Assignment 6 controllership

Mergers: Reshaping the Corporate Landscape

Over the past several years, a series of large mer- gers have reshaped the corporate landscape. These mergers include the $85 billion merger between Exxon and Mobil in 1998, Procter & Gamble’s $55 billion bid for Gillette in 2005, InBev’s $52 billion acquisition of Anheuser-Busch in 2008, and the infamous $160 billion deal between America Online and Time Warner in 2000.

More recently, in 2013 Verizon paid $130 billion for Vodafone’s 45% stake in Verizon Wire- less. And in early 2014, AT&T made a proposal to acquire DirecTV for $48.5 billion, and Comcast made an offer to acquire Time Warner Cable for $45 billion. These proposed deals have attracted criticism from policymakers, consumer groups, and companies such as Netflix who worry about the increased market power created by these mergers.

In recent years, there have also been a num- ber of somewhat smaller, but still noteworthy, deals taking place. These deals include Microsoft’s

acquisition of Skype Global, Google’s purchase of Nest and Motorola’s phone business, Facebook’s buyout of WhatsApp, and Apple’s purchase of Beats Music and Beats Entertainment. In each case, these transactions bring together interesting companies with diverse technologies, but they also have some risk.

Although it will be interesting to see how these deals turn out, it’s worth noting that while target shareholders generally benefit when their firm is acquired, the track record for acquiring firms in large deals has not been very successful. In an article written for The Wall Street Journal shortly after the P&G–Gillette announced deal, David Harding and Sam Rovit discussed the potential pitfalls of large acquisitions. They estimated that only 3 out of 10 large deals in recent years created meaningful benefits for the acquiring firm’s shareholders. Harding and Rovit (who are Bain & Company partners and coauthors of the book titled Mastering the

C H A P T E R

21 Mergers and Acquisitions

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Merger: Four Critical Decisions That Make or Break the Deal) argue that five major criteria will determine whether a merger is successful:

1. Is management successful in deal making? Experienced acquirers tend to do better than firms that make infrequent acquisitions.

2. Will the acquisition strengthen the buyer’s core? Firms tend to do better when they acquire companies that operate in businesses they understand.

3. Did management do its homework? Successful acquirers take time to do the necessary due diligence.

4. Is the company addressing merger integration issues up front? Deals can often unravel because there is no clear plan for how the two management teams are going to be integrated after the acquisition.

5. Is the executive team prepared for the unexpected? History shows that nothing turns out the way it was planned. Successful acquirers anticipate the unexpected and are able to adapt well to changing circumstances.

Sources: Tom Gara, “Comcast: Netflix Is Worried About Its Business Model, Not Its Customers,” The Wall Street Journal (online.wsj.com), April 21, 2014; Shalini Ramachandran, Dana Cimilluca, and Dana Mattioli, “Cable Company Got Its Price, With Tradeoffs,” The Wall Street Journal (online.wsj.com), February 13, 2014; Cecilia Kang Jia Lynn Yang, “Microsoft-Skype Deal to Boost the Online Free-Calling Service,” The Washington Post, May 11, 2011, p. A10; Shayndi Raice, “When Google Met Moto,” The Wall Street Journal, August 17, 2011, pp. B1-B2; David Harding and Sam Rovit, “Five Ways to Spot a Good Deal,” The Wall Street Journal, March 29, 2005, p. B2; and David Harding and Sam Rovit, Mastering the Merger: Four Critical Decisions That Make or Break the Deal (Boston, MA: Bain and Company, Inc., 2004).

Most corporate growth occurs by internal expansion, which takes place when a firm’s existing divisions grow through normal capital budgeting activities. How- ever, the most dramatic examples of growth, and often the largest increases in firms’ stock prices, result from mergers. In this chapter, we will describe various aspects related to corporate mergers.

When you finish this chapter, you should be able to:

• Identify the different types of mergers and the various rationales for mergers. • Conduct a simple analysis to evaluate the potential value of a target firm, and

discuss the various considerations that influence the bid price. • Explain whether the typical merger creates value for the participating

shareholders. • Discuss the value of other transactions such as leveraged buyouts (LBOs),

corporate alliances, and divestitures.

21-1 RATIONALE FOR MERGERS Financial managers and theorists have proposed many reasons for the high level of U.S. merger activity. The primary motives behind corporate mergers are pre- sented in this section.1

1As we use the term, merger means any combination that forms one economic unit from two or more previous ones. For legal purposes, there are distinctions among the various ways these combinations can occur, but our focus is on the fundamental economic and financial aspects of mergers.

Merger The combination of two or more firms to form a single firm.

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21-1A SYNERGY The primary motivation for most mergers is to increase the value of the combined enterprise. If Companies A and B merge to form Company C, and if C’s value exceeds that of A and B taken separately, then synergy is said to exist. Such a merger should be beneficial to both A’s and B’s stockholders.2 Synergistic effects can arise from four sources: (1) operating economies, which result from economies of scale in management, marketing, production, or distribution; (2) financial econo- mies, including lower transactions costs and better coverage by security analysts; (3) differential efficiency, which implies that the management of one firm is more efficient and that the weaker firm’s assets will be more productive after the merger; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase man- agerial efficiency, but mergers that reduce competition are socially undesirable and often illegal.3

21-1B TAX CONSIDERATIONS Tax considerations have stimulated a number of mergers. For example, a profit- able firm in the highest tax bracket could acquire a firm with large accumulated tax losses. These losses could then be turned into immediate tax savings rather than carried forward and used in the future.4 In other cases, cross-border mergers have arisen to take advantage of varying tax rates across countries.5 Also, mergers can serve as a way of minimizing taxes when disposing of excess cash. For example, if a firm has a shortage of internal investment opportunities compared with its free cash flow, it could (1) pay an extra dividend, (2) invest in marketable securities, (3) repurchase its own stock, or (4) purchase another firm. If it pays an extra dividend, its stockholders would have to pay immediate taxes on the distribution. Marketable securities often provide a good place to keep money temporarily, but they generally earn rates of return less than those required by stockholders. A stock repurchase might result in a capital gain for the remaining stockholders. However, using surplus cash to acquire another firm would avoid all these problems, and this has motivated a number of mergers.

21-1C PURCHASE OF ASSETS BELOW THEIR REPLACEMENT COST Sometimes a firm will be touted as an acquisition candidate because the cost of replacing its assets is considerably higher than its market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying other oil companies than by conducting exploratory drilling. Thus, Chevron acquired Gulf Oil to augment its reserves. Similarly, in the 1980s, several steel

2When synergy exists, the whole is greater than the sum of the parts. Synergy is also called the “2 plus 2 equals 5 effect.” The distribution of the synergistic gain between A’s and B’s stockholders is determined by negotiation. This point is discussed later in the chapter. 3In the 1880s and 1890s, many mergers occurred in the United States, and some of them were obviously directed toward gaining market power rather than increasing efficiency. As a result, Congress passed a series of acts designed to ensure that mergers are not used as a method of reducing competition. The principal acts include the Sherman Act (1890), the Clayton Act (1914), and the Celler Act (1950). These acts make it illegal for firms to merge if the merger tends to lessen competition. The acts are enforced by the antitrust division of the Justice Department and by the Federal Trade Commission. For example, AT&T’s planned purchase of T-Mobile was met with opposition from the Department of Justice because the proposed merger would reduce competition in U.S. wireless communication services, and AT&T subsequently dropped its merger bid. 4Mergers undertaken only to use accumulated tax losses would probably be challenged by the IRS. In recent years, Congress has made it increasingly difficult for firms to pass along tax savings after mergers. 5Refer to “The Rush of Firms Fleeing America for Tax Reasons Is Set to Continue,” The Economist (www.economist.com), June 21, 2014.

Synergy The condition wherein the whole is greater than the sum of its parts; in a synergistic merger, the post-merger value exceeds the sum of the separate companies’ pre-merger values.

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company executives stated that it was cheaper to buy an existing steel company than to construct a new mill. For example, LTV (the fourth largest steel company at the time) acquired Republic Steel (the sixth largest steel company at the time), to create the second largest firm in the industry.

21-1D DIVERSIFICATION Managers often cite diversification as a reason for mergers. They contend that diversification helps stabilize a firm’s earnings and thus benefits its owners. Stabilization of earnings is certainly beneficial to employees, suppliers, and cus- tomers, but its value is less certain from the standpoint of stockholders. Why should Firm A acquire Firm B to stabilize earnings when stockholders can simply buy the stock of both firms? Indeed, research of U.S. firms suggests that in most cases, diversification does not increase the firm’s value. To the contrary, many studies find that diversified firms are worth significantly less than the sum of their individual parts.6

21-1E MANAGERS’ PERSONAL INCENTIVES Financial economists like to think that business decisions are based only on economic considerations, especially maximization of firms’ values. However, many business decisions are based more on managers’ personal motivations than on economic analyses. Business leaders like power, and more power is attached to running a larger corporation than a smaller one. Obviously, no executive would admit that his or her ego was the primary reason behind a merger, but egos do play a prominent role in many mergers.

It has also been observed that executive salaries are highly correlated with company size—the larger the company, the higher the salaries of its top officers. This too could play a role in corporate acquisition programs.

