Finance 402

1
CHAPTER 25 Mergers, LBOs, Divestitures, and
Holding Companies

• Recent Mergers
• Reasons for Mergers
• Types of Mergers
• Merger Analysis
• Accounting for Mergers
• Role of Investment Bankers
• Corporate Alliances, Leveraged
  Buyouts, and Divestitures
• Holding Companies

2
Mergers Announced in 2005

• America West and US Airways
• 1.5 billion - Announced May 19, 2005
• Lenovo Goup and IBM PC Division
• 1.25 billion Announced April 20th, 2005
• Verizon and MCI
• 7.6 billion Announced March 29, 2005
• Proctor and Gamble and Gillette
• 57 billion Announced March 28, 2005
• IAC/Interactive and Ask Jeeves
• 1.9 billion Announced March 21, 2005
• Met Life and Travelers Group
• 11.5 billion Announced January 31, 2005

3
Mergers Announced in 2004

• K Mart and Sears Roebuck
• 11 billion Announced November 17, 2004
• Wachovia and South Trust
• 14.3 billion Announced June 21, 2004
• May Company and Marshall Field
• Purchased from Target (an Acquisition)
• 3.24 billion Announced June 9, 2004
• Wells Fargo and Strong Capital Management
• 400 million (estimated) Announced May 27, 2004
• Marsh McLennan Kroll, Inc
• 1.96 billion Announced May 18, 2004

4
Mergers Announced in 2004 - Continued

• Sun Trust and National Commerce Financial
• 6.98 billion Announced May 9, 2004
• Cingular Wireless and AT T Wireless
• 47 billion Announced February 17, 2004
• J P Morgan Chase and Bank One

5
Mergers Announced in 2003

• St. Paul Companies and Travelers Property
  Casualty
• 16.5 billion
• Announced November 17th, 2003
• Bank of America and Fleet Boston
• 48 billion
• Announced October 27, 2003
• Manulife and John Hancock Financial Services
• 10.4 billion
• Announced November 4, 2003
• Anthem and Wellpoint
• 16.4 billion
• Announced October 27, 2003

6
Mergers Announced in 2003 -Continued

• R.J. Reynolds and British American Tobacco PLC
• 3 billion for U.S. units of British American
  Tobacco
• Announced October 27, 2003
• Oracle and PeopleSoft
• 5.1 billion hostile takeover updated in 2004
  to 9.2 billion
• First Announced June 9, 2003
• Manufactured Home and Chateau Communities
• 1.8 billion
• May, 2003
• Berkshire Hathaway and Clayton Homes
• 1.7 billion
• April, 2003
• Viacom and Comedy Central
• 1.2 billion
• April, 2003

7
Five Largest Completed Mergers(as of January
2002)

• VALUE
• BUYER TARGET (Billion)
• Vodafone AirTouch Mannesman 161
• Pfizer Warner-Lambert 116
• America Online Time Warner 106
• Exxon Mobil 81
• Glaxo Wellcome SmithKline Beecham 74

8
Foreign Acquisitions of U.S. Firms

• Manulife and John Hancock Financial Services
• Bridgestone and Firestone
• Daimler Benz and Chrysler
• HSBC Holdings and Household International
• British Petroleum and Amoco, Sohio, and Atlantic
  Richfield
• Ahold and Giant Food stores, Harris Teeter, and
  Price Chopper
• Michelin and B.F. Goodrich
• Grand Metropolitan and Pillsbury
• Thomson and G.E. Small Appliances

More
9
Foreign Acquisitions and U.S. Firms - Continued

• Credit Suisse and First Boston
• Zurich Insurance and Scudder, Stevens
• Bank of Tokyo-Mitsubishi and UnionBanCal
• Toronto Dominion Bank and Waterhouse Securities
• Hong Kong and Shanghai Bank and Marine Midland
• Matushita and MCA
• Broken Hill Proprietary and Utah International
  (from G. E.)
• UBS and Paine Webber
• Bertelsmann and Napster

10
Which of the reasons that have been proposed as
justification for mergers are economically
justifiable?

• Synergy Value of the combined firm exceeds the
  sum of the values of the firms taken separately.
  Arises from
• Operating economies
• Financial economies
• Differential management efficiency
• Tax Effects (possibly use accumulated losses)
  (More...)

11

• Increased Market Power Due to reduced
  competition
• Corporate Focus
• World Wide Competition (Globalization)
• Acquire Technological Skills

12
Break-up Value

• Break-up value A companys assets would be more
  valuable if sold to and then operated by some
  other company or spun off.

