Mergers and Aquisitions

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Mergers and Aquisitions
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Terminology

• Target
• Potential takeover candidate
• Acquirer (Bidder)
• Firm doing the taking over
• Merger
• Friendly combination of two firms
• Tender Offer (Hostile Takeover)
• Opposed by target management

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Terminology, cont.

• Leveraged Buyout
• Management Buyout
• Same as LBO, except existing management is major
  shareholder
• Proxy Contest
• Voting by S/H on major corporate transactions
• Restructuring
• Significant change in allocation of corporate
  resources
• Current management stays on

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Selecting a Target Synergy Creation

• Corporate Strategy ? should drive process
• Ex Vertical Integration (up/down value chain)
• Excess Capacity
• Product gt Distribution
• Pepsi Taco Bell
• Distribution gt Product
• (AOL/Time Warner Paramount)
• Ex Strategic Enter a new market
• Ex Diversification Financial v. Strategic

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Issues

• What businesses should a corporation compete in?
• How should these businesses be managed to jointly
  create more value than if they were freestanding
  units?
• The value created is synergy

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Related Diversification

• Diversifying into related businesses
• Horizontal relationships
• Value created from businesses sharing ?
• Leveraging Core competencies
• Economies of scale production or distribution
• Creating market power
• Negotiating power
• Vertical integration

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Unrelated Diversification

• Diversifying into unrelated businesses
• Hierarchical relationships
• Value created from corporate office
• Economies of scale management administration
• Human resource practices reward and evaluation
  systems
• Information systems planning budgeting
• Financing resource allocation

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Valuation

• PVt PV of target (stand alone)
• PVa PV of acquiring firm (stand alone)
• PVc PV of combined firm
• TP tender price

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Synergy

• Synergy is the value created by the proposed
  merger/acquisition
• PVc - (PVa PVt) Total Synergy
• Value of combined firm sum of stand-alone firm
  value

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Net Present Value

• NPV of acquisition to acquiring firm
• PVc - (Pva PVt) - (TP - PVt)
• Total synergy - synergy to target
• Synergy to target goes to target S/H

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Synergy Financial View

• Financial Viewpoint
• Revenue Enhancement
• Cost reduction
• Combination of both
• More specifically, what impact on the inputs to
  value?
• EBIT, Capital Spending needs, NWC needs, cost of
  capital

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Calculation of Synergy

• Estimate combined cash flows and subtract sum
  of the parts
• PVc - (Pva PVt) ? usually most difficult
• Estimate the change in cash flows
• Or change in target value if only changes occur
  there
• Must identify the source of value
• Revenue enhancement
• Cost reduction
• Change in reinvestment needs (NWC PPE)

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Acquisition

• What is already reflected in Targets current
  share price? (assuming publicly traded)
• Value as is
• Value with expected changes (current mgmt)
• Value in play
• How much of a change in control premium is
  already reflected in price? (is company already
  in play?)

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Acquisition

• Acquirer must offer a Premium to induce S/H to
  tender
• Must bid less than target stand-alone value plus
  synergy (Neg NPV)
• Do other Bidders exist? Is source of value
  generic or specific?
• Provision of information to market
• If value highest to you, you can win

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Acquisition, cont.

• Strategy Bid high enough to deter potential
  bidders, but low enough to retain value
• Avoid Winners Curse
• Target
• Defensive Tactics

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Valuation Discounted Cash Flow

• Free Cash Flow (FCF)
• EBIT (1 t)
• Non-Cash items (depreciation, amortization)
• - ? NWC
• - Capital Spending
• FCF

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Change in Net Working Capital

• NWC Current Assets Current Liabilities
• ? NWC End NWC Beg NWC
• NWC should be consistent with sales assumptions
• Usually maintain constant of sales
• Assumes current level is optimal ? use ratio
  analysis for this

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Capital Spending

• ? in Gross Fixed Assets
• What is current capacity?
• Should be consistent with sales forecast
• Long-run
• Equal to Depreciation nominal growth only
• Slightly higher than depreciation some real
  growth

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Two-Stage Model High Early Growth Long-run
constant Growth
FCF
Time
t
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Growth