Personal considerations deter as well as motivate mergers. After most take- overs, some managers of the acquired companies lose their jobs—or at least their autonomy. Therefore, managers who own less than 51% of their firms’ stock look to devices that will lessen the chances of a takeover. Mergers can serve as such a device. For example, several years ago Paramount made a bid to acquire Time Inc. Time’s managers received a great deal of criticism when they rejected Paramount’s bid and chose instead to enter into a heavily debt-financed merger with Warner Brothers that enabled them to retain power. Such defensive mergers are hard to defend on economic grounds. The managers involved invariably argue that synergy, not a desire to protect their own jobs, motivated the acquisition, but observers suspect that many mergers were designed more to benefit managers than stockholders.

21-1F BREAKUP VALUE Firms can be valued by book value, economic value, or replacement value. Recently, takeover specialists have begun to recognize breakup value as another basis for valuation. Analysts estimate a company’s breakup value, which is the value of the individual parts of the firm if they are sold off separately. If this value is higher than the firm’s current market value, a takeover specialist could acquire the firm at or even above its current market value, sell it off in pieces, and earn a substantial profit.

6See, for example, Philip Berger and Eli Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics, vol. 37 (1995), pp. 37–65; and Larry Lang and Rene Stulz, ‘Tobin’s Q, Corporate Diversification, and Firm Performance,” Journal of Political Economy, vol. 102 (1994), pp. 1248–1280.

Defensive Mergers Mergers designed to make a company less vulnerable to a takeover.

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21-2 TYPES OF MERGERS Economists classify mergers into four types: (1) horizontal, (2) vertical, (3) con- generic, and (4) conglomerate. A horizontal merger occurs when one firm combines with another in its same line of business—the merger between Sirius Satellite Radio and XM Satellite Radio is an example. An example of a vertical merger is a steel producer’s acquisition of one of its own suppliers, such as an iron or coal mining firm, or an oil producer’s acquisition of a petrochemical firm that uses oil as a raw material. Congeneric means “allied in nature or action”; hence, a congeneric merger involves related enterprises, but not producers of the same product (horizontal) or firms in a producer-supplier relationship (ver- tical). The Bank of America and Countrywide Financial merger is such an example. A conglomerate merger occurs when unrelated enterprises combine. Conglomerate mergers tend to produce few, if any synergies, and have become less popular in recent years.

Operating economies (and anticompetitive effects) are at least partially depen- dent on the type of merger involved. Vertical and horizontal mergers generally provide the greatest synergistic operating benefits, but they are also the mergers most likely to be attacked by the Department of Justice as anticompetitive. In any event, it is useful to think of these economic classifications when analyzing pro- spective mergers.

21-3 LEVEL OF MERGER ACTIVITY Five major “merger waves” have occurred in the United States. The first was in the late 1800s, when consolidations occurred in the oil, steel, tobacco, and other basic indus- tries. The second was in the 1920s, when the stock market boom helped financial promoters consolidate firms in a number of industries, including utilities, communica- tions, and autos. The third was in the 1960s, when conglomerate mergers were the rage. The fourth occurred in the 1980s, when LBO and other firms began using junk bonds to finance acquisitions. The fifth, which involves strategic alliances designed to enable firms to compete better in the global economy, is in progress today.

S E L F T E S T

What are the four economic types of mergers?

S E L F T E S T

Define synergy. Is synergy a valid rationale for mergers? Describe several situations that might produce synergistic gains.

Give two examples of how tax considerations can motivate mergers.

Suppose your firm could purchase another firm for only half its replacement value. Would that be a sufficient justification for the acquisition? Explain.

Discuss the pros and cons of diversification as a rationale for mergers.

What is breakup value?

Horizontal Merger A combination of two firms that produce the same type of good or service.

Vertical Merger A merger between a firm and one of its suppliers or customers.

Conglomerate Merger A merger of companies in totally different industries.

Congeneric Merger A merger of firms in the same general industry, but for which no customer or supplier relationship exists.

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Table 21.1 lists some of the large high-profile mergers that have been announced since the late 1990s. In general, those mergers have been significantly different from mergers of the 1980s.7 Most mergers in the 1980s were financial transactions in which buyers sought companies that were selling at less than their true value as a result of incompetent or sluggish management. If a target company could be managed better, if redundant assets could be sold, and if operating and administrative costs could be cut, profits and stock prices would rise. On the other hand, most of the more recent mergers have been strategic in nature—companies are merging to gain economies of scale or scope and thus to be better able to compete in the world economy. Indeed, many recent mergers have involved companies in the financial, airline, defense, media, computer, telecommunications, and health care industries, all of which are experiencing structural changes and intense competition.

TABLE 2 1.1 A Sample of Large Mergers Announced Since the Late 1990s

Buyer Target Announcement Date Value

(Billions, U.S. $)

America Online Time Warner January 10, 2000 $160.0

Vodafone AirTouch Mannesmann November 14, 1999 148.6

BHP Billiton Rio Tinto May 11, 2007 145.3

Verizon Communications Verizon Wireless September 1, 2013 130.0

RBS, Fortis, & Banco Santander ABN-AMRO Holding July 16, 2007 99.4

Pfizer Warner-Lambert November 4, 1999 90.0

Exxon Mobil December 1, 1998 85.2

Bell Atlantic GTE July 28, 1998 85.0

SBC Communications Ameritech May 11, 1998 80.6

Glaxo Wellcome SmithKline Beecham January 18, 2000 76.0

Vodafone AirTouch January 18, 1999 74.4

Royal Dutch Petroleum Shell Trans. & Trading October 28, 2004 74.3

AT&T BellSouth Corp. March 6, 2006 72.7

Travelers Group Citicorp April 6, 1998 70.0

Pfizer Wyeth January 26, 2009 68.4

NationsBank Corp. Bank America Corp. April 13, 1998 62.0

British Petroleum Amoco August 11, 1998 61.7

AT&T MediaOne Group May 6, 1999 61.0

Sanofi-Synthelabo Aventis January 26, 2004 60.2

Pfizer Pharmacia Corporation July 15, 2002 60.0

JPMorgan Chase Bank One January 14, 2004 58.8

Procter & Gamble Gillette January 28, 2005 55.0

InBev Anheuser-Busch June 11, 2008 50.5

*AT&T DirecTV May 18, 2014 48.5

Comcast AT&T Broadband July 8, 2001 47.0

Roche Holding Genentech July 21, 2008 46.8

*Comcast Time Warner Cable February 13, 2014 45.2

*These mergers have only been proposed. As of June 25, 2014, they have not been approved.

Source: Adapted from recent ‘Year-End Review” articles from The Wall Street Journal.

7For detailed reviews of the 1980s merger wave, see Andrei Shleifer and Robert W. Vishny, “The Takeover Wave of the 1980s,” Journal of Applied Corporate Finance, Fall 1991, pp. 49–56; Edmund Faltermayer, “The Deal Decade: Verdict on the ‘80s,” Fortune, August 26, 1991, pp. 58–70; and “The Best and Worst Deals of the ’80s: What We Learned from All Those Mergers, Acquisitions, and Takeovers,” BusinessWeek, January 15, 1990, pp. 52–57.

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Recently, there has also been an increase in cross-border mergers. Many of these mergers have been motivated by large shifts in the value of the world’s leading currencies. For example, many suggest that the recent decline in the U.S. dollar helped spur InBev’s bid for Anheuser-Busch.

21-4 HOSTILE VERSUS FRIENDLY TAKEOVERS In the vast majority of merger situations, one firm (generally the larger of the two) decides to buy another company, negotiates a price with the management of the target firm, and then acquires the target company. Occasionally, the acquired firm will initiate the action, but it is more common for a firm to seek acquisitions than to seek to be acquired.8 Following convention, we call a company that seeks to acquire another firm the acquiring company and the firm that it seeks to acquire the target company.

Once an acquiring company has identified a possible target, it must (1) establish a suitable price or range of prices and (2) tentatively set the terms of payment—will it offer cash, its own common stock, bonds, or some combination of cash and securities? Next, the acquiring firm’s managers must decide how to approach the target company’s managers. If the acquiring firm has reason to believe that the target’s management will approve the merger, it will propose a merger and try to work out suitable terms. If an agreement is reached, the two management groups will issue statements to their stockholders indicating that they approve the merger, and the target firm’s management will recommend to its stockholders that they agree to the merger. Generally, the stockholders are asked to tender (or send in) their shares to a designated financial institution, along with a signed power of attorney that transfers ownership of the shares to the acquiring firm. The target firm’s stockholders then receive the specified payment—common stock of the acquiring company (in which case the target company’s stockholders become stockholders of the acquiring company), cash, bonds, or some mix of cash and securities. This is a friendly merger.

Often, however, the target company’s management resists the merger. Per- haps they think that the price offered is too low, or perhaps they want to keep their jobs. In either case, the acquiring firm’s offer is said to be hostile rather than friendly, and the acquiring firm must make a direct appeal to the target firm’s stockholders. In a hostile merger, the acquiring company will again make a tender offer and again ask the stockholders of the target firm to tender their shares in exchange for the offered price. This time, though, the target firm’s managers will

S E L F T E S T

What five major “merger waves” have occurred in the United States?

What are some reasons for the current merger wave?

Tender Offer The offer of one firm to buy the stock of another by going directly to the stockholders, frequently (but not always) over the opposition of the target company’s management.

Hostile Merger A merger in which the target firm’s management resists acquisition.

Friendly Merger A merger whose terms are approved by the managements of both companies.

Target Company A firm that another company seeks to acquire.

Acquiring Company A company that seeks to acquire another firm.

8However, if a firm is in financial difficulty; if its managers are elderly and do not think that suitable replacements are on hand; or if it needs the support (often the capital) of a larger company, it may seek to be acquired. Thus, when a number of Texas, Ohio, and Maryland financial institutions were in trouble in the 1980s, they lobbied to get their state legislatures to pass laws that would make it easier for them to be acquired. Out-of-state banks then moved in to help salvage the situation and minimize depositor losses.

