University of Durham

Mergers and AcquisitionsSummative Assignment

BySamuel Tedjasukmana

April 2007

I. Introduction

Targeting private firms seems to be the current trend in mergers and

acquisitions. In the US alone, the year 1996 saw 84% increase of

takeover deals involving private firms as the target compared to the

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previous year (Ang and Kohers, 2001). The total value of these

transactions reached £40 billion.

This paper seeks to investigate the issues surrounding mergers and

acquisitions, both in general and specifically of a privately owned

business, as the following: estimating the value of a privately owned

business, determining the value of an acquisition deal settlement, how to

eliminate a competitive bidder, and how asymmetric information

influences company’s corporate financing policies, including those

involving merger.

These issues are observed from the acquirer’s point of view, which in this

study is London Globe. The target company is Murdoch Incorporated, and

for the purpose of valuation, McIntosh Corporation (a public company

similar to Murdoch in terms of industry) is used as a comparable

company.

London Globe is a construction company, and has been blessed by the

current boom in the housing market. The industry classification for this

company is assumed as Building – residential and commercial (see

appendix for details). Murdoch the target company has the core business

of gas pipeline construction and related equipment, which is similar to a

public company, McIntosh Corporation.

II. The value of the target company and the maximum price of the

acquisition

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Murdoch Incorporated (Murdoch) is a privately owned business. It does mean that in

the process of searching for its value, some basic principles of comparable method of

valuation should be used. The following analysis uses the information gathered from

the comparable public company, which is the McIntosh Corporation (McIntosh).

Murdoch McIntoshShares outstanding 25 millions 30 millionsShare price - £25Market value of equity

- £750 million

Debt £500 million £80 millionβ - 1.20Tax rate 35% 35%Risk-free rate 8% 8%Risk premium 8% 8%Table 1. Preliminary review

There are three main components of valuation: the weighted average cost

of capital (WACC), the free cash flow (FCF), and the expected growth of

cash flow items (Damodaran, 2002). The first step in valuing Murdoch

would be to determine the cost of equity – as a part of WACC calculation

– by using McIntosh’s data, both firm-specific as well as its market

information.

The basic assumption underlying this calculation is that both companies

are within the same industry, which also means being in the same

market. Therefore, both of them will have the same risk-free rate,

corporate tax rate, and utterly the same risk premium. Finally, to

estimate the β for Murdoch, the calculation should assume that

Murdoch’s β will eventually converge to its industry average β (using

McIntosh’s β as proxy) by the time it goes public (Damodaran, 2002). The

detailed calculation process and results are presented in the following

table.

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McIntosh

Murdoch

Details

β (levered) 1.20 -β (un-levered) 1.12 -β (private entity) - 1.41 Debt-equity

ratioB/S = 0.4(target)

Cost of equity 19.28%

Cost of debt 8.85%

CR = Interest

coverage ratio

Bond rating A Cost of borrowing =

0.85% above the risk-free rate1

Cost of debt after tax 5.75%

WACC 15.42%

Net Income (projected)

£200.00m

EBIT £357.69m

Contingent loss £40.00mEBIT (corrected) £317.69

mEBIT (1-tax) £206.50mInvestment £50.00mFCF £156.50mExpected growth (g)

2%

Value £1,177.67m

1 See appendix for more details on the synthetic bond rates4

Equity valueEquity value/share £677.67m

£27.11

Table 2. Calculation for Murdoch’s (target company) value

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Comments on results

Since London Globe is a public company, the deal of acquiring Murdoch

is not a private deal. In that sense, the calculation of Murdoch’s cost of

capital would have been different if the deal was private. This very much

affects the assumption of what borrowing rate should be used. Given that

Murdoch is a private business, it cannot generate debt from the market.

Instead, it raises debt from bank loans. The interest rate for this loan is

10 percent for Murdoch [50m/500m x 100%]. This rate does not resemble

Murdoch’s credit rating in the market. Since the nature of the deal is

public, the calculation should use the appropriate rate, which is the bond

rate (Damodaran, 2002). Taking into the account the interest coverage

ratio, provided as the company’s information, the bond rate can be

estimated to reflect the company’s credit rating in the market.