• Short-run reflected in pro-formas
• Long-run g What is reasonable?
• Growth Economy, Industry, Company
• Sustainable growth rate (ROE x r)

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Discounted Cash Flow

• Project out cash flows until stable
• Calculate Terminal Value
• Terminal Value Value of perpetual cash flow
  stream TVt FCFt1/(WACC - g)
• Discount Projected CFs TV to present

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Discount Rate

• Discount Rate
• WACC
• Firm being valued (acquired)
• WACC Re E/(DE) Rd(1-t)D/(DE)
• Weights S/B market values

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Calculation of Rd

• Rd cost of debt
• Use yield to maturity on outstanding debt
• Or YTM for similar debt
• Firms having similar rating
• Firms having similar business risk and financial
  leverage

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Calculation of Re

• Re cost of equity
• Re Rf B(Rm Rf)
• Where B firms Beta
• Beta changes with leverage and life-cycle of firm
• Beta of similar firms (business risk can adjust
  for leverage)

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Example Pre-acquisition assumptions

• Assume the following projected FCFs on a
  stand-alone basis for the target.
• Long-run growth after 2008 is 4
• The firm currently has 100 million in 8 debt
  O/S. Capital structure is 1/3 Debt and 2/3
  equity
• Tax rate 40

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Calculation of Re

• Beta 1.38
• Rf 5.0 (10 yr T-Bond)
• Market Risk Premium 5.5 (Ibbotson)
• Re Rf B(Rm Rf)
• Re 5 1.38(5.5)
• Re 12.6

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Calculation of WACC

• WACC Re E/(DE) Rd(1-t)D/(DE)
• WACC 12.6 x 2/3 8 x (1-40) x 1/3
• WACC 8.4 1.6
• WACC 10

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Target Cash Flows Before Acquisition (Millions)
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Target Cash Flows Before Acquisition (Millions)
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Pro-Forma Balance Sheet and Income Statement
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Post Acquisition Assumptions(Should specifically
identify)

• Transition Costs 40 million in first year,
  declining by 10 million per year
• Severance pay
• Disruption Learning curve Cultural change
• Additional Capital Spending 10 million first
  year then 5 million thereafter
• Depreciation 5 million more/yr
• Change in NWC 18 in 06 8 in 07 and 9 in
  08

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Post Acquisition Assumptions(Should specifically
identify)

• Sales 60 higher in years 05-08 post-tax
  operating margin on additional sales assumed to
  be 13.44
• Long-run growth increased to 5
• Capital Structure constant
• Beta unchanged

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Acquisition Effect on EBIT
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Target Cash Flows After Acquisition (Millions)
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Target Cash Flows After Acquisition (Millions)
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Reasonableness Implied Market Multiples

• Firm Value/EBITDA 500/70 7.14
• (note the above is a firm value)
• P/E 400/25.2 15.9
• (note the above is an equity value)
• Compare these to similar company multiples

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Synergy

• Equity Firm
• Post Acquisition Value 413.8 513.8
• Pre-Acquisition Value 362.2 462.2
• Total Synergy 51.6 51.6

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Net Present Value

• Assume Acquirer offers a 10 premium on Equity
  Value
• Offers 400 for equity 500 for assets
• Total synergy 51.6
• Synergy to target S/H 37.8 (400 362.2)
• NPV 13.8

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Alternatively Change in FCF

• Assuming Existing Estimated FCF stream of target
  is fairly
• valued ? we can Examine the Change in FCF as a
• Capital Budgeting Project

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Projecting Combined I/S B/S

• Why?
• Financing Needs consolidated
• Benchmark
• Impact on Financial ratios
• Short-run v. Long-run effect
• Negative short-run
• Positive long-run

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Biotech or similar

• Very high RD in early years
• Payoff in later years
• Negative FCF for 3-5 or more years
• Most if not all value in Terminal Value
• Very long payback periods

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Target

• Assume Pre-acquisition value is appraised value
  with
• Difference reflected in Net Fixed Assets

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Combined Balance Sheet at Acquisition

• Assuming Purchase Assets for 500 100 cash 400
  debt