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CHAPTER 26

CHAPTER 26. Mergers, LBOs, Divestitures, and Holding Companies. Topics in Chapter. Types of mergers Merger analysis Role of investment bankers LBOs, divestitures, and holding companies. Economic Justifications for Mergers. Synergy = Value of the whole exceeds sum of the parts

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CHAPTER 26

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  1. CHAPTER 26 Mergers, LBOs, Divestitures, and Holding Companies

  2. Topics in Chapter • Types of mergers • Merger analysis • Role of investment bankers • LBOs, divestitures, and holding companies

  3. Economic Justifications for Mergers • Synergy = Value of the whole exceeds sum of the parts • Operating economies • Financial economies • Differential management efficiency • Taxes (use accumulated losses) • Break-up value = Assets more valuable broken up and sold

  4. QuestionableReasons for Mergers • Diversification • Purchase of assets below replacement cost • Acquire other firms to increase size, thus making it more difficult to be acquired

  5. Merger Types • Horizontal • Vertical • Congeneric • Related but not same industry • Conglomerate • Unrelated enterprises

  6. Five Largest Completed Mergers(as of December, 2007) TABLE 26-1

  7. Friendly & Hostile Mergers • Friendly merger: • Supported by management of both firms • Hostile merger: • Target firm’s management resists the merger • Acquirer must go directly to the target firm’s stockholders – “tender offer” - try to get 51% to tender their shares. • Often, mergers that start out hostile end up as friendly, when offer price is raised

  8. Merger Analysis • DCF Analysis • Corporate Valuation (Ch 11) • Adjusted Present Value Method (Ch 26.7) • Equity Residual Model (Ch 26.8) • = Free Cash Flow to Equity Method • Market Multiples Analysis • Provides a “benchmark”

  9. Value of firm if it had no debt + Value of tax savings due to debt = Value of operations First term = unlevered value of the firm Second term = value of the interest tax shield The APV Model

  10. The APV Model (15-7) (16-4) (26-1) (15-1) (26-2) (26-3)

  11. APV Model • VU = Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity, rsU • VTS = Value of interest tax shield = PV of interest tax savings discounted at unlevered cost of equity, rsU Interest tax savings = Interest * (tax rate) = TSt

  12. APV vs. Corporate Valuation • Best model when capital structure is changing • Merger often causes capital structure changes over the first several years • Causes WACC to change from year to year • Hard to incorporate year-to-year WACC changes in the corporate valuation model • Corporate Valuation (i.e., discount FCF at WACC) = easier than APV when capital structure is constant

  13. Steps in APV Valuation • Calculate unlevered cost of equity, rsU • Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter. (16-6) (26-4) (26-5)

  14. Steps in APV Valuation • Project horizon growth rate, g • Calculate horizon value of unlevered firm using constant growth formula and FCFN • Calculate horizon value of tax shields using constant growth formula and TSN (26-7) (26-8)

  15. Steps in APV Valuation • Calculate Value of Operations • Calculate unlevered value of firm as PV of unlevered horizon value and FCFt • Calculate value of tax shields as PV of tax shield horizon value and TSt (26-9) (26-10)

  16. Steps in APV Valuation • Calculate Value of Operations • Calculate Vop as sum of unlevered value and tax shield value • Find total value of the firm (26-11)

  17. The FCFE Approach • FCFE = Free Cash Flow to Equity • Cash flow available for distribution to common shareholders (26-12)

  18. FCFE Approach • Value of Equity = • Assuming constant growth: (26-13) (26-14) (26-15) (26-16)

  19. TABLE 26-2

  20. Valuation Examples • Caldwell Inc’s acquisition of Tutwiler • Tutwiler • Market value of equity = $62.5 m • Debt = $27 m • Total market value = $89.5 m • % Debt = 30.17% • Cost of debt, rd = 9% • 10 million shares outstanding

  21. Tutwiler Acquisition • Tutwiler’s pre-merger beta = 1.20 • Risk-free rate = 7% • Market risk premium = 5% • CAPM rsL= 13%

