CHAPTER 26
Mergers, LBOs, Divestitures,
and Holding Companies
Topics in Chapter




Types of mergers
Merger analysis
Role of investment bankers
LBOs, divestitures, and holding
companies
26-2
Economic Justifications for
Mergers

Synergy = Value of the whole exceeds
sum of the parts





Operating economies
Financial economies
Differential management efficiency
Taxes (use accumulated losses)
Break-up value = Assets more valuable
broken up and sold
26-3
Questionable
Reasons for Mergers



Diversification
Purchase of assets below replacement
cost
Acquire other firms to increase size,
thus making it more difficult to be
acquired
26-4
Merger Types



Horizontal
Vertical
Congeneric


Related but not same industry
Conglomerate

Unrelated enterprises
26-5
Five Largest Completed Mergers
(as of December, 2007)
TABLE 26-1
26-6
Friendly & Hostile Mergers

Friendly merger:


Supported by management of both firms
Hostile merger:



Target firm’s management resists the merger
Acquirer must go directly to the target firm’s
stockholders – “tender offer” - try to get 51% to
tender their shares.
Often, mergers that start out hostile end up as
friendly, when offer price is raised
26-7
Merger Analysis

DCF Analysis



Corporate Valuation (Ch 11)
Adjusted Present Value Method (Ch 26.7)
Equity Residual Model (Ch 26.8)


= Free Cash Flow to Equity Method
Market Multiples Analysis

Provides a “benchmark”
26-8
The APV Model
+
=
Value of firm if it had no debt
Value of tax savings due to debt
Value of operations
First term = unlevered value of the firm
Second term = value of the interest tax shield
26-9
The APV Model
VL  VU  TD
(15-7)
(16-4)
(26-1)

VOP
FCFt
 VU  
t
(
1

R
)
t 1
sU
(15-1)
(26-2)

VTS
TSt

t
t 1 ( 1  r sU )
(26-3)
26-10
APV Model

VU = Unlevered value of firm
= PV of FCFs discounted at unlevered cost of
equity, rsU

VTS = Value of interest tax shield
= PV of interest tax savings discounted at
unlevered cost of equity, rsU
Interest tax savings = Interest * (tax rate) = TSt
26-11
APV vs. Corporate Valuation

Best model when capital structure is changing




Merger often causes capital structure changes
over the first several years
Causes WACC to change from year to year
Hard to incorporate year-to-year WACC changes in
the corporate valuation model
Corporate Valuation (i.e., discount FCF at
WACC) = easier than APV when capital
structure is constant
26-12
Steps in APV Valuation
1. Calculate unlevered cost of equity, rsU
rsL  rsU  ( rsU  rd )( 1  T )( D S )
rsU  w s rsL  w d rd
(16-6)
(26-4)
(26-5)
2. Project FCFt ,TSt until company is at its
target capital structure for one year and
is expected to grow at a constant rate
thereafter.
26-13
Steps in APV Valuation
Project horizon growth rate, g
3.

Calculate horizon value of unlevered firm
using constant growth formula and FCFN
HV U ,N

FCFN 1 FCF( 1  g )

rsU  g
rsU  g
(26-7)
Calculate horizon value of tax shields using
constant growth formula and TSN
TSN 1
TS( 1  g )
HV TS ,N

rsU  g
rsU  g
(26-8)
26-14
Steps in APV Valuation
4. Calculate Value of Operations

Calculate unlevered value of firm as PV of
unlevered horizon value and FCFt
HVU ,N
FCFt
VU  

t
N
(
1

r
)
(
1

r
)
t 1
s ,U
sU
N

(26-9)
Calculate value of tax shields as PV of tax
shield horizon value and TSt
HVTS,N
TSt


t
( 1  rsU ) N
t 1 ( 1  rs ,U )
N
VTS
(26-10)
26-15
Steps in APV Valuation
4. Calculate Value of Operations

Calculate Vop as sum of unlevered value and tax
shield value
VOP  VU  VTS
5.
(26-11)
Find total value of the firm
VU  VTS  Vop
Vop  Value of non - ope ratingas s e ts VF
S  VF  Value of de bt
P  S # s hare s
26-16
The FCFE Approach

FCFE = Free Cash Flow to Equity

Cash flow available for distribution to common
shareholders
FCFE  FCF  After- tax interestexpenseprincipalpaym ents new lyissueddebt
(26-12)
FCFE  NI  Net investm entin operatingcapital 
interesttax shield net changein debt
26-17
FCFE Approach