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urge stockholders not to tender their shares, generally stating that the price offered (cash, bonds, or stocks in the acquiring firm) is too low.

Although most mergers are friendly, a number of interesting cases have involved high-profile firms that have attempted hostile takeovers. For example, Warner- Lambert tried to fight off a hostile bid by Pfizer; however, the merger was completed in 2000. Overseas, Olivetti successfully conducted a hostile takeover of Telecom Italia; and in another telecommunications merger, Britain’s Vodafone AirTouch made a hostile bid for its German rival, Mannesmann AG, which was successful.

21-5 MERGER ANALYSIS In theory, merger analysis is quite simple. The acquiring firm performs an analysis to value the target company and then determines whether the target can be bought at that value or, preferably, for less than the estimated value. The target company, on the other hand, should accept the offer if the price exceeds either its value if it continued to operate independently or the price it could receive from some other bidder. Theory aside, however, some difficult issues are involved. In this section, we discuss valuing the target firm, which is the initial step in a merger analysis. Then we discuss setting the bid price and post-merger control.

21-5A VALUING THE TARGET FIRM Several methodologies are used to value target firms, but we will confine our discussion to the two most common: (1) the discounted cash flow approach and (2) the market multiple method. However, regardless of the valuation methodol- ogy, it is crucial to recognize two facts. First, the target company typically does not continue to operate as a separate entity, but becomes part of the acquiring firm’s portfolio of assets. Therefore, changes in operations affect the value of the business and must be considered in the analysis. Second, the goal of merger valuation is to value the target firm’s equity because a firm is acquired from its owners, not from its creditors. Thus, although we use the expression valuing the firm, our focus is on the value of the equity rather than on total value.

Discounted Cash Flow Analysis The discounted cash flow (DCF) approach to valuing a business involves the application of capital budgeting procedures to an entire firm rather than to a single project. To apply this method, two key items are needed: (1) pro forma statements that forecast the incremental cash flows expected to result from the merger and (2) a discount rate, or cost of capital, to apply to the projected cash flows.

Pro Forma Cash Flow Statements Obtaining accurate post-merger cash flow forecasts is by far the most important task in the DCF approach. In a pure financial merger, in which no synergies are expected, the incremental post- merger cash flows are simply the expected cash flows of the target firm. In an

S E L F T E S T

What’s the difference between a hostile and a friendly merger?

Financial Merger A merger in which the firms involved will not be operated as a single unit and from which no operating economies are expected.

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operating merger, where the two firms’ operations are to be integrated, forecast- ing future cash flows is more difficult.

Table 21.2 shows the projected cash flow statements for Apex Corporation, which is being considered as a target by Hightech, a large conglomerate. The projected data are for the post-merger period, and all synergistic effects have been included. Apex currently uses 50% debt; and if it is acquired, Hightech will keep the debt ratio at 50%. Both Hightech and Apex have a 40% marginal federal-plus- state tax rate.

Lines 1 through 4 of the table show the operating information that Hightech expects for the Apex subsidiary if the merger takes place, and line 5 contains the earnings before interest and taxes (EBIT) for each year. Unlike a typical capital budgeting analysis, a merger analysis usually incorporates interest expense into the cash flow forecast, as shown on line 6. This is done for three reasons: (1) Acquiring firms often assume the debt of the target firm, so old debt at different coupon rates is often part of the deal; (2) the acquisition is often financed partially by debt; and (3) if the subsidiary is to grow in the future, new debt must be issued over time to support the expansion. Thus, debt associated with a merger is typically more complex than the single issue of new debt associated with a

Projected Post-Merger Cash Flow Statements for the Apex Subsidiary as of December 31 (Millions of Dollars)

TABL E 21.2

2015 2016 2017 2018 2019

1. Net sales $105.0 $126.0 $151.0 $174.0 $191.0

2. Cost of goods sold 75.0 89.0 106.0 122.0 132.0

3. Selling and administrative expenses 10.0 12.0 13.0 15.0 16.0

4. Depreciation 8.0 8.0 9.0 9.0 10.0

5. EBIT $ 12.0 $ 17.0 $ 23.0 $ 28.0 $ 33.0

6. Interesta 8.0 9.0 10.0 11.0 11.0

7. EBT $ 4.0 $ 8.0 $ 13.0 $ 17.0 $ 22.0

8. Taxes (40%)b 1.6 3.2 5.2 6.8 8.8

9. Net income $ 2.4 $ 4.8 $ 7.8 $ 10.2 $ 13.2

10. Plus depreciation 8.0 8.0 9.0 9.0 10.0

11. Cash flows $ 10.4 $ 12.8 $ 16.8 $ 19.2 $ 23.2

12. Less retentions needed for growthc 4.0 4.0 7.0 9.0 12.0

13. Plus continuing valued 127.8

14. Cash flows to Highteche $ 6.4 $ 8.8 $ 9.8 $ 10.2 $ 139.0

Notes: aInterest payments are estimates based on Apex’s existing debt plus additional debt required to finance growth. bHightech will file a consolidated tax return after the merger. Thus, the taxes shown here are the full corporate taxes attributable to Apex’s operations. No additional taxes on any cash flows will be passed from Apex to Hightech. cSome of the cash flows generated by the Apex subsidiary after the merger must be retained to finance asset replacements and growth, while some will be transferred to Hightech to pay dividends on its stock or for redeployment within the corporation. These retentions are net of any additional debt used to help finance growth. dApex’s available cash flows are expected to grow at a constant 5% rate after 2019. The value of all post-2019 cash flows as of December 31, 2019, is estimated by use of the constant growth model to be $127.8 million.

V2019 ¼ CF2020 rs � g

¼ ð$23:2 � $12:0Þð1:05Þ 0:142 � 0:05 ¼ $127:8 million

In the next section, we discuss the estimated 14.2% cost of equity. The $127.8 million is the PV at the end of 2019 of the stream of cash flows for Year 2020 and thereafter. eThese are the cash flows projected to be available to Hightech by virtue of the acquisition. The cash flows could be used to make dividend payments to Hightech’s stockholders, to finance asset expansion in Hightech’s other divisions and subsidiaries, and so forth.

Operating Merger A merger in which operations of the firms involved are integrated in hope of achieving synergistic benefits.

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normal capital project, and the easiest way to properly account for the complex- ities of merger debt is to specifically include each year’s expected interest expense in the cash flow forecast. Therefore, we are using what is called the equity residual method to value the target firm. Here the estimated cash flows are residuals that belong solely to the acquiring firm’s shareholders. Therefore, the estimates should be discounted at the cost of equity. This is in contrast to the corporate valuation model of Chapter 9, where the free cash flows (which belong to all investors, not just shareholders) are discounted at the WACC. Using con- sistent underlying assumptions, both methods lead to the same estimate of equity value.

Line 7 contains the earnings before taxes (EBT), and line 8 gives taxes based on Hightech’s 40% marginal rate. Line 9 lists each year’s net income, and depreciation is added back on line 10 to obtain each year’s cash flow, as shown on line 11. Because some of Apex’s assets will wear out or become obsolete and because Hightech plans to expand the Apex subsidiary should the acquisition occur, some equity funds must be retained and reinvested in the business. These retentions, which are not available for transfer to the parent, are shown on line 12. Finally, we have projected only 5 years of cash flows, but Hightech would likely operate the Apex subsidiary for many years—in theory, forever. Therefore, we applied the constant growth model to the 2019 cash flow to estimate the value of all cash flows beyond 2019. (See Note d in Table 21.2.) This “continuing value” represents Apex’s projected value at the end of 2019 and is shown on line 13.

The cash flows shown on line 14 would be available to Hightech’s stock- holders, and they are the basis of the valuation.9 Of course, the post-merger cash flows are extremely difficult to estimate, and in a complete merger valuation, just as in a complete capital budgeting analysis, sensitivity, scenario, and simulation analyses should be conducted. Indeed, in a friendly merger the acquiring firm would send a team consisting of dozens of accountants, engineers, and so forth, to the target firm’s headquarters. They would go over its books, estimate required maintenance expenditures, set values on assets such as real estate and petroleum reserves, and the like. Such an investigation, which is called due diligence, is an essential part of any merger analysis.

Estimating the Discount Rate The bottom-line cash flows shown on line 14 are after interest and taxes; hence, they represent equity. Therefore, they should be discounted at the cost of equity rather than at the overall cost of capital. Further, the discount rate used should reflect the risk of the cash flows in the table. The most appropriate discount rate is Apex’s cost of equity, not that of Hightech or the consolidated post-merger firm.

Although we will not illustrate it here, Hightech could perform a risk analysis on the Table 21.2 cash flows just as it does on any set of capital budgeting cash flows. Sensitivity analysis, scenario analysis, and/or Monte Carlo simulation could be used to give Hightech’s management a feel for the risks involved with the acquisition. Apex is a publicly traded company, so we can assess directly its market risk. Apex’s market-determined pre-merger beta was 1.63. Because the merger would not change Apex’s capital structure or tax rate, the firm’s post- merger beta would remain at 1.63. However, if Apex’s capital structure had changed, the Hamada equation (which was discussed in Chapter 14) could have been used to determine the firm’s new beta corresponding to its changed capital structure.

Equity Residual Method A method used to value a target firm using cash flows that are residuals and belong solely to the acquiring firm’s shareholders.

