Practical financial management lasher 7th ed chapter 017

Why Unfriendly Mergers are Unfriendly A target's management may resist a takeover because: – Acquiring firm offered too low a price for the stock – Target’s management often loses jobs,

Mergers and Acquisitions

Merger – a combination of two or more businesses under one ownership

Acquisition or Takeover - one firm acquires the stock of another

– Acquired firm is the target

Consolidation - combining firms dissolve forming a new legal entity

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Figure 17-1 Basic Business Combinations

Mergers and Acquisitions

Relationships

– Consolidation implies the firms combined willingly

– Acquisition can be a friendly or hostile takeover

Stockholders

– Must be willing to give up their shares for the offered price

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Mergers and Acquisitions

Friendly Procedure

– Target firm's management

approves and cooperates with

– Acquiring firm makes a tender offer

to the target's shareholders

Why Unfriendly Mergers

are Unfriendly

A target's management may resist a takeover because:

– Acquiring firm offered too low a price for the stock

– Target’s management often loses jobs, power, and influence

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Economic Classification of Business Combinations

Role of Investment Banks

Help companies issue securities

Instrumental in acting as advisors to acquiring companies Assist in establishing a value for target

Help acquiring firm raise money for acquisition

Advise reluctant targets on defensive measures

The Antitrust Laws

U.S is committed to a competitive economy

Antitrust laws (enacted 1890 - 1930s) prohibit certain activities that can reduce competitive nature of the economy

Mergers have potential to reduce competition

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The Reasons Behind Mergers

– External growth through acquisition is faster than internal growth

Diversification to Reduce Risk

– Collection of diverse businesses less risky than a single line

– Variations in different business lines offset each other

The Reasons Behind Mergers

Economies of Scale

Guaranteed Sources and Markets

Acquiring Assets Cheaply

Tax Losses

Ego and Empire

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Tax Losses

Combined Businesses pay less total tax.

But IRS will not recognize if sole purpose is to reduce tax.

$650 ($1,000)

$1,400 Net Income

350 -0-

700 Tax (35%)

$1,000 ($1,000)

$2,000 EBT

Merged Poor Inc.

Rich Inc.

Holding Companies

Corporation that owns other corporations

– Companies owned are subsidiaries

– Holding company is the parent of the subsidiary

Advantages

– Keeps business operations separate and distinct

– Can keep liabilities of subsidiaries separate

– It’s possible to control a subsidiary without owning all of its stock

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The History of Merger Activity in the U.S

Wave 1: The Turn of the Century, 1897-1904

– Horizontal mergers transformed the U.S into a nation of industrial giants, with some monopolies

Wave 2: The Roaring Twenties, 1916-1929

– Began with World War I and ended with the stock market crash of 1929

– Horizontal mergers led to oligopolies

The History of Merger Activity in the U.S

Wave 3: The Swinging Sixties, 1965-1969

– Conglomerate mergers - unrelated fields

– Stock market driven

An Important Development During the 1970s

– Hostile takeovers uncommon prior to 1970s

– 1974 INCO acquires ESB assisted by respected investment bank Morgan Stanley

– After that hostile takeovers became acceptable

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The History of Merger Activity in the U.S.

Wave 4: Megamergers, 1981 – 1990

– Very large firms, often industry leaders, merge

Wave 5: Globalization, 1992 – 2000

– Large number of international mergers

Wave 6: Private Equity, 2003 – 2008

– Private equity groups bought companies for financial reasons

– Ended with the financial crisis of 2008

Mergers since the 1980s

Mergers since the 1980s are characterized by:

Megamergers since the 1980s

Companies Year Industry $ Size

Citicorp and Travelers 1988 Financial Services $140 billion MCI and WorldCom 1998 Telecom $ 37 billion Daimler-Benz and Chrysler 1998 Automotive $ 75 billion AOL and Time Warner 2000 Media and Entertainment $ 350 billion Hewlett-Packard and Compaq 2001 Computer hardware $ 25 billion

Social, Economic, and Political Effects

Large mergers have implications regarding the concentration of power and influence

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Merger Analysis and the

Price Premium

What is the most an acquiring company should pay for a target in total and per share?

