Mergers, LBOs, Divestitures, and Holding Companies

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CHAPTER 26

• Mergers, LBOs, Divestitures, and Holding Companies

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Topics in Chapter

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

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What are some valid economicjustifications 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)

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Valid Reasons (Continued)

• Break-up value Assets would be more valuable if
  broken up and sold to other companies.

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What are some questionablereasons for mergers?

• Diversification
• Purchase of assets at below replacement cost
• Acquire other firms to increase size, thus making
  it more difficult to be acquired

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Five Largest Completed Mergers(as of January,
2006)
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Differentiate between hostile and friendly mergers

• Friendly merger
• The merger is supported by the managements of
  both firms.

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• Hostile merger
• Target firms management resists the merger.
• Acquirer must go directly to the target firms
  stockholders, try to get 51 to tender their
  shares.
• Often, mergers that start out hostile end up as
  friendly, when offer price is raised.

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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 RD
  activities

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Reason for 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.
• It is hard to incorporate year-to-year changes in
  WACC in the corporate valuation model.

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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.

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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(tax rate) TSt.

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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.

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Steps in APV Valuation

• Project FCFt ,TSt until company is at its target
  capital structure for one year and is expected to
  grow at a constant rate thereafter.
• Project horizon growth rate.
• Calculate the unlevered cost of equity, rsU.
• Calculate horizon value of tax shields using
  constant growth formula and TSN.
• Calculate horizon value of unlevered firm using
  constant growth formula and FCFN.

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Steps in APV Valuation

• 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
• Calculate Vops as sum of unlevered value and tax
  shield value.

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Steps in APV Valuation

• Value of operations
• Value of any non-operating assets
• Total value of the firm
• - Value of debt (pre-merger)
• Value of equity

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APV Valuation Analysis (In Millions) Based on
Post-Acquisition Cash Flows
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Cash flows continued
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Interest Tax Savings after Merger
Note Tax savings interest expense (Tax rate).
The tax rate is 40
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What is investment in net operating capital?

• Recall that firms must reinvest in order to
  replace worn out assets and grow.
• Investment in net operating capital change in
  total net operating capital.
• This is equivalent to gross investment in
  operating capital minus depreciation

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Non-Operating Assets

• Short-term investments and marketable securities
  are non-operating assets. The Target has none of
  these.

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What is the appropriate discount rate to apply to
the targets cash flows?

• After acquisition, the free cash flows belong to
  the remaining debtholders in the target and the
  various investors in the acquiring firm their
  debtholders, stockholders, and others such as
  preferred stockholders.
• These cash flows can be redeployed within the
  acquiring firm.

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Discount rate

• Free cash flow is the cash flow that would occur
  if the firm had no debt, so it should be
  discounted at the unlevered cost of equity, rsU
• The interest tax shields are also discounted at
  the unlevered cost of equity, rsU

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Note Comparison of APV with Corporate Valuation
Model

• APV discounts FCF at rsU and also the tax shields
  at rsU the value of the tax savings is
  incorporated explicitly.
• Corp. Val. Model discounts FCF at WACC, which has
  a (1-T) factor to account for the value of the
  tax shield.
• Both models give same answer if the capital
  structure is constant. But if the capital
  structure is changing, then APV should be used.

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Discount Rate for Horizon Value

• The last year of projections must be at the
  target capital structure with constant growth
  thereafter.
• Discount the FCFs using the constant growth
  formula to find the unlevered horizon value.
• Discount the tax shields using the constant
  growth formula to find the horizon value of the
  tax shields.

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Discount Rate Calculations
rsL rRF (rM - rRF)bTarget 7 (4)1.3
12.2 rsU wdrd wsrsL 0.20(9)
0.80(12.2) 11.56
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Unlevered Horizon Value
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Unlevered Value
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Unlevered Value

• The unlevered value is the value of the firms
  operations if it had no debt. In this case
  Lyons operations would be worth 298.9 million
  if it were financed with 100 equity.

