Assignment 6 controllership

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Mergers and Divestitures

Types of Mergers Merger Analysis Continuing Value

Shareholder Wealth Role of Investment Bankers

Mergers-Acquisitions

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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What are some good reasons for mergers?

• Synergy: value of the whole exceeds sum of the parts. Could arise from: – Operating economies – Financial economies – Differential management efficiency – Increased market power – Taxes (use accumulated losses)

• Break-up value: assets would be more valuable if sold to some other company.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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What are some questionable reasons for mergers?

• Diversification • Purchase of assets at below-replacement cost • Get bigger using debt-financed mergers to help

fight off takeovers

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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What is the difference between a “friendly” and a “hostile” merger?

• Friendly merger – The merger is supported by the managements of

both firms. • Hostile merger

– Target firm’s management resists the merger. – Acquirer must go directly to the target firm’s

stockholders and try to get 51% to tender their shares.

– Often, mergers that start out hostile end up as friendly when offer price is raised.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Merger Analysis: Post-Merger Cash Flow Statements

2015 2016 2017 2018 Net sales $60.0 $90.0 $112.5 $127.5 - Cost of goods sold 36.0 54.0 67.5 76.5 - Selling/admin exp 4.5 6.0 7.5 9.0 - Interest expense 3.0 4.5 4.5 6.0 EBT 16.5 25.5 33.0 36.0 - Taxes 6.6 10.2 13.2 14.4 Net income 9.9 15.3 19.8 21.6 Retentions 0.0 7.5 6.0 4.5 Cash flow 9.9 7.8 13.8 17.1

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Why is interest expense included in the analysis?

• Debt associated with a merger is more complex than the single issue of new debt associated with a normal capital project. – Acquiring firms often assume the debt of the

target firm, so old debt at different coupon rates is often part of the deal.

– The acquisition is often financed partially by debt.

– If the subsidiary is to grow in the future, new debt will have to be issued over time to support the expansion.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Why are earnings retentions deducted in the analysis?

• If the subsidiary is to grow, not all income may be assumed by the parent firm. – Like any other company, the subsidiary must

reinvest some its earnings to sustain growth.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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What is the appropriate discount rate to apply to the target’s cash flows?

• Estimated cash flows are residuals which belong to the acquirer’s shareholders.

• They are riskier than the typical capital budgeting cash flows. Because fixed interest charges are deducted, this increases the volatility of the residual cash flows.

• Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Discounting the Target’s Cash Flows

• The cash flows reflect the target’s business risk, not the acquiring company’s.

• However, the merger will affect the target’s leverage and tax rate, hence its financial risk.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Calculating Continuing Value

• Find the appropriate discount rate

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%2.14)3.1%)(4(%9 b)rr(rr TargetRFMRF(Target)s

=+=

−+=

million 0.221$ )06.0142.0/()06.1(1.17$

)gr/()g1(CFvalue Continuing s20182018

= −=

−+= • Determine continuing value

INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash Flow Stream

2015 2016 2017 2018 Annual cash flow $9.9 $7.8 $13.8 $ 17.1 Continuing value 221.0 Cash flow $9.9 $7.8 $13.8 $238.1

• Value of target firm – Enter CFs in calculator CFLO register, and enter

I/YR = 14.2%. Solve for NPV = $163.9 million

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Would another acquiring company obtain the same value?

• No. The input estimates would be different, and different synergies would lead to different cash flow forecasts.

• Also, a different financing mix or tax rate would change the discount rate.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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The Target Firm Has 10 Million Shares Outstanding at a Price of $9.00 per Share

• What should the offering price be? – The acquirer estimates the maximum price they

would be willing to pay by dividing the target’s value by its number of shares:

• Offering range is between $9 and $16.39 per share.

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$16.39 million million/10 $163.9

shares of value/# sTarget'price Max.

= = =

INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Making the Offer

• The offer could range from $9 to $16.39 per share.

• At $9 all the merger benefits would go to the acquirer’s shareholders.

• At $16.39, all value added would go to the target’s shareholders.

• Acquiring and target firms must decide how much wealth they are willing to forego.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Shareholder Wealth in a Merger

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Shareholders’ Wealth

Acquirer Target

Bargaining Range

Price Paid for Target

$9.00 $16.39

0 5 10 15 20

INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Shareholder Wealth

• Nothing magic about crossover price from the graph.

• 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 $9.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Shareholder Wealth

• Acquirer might want to make high “preemptive” bid to ward off other bidders, or make a low bid and then plan to increase it. It all depends upon its strategy.

• Do target’s managers have 51% of stock and want to remain in control?

• What kind of personal deal will target’s managers get?

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Do mergers really create value?

• The evidence strongly suggests: – 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, because of competitive bids.

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE

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Functions of Investment Bankers in Mergers

• Arranging mergers • Assisting in defensive tactics • Establishing a fair value • Financing mergers • Risk arbitrage

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INTRO MERGER TYPES SHRHLDR WEALTH MERGER ANALYSIS INVESTMT BNKRS CONTINUING VALUE