9We purposely made the cash flows relatively simple to keep the focus on key issues. In an actual merger valuation, the cash flows would be more complex, normally including items such as additional capital furnished by the acquiring firm, tax loss carry-forwards, tax effects of plant and equipment valuation adjustments, and cash flows from the sale of some of the subsidiary’s assets.

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We use the Security Market Line to estimate Apex’s post-merger cost of equity. If the risk-free rate is 6% and the market risk premium is 5%, Apex’s cost of equity, rs, after the merger with Hightech, will be about 14.2%.

10

rs ¼ rRF þ RPMð Þb ¼ 6% þ 5%ð Þ1:63 ¼ 14:15% ¼ 14:2%

Valuing the Cash Flows The current value of Apex’s stock to Hightech is the present value of the cash flows expected from Apex, discounted at 14.2% (in millions of dollars):

V12= 31=14 ¼ $6:4

1:142ð Þ1 þ $8:8

1:142ð Þ2 þ $9:8

1:142ð Þ3 þ $10:2

1:142ð Þ4 þ $139:0

1:142ð Þ5 ¼ $96:5

Thus, the value of Apex’s stock to Hightech is $96.5 million. Note that in a merger analysis, the value of the target consists of the target’s

pre-merger value plus any value created by operating or financial synergies. In this example, we held the target’s capital structure and tax rate constant. There- fore, the only synergies were operating synergies, and these effects were incorpo- rated into the forecasted cash flows. If there had been financial synergies, the analysis would had to have been modified to reflect this added value. For exam- ple, if Apex had been operating with only 30% debt and if Hightech could have lowered Apex’s overall cost of capital by increasing the debt ratio to 50%, Apex’s merger value would have exceeded the $96.5 million calculated previously.

Market Multiple Analysis The second method of valuing a target company is market multiple analysis, which applies a market-determined multiple to net income, earnings per share, sales, or book value, or for businesses such as cable TV or cell phone systems, the number of subscribers. Although the DCF method applies valuation concepts in a precise man- ner focusing on expected cash flows, market multiple analysis is more judgmental. To illustrate the concept, note that Apex’s forecasted net income is $2.4 million in 2015, it rises to $13.2 million in 2019, and averages $7.7 million over the 5-year forecast period. The average P/E ratio for publicly traded companies similar to Apex is 12.5.

To estimate Apex’s value using the market P/E multiple approach, multiply its $7.7 million average net income by the market multiple of 12.5 to obtain the value of $7.7(12.5) ¼ $96.25 million. This is the equity, or ownership, value of the firm. Note that we used the average net income over the next 5 years to value Apex. The market P/E multiple of 12.5 is based on the current year’s income of comparable companies, but Apex’s current income does not reflect synergistic effects or managerial changes that will be made. By averaging future net income, we are attempting to capture the value added by Hightech to Apex’s operations.

Note that measures other than net income can be used in the market multiple approach. For example, another commonly used measure is earnings before interest, taxes, depreciation, and amortization (EBITDA). The procedure is identical to the one

Market Multiple Analysis A method of valuing a target company that applies a market- determined multiple to net income, earnings per share, sales, book value, and so forth.

10In this example, we used the Capital Asset Pricing Model to estimate Apex’s cost of equity; thus, we assumed that investors require a premium for market risk only. We also could have conducted a corporate risk analysis in which the relevant risk would be the contribution of Apex’s cash flows to the total risk of the post-merger firm.

In actual merger situations among large firms, companies usually hire an investment banker to help develop valuation estimates. For example, when General Electric acquired Utah International (UI), GE hired Morgan Stanley to determine UI’s value. We discussed the valuation process with the Morgan Stanley analyst in charge of the appraisal, and he confirmed that Morgan Stanley applied all of the standard procedures discussed in this chapter. Note, though, that merger analysis, like the analysis of any other complex issue, requires judgment, and people’s judgments differ as to how much weight to give to different methods in any given situation.

Chapter 21 Mergers and Acquisitions 727

just described, except that the market multiple is price divided by EBITDA rather than earnings per share, and this multiple is multiplied by Apex’s EBITDA.

As noted, in some businesses such as cable TV and cell phones, an important element in the valuation process is the company’s number of customers. The acquirer has an idea of the cost required to obtain a new customer and the average cash flow per customer. Managed care companies such as HMOs have applied similar logic in acquisitions, basing their valuations on the number of people insured.

21-5B SETTING THE BID PRICE Using the DCF valuation results, $96.5 million is the most Hightech could pay for Apex—if it pays more, Hightech’s own value will be diluted. On the other hand, if Hightech can acquire Apex for less than $96.5 million, Hightech’s stockholders will gain value. Therefore, Hightech will bid something less than $96.5 million when it makes an offer for Apex.

Figure 21.1 graphs the merger situation. The $96.5 million is shown as a point on the horizontal axis, and it is the maximum price that Hightech can afford to pay. If Hightech pays less (say, $86.5 million), its stockholders will gain $10 million from the merger; but if Hightech pays more, its stockholders will lose. What we have then is a 45-degree line that cuts the X-axis at $96.5 million, and that line shows how much Hightech’s stockholders can expect to gain or lose at different acquisition prices.

Now consider the target company, Apex. It has 10 million shares of stock that sell for $6.25, so its value as an independent operating company is presumably $62.5 million. [In making this statement, we assume (1) that the company’s present management is doing a good job of operating the company and (2) that the $6.25 market price per share does not include a “speculative merger premium” in addition to the PV of its operating cash flows.] If Apex is acquired at a price greater than $62.5 million, its stockholders will gain value, whereas they will lose value at any lower price. Thus, we can draw another 45-degree line, this one with an upward slope, to show how the merger price affects Apex’s stockholders.

F I G U R E 2 1 . 1 A View of Merger Analysis (Millions of Dollars)

Hightech (Acquirer) Apex (Target)

Price Paid for Target ($)

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The difference between $62.5 and $96.5 million, or $34 million, represents synergistic benefits expected from the merger. Here are some points to note:

1. If there were no synergistic benefits, the maximum bid would be equal to the current value of the target company. The greater the synergistic gains, the greater the gap between the target’s current price and the maximum the acquiring company could pay.

2. The greater the synergistic gain, the more likely a merger is to be consummated.

3. The issue of how to divide the synergistic benefits is critically important. Obviously, both parties want to get as much as possible. In our example, if Apex’s management knew the maximum price that Hightech could pay, it would argue for a price close to $96.5 million. Hightech, on the other hand, would try to get Apex at a price as close to $62.5 million as possible.

4. Within the $62.5 to $96.5 million range, where will the actual price be set? The answer depends on a number of factors, including whether Hightech offers to pay with cash or securities, the negotiating skills of the two management teams, and (most importantly) the bargaining positions of the two parties as determined by fundamental economic conditions. To illustrate the latter point, suppose Hightech could acquire many companies similar to Apex, but no company other than Hightech could gain synergies by acquiring Apex. In this case, Hightech would probably make a relatively low, take-it-or-leave-it offer, and Apex would probably take it because some gain is better than none. On the other hand, if Apex has some unique technology or some other asset that many companies want, once Hightech announces its offer, other firms will probably make competing bids, and the final price will probably be close to or even above $96.5 million. A price above $96.5 million would presumably be paid by some other company that had a better synergistic fit or perhaps whose management was more optimistic about Apex’s cash flow potential. In Figure 21.1, this situation would be represented by a line parallel to that for Hightech but shifted to the right of the Hightech line.

5. Hightech would, of course, want to keep its maximum bid secret, and it would plan its bidding strategy carefully and consistently with the situation. If it

MORE THAN JUST FINANCIAL STATEMENTS

When corporations merge, they combine more than just their financial statements. Mergers bring together two orga- nizations with different histories and corporate cultures. Deals that look good on paper can fail if the individuals involved are unwilling or unable to work together to gen- erate the potential synergies. Consequently, when analyzing a potential merger, it is important to determine whether the two companies are compatible. Many deals fall apart because, during the “due diligence”

phase, synergistic benefits are revealed to be less than was originally anticipated, so there is little economic rationale for the merger. Other negotiations break off because the two parties cannot agree on the price to be paid for the acquired firm’s stock. In addition, merger talks often collapse because of “social issues.” These social issues include both the “chemistry” of the companies and their personnel and such basic issues as these: What will be the name of the combined company? Where will headquarters be located? And, most important:

Who will run the combined company? Robert Kindler, a part- ner at Cravath, Swaine & Moore, a prominent New York law firm that specializes in mergers, summarizes the importance of these issues as follows: “Even transactions that make absolute economic sense don’t happen unless the social issues work.” Investment bankers, lawyers, and other professionals state

that mergers tend to be most successful if there is a clear and well-arranged plan spelling out who will run the company. This issue is straightforward if one firm is clearly dominant and is acquiring the other. However, in cases where there is “a merger of equals,” senior personnel issues often become sticky. This situation is made considerably easier if one of the chief execu- tives is at or near the retirement age. Some analysts believe that social issues often play too large

a role, derailing mergers that should take place. In other cases where a merger occurs, concerns about social issues preclude managers from undertaking the necessary changes—like lay- ing off redundant staff—for the deal to benefit shareholders.

Source: “In Many Merger Deals, Ego and Pride Play Big Roles in Which Way Talks Go,” The Wall Street Journal, August 22, 1996, p. C1.

Chapter 21 Mergers and Acquisitions 729

thought that other bidders would emerge or that Apex’s management might resist in order to preserve their jobs, it might make a high “preemptive” bid in hopes of scaring off competing bids and/or management resistance. On the other hand, it might make a lowball bid in hopes of “stealing” the company.

