = $20.6 million
Realizing synergies has been problematic in many mergers

34. Caldwell’s Bid Offer range = $62.5m to $83.1m
$62.5m → merger benefits would go to the acquiring firm’s shareholders
$83.1m →all value added would go to the target firm’s shareholders

35. Bid Strategy Issues High “preemptive” bid to ward off other bidders
Low bid and then plan to go up
Do target’s managers have 51% of stock and want to remain in control?
What kind of personal deal will target’s managers get?

36. Do mergers really create value?
According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management.
Target firm shareholders reap most of the benefits
Final price close to full value
Target management can always say no
Competing bidders often push up prices

37. Acquisition with Permanent Change in Capital Structure
Tutwiler currently:
$62.5m value of equity
$27m debt = 30.17% debt
Caldwell’s plan
Increase debt to 50%
Maintain level from 2012 on
New rate on debt = 9.5%
Tax shield, WACC and bid price will change

38. Change in Tax Shield
This last debt level is consistent with the assumed long-term capital structure
The last interest payment is consistent with the long-term capital structure

39. Effect on the Bid Price
Horizon value of Tax Shields is larger due to increased debt level.

40. Revised Value of Tutwiler

41. Recap: Value of Tutwiler Equity

42. Merger Payment Cash Shares in acquiring firm
Debt of the acquiring firm
Combination

43. Bid Structure Effects Capital structure of post-merger firm
Tax treatment of shareholders
Ability of target shareholders to benefit from post merger gains
Federal & state regulations applied to acquiring firm

44. Tax Consequences Shareholders
Taxable Offer
Payment = primarily cash or bonds
IRS views as a “sale”
Target shareholders taxed on gain
Original purchase price vs. Offer price
Taxed in year of merger

45. Tax Consequences Shareholders
Non-taxable Offer
Payment = primarily stock
IRS views as an “exchange”
Target shareholder pay no taxes at time of merger
Taxed at time of stock sale
Preferred by shareholders

46. Tax Consequences Firms
Non-taxable offer
Simple merger of balance sheets
Continue depreciating target’s assets as previously
Taxable offer – depends on offer type
Offer for target’s assets
Offer for target’s stock

47. Tax Consequences Firms
Taxable Offer for Target’s assets
Acquirer pays gain on offer – asset value
Acquirer records target’s assets at appraised value
Depreciation based on new valuation
“Goodwill” = offer – new valuation
Amortized over 15 years/straight line

48. Tax Consequences Firms
Taxable Offer for Target’s Stock
2 Choices of tax treatment
1. Record acquired assets at book value and continue depreciating on current schedule
2. Record acquired assets at appraised value and generate goodwill

49. Figure 26-1

50. Purchase Accounting Purchase:
Assets of acquired firm are “written up or down” to reflect purchase price relative to net asset value
Goodwill often created
An asset on the balance sheet
Common equity account increased to balance assets and claims

51. Table 26-4

52. Income Statement Effects
Table 26-5

53. Goodwill Amortization
No longer amortized over time for shareholder reporting
Still amortized for Federal Tax purposes
Goodwill subject to annual “impairment test”
If fair market value has declined, then goodwill is reduced

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

55. Defensive Tactics “Super Majority” Convince target price is too low
1/3 of Directors elected each year
75% approval for merger versus simple majority
Convince target price is too low
Raising anti-trust issues
Open market repurchase of stock to push price up
Finding a “White Knight”
Finding a “White Squire”
Taking a “Poison Pill”
ESOP plans

56. Poison Pills Any technique used to discourage hostile takeovers
Borrowing on terms that require immediate repayment if acquired
Selling desirable assets at low prices
Granting lucrative “golden parachutes”
Allowing current shareholders to buy shares at reduced prices

57. Risk Arbitrage “Arbitrageurs” or “arbs”
Speculation in likely takeover targets
Insider trading scandals
Ivan Boesky

58. Who Wins? Takeovers increase the wealth of target firm shareholders
Benefit to acquiring firm debatable
“Event Studies” – Target stock price
 30% for hostile tender offers
 20% for friendly mergers

59. Alliances versus 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

60. Leveraged Buyout (LB0)
Small group of investors buys all publicly held stock
Takes the firm private
Group usually includes management
Purchase often financed with large amounts of high-yield debt
Investors take firm public to “cash out”

61. Advantages and Disadvantages of Going Private
Administrative cost savings
Increased managerial incentives
Increased managerial flexibility
Increased shareholder participation
Disadvantages:
Limited access to equity capital
No way to capture return on investment

62. Types of Divestitures Sale of entire subsidiary to another firm
“Spin-off”
Spinning off a corporate subsidiary by giving the stock to existing shareholders
“Carve-out”
Selling a minority interest in a subsidiary
Outright liquidation of assets

63. Motivation for Divestitures
Subsidiary worth more to buyer than when operated by current owner
Settle antitrust issues
Subsidiary’s value increased operated independently
Change strategic direction
Shed money losers
Get needed cash when distressed

64. Holding Companies
Corporation formed for sole purpose of owning the stocks of other companies
Typically, subsidiary companies:
Issue their own debt
Equity held by the holding company
Holding company sells stock to individual investors

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