– Merger analysis attempts to answer this question

– Acquiring firm forecasts the target's cash flows and chooses

appropriate discount rate

Merger Analysis and the

Price Premium Estimating Merger Cash Flows

– Should be a straightforward cash flow estimation with two exceptions

Adjustments for expected synergies

Adjustments for reinvestment necessary to support growth

– Pitfalls of estimating cash flows

May not have access to the target's detailed information about future

prospects or the past

Uncertainty of future

Biases of people making estimates

– Acquirer tends to overestimate target’s value

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Merger Analysis

Appropriate Discount Rate

– An acquisition is an equity transaction

– Use target’s estimated equity rate (CAPM)

Value to the Acquirer is the PV of estimated cash flows from target

– Maximum value makes NPV=0 if viewed in capital budgeting terms

Payment for target’s stock is C0 – the initial outlay

Maximum Per-share Price is Maximum PV ÷ number shares

Merger Analysis and the

Price Premium

Price Premium

– The price offered to target shareholders must be higher than the stock's market price

High enough to induce stockholders to sell now

Offering price exceeds the current market price by the price premium

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The Price Premium

Effect on market price

– Certainty of a premium creates a speculative opportunity

– Investor strategy - buy stock in potential takeover targets to get premium

– Size of Premium is the Point of negotiations

Remember: Insider trading illegal

Calculating a Price and the Problem of

Terminal Values

Remember

In merger analysis, C0 is the amount acquirer will pay for the target’s stock

If the merger is to make sense for the acquirer, C0 must be no more than the sum of the PVs of all the other Cs

The maximum price makes NPV=0

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Concept Connection Example 17-1

Basic Merger Analysis

Alpha is interested in acquiring Beta The appropriate interest rate for the analysis is 12% Beta’s cash flows including synergies are estimated for the next three years as follows ($000).

Beta has 12,000 shares of stock outstanding

What is the maximum price Alpha should be willing to pay for a share of Beta’s stock?

Concept Connection Example 17-1

Basic Merger Analysis

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Solution: T he PV of Beta’s cash flows is:

The maximum Alpha should pay for all of Beta’s stock is $531,914

the maximum per share price Alpha should be willing to pay is:

Maximum acquisition price = $531,914/12,000 = $44.33

Merger Analysis with Terminal Values

Justifying a merger based on a few years of cash flows can be difficult

Acquisition looks better by assuming cash flows after the last year E.g.

– Sale of the target at a high price

– Continuing operating cash flows for a long time or indefinitely

Constant

Growing

Terminal Values (TVs)

TVs can overwhelm detailed forecast.

– Especially an infinite stream of income

TV is valued as the PV of a perpetuity starting at end of detailed forecast.

– TVs are favored by people who want the acquisition for non financial reasons

– It’s up to Finance (CFO) to keep the assumptions reasonable

Terminal Value assumptions often lead to overpaying for an

acquisition

Paying for the Acquisition The Junk Bond Market

Acquiring firm pays the target firm:

– Cash – have it or raise it

– Stock in the acquiring firm

– Debt of the acquiring firm

Junk bond market began in the 1980s and has helped firms raise cash to finance many mergers

Paying for the Acquisition The Junk Bond Market

Junk bonds are low quality (risky) bonds that pay high yields

Prior to 1980s small, risky companies could not borrow via bonds

– Investment bankers pooled risky bonds into funds creating the junk bond market

– The idea collapsed in the late 1980s

Since 1990’s, high yield debt has reemerged

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The Capital Structure Argument to Justify High Premiums

Using debt to raise cash for buying out a target's stockholders, makes the firm more leveraged

– It can be argued that this increases its value

See Chapter 14 on capital structure and leverage

-The Effect of Paying Too Much

– An acquiring firm that pays too much for a target transfers value from its shareholders to the target’s shareholders

Defensive Tactics:

After a Takeover is Underway

Defensive Tactics are things targets do to keep from being acquired

Tactics After a Takeover is Under Way

– Challenge the price

– Claim an antitrust violation

– Seek a white knight

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Defensive Tactics:

In Anticipation of a Takeover

Tactics in Anticipation of a Takeover

– Staggered Election of Directors

Leveraged Buyouts (LBOs)