We will have more to say about these points in the sections that follow, and you should keep Figure 21.1 in mind as you read the rest of the chapter.

21-5C POST-MERGER CONTROL The employment/control situation is often of vital interest in a merger analysis. First, consider the situation in which a small, owner-managed firm sells out to a larger concern. The owner-manager may be anxious to retain a high-status posi- tion, and he or she may also have developed a camaraderie with the employees and thus be concerned about their retention after the merger. If so, these points would be stressed during the merger negotiations.11 When a publicly owned firm that is not owned by its managers is merged with another company, the acquired firm’s managers will be worried about their post-merger positions. If the acquiring firm agrees to retain the old management, management may be willing to support the merger and to recommend its acceptance to the stockholders. If the old management is to be removed, management will probably resist the merger.12

S E L F T E S T

What is the difference between an operating merger and a financial merger?

Describe the way post-merger cash flows are estimated in a DCF analysis.

What is the basis for the discount rate in a DCF analysis? Describe how this rate might be estimated.

Describe the market multiple approach.

What are some factors that acquiring firms consider when they set a bid price?

How do control issues affect mergers?

Assuming the following facts, what is the value of XYZ Corporation to JKL Enterprises? XYZ’s post-merger cash flows in Years 1–3 are estimated to be $7 million, $10 million, and $12 million, respectively. In addition, its continuing value in Year 3 is $318 million. The firm’s cost of equity is 10%, and its growth rate is 6%. ($262.56 million)

11The acquiring firm may also be concerned about this point, especially if the target firm’s management is quite good. Indeed, a condition of the merger may be that the management team agrees to stay on for a period such as 5 years after the merger. In this case, the price paid may be contingent on the acquired firm’s performance subsequent to the merger. For example, when International Holdings acquired Walker Products, the price paid was an immediate 100,000 shares of International Holdings stock worth $63 per share plus an additional 30,000 shares each year for the next 3 years, provided Walker Products earned at least $1 million during each of those years. Because Walker’s managers owned the stock and would receive the bonus, they had a strong incentive to stay on and help the firm meet its targets.

Finally, if the managers of the target company are highly competent but do not want to remain on after the merger, the acquiring firm may build into the merger contract a noncompete agreement with the old management. Typically, the acquired firm’s principal officers must agree not to affiliate for a specified period with a new business that is competitive with the one they sold (e.g., 5 years). Such agreements are especially important with service-oriented businesses. 12Managements of firms that are thought to be attractive merger candidates often arrange golden parachutes for themselves. Golden parachutes are extremely lucrative retirement plans that take effect if a merger is consummated. Thus, when Bendix Corp. was acquired by Allied Automotive, Bill Agee, Bendix’s chairman, “pulled the ripcord of his golden parachute” and walked away with $4 million. If a golden parachute is large enough, it can also function as a poison pill—for example, where the president of a firm worth $10 million would have to be paid $8 million if the firm is acquired, this will prevent a takeover. Stockholders are increasingly resisting such arrangements, but some still exist.

730 Part 7 Special Topics in Financial Management

21-6 THE ROLE OF INVESTMENT BANKERS Investment bankers are involved with mergers in a number of ways: (1) They help arrange mergers; (2) they help target companies develop and implement defensive tactics; (3) they help value target companies; (4) they help finance mergers; and (5) they invest in the stocks of potential merger candidates. These merger-related activities have been quite profitable. For example, Thomson Reuters estimated that in 2012, financial advisers received $24.7 billion in fees from completed merger transactions. No wonder investment banking houses are able to make top offers to finance graduates! Table 21.3 provides a list of the top merger advisors as of early 2014.

21-6A ARRANGING MERGERS The major investment banking firms have merger and acquisition groups that operate within their corporate finance departments. (Corporate finance depart- ments offer advice, as opposed to underwriting or brokerage services, to business firms.) Members of these groups identify firms with excess cash that might want to buy other firms; companies that might be willing to be bought; and firms that might, for a number of reasons, be attractive to others. Also, if an oil company, for instance, decided to expand into coal mining, it might enlist the aid of an invest- ment banker to help it acquire a coal company. Similarly, dissident stockholders of firms with poor track records might work with investment bankers to oust management by helping to arrange a merger. Investment bankers are reported to have offered financing packages to corporate raiders, where the package included designing the securities to be used in the tender offer, as well as lining up people and firms to buy the target firm’s stock, and then tendering the stock once the final offer was made.

Investment bankers have occasionally taken illegal actions in the merger arena. For example, they are reported to have parked stock—purchasing it for a raider under a guaranteed buy-back agreement—to help the raider de facto

Top Financial Advisors for Worldwide Mergers and Acquisitions Through 1st Quarter, 2014 TABL E 21.3

Rank Firm Number of Deals Value, in Billions

1 Morgan Stanley 64 $227

2 Goldman Sachs 89 209

3 JPMorgan Chase 65 196

4 Bank of America Merrill Lynch 56 159

5 Deutsche Bank 35 134

6 Credit Suisse 44 134

7 Citigroup 48 122

8 Barclays 53 114

9 Centerview Partners 10 92

10 Allen & Company 2 90

11 Paul J. Taubman 1 71

12 LionTree Advisors 4 64

13 Guggenheim Securities 3 63

14 Lazard 51 59

15 Rothschild 52 58

Source: James B. Stewart, “Goldman, Citi, UBS … and a Guy in an Office,” The New York Times (www.nytimes.com), April 18, 2014.

Chapter 21 Mergers and Acquisitions 731

accumulate more than 5% of the target’s stock without disclosing the position. People have gone to jail for this.

21-6B DEVELOPING DEFENSIVE TACTICS Target firms that do not want to be acquired generally enlist the help of an investment banking firm, along with a law firm that specializes in mergers. Defenses include such tactics as (1) changing the bylaws so that only one-third of the directors are elected each year and/or so that a 75% approval (a supermajority) versus a simple majority is required to approve a merger; (2) trying to convince the target firm’s stockholders that the price being offered is too low; (3) raising antitrust issues in the hope that the Justice Department will intervene; (4) repurchasing stock in the open market in an effort to push the price above that being offered by the potential acquirer; (5) getting a white knight who is acceptable to the target firm’s management to compete with the potential acquirer; (6) getting a white squire who is friendly to current management to buy enough of the target firm’s shares to block the merger; and (7) taking a poison pill, as described next.

Poison pills—which occasionally amount to committing economic suicide to avoid a takeover—are tactics such as borrowing on terms that require immediate repayment of all loans if the firm is acquired, selling off at bargain prices the assets that originally made the firm a desirable target, granting such lucrative golden parachutes to their executives that the cash drain from these payments render the merger infeasible, and planning defensive mergers that leave the firm with new assets of questionable value and a huge debt load. Currently, the most popular poison pill is for a company to give its stockholders stock purchase rights that allow them to buy the stock of an acquiring firm at half price should the firm be acquired. The blatant use of poison pills is constrained by directors’ awareness that excessive use may trigger stockholders to bring personal suits against direc- tors who voted for them and perhaps, in the near future, by laws that further limit management’s use of pills. Still, investment bankers and antitakeover lawyers are busy thinking up new poison pill formulas, and others are just as busy trying to come up with antidotes.13

Another takeover defense that is being used is the employee stock ownership plan (ESOP). ESOPs are designed to give lower-level employees an ownership stake in the firm, and current tax laws provide generous incentives for companies to establish such plans and fund them with the firm’s common stock.

21-6C ESTABLISHING A FAIR VALUE If a friendly merger is being worked out between two firms’ managements, it is important to document that the agreed-upon price is a fair one; otherwise, the stockholders of either company may sue to block the merger. Therefore, in most large mergers, each side hires an investment banking firm to evaluate the target company and to help establish the fair price. A recent study of fairness opinions in mergers suggests that advisors working for the acquiring firms tend to produce overly optimistic valuations of the target firm, whereas the advisors working for the target firms tend to produce more accurate estimates of the target’s value. The study also concludes that the market often gains useful information from the fairness opinions provided by the target’s advisors.14

Golden Parachutes Large payments made to the managers of a target firm if it is acquired.

Poison Pill An action that will seriously hurt a company if it is acquired by another.

White Squire An individual or company who is friendly to current management and will buy enough of the target firm’s shares to block a hostile takeover.

White Knight A company that is acceptable to the management of a firm under threat of a hostile takeover and that will compete with the potential acquirer.

13It has become extremely difficult and expensive for companies to buy “directors’ insurance,” which protects the board from such contingencies as stockholders’ suits; and even when insurance is avail- able, it often does not pay for losses if the directors have not exercised due caution and judgment. This exposure is making directors extremely leery of actions that might trigger stockholder suits. 14Matthew D. Cain, “The Information Content of Fairness Opinions in Negotiated Mergers,” 2007 PhD dissertation, Purdue University.

732 Part 7 Special Topics in Financial Management

21-6D FINANCING MERGERS Many mergers are financed with the acquiring company’s excess cash. However, if the acquiring company has no excess cash, it will require a source of funds. Perhaps the single most important factor behind the 1980s merger wave was the development of junk bonds for use in financing acquisitions.

Drexel Burnham Lambert was the primary developer of junk bonds, defined as bonds rated below investment grade (BBB/Baa). Prior to Drexel’s actions, it was almost impossible to sell low-grade bonds to raise new capital. Drexel then pioneered a procedure under which a target firm’s situation would be appraised very closely, and a cash flow projection similar to that in Table 21.2 (but more detailed) would be developed.