Value of Equity = VFCFE   FCFEt
t

Assuming constant growth:
t 1 ( 1  r sL )
(26-13)
FCFEN 1 FCFE( 1  g )
HV FCFE ,N

rsL  g
rsL  g
(26-14)
HVFCFE ,N
FCFEt


t
( 1  rsL ) N
t 1 ( 1  rsL )
(26-15)
N
VFCFE
S  VFCFE  Non - operatingassets
(26-16)
26-18
TABLE 26-2
26-19
Valuation Examples


Caldwell Inc’s acquisition of Tutwiler
Tutwiler






Market value of equity = $62.5 m
Debt = $27 m
Total market value = $89.5 m
% Debt = 30.17%
Cost of debt, rd = 9%
10 million shares outstanding
26-20
Tutwiler Acquisition



Tutwiler’s pre-merger beta = 1.20
Risk-free rate = 7%
Market risk premium = 5%

CAPM rsL= 13%
WACC  w d ( 1  T )rd  w s rsL
WACC  0.3017 ( 0.60 )( 9%)  0.6983( 13%)
WACC  10.707%
26-21
Tutwiler Acquisition



Both firms = 40% tax rate
Post-horizon g= 6%
Caldwell will issue debt to maintain
constant capital structure:

$6.2 m debt increase at merger
26-22
Projecting Post-Merger CFs
01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel A: Selected Items
1
Net Sales
$105.0
$126.0
$151.0
$174.0
$191.0
2
Cost of goods sold
80.0
94.0
113.0
129.3
142.0
3
Selling & Admin 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
7.0
12.0
16.0
20.7
23.0
6
Interest Expense
3.0
3.2
3.5
3.7
3.9
7
Debt
33.2
35.8
38.7
41.1
43.6
46.2
8
Total Net Operating Capital
116.0
117.0
121.0
125.0
131.0
138.0
26-23
Post-Merger CF Projections
01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel B Corporate Valuation CFs
9
NOPAT=EBIT(1-T) (T=40%)
$4.2
$7.2
$9.6
$12.4
$13.8
10
Less net invest. In op cap
1.0
4.0
4.0
6.0
7.0
11
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
$6.8
Panel C: APV Model Cash Flows
12
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
$6.8
13
Interst tax savings = INT(T)
1.2
1.28
1.4
1.48
1.56
Panel D: FCFE Model Cash Flows
14
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
$6.8
15
Less A-T Interest=INT(1-T)
1.8
1.9
2.1
2.2
2.4
16
Plus Δdebt
6.2
2.6
2.9
2.5
2.5
2.6
17
FCFE
$6.2
$4.0
$4.1
$6.0
$6.7
$7.1
26-24
Tutwiler – Corporate Valuation
FCF2015
FCF2014 ( 1  g )
HV OP ,2014 

WACC  g
WACC  g
(26-7)
$6.800( 1.06 )
HV OP ,2014 
 $153.1m
0 / 1070  0.06
VOperation  $110.1
Value of Equity  $110.1  $27  $83.1m
26-25
Tutwiler: Corporate Valuation
Panel B Corporate Valuation CFs
9
NOPAT=EBIT(1-T) (T=40%)
$4.2
$7.2
$9.6
$12.4
$13.8
10
Less net invest. In op cap
1.0
4.0
4.0
6.0
7.0
11
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
$6.8
Horizon value
$153.1
FCF
Present Value of FCF
$3.2
$3.2
$5.6
$6.4
$159.9
$110.1
Minus Value of current debt
$27.0
Value of Equity
$83.1
26-26
Tutwiler – APV Approach
Estimate Tutwiler’s Unlevered Cost of Equity:
rsU  w s rsL  w d rd
(26 - 5)
rsU  0.6983( 13%)  0.3017 ( 9%)
rsU  11.793%
26-27
Tutwiler – APV Approach
Panel C: APV Model Cash Flows
12
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
Horizon Value of FCF
$124.4
Total FCF
Value (Unlevered)
13
$6.8
$3.2
$3.2
$5.6
$6.4
$131.2
1.2
1.28
1.4
1.48
1.56
$88.7
Interest tax savings = INT(T)
Horizon Value of tax savings
$28.7
Total Tax Shield
$1.2
$1.3
$1.4
$1.5
Value(Tax Shield)
$21.4
Total Value of Firm
$110.1
Minus Value of current debt
$27.0
r(sU)
11.793%
Value of Equity
$83.1
g=
6%
$30.3
26-28
Tutwiler – FCFE Model
HVFCFE ,2014
FCFE2015
FCFE( 1  g )


