FM11 Ch 25 Mergers, LBOs, Divestitures, and Holding Companies

The APV Model Value of firm if it had no debt + Value of tax savings due to debt = Value of operations First term is called the unlevered value of the firm.. APV ModelUnlevered value of

Types of mergers

Merger analysis

Role of investment bankers

LBOs, divestitures, and holding companies

CHAPTER 25

Mergers, LBOs, Divestitures,

and Holding Companies

Synergy: Value of the whole

exceeds sum of the parts Could

arise from:

Operating economies

Financial economies

Differential management efficiency

Taxes (use accumulated losses)

What are some valid economic justifications for mergers?

(More )

Break-up value : Assets would be more valuable if broken up and

sold to other companies.

Purchase of assets at below

replacement cost

Acquire other firms to increase

size, thus making it more difficult

to be acquired

What are some questionable

reasons for mergers?

Friendly merger :

The merger is supported by the

managements of both firms.

Differentiate between hostile and

friendly mergers

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Often, mergers that start out

hostile end up as friendly, when offer price is raised.

Access to new markets and

Antitrust laws can shelter

cooperative R&D activities

Reasons why alliances can make more

sense than acquisitions

Reason for APV

Often in a merger the capital

structure changes rapidly over the first several years.

This causes the WACC to change

from year to year.

It is hard to incorporate year-to-year changes in WACC in the corporate valuation model.

The APV Model

Value of firm if it had no debt

+ Value of tax savings due to debt

= Value of operations

First term is called the unlevered value

of the firm The second term is

called the value of the interest tax

shield

(More )

APV Model

Unlevered value of firm = PV of FCFs discounted at unlevered cost of

equity, r sU

Value of interest tax shield = PV of

interest tax savings at unlevered

cost of equity Interest tax savings = Interest(tax rate) = TS t

Note to APV

APV is the best model to use when

the capital structure is changing.

The Corporate Valuation model is

easier than APV to use when the

capital structure is constant—such

as at the horizon.

Steps in APV Valuation

1 Project FCF t ,TS t , horizon growth rate,

and horizon capital structure.

2 Calculate the unlevered cost of equity,

r sU .

3 Calculate WACC at horizon.

4 Calculate horizon value using constant

growth corporate valuation model.

5 Calculate V ops as PV of FCF t , TS t and

horizon value, all discounted at r sU .

APV Valuation Analysis (In Millions)

2005 2006 2007 2008 Free Cash Flows after Merger Occurs

Interest Tax Savings after Merger

Interest expense 5.0 6.5 6.5 7.0 Interest tax savings 2.0 2.6 2.6 2.8

Interest tax savings are calculated as

interest(T) T = 40%

2005 2006 2007 2008

What are the net retentions?

Recall that firms must reinvest in

order to replace worn out assets and grow.

Net retentions = gross retentions –

depreciation.

 After acquisition, the free cash flows belong

to the remaining debtholders in the target

and the various investors in the acquiring

firm: their debtholders, stockholders, and

others such as preferred stockholders

 These cash flows can be redeployed within

the acquiring firm.

discount rate to apply to the

target’s cash flows?

(More )

Free cash flow is the cash flow that would occur if the firm had no debt,

so it should be discounted at the

unlevered cost of equity.

The interest tax shields are also

discounted at the unlevered cost of equity.

Corporate Valuation Model

 APV discounts FCF at r sU and adds in

present value of the tax shields—the value

of the tax savings are incorporated

explicitly.

 Corp Val Model discounts FCF at WACC,

which has a (1-T) factor to account for the value of the tax shield.

 Both models give same answer IF

carefully done BUT it is difficult to apply the Corp Val Model when WACC is

Discount rate for Horizon Value

At the horizon the capital structure is constant, so the corporate valuation model can be used, so discount

FCFs at WACC.

g) )(1

(FCF 2008

− +

06 0 1084

0

) 06 1 ( 7 20

$

−

2005 2006 2007 2008

Free Cash Flow $11.7 $10.5 $16.5 $ 20.7 Horizon value 453.3 Interest tax shield 2.0 2.6 2.6 2.8 Total $13.7 $13.1 $19.1 $476.8

V Ops = + + +

= $344.4 million

$13.7 (1.1156) 1

$13.1 (1.1156) 2

$19.1 (1.1156) 3

$476.8 (1.1156) 4

What is the value of the Target’s

equity?

The Target has $55 million in debt.

Vops – debt = equity

344.4 million – 55 million = $289.4

million = equity value of target to the acquirer.

No The cash flow estimates would

be different, both due to forecasting inaccuracies and to differential

synergies.