Moreover, the fact that Murdoch, with certainty will incur contingent

loss, i.e. lawsuit liability amounting £40 million, and the event is assumed

will take place after the acquisition; London Globe is entitled to get a tax

deduction (Maples, 2003). London Globe saves £14 million worth of tax

due to the inclusion of lawsuit liability (contingent loss) in the valuation of

Murdoch.

To convert the information of net income into earnings before interest

and tax (EBIT), the fixed charge of interest should be included as the

standard accounting procedure. However in the next step of determining

the FCF, the direct taxation of EBIT is justified (Damodaran, 1997). The

value of FCF estimated is assumed to grow in perpetuity, which is why

the growth rate becomes a multiplying factor of FCF.

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Reliability of the method used, and other methods could have been

used

Comparable method used in the calculation carries some limitations.

Since only one company used as a comparison to estimate Murdoch’s cost

of equity, assuming they are in the same field of business, it raises a

concern over the estimation’s reliability. Moreover, the danger of

misestimating becomes more apparent when it assumes McIntosh as the

proxy for the industry average. Such method, namely comparable

company method, has less accuracy than the comparable transaction or

comparable industry transaction method (Kaplan and Ruback, 1995).

Either method would give more accurate results in estimating Murdoch’s

cost of capital at market rate, since they consider information from

several – or all – companies within the industry.

The discounted cash flow method (DCF) allows more in-depth analysis in

valuing a firm. However, given the nature of Murdoch as a private

business, it will be quite difficult to find information conforming to the

market’s standards, e.g. LSE-conforming financial statement, future

investment plan, a change in the management, etc, to perform such

analysis.

The maximum price of the acquisition bid

The maximum price London Globe should pay for each share of Murdoch

is simply the equity value per shares outstanding, which is £27.11/share

(as seen on the table).

III. Finalising the deal

As London Globe figured out the value of Murdoch, then the next is to

know for what price the deal is going to be sealed (assuming there is no

other bidder takes part).

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The premiums paid to a privately owned business is higher than the

average public-owned ones (Ang and Kohers, 2001). Especially for cash

as the method of payment, shareholders of private firms have received

premium in the amount of 2.2 times their book value of holdings, or in

other words the offer-to-book ratio is 2.2 (Ang and Kohers, 2001). For the

publicly traded target companies, Ang and Kohers find the ratio figure as

1.9 on average.

Given that the equity value is £27.11/share, and the deal will be in cash,

thus according to the offer-to-book ratio of 2.2, the deal might be settled

at £27.11 times 2.2, amounting £59.63/share. However, since the

calculation has estimated the equity value of Murdoch at the market rate,

not the book value, the usage of such ratio can be misleading. Another

fact, given that the average premium paid in an acquisition deal for a

public company is about 30 to 40 percent from the market value of equity

of the target (Weston et al, 2004), this ratio may well be the most

relevant in Murdoch case. The problem is, Murdoch is a private firm. It is

necessary to estimate the proper premium ratio that reflects offer-to-

market-value ratio for private firms.

As aforementioned, there are two ratios to be observed: the offer-to-book

for private firms at 2.2; and the offer-to-market for public companies at

1.35 (average between 30 and 40 percent of premium rate). Following the

argument that private firms receive more premium than the average

public companies (Ang and Kohers, 2001), then the offer-to-market for

private firms, in consistency will also be higher than that of public

companies. Taking the average of both 2.2 and 1.35, the number will be

at 1.8. Consider this as the estimation of offer-to-market ratio for private

firms gives the figure of £27.11 x 1.8 = £48.79/share (£1.22 billion) as

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the final deal value in this acquisition. In theoretical sense, this means

that London Globe will have to pay more than it should. Since the synergy

value has been included the valuation of Murdoch, this excess premium

will to some extent degrade the value of London Globe itself. In reality,

the case for the acquisition of private firms involves very high premiums.

The reason being is that the shareholders of private firms have stronger

bargaining power due to the very low likelihood of the agency cost

problem to occur (Ang and Kohers, 2001). Or in other words, since the

shareholders are actually in the management board, which means they

know exactly what the business is all about and its prospects in the

future, it requires very high premium to acquire a private firm.