13
What are some questionable reasons for mergers?

• Diversification
• Stockholders can achieve diversification at lower
  cost than firms
• Transfers wealth from stockholders to debt
  holders
• No synergistic effects
• Purchase of assets at below replacement
  cost (more)

14
What are some questionablereasons for mergers? -
continued

• Retention of control
• Acquire other firms to increase size, thus making
  it more difficult to be acquired
• Managers personal incentives

15
Types of Mergers

• Horizontal
• First Union and Wachovia
• Vertical
• DuPont and Conoco
• Congeric - Related Enterprises
• Duke Power and Pan Energy
• Conglomerate
• Mobil Oil and Montgomery Ward

16
Differentiate between hostile and friendly mergers

• Friendly merger
• Management of one firm (acquirer) agrees to buy
  another firm (target).
• This merger is supported by the management of
  both firms.

17

• 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 the offer price is raised.
• Tender offer
• Proxy fights

18
Merger Regulation - The Williams Act of 1968

• Acquirers must disclose their current holdings
  within 10 days of amassing 5 of companys stock
• Acquirers must disclose source of funds to be
  used in the acquisition
• Target firms SH must be allowed at least 20 days
  to tender their shares
• If the acquiring firm increases the offer price,
  all SH who tendered must receive the higher
  price.

19
M A Terms

• Poison Put
• Poison Pill
• White Knight
• Shark Repellent
• Greenmail
• Golden Parachute
• Super Majority
• ESOP

20
Reason for Adjusted Present Value (APV) Merger
Analysis

• 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.

21
The Adjusted Present Value (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.

(More...)
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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 .

23
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
  constantsuch as at the horizon.

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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.

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APV Valuation Analysis (In Millions)
Free Cash Flows after Merger Occurs
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
• Net Retentions 0.0 7.5 6.0 4.5
• Free Cash Flow 11.7 10.5 16.5 20.7

From Mini Case in Chapter 25
26
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(T). T 40

27
What are the net retentions?

• Recall that firms must reinvest in order to
  replace worn out assets and grow.
• Net retentions gross retentions depreciation.

28
Conceptually, 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.

(More...)
29

• 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.
• The interest tax shields are also discounted at
  the unlevered cost of equity.

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Note Comparison of APV with Corporate Valuation
Model

• APV discounts FCF at rsU and adds in present
  value of the tax shieldsthe 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.
• Both models give same answer IF carefully done.
  BUT it is difficult to apply the Corp. Val. Model
  when WACC is changing from year-to-year.

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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.

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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 WACC wd(1-T)rd wsrsL
0.20(0.60)9 0.80(12.2) 10.84
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Horizon, or Continuing, Value

• Horizon value
• 453.3 million.

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What Is the value of the Target Firms operations
to the Acquiring Firm? (In Millions)
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 million.
35
What is the value of the Targets 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.

36
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.
• Additionally, a different estimating procedure
  could result in a different discount rate.

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• Estimate of targets value 289.4 million
• Targets current value 220.0million
• 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.
(More...)
38
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?
39

• 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.

40
Change in Shareholders Wealth
Acquirer
Target
0
11.00
14.47
Price Paid for Target
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. Most of the time the
  targets stockholders receive the vast majority
  of the benefits.

(More...)
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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?

43
What if the Acquirer intended to increase the
debt level in the Target to 40 with an interest
rate of 10?

• Free cash flows wouldnt change
• Assume interest payments in short term wont
  change (if they did, it is easy to incorporate
  that difference)
• Long term rsLwill change, so horizon WACC will
  change, so horizon value will change.

44
New WACC Calculation
New rsL rsU (rsU rd)(D/S) 11.56
(11.56 - 10)(0.4/0.6) 12.60 New WACC
wdrd(1-T) wsrsL 0.4(10)(1-0.4)
0.6(12.6) 9.96
All data are from the mini case.
45
New Horizon Value Calculation

• Horizon value
• 554.1 million.

46
New Vops and Vequity
2004 2005 2006 2007
Free Cash Flow 11.7 10.5 16.5 20.7 Horizon
value 554.1 Interest
tax shield 2.0 2.6 2.6
2.8 Total 13.7 13.1 19.1 577.6
13.7 (1.1156)1
13.1 (1.1156)2
19.1 (1.1156)3
577.6 (1.1156)4
VOps
409.5 million.
47
New Equity Value

• 409.5 million - 55 million 354.5 million
• This is 65.1 million, or 3.26 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.

