CHAPTER 21

1. CHAPTER 21 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. What are some valid economicjustifications for mergers? • Synergy: Value of the whole exceeds sum of the parts. Could arise from: • Operating economies • Financial economies • Differential management efficiency • Taxes (use accumulated losses) (More...)

4. Valid Reasons (Continued) • Break-up value: Assets would be more valuable if broken up and sold to other companies.

5. What are some questionablereasons for mergers? • Diversification • Purchase of assets at below replacement cost • Acquire other firms to increase size, thus making it more difficult to be acquired

6. Five Largest Completed Mergers(as of December, 2008)

7. Differentiate between hostile and friendly mergers • Friendly merger: • The merger is supported by the managements of both firms. (More...)

8. Hostile merger: • Target firm’s management resists the merger. • Acquirer must go directly to the target firm’s stockholders, try to get 51% to tender their shares. • Often, mergers that start out hostile end up as friendly, when offer price is raised.

9. Reasons why alliances can make more sense than acquisitions • Access to new markets and technologies • Multiple parties share risks and expenses • Rivals can often work together harmoniously • Antitrust laws can shelter cooperative R&D activities

10. Reason to Use APV in Merger Valuation • Often in a merger the capital structure changes rapidly over the first several years. • This causes the WACC to change from year to year. • It is hard to incorporate year-to-year changes in WACC in the corporate valuation model.

11. 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. The APV Model (More...)

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

13. Note to APV • APV is the best model to use when the capital structure is changing. • The Corporate Valuation model (i.e., discount FCF at WACC) is easier to use than APV when the capital structure is constant.

14. Steps in APV Valuation • Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter. • Project horizon growth rate. • Calculate the unlevered cost of equity, rsU. • Calculate horizon value of tax shields using constant growth formula and TSN. • Calculate horizon value of unlevered firm using constant growth formula and FCFN. (More...)

15. Steps in APV Valuation (Continued) • 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 • Calculate Vops as sum of unlevered value and tax shield value.

16. Estimating the Value of Equity Value of operations + Value of any non-operating assets = Total value of the firm - Value of debt (pre-merger) = Value of equity

17. 2010 2011 2012 Net sales $ 60.00 $ 90.00 Cost of goods sold (60%) 36.00 54.00 Selling/administrative expense 4.50 6.00 EBIT 19.50 30.00 Taxes on EBIT (40%) 7.80 12.00 NOPAT 11.70 18.00 Total net operating capital 150.0 150.00 157.50 Investment in net operating capital 0.00 7.50 Free Cash Flow 11.70 10.50 APV Valuation Analysis (In Millions) Based on Post-Acquisition Cash Flows

18. 2013 2014 2015 Net sales $ 112.50 $ 127.50 $ 139.70 Cost of goods sold (60%) 67.50 76.50 83.80 Selling/administrative expense 7.50 9.00 11.00 EBIT 37.50 42.00 44.90 Taxes on EBIT (40%) 15.00 16.80 17.96 NOPAT 22.50 25.20 26.94 Total net operating capital 163.50 168.00 173.00 Investment in net operating capital 6.00 4.50 5.00 Free Cash Flow 16.50 20.70 21.94 Cash flows… continued

19. 2010 2011 2012 Interest expense 5.00 6.50 Tax savings from interest $ 2.00 $ 2.60 2013 2014 2015 Interest expense 6.50 7.00 8.16 Tax savings from interest $ 2.60 $ 2.80 $ 3.26 Interest Tax Savings after Merger Note: Tax savings = interest expense (Tax rate). The tax rate is 40%

20. What is investment in net operating capital? • Recall that firms must reinvest in order to replace worn out assets and grow. • Investment in net operating capital = change in total net operating capital. • This is equivalent to gross investment in operating capital minus depreciation

21. Non-Operating Assets • Short-term investments and marketable securities are non-operating assets. The Target has none of these.

22. What is the appropriate discount rate to apply to the target’s 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 such as preferred stockholders. • These cash flows can be redeployed within the acquiring firm. (More...)

23. Discount rate… • 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, rsU • The interest tax shields are also discounted at the unlevered cost of equity, rsU

24. Note: Comparison of APV with Corporate Valuation Model • APV discounts FCF at rsU and also the tax shields at rsU; the value of the tax savings is 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 the capital structure is constant. But if the capital structure is changing, then APV should be used.

25. Discount Rate for Horizon Value • The last year of projections must be at the target capital structure with constant growth thereafter. • Discount the FCFs using the constant growth formula to find the unlevered horizon value. • Discount the tax shields using the constant growth formula to find the horizon value of the tax shields.