IV. Eliminating competitive bidder

The first bidder (FB), which is London Globe, will have to make a bidding

strategy against the second bidder (SB) who is assumed to have valuated

Murdoch and their results on synergy ranging uniformly between -50 and

200 from FB’s valuation of the maximum price.

The maximum price that FB has calculated is £677.77 million. The next

step is to determine at what price that FB can deter the competition from

SB, i.e. determining the pre-emptive bid. According to Fishman model

(1988), we can formulate the pre-emptive bid by using SB’s valuation

range [l, h] ~ [-50, 200], the cost of acquisition by SB, and the market

value of the target.

For such purpose, the following assumptions are used:

The market equity value of Murdoch is £677.77 million, since SB

has assumed the synergy valuation by FB as the fair equity market

value of Murdoch.

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The cost of acquiring Murdoch by SB is assumed 5% from the

market value of Murdoch.

The calculation uses the following formula (Fishman, 1988):

Detailed process of the calculation is presented in the following table.

Variable input Calculation stepsh=200

l=-50Vo= £677.77mC2= 5%*£677.77m = £33.88m

Table 6. Pre-emptive bid by Fishman modelPre-emptive bid value: £1,032.35m, or £41.29/share.

Bidding strategy

Fishman model (1988) provides a straightforward look at calculating the

pre-emptive bid. However, this model depends very heavily on the

assumption of the cost of acquisition by the SB. The 5% cost stated in the

calculation is just an illustration, and might be the case that it is not

accurately estimated. This cost may comprise of the investment bank fee

for investigation, legal consulting fee, insider information attainment, etc,

which plays a very crucial role in determining the gain from the

acquisition deal (Fishman, 1988).

One point to look at as well is that when there is a competing bidder for

an acquisition, the bidding can turn out to be costly. Even though London

Globe has realised the amount of cash they have to generate to prevent

competition, it might be the case that Murdoch is not worth the efforts.

Thus, London Globe has to formulate a bidding strategy in order to win

the bid as efficiently as possible. One way to do is to put the first bid at a

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low value. The first bid by FB is the source of valuation signalling for the

SB (Hirshleifer, 1995). SB usually determines the minimum threshold of

FB’s valuation by looking at their first bid value. From that value, SB will

begin to investigate and assume the initial bid value to compete with FB.

In general, when there is no significant gap between two bids (no far

higher offer compared to the other), the deal will be closed at relatively

low price (Hirshleifer, 1995). At least, London Globe has figured out (at

5% cost) that the pre-emptive bid will be, at the most, £41.29/share

(£1,032.35m). The bidding then can start from the initial point of

£27.11/share through £41.29/share.

V. External vs. internal equity financing

Capital Structure External financing Internal financingEquityLondon Globe2 £4,000.00m £4,000.00mMurdoch £677.67m £677.67m

£4,677.67m £4,677.67mGenerate £50m cash £50.00m -Total equity £4,727.67m £4,677.67m

DebtLondon Globe £150.00m £150.00mMurdoch £500.00m £500.00mTotal debt £650.00m £650.00m

Debt-equity ratio 0.137 0.138Beta un-levered 1.21 1.21Beta levered 1.32 1.32Cost of equity 18.54% 18.55%Cost of debt after tax 5.20% 5.20%WACC 16.93% 16.92%

Table 7. Capital structure between external and internal equity financing

To finance Murdoch’s plant restructuring, or in other words pledging in a

new investment, London Globe should always consider the financing

method suitable for the feasible capital structure of the company. Table 7

presents how capital structure will look like using two different financing

strategies. The first one is the external equity financing and the other

internal one. External equity financing involves issuing either common 2 London Globe has 50 million shares outstanding at current market price of £80/share.

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stocks or warrants (Damodaran, 1997); whilst the internal one reserves

cash from the retained earnings the company has produced.

Suppose that the un-levered beta of the combined firms (between London

Globe and Murdoch) is known3, the cost of capital from both scenarios

can be observed. The figures showed do not really reflect any substantial

difference between the two costs of capital. This is because the amount of

cash London Globe has to generate is immaterial compared to the

combined equity value, i.e. £50 million compared to more than £4.5

billion.