To be successful in the mergers and acquisitions (M&A) business, an invest- ment banker must be able to offer a financing package to clients, whether they are acquirers who need capital to take over companies or target companies trying to finance stock repurchase plans or other defenses against takeovers. Drexel was the leading player in the merger financing game during the 1980s, but since Drexel’s bankruptcy, Morgan Stanley, Goldman Sachs, JPMorgan Chase, Bank of America Merrill Lynch, Deutsche Bank, Credit Suisse, and others are continually vying for this title.

21-6E ARBITRAGE OPERATIONS Arbitrage generally means simultaneously buying and selling the same commod- ity or security in two different markets at different prices and pocketing a risk-free return. However, the major brokerage houses, as well as some wealthy private investors, are engaged in a different type of arbitrage called risk arbitrage. The arbitrageurs, or “arbs,” speculate in the stocks of companies that are likely takeover targets. Vast amounts of capital are required to speculate in a large number of securities and thus reduce risk—and to make money on narrow spreads. How- ever, the large investment bankers have the wherewithal to play the game. To be successful, arbs need to be able to sniff out likely targets, assess the probability of offers reaching fruition, and move in and out of the market quickly, incurring low transactions costs.

21-7 DO MERGERS CREATE VALUE? THE EMPIRICAL EVIDENCE All the recent merger activity has raised two questions: (1) Do corporate acquisi- tions create value? (2) If so, how do the parties share the value? Most researchers agree that takeovers increase the wealth of the shareholders of target firms; otherwise, they would not agree to the offer. However, there is a debate as to whether mergers benefit the acquiring firm’s shareholders. In particular, manage- ments of acquiring firms may be motivated by factors other than shareholder wealth maximization. For example, they may want to merge merely to increase the size of the corporations they manage because increased size usually brings larger salaries in addition to job security, perquisites, power, and prestige.

S E L F T E S T

What are some defensive tactics that firms can use to resist hostile takeovers?

What role did junk bonds play in the merger wave of the 1980s?

What is the difference between pure arbitrage and risk arbitrage?

Arbitrage The simultaneous buying and selling of the same commodity or security in two different markets at different prices and pocketing a risk-free return.

Chapter 21 Mergers and Acquisitions 733

The validity of the competing views on who gains from corporate acquisitions can be tested by examining the stock price changes that occur around the time of a merger or takeover announcement. Changes in the stock prices of the acquiring and target firms represent market participants’ beliefs about the value created by the merger and about how that value will be divided between the target and acquiring firms’ shareholders. So examining a large sample of stock price move- ments can shed light on the issue of who gains from mergers.

We cannot simply examine stock prices around merger announcement dates, because other factors influence stock prices. For example, if a merger were announced on a day when the entire market advanced, the fact that the target firm’s price rose would not necessarily signify that the merger was expected to create value. Hence, studies examine abnormal returns associated with merger announcements, where abnormal returns are defined as that part of a stock price change caused by factors other than changes in the general stock market.

Many studies have examined both acquiring and target firms’ stock price responses to mergers and tender offers.15 Jointly, these studies have covered nearly every acquisition involving publicly traded firms from the early 1960s to the present, and they are remarkably consistent in their results: On average, the stock prices of target firms increase by about 30% in hostile tender offers, while in friendly mergers the average increase is about 20%. However, for both hostile and friendly deals, the stock prices of acquiring firms, on average, remain constant. However, as the accompanying box titled “The Track Record of Large Mergers” suggests, abnormal returns vary considerably among mergers, and it is not unu- sual for acquiring firms to see their stock prices fall when mergers are announced. On balance, the evidence indicates (1) that acquisitions do create value but (2) that shareholders of target firms reap virtually all the benefits.

In hindsight, these results are not too surprising. First, because target firm’s shareholders can always say no, they are in the driver’s seat. Second, takeovers are a competitive game, so if one potential acquiring firm does not offer full value for a potential target, another firm will generally jump in with a higher bid. Finally, managements of acquiring firms might be willing to give up all the value created by the merger because the merger would enhance the acquiring managers’ personal positions without harming their shareholders.

It has also been argued that acquisitions may increase shareholder wealth at the expense of bondholders—in particular, there is concern that leveraged buy- outs dilute the claims of bondholders. Specific instances can be cited in which bonds were downgraded, and bondholders did suffer losses, sometimes quite large ones, as a direct result of an acquisition. However, most studies find no evidence to support the contention that bondholders, on average, lose in corpo- rate acquisitions.

S E L F T E S T

Explain how researchers can study the effects of mergers on shareholder wealth.

Do mergers create value? If so, who profits from this value?

Do the research results discussed in this section seem logical? Explain.

15For an excellent summary of the effects of mergers on value, see Michael C. Jensen and Richard S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics, April 1983, pp. 5–50.

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21-8 CORPORATE ALLIANCES Mergers are one way for two companies to join forces, but many companies are striking cooperative deals, called corporate, or strategic, alliances, which stop far short of merging. Whereas mergers combine all of the assets of the firms involved, as well as their ownership and managerial expertise, alliances allow firms to create combinations that focus on specific business lines that offer the most potential synergies. These alliances take many forms, from simple marketing agreements to joint ownership of worldwide operations.

One form of corporate alliance is the joint venture, in which parts of compa- nies are joined to achieve specific, limited objectives.16 A joint venture is controlled by a management team consisting of representatives of the two (or more) parent companies. Joint ventures have been used often by U.S., Japanese, and European firms to share technology and/or marketing expertise. For example, Whirlpool announced a joint venture with the Dutch electronics giant Philips to produce appliances under Philips’s brand names in five European countries.17 By joining with their foreign counterparts, U.S. firms are attempting to gain a stronger foothold in Europe. Although alliances are new to some firms, they are established practices to others. In fact, Corning Inc. began its policy of working with compa- nies through joint ventures during the 1930s.

THE TRACK RECORD OF LARGE MERGERS

Academics have long known that acquiring firm’s share- holders rarely reap the benefits of mergers. However, this important information never seemed to make it up to the offices of corporate America’s decision makers; the 1990s saw bad deal after bad deal, with no apparent awareness on the part of acquisitive executives. BusinessWeek published an analysis of 302 large mergers

from 1995 to 2001, and it found that 61% of them led to losses by the acquiring firms’ shareholders. Indeed, those losing shareholders’ returns during the first post-merger year averaged 25 percentage points less than the returns on other companies within the same industry. The average returns for all merging companies, both winners and losers, were 4.3% below industry averages and 9.2% below the S&P 500 average return. The article cited four common mistakes:

1. The acquiring firms often overpaid. Generally, the acquirers gave away all of the synergies from the mergers to the acquired firms’ shareholders, and then some.

2. Management overestimated the synergies (cost savings and revenue gains) that would result from the merger.

3. Management took too long to integrate operations between the merged companies. This irritated customers and employees alike, and it postponed any gains from the integration.

4. Some companies cut costs too deeply, at the expense of maintaining sales and production infrastructures.

The worst performance came from companies that paid for their acquisitions with stock. The best performance, albeit a paltry 0.3% better than industry averages, came from companies that used cash for their acquisitions. On the bright side, shareholders of the companies that were acquired fared quite well, earning on average 19.3% more than their industry peers, and all of those gains came in the two weeks surrounding the merger announcement.

Source: David Henry, “Mergers: Why Most Big Deals Don’t Pay Off,” BusinessWeek, October 14, 2002, pp. 60–70.

Joint Venture A corporate alliance in which two or more independent companies combine their resources to achieve a specific, limited objective.

Corporate, or Strategic, Alliances Cooperative deals that stop short of a merger.

16Cross-licensing, consortia, joint bidding, and franchising are still other ways for firms to combine resources. For more information on joint ventures, see Sanford V. Berg, Jerome Duncan, and Phillip Friedman, Joint Venture Strategies and Corporate innovation (Cambridge, MA: Oelgeschlager, Gunn and Hain, 1982). 17The joint venture between Whirlpool and Philips began in 1988, with Whirlpool owning 53% of the company. In 1991, Whirlpool became the full owner of Whirlpool International by buying out Philips’s share of the company.

Chapter 21 Mergers and Acquisitions 735

21-9 PRIVATE EQUITY INVESTMENTS Not all target firms are acquired by publicly traded corporations. In recent years, an increasing number of firms, including California Pizza Kitchen, On the Border, Outback Steakhouse, and Neiman Marcus, have been acquired by private equity firms. Private equity firms raise capital from wealthy individuals and look for opportunities to make profitable investments. Today’s leading private equity firms include TPG Capital, Goldman Sachs Principal Investment Area, The Carlyle Group, Kohlberg Kravis Roberts (KKR), and The Blackstone Group. In many cases, these firms engage in a leveraged buyout (LBO) where a small group of investors, which usually includes current management, acquires a firm in a transaction financed largely by debt. The debt is serviced with funds generated by the acquired company’s operations and often by the sale of some of its assets. Sometimes the acquiring group plans to run the acquired company for a number of years, boost its sales and profits, and then take it public again as a stronger company. In other instances, the LBO firm plans to sell divisions to other firms that can gain synergies. In either case, the acquiring group expects to make a substantial profit from the LBO, but the inherent risks are great due to the heavy use of financial leverage.

21-10 DIVESTITURES Although corporations do more buying than selling of productive facilities, a good bit of selling does occur. In this section, we briefly discuss the major types of divestitures, after which we present some examples and rationales for divestitures.