Further, a different beta estimate,

financing mix, or tax rate would

change the discount rate.

obtain the same value?

Assume the target company has

20 million shares outstanding The stock last traded at $11 per share,

which reflects the target’s value on a stand-alone basis How much should

the acquiring firm offer?

Estimate of target’s value = $289.4 million Target’s current value = $220.0million Merger premium = $ 69.4 million

Presumably, the target’s value is

increased by $69.4 million due to

merger synergies, although realizing

such synergies has been problematic

in many mergers.

(More )

 The offer could range from $11 to $289.4/20

= $14.47 per share.

 At $11 , all merger benefits would go to the

acquiring firm’s shareholders.

 At $14.47 , all value added would go to the

target firm’s shareholders.

 The graph on the next slide summarizes the

situation.

0 5 10 15 20

Wealth

Acquirer Target

Bargaining Range = Synergy

Price Paid for Target

Points About Graph

 Nothing magic about crossover price.

 Actual price would be determined by

bargaining Higher if target is in better

bargaining position, lower if acquirer is.

 If target is good fit for many acquirers, other

firms will come in, price will be bid up If

not, could be close to $11.

(More )

Acquirer might want to make high

“preemptive” bid to ward off other

bidders, or low bid and then plan to

go up Strategy is important.

Do target’s managers have 51% of

stock and want to remain in control?

What kind of personal deal will

target’s managers get?

What if the Acquirer intended to

increase the debt level in the Target to

40% with an interest rate of 10%?

Free cash flows wouldn’t change

Assume interest payments in short

term won’t change (if they did, it is

easy to incorporate that difference)

Long term r sL will change, so horizon WACC will change, so horizon value will change.

New WACC Calculation

New Horizon Value Calculation

Horizon value =

=

= $554.1 million.

g WACC

g) )(1

(FCF 2008

− +

06

0 1084

0

) 06

1 ( 7 20

$

−

ops equity

2005 2006 2007 2008

Free Cash Flow $11.7 $10.5 $16.5 $ 20.7 Horizon value 554.1 Interest tax shield 2.0 2.6 2.6 2.8 Total $13.7 $13.1 $19.1 $577.6

V Ops = + + +

= $409.5 million

$13.7 (1.1156) 1

$13.1 (1.1156) 2

$19.1 (1.1156) 3

$577.6 (1.1156) 4

New Equity Value

The added value is the value of the

additional tax shield from the

increased debt

According to empirical evidence,

acquisitions do create value as a result

of economies of scale, other synergies, and/or better management.

Shareholders of target firms reap most

of the benefits, that is, the final price is close to full value.

Target management can always say no.

Competing bidders often push up prices.

Pooling of interests is GONE Only

purchase accounting may be used

now.

What method is used to account for

for mergers?

(More )

The assets of the acquired firm are

“written up” to reflect purchase price if it

is greater than the net asset value.

Goodwill is often created, which appears

as an asset on the balance sheet.

Common equity account is increased to

balance assets and claims.

Goodwill Amortization

Goodwill is NO LONGER amortized

over time for shareholder reporting.

Goodwill is subject to an annual

“impairment test.” If its fair market

value has declined, then goodwill is reduced Otherwise it is not.

Goodwill is still amortized for Federal Tax purposes.

Identifying targets

Arranging mergers

Developing defensive tactics

Establishing a fair value

Financing mergers

Arbitrage operations

activities of investment bankers?

In an LBO , a small group of

investors, normally including

management, buys all of the

publicly held stock, and hence

takes the firm private

Purchase often financed with debt.

After operating privately for a

number of years, investors take

the firm public to “cash out.”

What is a leveraged buyout (LB0)?

Administrative cost savings

Increased managerial incentives

Increased managerial flexibility

Increased shareholder participation

Disadvantages:

Limited access to equity capital

No way to capture return on investment

disadvantages of going private?

Sale of an entire subsidiary to

another firm.

Spinning off a corporate subsidiary

by giving the stock to existing

shareholders.

Carving out a corporate subsidiary

by selling a minority interest.

Outright liquidation of assets.

What are the major types of

divestitures?

Subsidiary worth more to buyer than when operated by current owner.

To settle antitrust issues.

Subsidiary’s value increased if it

operates independently.

To change strategic direction.

To shed money losers.

To get needed cash when distressed.

A holding company is a corporation formed for the sole purpose of

owning the stocks of other

companies.

In a typical holding company, the

subsidiary companies issue their own debt, but their equity is held by the

holding company, which, in turn, sells

What are holding companies?

Control with fractional ownership.

Isolation of risks.

Disadvantages:

Partial multiple taxation.

Ease of enforced dissolution.

disadvantages of holding companies?