Vienna MBA Mergers

1
Vienna MBA Mergers Acquisitions

• Instructor Adlai Fisher

2
About the Course

• Mergers, acquisitions, and restructurings
• offer a lens into a variety of financial
  management practices at a critical time in the
  life of a corporation
• Managers make decisions with guidance from
• Relevant financial theory
• Advanced quantitative methods
• Careful study of previous business decisions and
  outcomes

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MA Foundations

• Successful transactions require managers to have
  solid understanding of a variety of finance
  topics and tools
• Valuation
• Capital structure
• Financial distress
• Financial statement analysis
• Working capital management
• Securities markets
• Securities issuance
• Agency theory
• Corporate governance
• Executive compensation
• Real and financial derivatives
• Etc.

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Course Outline
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• 1 Introduction and MA Overview, Valuation
• Theoretical frameworks, historical and
  international perspective, participants
• DCF, multiples, due diligence, wealth effects
• Case Ducati (Instructor presented)

• 2 Transaction Structuring
• Merger legal process, payment method, deal
  protection, accounting, tax, antitrust
• Case Seagate

• 3 Hostile Transactions
• Takeover strategies and defenses, duties of
  directors
• Case Vodafone

5
An Example of MA MSFT bids for Yahoo
44 Billion
Feb 1, 2008
62 premium
7
47
The combination also offers an increasingly
exciting set of solutions for consumers,
publishers and advertisers while becoming better
positioned to compete in the online services
market
This odd and opportunistic alliance of Microsoft
has anything but the interests of Yahoo!'s
stockholders in mind
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Vienna MBAMergers and Acquisitions

• MA Overview Motives and History

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Overview Outline

• MA objectives, creating shareholder value
• Three theoretical frameworks
• Historical and international perspective
• Current trends
• Participants
• Deal taxonomies

8
MA and Shareholder Value

• Creating shareholder value is the dominant
  paradigm for thinking about the role of the firm
• Ways of increasing shareholder value
• Operations
• Finance
• Strategy

9
The Corporate Objective Reconsidered

• Legal framework
• U.S. Shareholder value is explicitly the
  objective
• Canada CBCA expresses goal of maximizing value
  of the firm (not necessarily the same)
• Europe broad set of explicit stakeholders
• Other areas China?
• In practice
• Managers may have very different incentives than
  shareholders (Microsoft / Yahoo)
• Other stakeholders can influence decisions
• Employees, trade groups, government, consumers,
  etc.
• E.g., China Petroleum / Unocal
• Inference Dont take the corporate objective for
  granted, likely many interests at stake

10
Creating Value

• An acquisition is only one among many possible
  tactics or strategies
• To create value focus on areas of expertise or
  special competencies ? competitive advantage
• An acquisition may be
• a well-planned way of achieving a corporate goal
  (strategic buyer), and/or
• it may be opportunistic (financial buyer )
• An acquisition generally should not be considered
  a corporate goal in and of itself

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Bidding Strategies / Winners Curse

• Common values auction all participants get a
  noisy signal Si V ei of true value V
• Example Put cash in envelope, and sealed bid
  auction to class. Everyone gets a noisy signal
  as described above.
• What is the equilibrium strategy?
• What happens if everyone bids their signal?
• Private values auction Each individual has a
  different true value Vi and receives signal Si
  Vi ei
• Is the winners curse larger or smaller than in
  common values auction?
• How does this relate to the bidding strategies of
  financial and strategic buyers?

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Three frameworks that help us to understand MA

• 1 Microeconomics
• 2 Principal Agent Theory
• 3 Financial engineering

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Three Theoretical Frameworks

• 1 Microeconomics
• Industry structure is an equilibrium involving
• Technology
• Legal and regulatory environment
• Macroeconomy
• Dynamics
• Slow adjustment internal investment /
  disinvestment
• Rapid adjustment MA becomes more important

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MA Frameworks

• 2 Principal Agent Theory
• Separation of ownership and management creates
  agency costs
• When do goals of managers and shareholders
  differ?
• Mature firm in declining industry
• Significant free cash flow (Jensens FCF
  Hypothesis)
• Underperforming firms become takeover targets
• LBOs, MBOs, and Hostile takeovers
• Example T. Boone Pickens and Mesa Petroleum

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MA Frameworks

• 3 Financial engineering
• Unlocking value by changing corporate or
  financial structure
• Tax motives (Profitable firm buys company with
  NOLs)
• Input hedging (e.g., Dupont Conoco)
• Risk synergies (debt capacity)

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Example Coca-Cola acquires Huiyuan Juice Corp
2.4 Billion in Cash
Sep 3, 2008
3 times Huiyuans price
0.2
167
This acquisition will deliver value to our
shareholders and provide a unique opportunity to
strengthen our business in China.
17
4
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Notable Deals