  22. Tutwiler Acquisition • Both firms = 40% tax rate • Post-horizon g= 6% • Caldwell will issue debt to maintain constant capital structure: • $6.2 m debt increase at merger

  23. Projecting Post-Merger CFs

  24. Post-Merger CF Projections

  25. Tutwiler – Corporate Valuation (26-7)

  26. Tutwiler: Corporate Valuation

  27. Tutwiler – APV Approach Estimate Tutwiler’s Unlevered Cost of Equity:

  28. Tutwiler – APV Approach

  29. Tutwiler – FCFE Model (26-14)

  30. Tutwiler – FCFE Model

  31. Tutwiler Value Recap Tutwiler is worth more as part of Caldwell than stand-alone

  32. The Bid PriceCaldwell’s Bid for Tutwiler • Caldwell will assume Tutwiler’s debt • Added short-term debt for acquisition • Analysis shows Tutwiler worth $83.1m to Caldwell • If Caldwell pays more Caldwell value diluted • How much should Caldwell offer?

  33. Caldwell’s Bid for Tutwiler • Target’s Estimated value = $83.1 million • Target’s current value = $62.5 million • Merger premium = $20.6 million •  “Synergistic Benefits” = $20.6 million • Realizing synergies has been problematic in many mergers

  34. Caldwell’s Bid • Offer range = $62.5m to $83.1m • $62.5m → merger benefits would go to the acquiring firm’s shareholders • $83.1m →all value added would go to the target firm’s shareholders

  35. Bid Strategy Issues • High “preemptive” bid to ward off other bidders • Low bid and then plan to go up • Do target’s managers have 51% of stock and want to remain in control? • What kind of personal deal will target’s managers get?

  36. Do mergers really create value? • According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management. • Target firm shareholders reap most of the benefits • Final price close to full value • Target management can always say no • Competing bidders often push up prices

  37. Acquisition with Permanent Change in Capital Structure • Tutwiler currently: • $62.5m value of equity • $27m debt = 30.17% debt • Caldwell’s plan • Increase debt to 50% • Maintain level from 2012 on • New rate on debt = 9.5% • Tax shield, WACC and bid price will change

  38. Change in Tax Shield This last debt level is consistent with the assumed long-term capital structure The last interest payment is consistent with the long-term capital structure

  39. Effect on the Bid Price Horizon value of Tax Shields is larger due to increased debt level.

  40. Revised Value of Tutwiler

  41. Recap: Value of Tutwiler Equity

  42. Merger Payment • Cash • Shares in acquiring firm • Debt of the acquiring firm • Combination

  43. Bid Structure Effects • Capital structure of post-merger firm • Tax treatment of shareholders • Ability of target shareholders to benefit from post merger gains • Federal & state regulations applied to acquiring firm

  44. Tax Consequences Shareholders • Taxable Offer • Payment = primarily cash or bonds • IRS views as a “sale” • Target shareholders taxed on gain • Original purchase price vs. Offer price • Taxed in year of merger

  45. Tax Consequences Shareholders • Non-taxable Offer • Payment = primarily stock • IRS views as an “exchange” • Target shareholder pay no taxes at time of merger • Taxed at time of stock sale • Preferred by shareholders

  46. Tax Consequences Firms • Non-taxable offer • Simple merger of balance sheets • Continue depreciating target’s assets as previously • Taxable offer – depends on offer type • Offer for target’s assets • Offer for target’s stock

  47. Tax Consequences Firms • Taxable Offer for Target’s assets • Acquirer pays gain on offer – asset value • Acquirer records target’s assets at appraised value • Depreciation based on new valuation • “Goodwill” = offer – new valuation • Amortized over 15 years/straight line

  48. Tax Consequences Firms • Taxable Offer for Target’s Stock • 2 Choices of tax treatment 1. Record acquired assets at book value and continue depreciating on current schedule 2. Record acquired assets at appraised value and generate goodwill

  49. Figure 26-1

  50. Purchase Accounting • Purchase: • Assets of acquired firm are “written up or down” to reflect purchase price relative to net asset value • Goodwill often created • An asset on the balance sheet • Common equity account increased to balance assets and claims

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