48
What method is used to account for for mergers?

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

(More...)
49

• 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.
• AOL Time Warner wrote down 54 billion of
  goodwill in 2002 because of impairment test.
• Goodwill is still amortized for Federal Tax
  purposes. Can amortize goodwill over 15 years
  using straight-line method.

51
Corporate Culture

• Should also consider factors other than cash
  flows, such as Corporate Culture, marketing
  philosophies, and personnel policies.
• Merger talks often collapse because of social
  issues and chemistry.
• Who will run the combined company?
• What will be the name of the combined firm?
• Where will the headquarters be located?

52
Analysis for a True Consolidation - Merger of
Equals

• Steps
• Develop pro forma financial statements for the
  consolidated corporation. Determine the projected
  consolidated free cash flows available to
  stockholders.
• Estimate the new companys unlevered cost of
  equity, and use that rate to discount the free
  cash flows and interest tax shields of the
  consolidated company.
• Decide how to allocate the new companys stock
  between the two sets of old stockholders.

53
What merger-related activities are undertaken by
investment bankers?

• Identify targets
• Help arrange mergers
• No parked stock
• Develop defensive tactics
• Value target companies
• Help finance mergers
• Invest in stocks of potential merger candidates
• Arbitrage operations
• Trend is away from using investment bankers,
  especially for smaller deals

54
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.

55

• Studies show stock price of target firms increase
  by 30 in hostile tender offers, while in
  friendly tender offers, the increase is 20.

56
Merger Failures

• 61 of buyers destroyed their own shareholders
  wealth
• In April 2002, AOL Time Warner took a 54 billion
  charge
• 17 out of the 21 winners in the merger spring
  of 1998 were a bust for investors who owned the
  shares

57
Reasons for Merger Failure

• Overpay by a sizeable premium
• Overestimate likely cost savings and synergies
• Delay over integrating operations after merger
• Emphasis on cost-cutting, damaging the business
  and losing key personnel

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Other Failure Results

• TYCO
• Paid 11.3 billion for CIT in June 2001 and
  completed an IPO for 4.6 billion in July 2002
  (loss of 6.7 billion)
• WorldCom
• ATT
• Vivendi
• Cisco Systems
• Conseco
• First Union Corp

59
Reasons why alliances can make more sense than
acquisitions

• Joint Venture
• 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

60
Leveraged Buyout (LBO)

• A small group of equity investors, usually
  including current management, acquires a firm in
  a transaction financed largely by borrowing. They
  go private. Typically buy publicly held stock.
  Can be a subsidiary of a public company.
• Purchase often financed mostly with debt.
• After operating privately for a number of years,
  investors might take the firm public to cash
  out.
• Very prevalent during the 1980s

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Leverage Buyout (LBO) Continued

• Between January 2002 and November 6, 2002, LBOs
  were up 50 vs. the same period the previous year
  to 20 billion. In the third quarter of 2002,
  LBOs accounted for almost 10 of all mergers
  acquisitions, their largest share since 1989.
• Nov. 19, 2002 Northrop Grumman Corp. sold TRW
  Automotive Business to Blackstone for 4.73
  Billion
• April, 2003 Investor Group purchased Aladdin
  Resort Casino for 500 million
• Nov. 17, 2003 DuPont sold its Invista textiles
  unit to Koch Industries for 4.4 billion

62
What are 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
• How to exit an LBO
• Go Public
• Sell to another company
• Another LBO

63
Types of Divestitures

• Sale of an entire subsidiary to another firm
• Target and Marshall Field
• Spin-Off
• Spinning off a corporate subsidiary by giving
  stock to existing shareholders
• ATT and Lucent Technologies
• Carve Out
• A minority interest in a corporate subsidiary is
  sold to new shareholders, so the parent gains
  new equity financing yet retains control
• Philip Morris and Kraft
• Outright liquidation of assets
• Woolworth

64
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.

65
Divestitures vs. Acquisitions

• Not the opposite side of a coin of an
  acquisition
• Like selling a house, one purchaser at a time
• Have to decide what it is worth to someone else
• Typically an admission of failure
• Hurts the Balance Sheet and benefits the Income
  Statement
• Risks and Returns are different

66
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.

67
Holding Companies - Advantages and Disadvantages

• Advantages
• Control with fractional ownership
• Isolation of risks (but often the parent is still
  responsible)

• Disadvantages
• Partial Multiple Taxation
• Ease of enforced dissolution

68
Conclusion

• Merger Trends
• Reasons for Mergers
• Types of Mergers
• Merger Analysis
• Accounting for Mergers
• Leveraged Buyouts
• Divestitures
• Holding Companies