• Magna Int. / Opel, GM division (55 stake, Sept
  2009)
• Kraft / Cadbury (17 billion, Sept 2009)
• Microsoft intended acquisition to Yahoo (44
  billion, 2008)
• Murdochs News Corporation/Dow Jones (5 billion,
  2007)
• Google / YouTube (1.65 billion in shares, 2006)
• Barrick / Placer (10.4 billion, hostile then
  friendly cash and share tender, 2006)
• Sanofi / Aventis (65 billion, 2004)
• Cingular / ATT Wireless (41 billion cash, 2004)
• JP Morgan / Banc One (58 billion, 2004)

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Historical Perspective

• Merger waves
• 1895-1904
• 1922-1929
• 1940-1947
• 1965-1969
• 1980s
• 1993-2000
• 2002-2006

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Historical Perspective

• 1895-1904
• Economy
• Rapid economic expansion
• Recession begins in 1903
• Technology
• Transcontinental railroads permit national
  markets
• Electricity
• Regulatory environment
• Permissive
• Supreme Court decision in 1903 begins enforcement
  of Sherman Act

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Mergers wave around 1900
Source Mergerstat Review 1989
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Historical Perspective

• 1895-1904 (cont.)
• Mergers
• Mostly horizontal characterized as merger for
  monopoly
• Concentrated within heavy manufacturing
• Forms U.S. Steel, DuPont, Standard Oil, GE, Kodak
• Activity peaks in 1901 result of failure of some
  merge

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Historical Perspective

• 1922-29
• Economy
• Rapid economic expansion
• Ends around time of crash
• Technology
• Automobiles increase consumer mobility, local
  distribution
• Radio permits product differentiation and
  development of national brands
• Regulatory environment
• Stricter enforcement against monopolies

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Historical Perspective

• 1922-29 (cont.)
• Mergers
• Characterized as merger for oligopoly
• Also vertical mergers, product extension,
  geographic extension
• Concentrated in public utilities, banking, food
  processing, chemicals, mining, retailing
• IBM, General Foods, Allied Chemical

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Historical Perspective

• 1940-1947
• Rapid growth of the economy
• Less technological change, smaller merger wave
• Wartime price controls lead to vertical mergers

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Historical Perspective

• 1960s Conglomerate Merger Wave
• Economy
• Rapid economic expansion
• Recession begins in 1971
• Regulatory
• Strict antitrust enforcement
• Mergers
• At peak in 1967-1968, only 17 of mergers are
  horizontal or vertical
• Product extension, 60
• Pure conglomerate, 23 (35 of assets)
• Roll-ups of many small-medium firms

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Historical Perspective

• 1960s Conglomerate Merger Wave (cont.)
• Other possible factors
• Theory that these were defensive/diversification
  driven management entrenchment
• Impact of management science
• EPS bootstrapping

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Historical Perspective

• Example Ling-Temco-Vought (LTV)
• Founder James Ling begins with 2000 investment
  in electronics in 1956
• Acquisitions
• American Microwave
• J L Steel
• Wilson sporting goods, meat packing, and
  pharmaceuticals
• Braniff Air commercial airline
• Temco, Vought military aircraft
• National Car Rental
• Banks, insurance companies
• Altec sound systems

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Historical Perspective

• 1980s
• Economy
• Expansion begins in earnest in 1984
• Recession begins in 1990
• Financial innovation
• Junk bonds, LBOs, MBOs
• M A
• Characterized as undoing the conglomerate merger
  wave
• Innovation in hostile takeover strategies

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Historical Perspective

• 1980s (cont.)
• Sharp decline in 1990-1992
• Recession
• Adverse court decisions, state anti-takeover
  amendments
• Failure of junk-bond market and many leveraged
  transactions

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Historical Perspective 1960
Source Houlihan Lokey Howard Zukin
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Decline of mergers1970
Source Mergerstat Review 1989
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Mergers from 1980-2006
Source Thompson Securities Financial Data (SDC)
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Historical Perspective

• 1993-2000
• Economy in rapid economic expansion
• Technology
• Telecommunications
• Semiconductors, Software
• Networking, the internet
• Regulatory environment
• Anti-trust policy changing because of convergence
  of previously segmented markets
• Technological convergence
• Geographic convergence international
• Takeover defenses strengthened
• Loosening of restrictions in broadcasting,
  banking, insurance, utilities

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Historical Perspective

• 1993-2000 (cont.)
• MA
• Strategic mergers, many across previously
  segmented but converging businesses
• Most are friendly, increasing stock financing
• Divestitures to increase focus

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Historical Perspective

• 2002-2006
• MAs more successful this time around?
• Potential explanations
• Deal management and governance Senior
  management today are much more attuned to
  shareholder opinions, and are more accountable
  for demonstrating shareholder value
• Better due diligence companies have learned
  from mistakes that were made in the last two
  merger waves
• Financial synergies and people integration
  Cultural synergies are taken much more seriously
  than they were in the previous two merger waves.

