Mergers, Divestitures, and Holding Companies

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Mergers, Divestitures, and Holding Companies

• Chapter 26

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Mergers

• Definition
• Any combination that forms one economic unit.
• Reasons for mergers
• Synergy
• A B merge to form C. Value of C exceeds that
  of A B taken separately.
• Operating or financial economies, differential
  efficiency, increased market power
• Example Lotus IBM

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Mergers

• Tax considerations
• Acquire firm with large accumulated tax losses
• Purchase assets below replacement cost
• Target because cost of replacing its assets is
  higher than market value
• Example Gulf Oil
• Diversification
• Stabilize earnings, but investors can do this
  themselves

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Mergers

• Managers personal incentives
• Power, compensation linked to size
• Defensive mergers
• Breakup value
• Breakup value gt market value
• Takeover specialists will acquire and sell off in
  pieces

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Hostile vs. Friendly

• Friendly
• Management from both firms support
• Acquirer propose workout
• Hostile
• Target firms management resists
• Acquirer must go directly to the target firms
  stockholders, try to get 51 to tender their
  shares
• Often starts out hostile but ends up as friendly
  (offer price is raised)
• White Knight

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Merger Analysis

• Valuing the target firm
• Approaches
• Corporate valuation model
• Equity residual model
• Adjusted present value model (APV)
• Focus on APV
• Capital structure changes rapidly over the first
  several years
• WACC may change from year to year
• Hard to incorporate changes in WACC in the
  corporate valuation model
• Corporate valuation model is easier than APV to
  use when the capital structure is constant

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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.
• 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

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APV Model

• Steps
• 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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Example Mini Case

• Hagers Home Repair Company is analyzing a
  potential target, Lyons Lighting (LL). Next
  slide gives estimates of sales, COGS, SGA,
  interest expense, and required retentions (net
  retentions) for 2007-2010 if LL came under
  Hagers management. The interest expense
  includes the interest on LLs existing debt (55m
  at 9) and on new debt expected to be issued for
  help finance expansion of LL. LLs tax rate is
  40. Debt is 20 of their capital structure.
• Analysts estimate LLs beta to be 1.3. The
  acquisition will not change LLs capital
  structure. LL also generates depreciation CFs,
  all of which must be reinvested in LL replace
  equipment. Net retentions are requirement
  reinvestment in addition to the depreciation cash
  flows.
• The risk free rate is 7 and the market risk
  premium is 4. FCF after 2010 will grow at a
  constant rate of 6.

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APV Valuation Analysis
Free Cash Flows after Merger Occurs
2007 2008 2009 2010
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
Be sure you can do these calcs on your own
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Interest Tax Savings after Merger
2007 2008 2009 2010

• 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), where T 40.

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Retentions

• What are they?
• Firms must reinvest in order to replace worn out
  assets and grow
• LL must keep
• Net retentions gross retentions depreciation

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Discount rate

• 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.
• These cash flows can be redeployed within the
  acquiring firm
• 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
• Target or acquirer unlevered cost of equity?

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APV and 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
• 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 Value

• Horizon value
• 453.3 million.

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Value of LL to Hagers
2007 2008 2009 2010
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
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Value of LLs Equity

• LL has 55 million in debt.
• Vops debt Value of equity
• 344.4 million 55 million 289.4 million
  equity value of target to the acquirer
• Would another acquirer get 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.

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Merger Premium

• Assume the target company has 20 m 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?
• Estimate of targets value 289.4 million
• Targets current value 220.0 million
• Merger premium 69.4
  millionPresumably, the targets value is
  increased by 69.4 million due to merger
  synergies, although realizing such synergies has
  been problematic in many mergers.

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Actual Offer

• 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.

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Actual Offer
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Actual Offer

• 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
• 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

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Actual Offer

• Control is important
• Do targets managers want to remain in control?
• What kind of personal deal will targets managers
  get?
• Will these impact price?

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What if . . .

• 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
• Long term rsLwill change, so horizon WACC will
  change. Thus, horizon value will change.

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New WACC Calculations
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
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For Practice

• You should get 554.1 million for new horizon
  value
• You should get Vops 409.5 million and 354.5
  million for the value of equity
• This is 65 million, or 3.25 per share more than
  if the horizon capital structure is 20 debt
• Added value is the value of the additional tax
  shield from the increased debt

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Who wins?

• Empirical evidence suggests that acquisitions do
  create value
• Economies of scale, other synergies, and/or
  better management
• Shareholders of target firms reap most of the
  benefits (final price is close to full value)
• Target management can say no
• Competing bidders often push up prices

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Divestitures

• Four Types
• Sale of an entire subsidiary to another firm
• Spinning off a corporate subsidiary by giving the
  stock to existing shareholders
• Carving out a corporate subsidiary by selling a
  minority interest
• Outright liquidation of assets

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Holding Companies

• Corporation formed for the sole purpose of owning
  the stocks of other companies
• Subsidiary companies issue their own debt, but
  their equity is held by the holding company,
  which, in turn, sells stock to individual
  investors

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Holding Companies

• Advantages
• Control with fractional ownership
• Isolation of risks
• Disadvantages
• Partial multiple taxation
• Ease of enforced dissolution
• Utilities, financial companies