Chapter 21Mergers, LBOs, Divestitures,

and Holding Companies

Types of mergers

Merger analysis

Role of investment bankers

LBOs, divestitures, and holding companies

3

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.

Reasons for Mergers

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

5

Horizontal Merger Vertical Merger Conglomerate Merger

Types of 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.

Friendly vs Hostile Mergers

Parties Involved

8

Acquisition Process

9

Market Multiple Analysis Corporate Valuation Model Equity Residual Model Adjusted Present Value (APV)

Target Valuation Approaches

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

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

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.

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.

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.

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.

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.

Steps in APV Valuation

1. Project FCFt ,TSt , horizon growth rate, and horizon capital structure.

2. Calculate the unlevered cost of equity, rsU.3. Calculate WACC at horizon.4. Calculate horizon value using constant growth

corporate valuation model.

5. Calculate Vops as PV of FCFt, TSt and horizon value, all discounted at rsU.

Net sales $60.0 $90.0 $112.5 $127.5Cost of goods sold (60%) 36.0 54.0 67.5 76.5Selling/admin. expenses 4.5 6.0 7.5 9.0EBIT 19.5 30.0 37.5 42.0Taxes on EBIT (40%) 7.8 12.0 15.0 16.8NOPAT 11.7 18.0 22.5 25.2Plus Depreciation 0.0 3.0 4.0 5.0Operating Cash Flow 11.7 21.0 26.5 30.2Less Gross Inv. In Opr Capital 0.0 10.5 10.0 9.5Free Cash Flow 11.7 10.5 16.5 20.7

APV Valuation Analysis (In Millions)

2004 2005 2006 2007

Projection of Free Cash Flows

Projection of Interest Tax Savings after Merger

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 x Tax Rate. T = 40%

2004 2005 2006 2007

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.

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.

Calculation of Discount Rates

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%

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%

Equation 17-15

Horizon value =

=

= $453.3 million.

g WACC

g))(1(FCF2007

06.01084.0

)06.1(7.20$

Calculation of Horizon Value

2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 453.3Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $476.8

VOps = + + +

= $344.4

$13.7 (1.1156)1

$13.1 (1.1156)2

$19.1 (1.1156)3

$476.8 (1.1156)4

Value of the Target Firm’s Operation

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.

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.

Would Another Potential Acquirer Obtain the Same Value?

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?

Offer Price: Assumptions

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.

Offer Price: Calculation

0 5 10 15 20

Change in Shareholders’

Wealth

Acquirer Target

Bargaining Range = Synergy

Price Paid for Target

$11.00 $14.47

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?

Offer Price: Bargaining

Due Diligence

32

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

33

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

34

Sales & Purchase Agreement: Key Areas

Timeline Consideration Condition Precedent Representation & Warranties Tax Matters Indemnification Book & Records Due Diligence

35

39

Why alliances can make more sense than acquisitions

Multiple parties share risks and expenses Rivals can often work together harmoniously Avoiding antitrust laws

Alliance, JV & MergerExample: Royal Dutch Shell

40

Royal DutchShell

Royal Dutch Shell

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

The Role of Investment Bankers

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.

Reasons for Divestiture

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.”

Leveraged Buy Outs (LBOs)

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

44

Potential Deal Issues

Seller/Buyer’s Expectations Potential Tax Exposure Availability of Information & Time for Due

Diligence Legal & Regulation Issues

45

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.

Holding Companies

Advantages: Control with fractional ownership.

Isolation of risks.

Disadvantages: Partial multiple taxation.

Ease of enforced dissolution.

Holding Companies:Advantages & Disadvantages