21-10A TYPES OF DIVESTITURES There are four types of divestitures: (1) selling an operating unit to another firm, (2) setting up the business to be divested as a separate corporation and then “spinning it off” to the divesting firm’s stockholders, (3) following the steps for a spin-off but selling only some of the shares, and (4) liquidating assets outright.

Sale to another firm generally involves the sale of an entire division or unit, usually for cash but sometimes for stock of the acquiring firm. In a spin-off, the firm’s existing stockholders are given new stock representing separate ownership rights in the division that was divested. The division establishes its own board of directors and officers, and it becomes a separate company. The stockholders end up owning shares of two firms instead of one, but no cash has been transferred. In a carve-out a minority interest in a corporate subsidiary is sold to new share-

S E L F T E S T

What is the difference between a merger and a corporate alliance?

What is a joint venture? Give some reasons joint ventures may be advantageous to the parties involved.

S E L F T E S T

What is an LBO?

What actions do companies typically take to meet the large debt burdens

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holders, so the parent gains new equity financing yet retains control. Finally, in a liquidation, the assets of a division are sold off piecemeal rather than as an operating entity. To illustrate the different types of divestitures, we present some high-profile examples in the next section.

21-10B DIVESTITURE ILLUSTRATIONS Over the past several decades, there have been a number of high profile divestitures. The table below from The Wall Street Journal provides a summary of the largest spinoffs since 2005.

YEAR

*Renamed CBS Corp. †Estimate ‡Renamed Mondelez Int’l Sources: Dealogic; Keefe, Bruyette & Woods (PayPal estimate) The Wall Street Journal

2008 Altria Group Philip Morris Int’l $106.6

2015 eBay PayPal $31.5†

2013 Abbott Labs $55.5AbbVie

2007 Altria Group $46.2Kraft Foods

2006 Viacom* $32.2Viacom

2009 Time Warner $22.5Time Warner Cable

2007 Tyco Int’l $21.5Covidien

2007 Duke Energy $20.8Spectra Energy

2012 ConocoPhillips $20.7Phillips 66

$26.9Kraft Foods Group2012 Kraft Foods‡

PARENT SPINOFF AND MARKET VALUE IN BILLIONS

PayPal likely would be among the 10 biggest spinoffs since 2005

Big Splits

The Wall Street Journal table was put together in September 2014, the day after eBay’s announced plans to spinoff its PayPal unit in 2015. Shortly thereafter, Hewlett-Packard disclosed plans for a major restructuring where it would split into two companies. One company, HP Inc. with revenue of $57.2 billion, will focus on PCs and printers, while the other company, Hewlett-Packard Enterprise with $58.4 billion in revenue, will focus on higher growth areas such as network- ing, cloud computing, and business consulting.

Apart from these blockbuster deals, some other very interesting deals were announced in 2014. These include:

• Healthcare firm Baxter International announced plans to spin off its biotech arm by mid-2015 to focus on medical products and equipment.

• Chesapeake Energy announced plans to spin off its oilfield services business, which will be called Seventy Seven.

• FMC Corporation, a diversified chemical company, announced plans to spin off its industrial minerals division to focus on its agriculture, health, and nutrition divisions.

Source: Greg Bensinger, David Benoit, and Daisuke Wakabayashi, “Ebay to Split as Apple, Others Prepare to Challenge PayPal,” The Wall Street Journal (online.wsj.com), September 30, 2014.

Liquidation Occurs when the assets of a division are sold off piecemeal, rather than as an operating entity.

Chapter 21 Mergers and Acquisitions 737

• Hertz Global Holdings announced plans to spin off its construction equipment rental business in early 2015.

• SINA Corp., an internet media company that operates Chinese language destination sites, carved out Weibo, a Chinese blogging site and social media platform. Weibo’s first trading day was April 17, 2014. The IPO raised $286 million and was priced at $17 per American depository share (ADS).

Looking back over a longer time period, there have been some other very notable transactions that have shifted the corporate landscape. Here are some examples.

1. Pepsi spun off its fast-food business, which included Pizza Hut, Taco Bell, and Kentucky Fried Chicken. The spun-off businesses operated under the name Tricon Global Restaurants (which was later changed to Yum! Brands Inc.). Pepsi originally acquired the chains because it wanted to increase the distribution channels for its soft drinks. Over time, however, Pepsi began to realize that the soft-drink and restaurant businesses were quite different and synergies between them were less than anticipated. The spin-off was part of Pepsi’s attempt to focus on its core business. However, Pepsi will try to maintain these distribution channels by signing long-term contracts that ensure that Pepsi products will be sold exclusively in each of the three spun-off chains.

2. United Airlines sold its Hilton International Hotels subsidiary to Ladbroke Group PLC of Britain for $1.1 billion and sold its Hertz rental car unit and its Westin hotel group. The sales culminated a disastrous strategic move by United to build a full-service travel empire. The failed strategy resulted in the firing of Richard J. Ferris, the company’s chairman at that time.

3. General Motors (GM) spun off its Electronic Data Systems (EDS) subsidiary. EDS, a computer services company founded in 1962 by Ross Perot, prospered as an independent company until it was acquired by GM in 1984. The rationale for the acquisition was that EDS’s expertise would help GM operate better in the information age and build cars that encompassed leading-edge computer technology. However, the spread of desktop computers and the movement of companies to downsize their internal computer staffs caused EDS’s non-GM business to soar. Ownership by GM hampered EDS’s ability to strike alliances and, in some cases, to enter into business agreements. The best way for EDS to compete in its industry was as an independent company; hence, it was spun off.

4. AT&T was broken up in 1983 to settle a Justice Department antitrust suit filed in the 1970s.18 The breakup was designed to strengthen competition and thus speed up technological change in those parts of the telecommunications industry that were not natural monopolies. Ironically, on November 18, 2005, SBC Communications, which can trace its roots back to the original Bell Telephone Co., acquired AT&T for $16 billion. The “new” firm, AT&T Inc., is a global telecommunications company.

As the preceding examples illustrate, the reasons for divestitures vary widely. Sometimes stock analysts and investors feel more comfortable when firms “stick to their knitting”; the Pepsi and United Airlines divestitures are examples. Other companies need cash to finance expansion in their primary business lines or to reduce a large debt burden, and divestitures can be used to raise this cash. The divestitures also show that running a business is a dynamic process—conditions change, and corporate strategies change in response; as a result, firms alter their asset portfolios by acquisitions and/or divestitures.

18Another forced divestiture involved DuPont and General Motors. In 1921, GM was in serious financial trouble and DuPont supplied capital in exchange for 23% of the stock. In the 1950s, the Justice Department won an antitrust suit that required DuPont to spin off (to DuPont’s stockholders) its GM stock.

738 Part 7 Special Topics in Financial Management

This chapter included discussions of mergers, divestitures, and LBOs. The majority of the discussion in this chapter was about mergers. We discussed the rationale for mergers, different types of mergers, the level of merger activity, and merger analysis. We showed how to use two different approaches to value the target firm: discounted cash flow and market multiple analyses. We also explained how the acquiring firm can structure its takeover bid and investment bankers’ roles in arranging and financing mergers. In addition, we discussed two cooperative arrangements that fall short of mergers: corporate, or strategic, alliances and joint ventures.

S E L F T E S T

Identify and briefly explain the four types of divestitures.

(Solutions Appear in Appendix A)

ST-1 KEY TERMS Define each of the following terms:

a. Synergy; merger b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger c. Friendly merger; hostile merger; defensive merger; tender offer; target company;

breakup value; acquiring company d. Operating merger; financial merger; equity residual method; market multiple analysis e. White knight; white squire; poison pill; golden parachute f. Arbitrage g. Joint venture; corporate, or strategic, alliance h. Divestiture; spin-off; leveraged buyout (LBO); carve-out; liquidation

ST-2 MERGER VALUE Pizza Place, a national pizza chain, is considering purchasing a smaller chain, Western Mountain Pizza. Pizza Place’s analysts project that the merger will result in incremental cash flows of $1.5 million in Year 1, $2 million in Year 2, $3 million in Year 3, and $5 million in Year 4. In addition, Western’s Year 4 cash flows are expected to grow at a constant rate of 5% after Year 4. Assume that all cash flows occur at the end of the year. The acquisition will be made immediately if it is undertaken. Western’s post-merger beta is estimated to be 1.5, and its post-merger tax rate would be 40%. The risk-free rate is 6%, and the market risk premium is 4%. What is the value of Western Mountain Pizza to Pizza Place?

QUESTIONS

21-1 Four economic classifications of mergers are (1) horizontal, (2) vertical, (3) conglomerate, and (4) congeneric. Explain the significance of these terms in merger analysis with regard to (a) the likelihood of governmental intervention and (b) possibilities for operating synergy.

Chapter 21 Mergers and Acquisitions 739

21-2 Firm A wants to acquire Firm B. Firm B’s management agrees that the merger is a good idea. Might a tender offer be used? Why or why not?

21-3 Distinguish between operating mergers and financial mergers.

21-4 In the spring of 1984, Disney Productions’ stock was selling for about $3.125 per share. (All prices have been adjusted for 4-for-l splits in 1986 and 1992.) Then Saul Steinberg, a New York financier, began acquiring it; after he had 12%, he announced a tender offer for another 37% of the stock—which would bring his holdings up to 49%—at a price of $4.22 per share. Disney’s management then announced plans to buy Gibson Greeting Cards and Arvida Corporation, paying for them with stock. It also lined up bank credit and (according to Steinberg) was prepared to borrow up to $2 billion and use the funds to repurchase shares at a higher price than Steinberg was offering. All of these efforts were designed to keep Steinberg from taking control. In June, Disney’s management agreed to pay Steinberg $4.84 per share, which gave him a gain of about $60 million on a 2-month investment of about $26.5 million.