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Historical Perspective Summary

• All of the U.S. merger waves are
• Associated with economic expansion, and end with
  recessions
• Greatly affected by the regulatory environment
• 1895-1904 Merger for monopoly
• 1922-1929 Merger for oligopoly
• 1960s Conglomerate
• 1993-2000 interstate banking, global industrial
  consolidation
• Greatly affected by technology
• 1895-1904 Transcontinental railroads permit
  concentration of heavy manufacturing industries
• 1922-1929 Radio permits product differentiation
  and development of national brands
• 1993-2000 telecommunications, semiconductors,
  the internet
• Financial innovation also plays a role
• LBOs, junk bonds, and the merger wave of the
  1980s Undoing the conglomerate merger wave

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International Perspective
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International Perspective

• 1999 Data Dramatic growth in European,
  cross-border, and Far Eastern MA volume
• North America 1.5 trillion
• Europe 1.1 trillion
• Asia 232 billion
• South America 21 billion
• Cross border
• North America Europe 350 billion
• North America Asia 54 billion
• Europe South America 36 billion
• Europe Asia 31 billion
• North America South America 18 billion

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European Merger Wage
Source Thompson Securities Financial Data (SDC)
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Australia Merger Wage
Source Thompson Securities Financial Data (SDC)
41
China Merger Wage
Source Thompson Securities Financial Data (SDC)
42
Japan Merger Wage
Source Thompson Securities Financial Data (SDC)
43
Key Elements of a Successful Deal

• The shocking truth most acquisitions hurt
  shareholder value!
• Search for synergies
• Added hurdle of takeover premium
• We can generally think of a deal as being
  composed of four stages
• Strategy
• Valuation
• Mechanics
• Implementation integration

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The Principal Participants

• Buyer / seller
• Board of Directors
• Managers
• Shareholders
• Employees
• Advisors
• Bankers
• Lawyers
• Accountants
• Consultants

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The Principal Participants (cont.)

• Regulators
• Antitrust
• Industry regulators
• Securities regulators
• Others
• Risk arbitrageurs
• Short term financiers
• All of these parties have separate interests
• Inference Need for leadership and orchestration

46
Deal Taxonomies

• By economic motivation
• Synergies in either costs or revenues
• Market power
• Wealth transfers from / to shareholders,
  debtholders, employees, the government
• MA as a solution to agency problems
• MA as a manifestation of agency problems
  empire building
• The winners curse and overpayment

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Types of Deals

• Takeover
• The transfer of control from one ownership group
  to another.
• Acquisition
• The purchase of one firm or set of assets by
  another
• Merger
• The combination of two firms into a new legal
  entity
• A new company is created
• Both sets of shareholders have to approve the
  transaction.

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Types of TransactionsHow the Deal is Financed

• Cash Transaction
• The receipt of cash for shares by shareholders in
  the target company.
• Share Transaction
• The offer by an acquiring company of shares or a
  combination of cash and shares to the target
  companys shareholders.

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Financial Data Source

• MA Thomson ONE Banker / SDC Platinum
  (http//toby.library.ubc.ca/resources/infopage.cfm
  ?id1423 )
• Financial statement and stock price
• Yahoo Finance (http//finance.yahoo.com/
  )
• Google Finance (http//finance.google.com/
  finance )
• Corporate News
• Factiva (http//toby.library.ubc.ca/resourc
  es/infopage.cfm?id970 )

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Vienna MBAMergers Acquisitions

• Valuation DCF Methods

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Outline

• DCF valuation techniques
• Weighted Average Cost of Capital (WACC)
• Adjusted Present Value (APV)
• Capital Cash Flows (CCF)
• Flow to Equity (FTE)

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Weighted Average Cost of Capital

• UCF Unlevered cash flow

• WACC After-tax weighted average cost of capital

53
Adjusted Present Value (APV)

• NPVF NPV of financing side effects
• rB required return on debt

• NPVU NPV of unlevered firm
• r0 required return on unlevered firm

• The NPVF formula above includes only interest
  tax shields
• Ideally, we would also like to capture other
  financing side effects (but this is often
  difficult)
• cost of financial distress, financing subsidies,
  issuing cost
• Similar caveat applies to WACC

54
Capital Cash Flow Method (CCF)

• You will sometimes hear a valuation method
  called capital cash flows discussed (e.g., Yell)
• This is just an APV method, where instead of
  using rB to discount the tax shield benefits of
  debt, use r0 to discount tax shield benefits of
  debt.