26. Discount Rate Calculations Target’s data: rRF = 7%; RPM = 4%, beta = 1.3, wd =20%, rd = 9%. rsL = rRF + (RPM)bTarget = 7% + (4%)1.3 = 12.2% rsU = wdrd + wsrsL = 0.20(9%) + 0.80(12.2%)= 11.56%

27. (FCF2015)(1+g) Unlevered Horizon Value = rsU - g = $21.94(1.06) 0.1156 – 0.06 = $418.3 million. Unlevered Horizon Value (Constant growth of 6%)

28. 2011 2012 2013 2014 2015 Free Cash Flow $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 21.94 Unlevered Horizon Value $ 418.3 Total $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 440.2 $10.5 $16.5 $11.7 $20.7 $440.2 VUL = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $298.9 million. Unlevered Value

29. Unlevered Value The unlevered value is the value of the firm’s operations if it had no debt. In this case Lyons’ operations would be worth $298.9 million if it were financed with 100% equity.

30. (TS2015)(1+g) Tax Shield Horizon Value = rsU - g = $3.26(1.06) 0.1156 – 0.06 = $62.2 million. Tax Shield Horizon Value

31. $ 2.6 $ 2.6 $ 2.0 $ 2.8 $ 65.5 VTS = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $45.5 million. Tax Shield Value 2011 2012 2013 2014 2015 Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 3.264 Tax shield horizon value $ 62.2 Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 65.5

32. What Is the value of the Target Firm’s operations to the Acquiring Firm? (In Millions) Value of operations = unlevered value + value of tax shield = 298.9 + 45.5 = $344.4 million

33. What is the value of the Target’sequity? • The Target has $55 million in debt. • Vops + non-operating assets – debt = equity • 344.4 million + 0 – 55 million = $289.4 million = equity value of target to the acquirer.

34. Would another potential acquirer obtain the 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.

35. The Bid Price • Assume the target company has • 20 million shares outstanding. The stock last traded at $11 per share, which reflects the target’s value on a stand-alone basis. How much should the acquiring firm offer?

36. Estimate of target’s value = $289.4 million • Target’s current value = $220.0 million • Merger premium = $ 69.4 million • Presumably, the target’s value is increased by $69.4 million due to merger synergies, although realizing such synergies has been problematic in many mergers. (More...)

37. The offer could range from $11 to $289.4/20 = $14.47 per share. • At $11, all merger benefits would go to the acquiring firm’s shareholders. • At $14.47, all value added would go to the target firm’s shareholders. • The graph on the next slide summarizes the situation.

38. Change in Shareholders’ Wealth Acquirer Target $11.00 $14.47 Price Paid for Target 0 5 10 15 20 Bargaining Range = Synergy

39. Points About Graph • Nothing magic about crossover price. • 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. If not, could be close to $11. (More...)

40. 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. • Do target’s managers have 51% of stock and want to remain in control? • What kind of personal deal will target’s managers get?

41. What if the Acquirer intended to increase the debt level in the Target to 40% with an interest rate of 10%? • Assume debt at the end of 2014 will be $221.6 million. • Free cash flows wouldn’t change • Assume interest payments in short term won’t change (if they did, it is easy to incorporate that difference). Interest in 2015 will change. • Interest2015 = 0.10(221.6) = $22.16 million • Tax Shield2015 = 22.16(0.40) = $8.864 million

42. (TS2015)(1+g) Tax Shield Horizon Value = rsU - g = $8.864(1.06) 0.1156 – 0.06 = $169.0 million. New Tax Shield Horizon Value Calculation

43. 2011 2012 2013 2014 2015 Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 8.864 Tax shield horizon value $ 169.0 Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 177.9 $ 2.6 $ 2.6 $ 2.0 $ 2.8 $177.9 VTS = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $110.5 million. New Tax Shield Value

44. Increase in Tax Shield • The old tax shield value was $45.5 million when the company was financed with 20% debt. • When the company is financed with 40% debt, the tax shield value increases to $110.5 million. The increase is due to the larger interest deductions.

45. New Vops and Vequity Value of operations = unlevered value + value of tax shield = 298.9 + 110.5 = $409.4 million Value of equity = Value of operations + non-operating assets – debt

46. New Equity Value • $409.4 million - $55 million = $354.4 million • This is $65 million, or $3.25 per share more than if the horizon capital structure is 20% debt. • The added value is the value of the additional tax shield from the increased debt.

47. 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. • Shareholders of target firms reap most of the benefits, that is, the final price is close to full value. • Target management can always say no. • Competing bidders often push up prices.

48. What method is used to account for mergers? • Pooling of interests is GONE. Only purchase accounting may be used now.

49. Purchase Accounting • Purchase: • The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value. • Goodwill is often created, which appears as an asset on the balance sheet. • Common equity account is increased to balance assets and claims.

50. Goodwill Amortization • Goodwill is NO LONGER amortized over time for shareholder reporting. • Goodwill is subject to an annual “impairment test.” If its fair market value has declined, then goodwill is reduced. Otherwise it is not. • Goodwill is still amortized for Federal Tax purposes.