When Disney’s buyback of Steinberg’s shares was announced, the stock price fell almost instantly from $4.25 to $2.875. Many Disney stockholders were irate, and they sued to block the buyout. Also, the Disney affair added fuel to the fire in a congressional committee that was holding hearings on proposed legislation that would (1) prohibit someone from acquiring more than 10% of a firm’s stock without making a tender offer for all the remaining shares; (2) prohibit poison pill tactics such as those Disney’s management had used to fight off Steinberg; (3) prohibit buybacks, such as the deal eventually offered to Steinberg, (greenmail) unless there was an approving vote by stockholders; and (4) prohibit (or substantially curtail) the use of golden parachutes (the one thing Disney’s management did not try).

Set forth the arguments for and against this type of legislation. What provisions, if any, should it contain? Also, look up Disney’s current stock price to see how its stockholders have fared. Note that Disney’s stock was split 3-for-l in July 1998.

21-5 Two large, publicly owned firms are contemplating a merger. No operating synergy is expected. However, because returns on the two firms are not perfectly positively correlated, the standard deviation of earnings would be reduced for the combined corporation. One group of consultants argues that this risk reduction is sufficient grounds for the merger. Another group thinks that this type of risk reduction is irrelevant because stockholders can hold the stock of both companies and thus gain the risk-reduction benefits without all the hassles and expenses of the merger. Whose position is correct? Explain.

PROBLEMS

The following information is required to work problems 21-1, 21-2, and 21-3.

Harrison Corporation is interested in acquiring Van Buren Corporation. Assume that the risk-free rate of interest is 5%, and the market risk premium is 6%.

21-1 VALUATION Van Buren currently expects to pay a year-end dividend of $2.00 a share D1 ¼ 2:00Þð . Van Buren’s dividend is expected to grow at a constant rate of 5% a year, and its beta is 0.9. What is the current price of Van Buren’s stock?

21-2 MERGER VALUATION Harrison estimates that if it acquires Van Buren, the year-end dividend will remain at $2.00 a share, but synergies will enable the dividend to grow at a constant rate of 7% a year (instead of the current 5%). Harrison also plans to increase the debt ratio of what would be its Van Buren subsidiary; the effect of this would be to raise Van Buren’s beta to 1.1. What is the per-share value of Van Buren to Harrison Corporation?

21-3 MERGER BID On the basis of your answers to problems 21-1 and 21-2, if Harrison were to acquire Van Buren, what would be the range of possible prices it could bid for each share of Van Buren common stock?

21-4 MERGER ANALYSIS Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded company, and its current beta is 1.30. Vaccaro has been barely profitable, so it has paid an average of only 20% in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just 25%.

Easy Problems 1–3

Intermediate Problems 4–5

740 Part 7 Special Topics in Financial Management

If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Apilado also would increase the debt capitalization in the Vaccaro subsidiary to 40% of assets, which would increase its beta to 1.47. Apilado’s acquisition department estimates that Vaccaro, if acquired, would produce the following cash flows to Apilado’s shareholders (in millions of dollars):

Year Cash Flows

1 $1.30

2 1.50

3 1.75

4 2.00

5 and beyond Constant growth at 6%

These cash flows include all acquisition effects. Apilado’s cost of equity is 14%, its beta is 1.0, and its cost of debt is 10%. The risk-free rate is 8%.

a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Apilado’s rs to determine the market risk premium.)

b. What is the dollar value of Vaccaro to Apilado? c. Vaccaro has 1.2 million common shares outstanding. What is the maximum price per

share that Apilado should offer for Vaccaro? If the tender offer is accepted at this price, what will happen to Apilado’s stock price?

21-5 CAPITAL BUDGETING ANALYSIS The Stanley Stationery Shoppe wants to acquire The Carlson Card Gallery for $400,000. Stanley expects the merger to provide incremental earnings of about $64,000 a year for 10 years. Ken Stanley has calculated the marginal cost of capital for this investment to be 10%. Conduct a capital budgeting analysis for Stanley to determine whether he should purchase The Carlson Card Gallery.

21-6 MERGER ANALYSIS TransWorld Communications Inc., a large telecommunications com- pany, is evaluating the possible acquisition of Georgia Cable Company (GCC), a regional cable company. TransWorld’s analysts project the following post-merger data for GCC (in thousands of dollars):

2015 2016 2017 2018

Net sales $450 $518 $555 $600

Selling and administrative expense 45 53 60 68

Interest 18 21 24 27

Tax rate after merger 35%

Cost of goods sold as a percent of sales 65%

Beta after merger 1.50

Risk-free rate 8%

Market risk premium 4%

Continuing growth rate of cash flow available to TransWorld 7%

If the acquisition is made, it will occur on January 1, 2015. All cash flows shown in the income statements are assumed to occur at the end of the year. GCC currently has a capital structure of 40% debt, but Trans World would increase that to 50% if the acquisition were made. GCC, if independent, would pay taxes at 20%; but its income would be taxed at 35% if it were consolidated. GCC’s current market-determined beta is 1.40, and its investment bankers think that its beta would rise to 1.50 if the debt ratio were increased to 50%. The cost of goods sold is expected to be 65% of sales, but it could vary somewhat. Depreciation-generated funds would be used to replace worn- out equipment, so they would not be available to TransWorld’s shareholders. The risk- free rate is 8%, and the market risk premium is 4%.

a. What is the appropriate discount rate for valuing the acquisition? b. What is the continuing value? c. What is the value of GCC to TransWorld?

Challenging Problem 6

Chapter 21 Mergers and Acquisitions 741

COMPREHENSIVE/SPREADSHEET PROBLEM

21-7 MERGER ANALYSIS Use the spreadsheet model to rework problem 21-6, and then answer the following question:

a. Suppose GCC has 120,000 shares outstanding. What is the maximum per-share price TransWorld should offer for GCC?

SMITTY’S HOME REPAIR COMPANY

21-8 MERGER ANALYSIS Smitty’s Home Repair Company, a regional hardware chain that specializes in do-it-yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Linda Wade, Smitty’s treasurer and your boss, has been asked to place a value on a potential target, Hill’s Hardware, a small chain that operates in an adjacent state, and she has enlisted your help.

Table IC 21.1 indicates Wade’s estimates of Hill’s earnings potential if it comes under Smitty’s manage- ment (in millions of dollars). The interest expense listed here includes the interest (1) on Hill’s existing debt, (2) on new debt that Smitty’s would issue to help finance the acquisition, and (3) on new debt expected to be issued over time to help finance expansion within the new “H division,” the code name given to the target firm. The retentions represent earnings that will be reinvested within the H division to help finance its growth.

Hill’s Hardware currently uses 40% debt financing, and it pays federal-plus-state taxes at a 30% rate. Security analysts estimate Hill’s beta to be 1.2. If the acquisition were to take place, Smitty’s would increase Hill’s debt ratio to 50%, which would increase Hill’s beta to 1.3. Further, because Smitty’s is highly profitable, taxes on the consolidated firm would be 40%. Wade realizes that Hill’s Hardware also generates depreciation cash flows, but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.

Wade estimates the risk-free rate to be 9% and the market risk premium to be 4%. She also estimates that cash flows after 2018 will grow at a constant rate of 6%. Smitty’s management is new to the merger game, so Wade has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Wade has developed the following questions, which you must answer and then defend to Smitty’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, and (5) synergy. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.

b. Briefly describe the differences between a hostile merger and a friendly merger. c. Use the data developed in Table IC 21.1 to construct the H division’s cash flow statements for 2015

through 2018. Why is interest expense deducted in merger cash flow statements, whereas it is not normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement?

d. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate?

e. What is the estimated continuing value of the acquisition; that is, what is the estimated value of the H division’s cash flows beyond 2018? What is Hill’s value to Smitty’s? Suppose another firm were evaluating Hill’s as an acquisition candidate. Would it obtain the same value? Explain.

f. Assume that Hill’s has 10 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $9 per share. Should Smitty’s make an offer for Hill’s? If so, how much should it offer per share?

g. What merger-related activities are undertaken by investment bankers?

742 Part 7 Special Topics in Financial Management

Estimates of Hill’s Hardware Data for Merger Analysis TABL E I C 2 1.1

2015 2016 2017 2018

Net sales $60.0 $90.0 $112.5 $127.5

Cost of goods sold (60%) 36.0 54.0 67.5 76.5

Selling/administrative expense 4.5 6.0 7.5 9.0

Interest expense 3.0 4.5 4.5 6.0

Necessary retained earnings 0.0 7.5 6.0 4.5

Use online resources to work on this chapter’s questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions.

USING DEALBOOK TO FOLLOW RECENT MERGER AND ACQUISITIONS ANNOUNCEMENTS

This chapter discussed the rationale for mergers, different types of mergers, and merger analysis. The chapter also presented some data on recent merger activity. To answer these questions, you should use The New York Times website.

1. Once on The New York Times website, go to the Business section. Then click Dealbook and select Mergers and Acquisitions. What new mergers have been announced? Select one and provide the terms of the merger.

2. Have there been any merger bids that have been dropped? Why?

3. Are there any firms that are competing for the same target? Who are the competing firms, and who is the target company?

Chapter 21 Mergers and Acquisitions 743