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Flow to Equity (FTE)
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Summary of the Methods

• All the three DCF methods are equivalent in
  theory
• In practice, some method may be easier,
  depending on the situation
• WACC and FTE assume constant debt/equity ratio.
  For time-varying debt/equity ratio, discount
  rates change each period.
• APV uses r0, which does not depend on capital
  structure.
• If debt/equity ratio is constant, then use WACC
  or FTE
• If the dollar value of debt over time is known,
  then use APV

57
Estimating rs

• The primary method of estimating the required
  return on equity is to use the CAPM. We will
  focus on this.
• Other models can also be used, e.g.,
  Fama-French, conditional CAPM (time-varying
  loadings/risk-premia)

58
Using the CAPM

• Beta Google finance, typically calculated from
  1-5 year market model regressions on monthly,
  weekly, or sometimes daily data
• Risk-free rate Intermediate or long-term
  government bond rate, usually chosen to match
  duration of cash flows Google finance
• The market risk premium Estimated from medium
  (10-20 year) to long-run (80 year) averages of
  excess market returns
• Elaborations conditioning variables,
  international data, structural breaks
• In practice, typically use values between 3.5
  and 7

59
Cautions when using the CAPM to get rs

• Remember that any beta estimate from Google or
  your own regression reflects the historical risk
  of the companys equity
• Equity risk can be changed by altering the
  financial structure of the company, or the asset
  mix
• Thus, if leverage is changing, or the assets
  are changing, need to think carefully about how
  to use historical beta

• Example 1 You have a historical equity beta
  estimate, and plan to use the same assets going
  forward, but with a different capital structure.
• Delever to get asset beta, relever for new equity
  beta
• Example 2 You are changing the asset mix of the
  company, or the way assets are used
• Find pure play comparables, delever to get asset
  betas, relever for your own capital structure

60
The All-equity cost of capital
Method 1 Use Modigliani-Miller Proposition II,
with taxes
Can use solver to obtain r0 or some algebra gives
61
MM Proposition II, no taxes
rsr0B/S(r0-rB)
r0
rWACC
rB
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MM Proposition II, with taxes
rsr0(B/S)(r0-rB)(1-T)
r0
rWACC
rB
63
The All-equity cost of capital
Method 2 Use the levering and delevering
formulas for betas, and the CAPM
Note you will often see the beta
levering/unlevering formula written without
(1-T) anywhere. This reflects an assumption that
the riskiness of debt tax shields is equal to the
risk of the unlevered assets.
64
Example

• Johnson and Johnson operate in several lines of
  business Pharmaceuticals, consumer products, and
  medical devices.
• To estimate the all-equity cost of capital for
  the medical devices division, we need a
  comparable, i.e., a pure play in medical devices
  (we should really have several).
• Data for Boston Scientific
• Equity beta 0.98
• Debt 1.3b
• Equity 9.1b
• Tax rate (T) 20

65
Example (cont.)

• Compute Boston Scientifics asset beta (assuming
  ?D 0)
• Let this be our estimate of the unlevered asset
  beta for the medical devices business.
• Use CAPM to calculate the all-equity cost of
  capital for that business (assuming 6 risk-free
  rate, 8 market risk premium)
• r0 6 0.88 8 13.04

66
Which WACC should we use, the acquirer or the
target?

• Generally, we use the target WACC.
• We should adjust the discount rate based on the
  riskiness of their investment.
• The riskiness of an acquisition depends upon the
  characteristics of the target, hence, we use
  target WACC.
• The first exception the target will be
  restructured
• If the acquirer plans to change the operations of
  the target and this would have a foreseeable
  effect on the riskiness of the target cash flows,
  then we would want to consider this.
• The second exception the target is private
• No market data available for WACC.
• Use the WACC of a publicly traded company that
  is most similar to the target.
• Use the acquirer WACC as a proxy

67
Whose capital structure to use, the acquirer or
the target?

• Generally, we use the target capital structure.
• Optimal capital structure is determined by the
  riskiness of the underlying assets
• It is not typically affected by a change of
  control.
• Again, one exception the target will be
  restructured
• Acquirer projects major changes that will
  predictably affect the riskiness of the target
  cash flows.
• Another exception risk synergies
• Two firms risk cancels each other.
• This is a minor issue

68
Market values or book values to weight
debt/equity?

• The weightings should be based on market values
  of both debt and equity.
• Because market and book value tend not to be very
  different for debt, the book value of debt is
  often used in practice.