Nonetheless, the observable point on table 7 is that the cost of capital for

internal equity financing is lower than that of external equity financing.

The probable reason for this is that the debt-to-equity ratio for the

combined firm has not been the optimal debt-to-equity ratio (Damodaran,

1997). Or in other words, the combined firm is under-levered, because if

it was over-levered, higher debt-equity would result in higher cost of

capital (Damodaran, 1997). In such condition then, it is better for London

Globe to finance the investment project with internal equity financing

rather than external one. In addition, given the fact that London Globe

has been blessed by the current booming in the housing market, there is

no immediate necessity to capitalise more in equity.

The role of asymmetric information on merger and external equity

financing

The external equity financing is a corporate capital structure policy upon

an investment opportunity. A company, from its own rational

consideration may go for this opportunity or leave it. In the case for a

3 To estimate the un-levered beta of the combined firm, the industry average un-levered beta of building industry in Europe, specifically the residential and commercial building industry, is used. This beta is 1.30. Taking the average between Murdoch’s un-levered beta of 1.12 and London Globe’s 1.30 gets the combined un-levered and levered beta of 1.21 and 1.32 respectively (see appendix for more details).

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public company, such decision on whether to take on the opportunity is

observed by the market. The market is digging the information about a

public company’s investment policies in order to price its stocks

efficiently based on the information obtained (Myers and Majluf, 1984).

Thus, asymmetric information is a condition when the managers of the

company know something that the market does not. For example, in the

case of external equity financing let’s say a company sees an investment

opportunity and need to finance it with external equity financing. The

project valuation figures show this as a promising project to take on. The

stockholders, however, are not sure about the cash that can be generated

from a further issue of stocks, since such issue might be sold at lower

price and thus lower the value of their holdings. The management board

might pull off and abandon this investment opportunity to retain the

stockholder’s wealth. The market, on the other hand, does not know

about this and perceive that no new issues of stocks as good news

(asymmetric information). In fact, missing out a profitable investment

opportunity decreases the value of the company and if the market knows

this, it will bring the stock price down (Myers and Majluf, 1984). On the

contrary, if the company undertakes the external financing for this

investment the market does not know how feasible this project will be,

and might reassess the level of corporate risk, especially when the

market knows that the company is undertaking a negative NPV

investment project for instance.

From the argument of asymmetric information, it might be the case that

the company will prefer internal equity financing by rearranging its

dividend payout ratio as an alternative to external equity financing

(Myers, 1984).

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Furthermore, as aforementioned, in the case of London Globe and

Murdoch as a combined entity, it has under-levered circumstances, which

makes its financing slack huge enough to carry more debt (Damodaran,

1997). Thus, even if the company does not posses enough internal

resource to finance any investment, it still has the option of optimising its

leverage ratio by undertaking debt financing, as illustrated below.

Capital Structure External financing Debt financingEquityLondon Globe £4,000.00m £4,000.00mMurdoch £677.67m £677.67m

£4,677.67m £4,677.67mGenerate £50m cash £50.00m -Total equity £4,727.67m £4,677.67m

DebtLondon Globe £150.00m £150.00mMurdoch £500.00m £500.00mGenerate £50m cash - £20.00mTotal debt £650.00m £700.00m

Debt-equity ratio 0.137 0.149Beta un-levered 1.21 1.21Beta levered 1.32 1.33Cost of equity 18.54% 18.62%Cost of debt after tax 5.20% 5.20%WACC 16.93% 16.87%Table 7. Capital structure between external equity and debt financing

The weighted average cost of capital (WACC) for debt financing is lower

than that of external equity financing scenario. This proves the point that

external financing, given the asymmetric information effect, is something

that any company wants to avoid.

Let’s make the circumstances even more intriguing. If a company has

little financing slack and retained earning, which means internal equity

and debt financing are out of the question, merger will be the answer to

increase value rather than issuing new stocks (Myers and Majluf, 1984).

A merger can combine both companies’ financing slack and internal

equity, avoiding them to undertake external equity financing.