rsL  g
rsL  g
(26-14)
$7.06( 1.06 )
HV FCFE ,N
 $106.9 m
0.13  0.06
26-29
Tutwiler – FCFE Model
Panel D: FCFE Model Cash Flows
14
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
$6.8
15
Less A-T Interest=INT(1-T)
1.8
1.9
2.1
2.2
2.4
16
Plus Δdebt
6.2
2.6
2.9
2.5
2.5
2.6
17
FCFE
$6.2
$4.0
$4.1
$6.0
$6.7
$7.1
Horizon value of FCFE
Total FCFE
Value of FCFE
106.9
$6.2
$4.0
$4.1
$6.0
$6.7
r(sL)
13.0%
g=
6%
$114.0
$83.1
26-30
Tutwiler Value Recap
TUTWILER Equity
Current Value of Equity
$62.5
Corporate Valuation
$83.1
APV Approach
$83.1
FCFE Model
$83.1
Tutwiler is worth more as part of
Caldwell than stand-alone
26-31
The Bid Price
Caldwell’s Bid for Tutwiler

Caldwell will assume Tutwiler’s debt


Analysis shows Tutwiler worth $83.1m
to Caldwell


Added short-term debt for acquisition
If Caldwell pays more Caldwell value
diluted
How much should Caldwell offer?
26-32
Caldwell’s Bid for Tutwiler





Target’s Estimated value
Target’s current value
Merger premium
 “Synergistic Benefits”
= $83.1 million
= $62.5 million
= $20.6 million
= $20.6 million
Realizing synergies has been problematic
in many mergers
26-33
Caldwell’s Bid

Offer range = $62.5m to $83.1m
 $62.5m → merger benefits would
go to the acquiring firm’s
shareholders
 $83.1m →all value added would go
to the target firm’s shareholders
26-34
Bid Strategy Issues




High “preemptive” bid to ward off other
bidders
Low bid and then plan to go up
Do target’s managers have 51% of
stock and want to remain in control?
What kind of personal deal will target’s
managers get?
26-35
Do mergers really create value?


According to empirical evidence,
acquisitions do create value as a result of
economies of scale, other synergies, and/or
better management.
Target firm shareholders reap most of the
benefits



Final price close to full value
Target management can always say no
Competing bidders often push up prices
26-36
Acquisition with Permanent
Change in Capital Structure

Tutwiler currently:



$62.5m value of equity
$27m debt = 30.17% debt
Caldwell’s plan



Increase debt to 50%
Maintain level from 2012 on
New rate on debt = 9.5%

Tax shield, WACC and bid price will change
26-37
Change in Tax Shield
9.
Debt
52.63
a
10. Interest
11. Interest tax savings
63.16
73.68
78.95
87.33
5.000
2.000
6.000
2.400
7.000
2.800
7.500
3.000
8.296
3.319
This last debt level is consistent with the assumed
long-term capital structure
The last interest payment is consistent with the long-term capital
structure
26-38
Effect on the Bid Price
New Horizon Value Calculation
First, calculate Tutwiler's horizon value if it were unlevered.
HVU
=
FCF 2014
*
(1 + g)
÷
HVU
=
6.8
*
1.060
÷
HVU
=
$124.42
(rU
-
g)
0.1179
-
0.06
Second, calculate the horizon value of Tutwiler's tax shields under new financing plan:
HVTS
=
TS 2014
*
(1 + g)
÷
(rU
HVTS
=
3.319
*
1.060
÷
0.1179
HVTS
=
g)
0.06
$60.72
Horizon value of Tax Shields is larger due to increased debt level.
26-39
Revised Value of Tutwiler
Panel C: APV Model Cash Flows with Increased Debt
12
Free Cash Flow
$3.2
$3.2
$5.6
$6.4
Horizon Value of FCF
$124.4
Total FCF
Value (Unlevered)
13
$6.8
$3.2
$3.2
$5.6
$6.4
$131.2
2.0
2.4
2.8
3.0
3.3
$88.7
Interest tax savings = INT(T)
Horizon Value of tax savings
$60.7
Total Tax Shield
$2.0
$2.4
$2.8
$3.0
Value(Tax Shield)
$44.3
Total Value of Firm
$133.0
Minus Value of current debt
$27.0
r(sU)
11.793%
Revised Value of Equity
$106.0
g=
6%
$64.0
26-40
Recap: Value of Tutwiler Equity
TUTWILER Equity
Total
Per Sh
Current Value of Equity
$62.5
$6.25
Original Merger Value
$83.1
$8.31
APV Approach Revised
$106.0
$10.60
26-41
Merger Payment