69
Summary

• Three DCF methods
• If debt-equity ratio is stable over time, use
  WACC or FTE
• If not, use APV (for LBO, use APV)

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• Appendix Valuation Example

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Singer Company Valuation Example

• Calculate value using
• WACC
• APV
• FTE

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Singer Company WACC Valuation
73
Singer Company APV Valuation
74
Singer Company FTE Valuation
75
Vienna MBAMergers Acquisitions

• Valuation II Multiples Valuation

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Multiples Valuation Introduction

• Basic idea use prices of a peer group to build
  up an estimate of value for the firm you are
  analyzing (law-of-one-price)
• Outline of typical steps
• Choose a relevant peer group (e.g., firms in an
  industry)
• Propose a quantity (e.g., EBITDA) that you
  believe correlates to value (e.g., EV) among
  firms in the peer group
• Calculate the corresponding ratio (e.g.,
  ?iEVi/EBITDAi) for all observations i in the
  peer group
• Designate the average multiple
• Apply this multiple to the firm you are analyzing
  to estimate its value

77
Multiples Valuation Theory

• You are already familiar with the theory behind
  some important multiples
• E.g., the price-dividend (P/D) ratio
• For a firm i with constant growth of dividends

Gordon Growth Formula

• Hence

Thus, the P/D ratio is driven by equity risk (rs)
and the growth rate (gD)
78
P/D Ratio Example

• For different values of rs and gD

• Higher risk (rs) reduces the P/D ratio
• Higher growth (gD) increases the P/D ratio

79
The P/E Multiple

• Note That
• Following the Gordon Growth formula again
• Again shows
• The higher the expected growth rate, g, the
  higher the P/E
• The higher the required rate of return, r, the
  lower the P/E
• Changing the payout ratio has two effects Direct
  effect in numerator, and indirect effect on g in
  denominator, which effect dominates depends on
  the investment opportunities of firm
• Good investment opportunities High plowback
  (reducing payout) should maximize P/E
• Poor investment opportunities High payout should
  maximize P/E

80
Intuition for P/E

• The ratio tells you how many times projected
  annual earnings (per share) the share is
  currently trading
• If you buy a company that is trading 10 times
  projected earnings, it may take 10 years of those
  earnings to recover your investment.
• If you buy a company trading 100 times projected
  earnings, it may take 100 years of those earnings
  to simply recover your investment (excluding time
  value on your investment).

81
The SP/TSX Composite P/E
Earnings volatility creates wide variations in
P/Es associated with the business cycle.
82
P/E Ratios in the Forest Industry
P/E is uninformative when company has negative
(or small) earnings
83
Other Ratios Motivated by Theory

• The enterprise value (EV or V) to free cash flow
  (FCFUCF) ratio

• Hence

EV/FCF is driven by firm risk (rWACC) and the
growth rate (gFCF)
84
Other Ratios Motivated by Theory

• The enterprise value (EV) to capital cash flow
  (CCF) ratio

• Hence

EV/CCF is driven by unlevered firm risk (r0) and
the growth rate (gCCF)
85
Varieties of Multiples Numerator and Denominator

• In the numerator
• Enterprise value, denoted V or EV
• Equity value, either per share (P) or total
  market cap (S)
• In the denominator
• Dividends (for P or S)
• Aggregate Dividends plus coupon payments (for EV)
• FCFUCF (for EV)
• CCF (for EV)
• LCF (per share for P, aggregate for S)
• EBIT (for EV)
• EBITDA (for EV)
• Sales/Revenues (for EV)
• of customers, web site hits, of employees,
  RD spending, (EV)
• Book value (of assets for EV, of equity for S, of
  equity per share for P)

86
Choosing the Numerator (P or EV)

• From theory we know that equity multiples (P)
  will be determined roughly by
• Equity risk rSr0(B/S)(r0-rB)(1-T)
• Growth rate of equity cash flows
• Enterprise value multiples (EV) are determined
  roughly by
• Firm risk (r0 or rWACC)
• Growth rate of FCF, CCF

Includes business risk (r0) and financial risk
(determined by B/S)
Much less sensitive to capital structure r0
invariant rWACC has only tax impacts
Using EV in the numerator has an important
advantage EV ratios are not as sensitive to
capital structure and corresponding variations in
equity risk
87
Choosing the Denominator

• With EV in the numerator, theory encourages us to
  look at FCF or CCF
• Many other variants that focus on income flows to
  all claimants
• EV/EBIT, EV/EBITDA, EV/(Net Income interest),
  etc.
• Accounting adjustments can be motivated if they
  help to smooth noise in cash flows, providing
  more accuracy
• Other attempts to smooth noise include taking an
  average of cash flows, EBIT, or EBITDA over
  multiple quarters / years

88
EV/Sales (or P/S)
Usually driven by industry that is not currently
profitable (e.g., internet companies in late
90s)

• Advantages
• Sales are less sensitive to accounting decisions
  and are never negative
• Not as volatile as earnings
• Provides information about corporate decisions
  such as pricing
• Disadvantage
• Does not include information about expenses and
  profit margins which are key determinants of
  corporate performance

• Other multiples based on profit potential
  (sometimes distant)
• customers, geographic coverage, web site hits,
  etc.

