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
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