Investors take a company private by buying all of its stock largely using borrowed money

Tends to be risky due to high debt burden

Less common today than in the 1980s

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A company decides to get rid of a particular business operation

– Reasons for divestitures

A firm needs cash

A division may not fit strategically into the firm's long-term plans Poor performance

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Methods of Divesting Companies

– Sale for cash and/or securities

can trade separately

– Liquidation —the divested business is closed down and its assets sold

Failure and Insolvency

Economic failure —a firm is unable to provide adequate return to its

stockholders

Commercial failure —a business cannot pay its debts (insolvent)

A business can be an economic failure without being a commercial failure

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Bankruptcy Concept and Objectives

Bankruptcy – protects a failing firm from creditors until a resolution is reached to close or continue it

Bankruptcy court protects a firm from its creditors and determines whether it should shut down or continue

– Liquidation

Bankruptcy Procedures—Reorganization, Restructuring, Liquidation

Reorganize

Insolvent company perceived as

recoverable will reorganize

Debt will be restructured and a

plan developed to pay creditors

as fairly as possible

Liquidate Insolvent company deemed unrecoverable will liquidate Assets will be sold under the court's supervision, with proceeds to pay creditors according to priority

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Bankruptcy Procedures—Reorganization, Restructuring, Liquidation

Bankruptcy petition can be initiated

– voluntarily by insolvent company or

– involuntarily by its creditors

A firm in bankruptcy is usually allowed to continue operations

– Trustee oversees the firm’s operations to protect the interests of its creditors

A plan under which an insolvent firm continues to operate while attempting to pay off its debts

Reorganization plans are judged on fairness and feasibility

– Fairness—claims are satisfied based on priorities

– Feasibility—likelihood the plan will actually work

Plan must be approved by the bankruptcy court, firm's creditors and stockholders

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Debt Restructuring

Debt-to-equity conversions are a common method of

restructuring debt

– Creditors give up debt claims in return for stock in the company

– Equity may be worth more in the long run than the debt given up

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Concept Connection Example 17-4 Debt Restructuring in Bankruptcy

Adcock has 50,000 shares of common stock outstanding at a book value of $40, pays 10% interest on its debt, and is in the following financial situation

200 Depreciation

($400) Net Income

Tax

-$8,000 Total capital

($400) EBT

2,000 Equity

600 Interest

$6,000 Debt

$200 EBIT

Capital Income and Cash Flow

Notice that although the company has positive EBIT, it doesn't earn enough to pay its interest let alone repay principal on schedule Without help of some kind it will fail shortly Devise a composition involving a debt for equity conversion that will keep

the firm afloat.

Concept Connection Example 17-4 Debt Restructuring in Bankruptcy

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Suppose creditors are willing to convert $3 million in debt to equity at the $40 book value Requires issuing 75,000 new shares, resulting in the following financial situation.

($50) Cash flows

(50) Principal Repayment

200 Depreciation

($100) Net Income

Tax

-$8,000 Total capital

($100) EBT

5,000 Equity

300 Interest

$3,000 Debt

$200 EBIT

Capital Income and Cash Flow

Notice that the company now has a slightly positive cash flow and can at least theoretically continue in business indefinitely However, creditors now own a

controlling interest in the firm.

Liquidation

Closing a troubled firm and selling its assets

Trustee attempts to recover any unauthorized transfers out of the firm Trustee supervises the sale of the assets, pools and distributes the funds

Claimants include

– Vendors - who sold to the firm on credit

– Stockholders - receive whatever is left

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Distribution Priorities

Bankruptcy code contains priorities for the distribution of assets among claimants Priority code payoffs of unsecured claimants:

– Administrative expenses of the bankruptcy proceedings

– Certain business expenses incurred after the bankruptcy petition is filed

– Certain unpaid wages

– Certain unpaid contributions to employee benefit plans

– Certain customer deposits

– Unpaid taxes

– Unsecured creditors

– Preferred stockholders

– Common stockholders

Bankruptcy Code Chapters

Chapter 7

– Liquidation

Chapter 11

– Reorganization

Notice that Bankruptcy is a Federal court procedure, not state

– Although some state laws do apply

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