89
EV/Assets

• The other main type of denominator is based on
  assets
• E.g., the ratio EV/(Book Value of Assets) is
  closely related to a theoretically motivated
  measure called Tobins Q

q provides a ratio describing value added by the
firm

• When Market/Book uses equity in the numerator and
  denominator, it is the inverse of the B/M ratio
  in the Fama-French 3-factor model

90
Choosing the Peer Group

• The first, and perhaps most important, step in
  multiples valuation is choosing a peer group
• Most commonly, peer group chosen by industry and
  country / geography of primary business location
• 4 digit SIC codes, NAIC codes, Fama-French
  industry definitions, Yahoo or Google stock
  screener industry definitions, etc.
• Choose firms that are legitimately in a similar
  line of business, that one would expect to have
  similar profit profiles and risk characteristics
• If EV in numerator, not essential that peers have
  similar capital structures for equity multiples,
  capital structure is an important control.

91
Two Primary Variants

• Trading Multiples Common general purpose
  technique
• Calculate multiples for peers based on the
  current trading values of equity and, where
  available, debt (otherwise can use book for debt)
• Typically require that peers are publically
  traded so that market value of equity can be
  obtained
• Discounts sometimes applied for illiquidity if
  the firm being valued is not publically traded.
• Does not include a control premium
• Transaction Multiples Used in MA settings
• Based on relatively recent transactions involving
  purchases or acquisitions of peer group firms
• Peer group transactions may be public or private
• Generally harder to find good peer comparisons,
  and sometimes the transactions are older than we
  would like
• Includes a control premium

92
Strengths and Weaknesses of Multiples Valuation

• Strengths
• Simple, easy to use, easy to understand
• Incorporates current information on how the
  market values peer firms
• Weaknesses
• Multiples are based on relative valuation and are
  only accurate if the market values other firms
  correctly
• By contrast, DCF methods use absolute valuation,
  and do not rely on the markets valuations of
  peer firms
• Paradox if all investors use only relative
  valuation, then nothing ties down the price level
  and the market becomes inefficient
• Use of relative valuation methods is often cited
  as an important contributor to speculative
  bubbles (internet bubble, housing bubble, etc.)

93
Choosing a Multiple to Use

• For any industry/situation, there are often a
  number of potential multiples one could use
• EV/EBITDA, EV/FCF, EV/sales, EV/Assets, etc.
• To compare accuracy of different multiples within
  peer group, interpret multiples valuation as a
  restricted (zero intercept) regression

94
Combining Information in Different Multiples

• Suppose we have several multiples that seem to
  work well
• One ad hoc way to combine information is to
  calculate implied values from each multiple, and
  average
• A more systematic way to approach the problem is
  to run a multiple regression, e.g.

Obtain estimates of regression coefficients using
peers, and apply these coefficients to the
corresponding variables for firm being analyzed
Need to check the correlation of your regressors
in first regression and collinearity diagnostics
if two or more are very closely related.
95
Which to Use, DCF or Multiples?

• Often, both are valuable
• Intuitively, DCF more accurate for projects with
  easy to forecast cash flows (e.g., infrastructure
  projects), and where the purchase will be buy and
  hold
• Multiples may tend to be more often used when
  cash flows are difficult to predict, and the
  asset will be sold at current market valuations
  (e.g., IPO)