VI. Concluding remarks

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The total value of Murdoch is £1,177.67 million with £677.67

(£27.11/share) of which being the market value estimate of equity as well

as the maximum price for London Globe to pay for the acquisition. It

seems though that London Globe has to spend £1.22 billion

(£48.79/share) to close the deal assuming there is no other bidder, given

the excess premium needed to acquire a private company. To prevent a

competing bidder from acquiring Murdoch, London Globe assumes the

pre-emptive bid to exceed £1.03 billion (£41.29/share).

Lastly, in choosing the method of financing the plan-restructuring,

London Globe should pursue either internal equity or debt financing

given the asymmetric information problem.

Appendix

For smaller and riskier firmsIf interest coverage ratio is      greater than ≤ to Rating is Spread is-100000 0.499999 D 20.00%0.5 0.799999 C 12.00%0.8 1.249999 CC 10.00%1.25 1.499999 CCC 8.00%1.5 1.999999 B- 6.00%2 2.499999 B 4.00%2.5 2.999999 B+ 3.25%3 3.499999 BB 2.50%3.5 3.9999999 BB+ 2.00%4 4.499999 BBB 1.50%4.5 5.999999 A- 1.00%6 7.499999 A 0.85%7.5 9.499999 A+ 0.70%9.5 12.499999 AA 0.50%12.5 100000 AAA 0.35%Synthetic bond rates table using the interest coverage ratio

Based on S&P 500 bond rating classes©2007 Aswath Damodaran, Stern Business School, New York University

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

Industry sector Firms Beta D/E Tax U-Beta Cash/ U-BetaValue Cash

Bldg Prod-Air&Heating 8 0.7014.27

%25.23

% 0.64 3.45% 0.66Bldg Prod-Cement/Aggreg 32 1.08

38.41%

24.43% 0.84 4.41% 0.88

Bldg Prod-Doors&Windows 3 0.53

21.40%

24.83% 0.45 3.04% 0.47

Bldg Prod-Wood 7 1.03 35.53 34.58 0.84 3.79% 0.87

15

% %Bldg&Construct Prod-Misc 31 0.91

17.23%

28.40% 0.81 7.18% 0.87

Bldg-Mobil Home/Mfd Hous 6 0.67

12.27%

27.01% 0.62

11.92% 0.70

Bldg-Residential/Commer 20 1.34

11.45%

25.45% 1.24 4.79% 1.30

Average industry financial data (abridged version)Based on European industry average

©2007 Aswath Damodaran, Stern Business School, New York Universityhttp://www.stern.nyu.edu/~adamodar/pc/datasets/betaEurope.xls

References

Ang, James; Kohers, Ninon, 2001. The takeover market for privately held companies: the US experience. Cambridge Journal of Economics, volume 25, page 723-748

Damodaran, Aswath, 2002. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (2/e). Chapter 24: Valuing Private Firms. John Wiley & Sons, Inc

Damodaran, Aswath, 1997. Corporate Finance: Theory and Practice, relevant chapters, John Wiley & Sons Inc

Fishman, Michael J., 1988. A Theory of Pre-emptive Takeover Bidding. The RAND Journal of Economics, volume 19, number 1, page 88-101

Hirshleifer, David, 1995. Mergers and Acquisitions: Strategic and Informational Issues. Chapter 26 in Jarrow, R.A., Maksimovic, V., Ziemba, W.T.; Handbooks in Operations Research and Management Science Volume 9, Elsevier BV

Kaplan, Steven N., Ruback, Richard S., 1995. The Valuation of Cash Flow Forecasts: An Empirical Analysis. The Journal of Finance, volume 50, number 4, page 1059-1093Maples, Larry, 2003. Taxation on Pending Claims. Journal of Accountancy, May 2003 edition, page 31-37

Myers, Stewart C., 1984. The Capital Structure Puzzle. The Journal of Finance, volume 39, number 3, page 575-592

Myers, Stewart C., Majluf, Nicholas S., 1984. Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have. National Bureau of Economic Research (NBER) Working Paper Series, Working Paper No. 1396

Weston, J.F., Mitchell, Mark L., Mulherin, J.H., 2004. Takeovers, Restructuring, and Corporate Governance (4/e). Chapter 9: Alternative Approach to Valuation. Pearson Education

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