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Tax Shield Horizon Value
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Tax Shield Value
2007
2008
2009
2010
2011
Interest tax shield
2.0


2.6


2.6


2.8


3.264


Tax shield horizon value
62.2


Total
2.0


2.6


2.6


2.8


65.5


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What Is the value of the Target Firms operations
to the Acquiring Firm? (In Millions)

• Value of operations
• unlevered value value of tax shield
• 298.9 45.5 344.4 million

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What is the value of the Targetsequity?

• The Target has 55 million in debt.
• Vops non-operating assets debt equity
• 344.4 million 0 55 million 289.4 million
  equity value of target to the acquirer.

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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 tax rate would change the discount rate.

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• Assume the target company has
• 20 million shares outstanding. The stock last
  traded at 11 per share, which reflects the
  targets value on a stand-alone basis. How much
  should the acquiring firm offer?

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• Estimate of targets value 289.4 million
• Targets current value 220.0 million
• Merger premium 69.4 million
• Presumably, the targets value is increased by
  69.4 million due to merger synergies, although
  realizing such synergies has been problematic in
  many mergers.

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• The offer could range from 11 to 289.4/20
  14.47 per share.
• At 11, all merger benefits would go to the
  acquiring firms shareholders.
• At 14.47, all value added would go to the target
  firms shareholders.
• The graph on the next slide summarizes the
  situation.

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Change in Shareholders Wealth
Acquirer
Target
11.00
14.47
Price Paid for Target
0
5
10
15
20
Bargaining Range Synergy
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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 11.

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• 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.
• Do targets managers have 51 of stock and want
  to remain in control?
• What kind of personal deal will targets managers
  get?

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What if the Acquirer intended to increase the
debt level in the Target to 40 with an interest
rate of 10?

• Assume debt at the end of 2010 will be 221.6
  million.
• Free cash flows wouldnt change
• Assume interest payments in short term wont
  change (if they did, it is easy to incorporate
  that difference). Interest in 2011 will change.
• Interest2011 0.10(221.6) 22.16 million
• Tax Shield2011 22.16(0.40) 8.864 million

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New Tax Shield Horizon Value Calculation
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New Tax Shield Value
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Increase in Tax Shield

• The old tax shield value was 45.5 million when
  the company was financed with 20 debt.
• When the company is financed with 40 debt, the
  tax shield value increases to 110.5 million.
  The increase is due to the larger interest
  deductions.

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New Vops and Vequity
Value of operations unlevered value value
of tax shield 298.9 110.5 409.4
million Value of equity Value of operations
non-operating assets debt
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New Equity Value

• 409.4 million - 55 million 354.4 million
• This is 65 million, or 3.25 per share more than
  if the horizon capital structure is 20 debt.
• The added value is the value of the additional
  tax shield from the increased debt.

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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.
• Shareholders of target firms reap most of the
  benefits, that is, the final price is close to
  full value.
• Target management can always say no.
• Competing bidders often push up prices.

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What method is used to account for mergers?

• Pooling of interests is GONE. Only purchase
  accounting may be used now.

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Purchase Accounting

• Purchase
• 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.

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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.
• Goodwill is still amortized for Federal Tax
  purposes.

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What are some merger-related activities of
investment bankers?

• Identifying targets
• Arranging mergers
• Developing defensive tactics
• Establishing a fair value
• Financing mergers
• Arbitrage operations

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What is a leveraged buyout (LB0)?

• 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.

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What are the advantages and disadvantages of
going private?

• Advantages
• 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

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What are the major types of divestitures?

• Sale of an entire subsidiary to another firm.
• Spinning off a corporate subsidiary by giving the
  stock to existing shareholders.
• Carving out a corporate subsidiary by selling a
  minority interest.
• Outright liquidation of assets.

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What motivates firms to divest assets?

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

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What are 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.

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Advantages and Disadvantages of Holding Companies

• Advantages
• Control with fractional ownership.
• Isolation of risks.
• Disadvantages
• Partial multiple taxation.
• Ease of enforced dissolution.