96
Appendix
97
Example
Consider the following target firm
Sales 10 M
EBITDA 3.3 M
EBIT 2.5 M
Net Income 1 M
of shares 0.5 M
Debt 5 M
Equity 5 M
Market Value of Equity 15 M
Ratio T1 T1 5-Yr. Avg. Ind. Avg.
P/E 15 X 14.5 16.5
Value/EBIT 8 X 5.5 7.5
Value/EBITDA 6.06 4.8 6
P/Sales 1.5X 1.35 1.6
P/Book 3 X 3 3.2
98
Example
Using the industry average as the justifiable
multiples
P/E P/E Net Income 16.5 1M 16.5 M
V/EBIT V/EBIT EBIT Debt 7.52.5 5 13.75 M
V/EBITDA V/EBITDA EBITDADebt 63.3-514.8 M
P/Sales P/Sales Sales 1.61016 M
P/Book P/BBook Value 3.2516 M
Using the 5 Yr. average as the justifiable
multiples
P/E P/E Net Income 14.5 1M 14.5 M
V/EBIT V/EBIT EBIT Debt 6.52.5 5 11.25 M
V/EBITDA V/EBITDA EBITDADebt 4.83.3-510.8 M
P/Sales P/Sales Sales 1.351013.5 M
P/Book P/BBook Value 3515 M
99
Multiples Using Number of Employees
This sample used for all plots in this file is
all Compustat firms in 2007. Each dot represents
a firm. The regression line is restricted to
have an intercept of zero.
100
Multiples Valuation Using Sales
101
Multiples Valuation Using EBIT
102
Multiples Valuation Using EBITDA
103
Multiples Valuation Using Book Value of Assets
104
Cross-Industry Comparison of R2 from Regressions
of EV on other variables
of Employees Sales EBIT EBITDA Assets
Manufacturing 0.42 0.67 0.67 0.70 0.72
Mining 0.16 0.87 0.88 0.86 0.79
Retail 0.90 0.92 0.97 0.97 0.94
Info. Tech. 0.54 0.61 0.48 0.35 0.58
Finance and Insurance 0.82 0.84 0.66 0.68 0.73
This table reports R2 from univariate regressions
of enterprise value (EV) on each of the variables
listed in the column headings. The initial
sample is all Compustat firms in the 2007 data,
and in each row the sample is restricted only to
firms in that industry.
105
Cross-Industry Comparison Regression Coefficient
of Employees Sales EBIT EBITDA Assets
Manufacturing 545.7 1.05 7.53 5.95 1.13
Mining 559 2.44 6.99 5.35 1.10
Retail 106 0.57 10.20 7.90 1.26
Info. Tech. 663.3 2.11 10.25 5.22 0.85
Finance and Insurance 899 1.34 2.86 2.81 0.09
This table reports the regression coefficients
from univariate regressions of enterprise value
(EV) on each of the variables listed in the
column headings. The initial sample is all
Compustat firms in the 2007 data, and in each row
the sample is restricted only to firms in that
industry.
106
Vienna MBAMergers Acquisitions

• MA Wealth Effects

107
Overview

• Large literature in finance studying the wealth
  and performance effects of MA activity
• E.g., Event Studies
• Findings Basic Wealth Effects in MA
• The Market Timing Hypothesis and Stock Market
  Driven Acquisitions
• Extras

108
Three approaches to measure MA profitability

• Event studies (most used in finance)
• Accounting studies
• 3. Surveys of executives ( seldom used in
  finance)

109
Procedures of event study

1. Identify the event of interest. (e.g., MA, CEO
   turnover)
2. Define the event period? (e.g., -1 days and 1
   day)
3. Compute the real stock return
4. Measure normal return using asset pricing model
   (CAPM, APT, Fama-French, etc)
5. Abnormal return real return normal return
6. Sum up abnormal return to get cumulative abnormal
   returns

110
Example of an event study
Date Rm (SP500) R (BA) AR(BA) R(BA)-Rm R (ML) AR( ML) R(ML)-Rm
16-Sep 1.75 11.30 9.55 30.01 28.26
15-Sep -4.71 -21.31 -16.60 0.06 4.77
12-Sep 0.21 2.06 1.84 -12.25 -12.46
Firm Accumulative abnormal returns (CAR3) MV Equity Dollar Gain/Loss
BM -7.95 155 Billion -12.3 Billion
ML 17.8 37 billion 6.6 Billion
111
Assumptions for event studies

• Event is unanticipated
• Abnormal returns are result of reaction
• No confounding effects
• Eliminate other events
• Markets are efficient (recall 3 forms of EMH
  hypothsis)
• Weak ( all past price and trading information)
• Semi-strong (all publicly known and available
  information)
• Strong (both public and private information)

112
Event studies

• Strengths
• A relatively direct measure of value to
  shareholders
• A forward-looking measure
• Weaknesses
• Requires strong assumptions
• Vulnerable to confounding events

113
Findings Wealth effects for Bidders

• Approximately zero returns to successful bidders
• Possibly higher return to bidders in tender
  offers (4) than in mergers (0)
• Slightly positive in 60s (5) and 70s (2), and
  slightly negative in 80s (-1)
• Very negative during late 90s and early 2000s

114
Wealth effects Targets

• Target shareholders gain
• Tender offer vs. merger
• Aggregate 30 abnormal return to targets in
  tender offers
• 20 abnormal return to targets in mergers

115
Predictive Ability of CAR

• If negative bidder returns on announcement
• Future divestiture is more likely
• The acquirer is more likely to become a target
  itself
• Positive event returns produce the opposite

116
Failed Transactions

• Both bidder and target have negative CAR after
  unsuccessful tender offer
• Markets initial reaction predict outcomes
• Targets of failed tender offers who are acquired
  within the next 60 days had the most positive
  initial announcement effects (50 compared to 23
  for others)
• For unsuccessful bidders
• If the target is acquired by another buyer in
  first 180 days, negative returns for initial
  bidder (CAR 0 to 180) are 8
• If the target is not acquired by another firm,
  the CAR (0 to 180) for the initial bidder is
  zero.