Cash
Shares in acquiring firm
Debt of the acquiring firm
Combination
26-42
Bid Structure Effects




Capital structure of post-merger firm
Tax treatment of shareholders
Ability of target shareholders to
benefit from post merger gains
Federal & state regulations applied to
acquiring firm
26-43
Tax Consequences
Shareholders

Taxable Offer
Payment = primarily cash or bonds
 IRS views as a “sale”
 Target shareholders taxed on gain

Original purchase price vs. Offer price
 Taxed in year of merger

26-44
Tax Consequences
Shareholders

Non-taxable Offer
Payment = primarily stock
 IRS views as an “exchange”
 Target shareholder pay no taxes at
time of merger
 Taxed at time of stock sale
 Preferred by shareholders

26-45
Tax Consequences
Firms

Non-taxable offer



Simple merger of balance sheets
Continue depreciating target’s assets as
previously
Taxable offer – depends on offer type


Offer for target’s assets
Offer for target’s stock
26-46
Tax Consequences
Firms

Taxable Offer for Target’s assets


Acquirer pays gain on offer – asset value
Acquirer records target’s assets at
appraised value


Depreciation based on new valuation
“Goodwill” = offer – new valuation

Amortized over 15 years/straight line
26-47
Tax Consequences
Firms

Taxable Offer for Target’s Stock

2 Choices of tax treatment
1. Record acquired assets at book value
and continue depreciating on current
schedule
2. Record acquired assets at appraised
value and generate goodwill
26-48
Figure
26-1
26-49
Purchase Accounting

Purchase:


Assets of acquired firm are “written up or
down” to reflect purchase price relative to
net asset value
Goodwill often created


An asset on the balance sheet
Common equity account increased to
balance assets and claims
26-50
Table 26-4
26-51
Income Statement Effects
Table 26-5
26-52
Goodwill Amortization

Goodwill amortization:



No longer amortized over time for
shareholder reporting
Still amortized for Federal Tax purposes
Goodwill subject to annual “impairment
test”

If fair market value has declined, then
goodwill is reduced
26-53
The Role of Investment Bankers

Arranging mergers





Identifying targets
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
26-54
Defensive Tactics

“Super Majority”









1/3 of Directors elected each year
75% approval for merger versus simple majority
Convince target price is too low
Raising anti-trust issues
Open market repurchase of stock to push price up
Finding a “White Knight”
Finding a “White Squire”
Taking a “Poison Pill”
ESOP plans
26-55
Poison Pills

Any technique used to discourage
hostile takeovers




Borrowing on terms that require
immediate repayment if acquired
Selling desirable assets at low prices
Granting lucrative “golden parachutes”
Allowing current shareholders to buy
shares at reduced prices
26-56
Risk Arbitrage



“Arbitrageurs” or “arbs”
Speculation in likely takeover
targets
Insider trading scandals

Ivan Boesky
26-57
Who Wins?



Takeovers increase the wealth of
target firm shareholders
Benefit to acquiring firm debatable
“Event Studies” – Target stock price


 30% for hostile tender offers
 20% for friendly mergers
26-58
Alliances versus Acquisitions




Access to new markets and technologies
Multiple parties share risks and expenses
Rivals can often work together
harmoniously
Antitrust laws can shelter cooperative
R&D activities
26-59
Leveraged Buyout (LB0)

Small group of investors buys all
publicly held stock




Takes the firm private
Group usually includes management
Purchase often financed with large
amounts of high-yield debt
Investors take firm public to “cash out”
26-60
Advantages and Disadvantages of
Going Private

Advantages:





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
26-61
Types of Divestitures


Sale of entire subsidiary to another firm
“Spin-off”


“Carve-out”


Spinning off a corporate subsidiary by
giving the stock to existing shareholders
Selling a minority interest in a subsidiary
Outright liquidation of assets
26-62
Motivation for Divestitures






Subsidiary worth more to buyer than
when operated by current owner
Settle antitrust issues
Subsidiary’s value increased operated
independently
Change strategic direction
Shed money losers
Get needed cash when distressed
26-63
Holding Companies


Corporation formed for sole purpose of
owning the stocks of other companies
Typically, subsidiary companies:



Issue their own debt
Equity held by the holding company
Holding company sells stock to individual
investors
26-64
Advantages and Disadvantages of
Holding Companies

Advantages:



Control with fractional ownership
Isolation of risks
Disadvantages:


Partial multiple taxation
Ease of enforced dissolution
26-65