The market is suspicious of both
Market reacts most positively initially for
targets who are most attractive in general
Suggests that the market believes there is a
problem with the buyer when deal fails and target
is acquired by different firm
117
Financing

• Higher abnormal returns for targets in cash
  offers than stock offers
• information effect (bidders use cash when they
  are more confident)
• Also possibly tax effect (higher premium may be
  needed since cash transactions taxed immediately,
  stock not)

118
Timing

• Average time between announcement and completion
  of acquisition is 66 days
• Twice as long for completion when securities are
  involved as opposed to an all cash transaction

119
Multiple bidders

• When multiple bidders arise
• Target CAR 26 on day 1, 45 to day 80
• For a single bidder
• Target CAR 26 on day 1, 26 to day 80
• Initial acquirer loses 2.4 when a second bid is
  announced

120
Predictors of Hostile vs. Friendly Structure

• Insider ownership
• Tends to be low in targets that get hostile bids
• High in targets that get friendly bids
• Previous performance of target
• Below average in hostile deals
• Above average in friendly deals

121
Surveys of managers

• Bruner (2002) conducted his own survey. According
  to the respondents
• 37 of deals create value for the buyer
• 21 of deals achieve their strategic goals

122
An important caveat

• Impossible to empirically test if stakeholders
  would have been better off if no MA activity
  hence, full tests of value of MA activity are
  impossible.

123
So, does MA pay? Summary of findings

• Target firms significant positive returns
• Acquirer firms no value creation (NPV0), on
  average.
• IF Cash offer zero or slightly positive returns
• IF stock offer negative returns
• Note acquirer is typically larger in size.
  Therefore effect of acquisition is smaller for
  acquirer, all else being equal
• Combined Target and Acquirer
• value is created, NPV gt 0

124
II. Market Timing and Stock Mergers

• Discussion based on Moeller, Schlingemann, and
  Stulz, Journal of Finance (2005)

125
Dollar Gain/Loss (M) in MA 1980-1997
Source Moeller, Schlingemann, Stulz, Journal of
Finance (2005)
126
Dollar Gain/Loss (M) in MA 1998-2001
Source Moeller, Schlingemann, Stulz, Journal of
Finance (2005)
127
Dollar Gain/Loss (M) in MA 1980-2001
Source Moeller, Schlingemann, Stulz, Journal of
Finance (2005)
128
Puzzle
What drove such massive losses, purely agency
costs?

• Market timing hypothesis an explanation for how
• bidder increases its fundamental value via
  mergers
• but bidder still has negative stock return

129
Market timing
Market timing issuing overvalued equity, buy
back undervalued equity
Good performance
Bad performance
If manager has private information, in which
situation should she issue equity? What is the
stock market reaction? Negative stock reaction
when firms issue equity Positive stock reaction
when firms repurchase equity
130
Stock market driven acquisition

• Current MV 100 shares 10/share1000
• Fundamental MV 100 1/share100
• Manager issues equity of 200 to undertake
  acquisitions

Information asymmetry
No Learning
Issuing Price 10
Shares Issued 200/10 20
Price (Short term) 10
Price (Long term) (100200)/1202.5
Full Learning
1
200/1200
1
(100200)/3001
Partial Learning
5
200/540
5
(100200)/1402.1
Without merger, more negative bidder return
131
Stock market driven acquisition

• Overvalued bidders use equity to acquire real
  assets from target
• Stock price of bidders go down during the merger
• But the merger still serves the interests of
  bidder shareholders, because the bidders stock
  return would be more negative without the merger.
• Most evident in the later 1990s (Internet bubble).

132
III. Extras

133
CARs for Successful and Unsuccessful Bidders
Full sample 1,815 deals. 1,401 successfully
(dotted line), and 414 Unsuccessful (dashed
line). Period 1971-1991.
Source Schwert, Journal of Financial Economics,
(1996), Markup Pricing in MA
134
A Refinement of Bidder Returns
Bidder CAR(-1,1) for deals in 1980 2005 Large
and small are the upper and lower quartile of
market cap at -42.
Source Eckbo, Betton, and Thorburn, Handbook of
Empirical Corporate Finance (2008)
135
Some Links

• Does MA Pay? (NY Times)
• New Merger Wave?
• CNN
• NY Times