Chapter 25
Mergers, LBOs, Divestitures, and Holding Companies
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
The BOC questions lead us through a verbal discussion of mergers and merger
analysis.
This is a useful exercise, but it does not explain the type of
quantitative analysis that a financial analyst would need to go through to
evaluate a potential merger. For a quantitative analysis, we recommend going
through the BOC model.
25-1 Horizontal: In the same business.
Example: Exxon merging with Mobil
Oil. Vertical: One is a supplier to the other. Example: DuPont buying
Conoco to get a supply of oil. Congeneric: The businesses are somewhat
related. Example: Citigroup (principally a bank) buying Salomon Smith
Barney (an investment banker/stock brokerage operation). Conglomerate:
The firms are in unrelated businesses. Example: GE buying NBC.
Justice Department intervention would depend on this question:
Would
the
merger
be
likely
to
reduce
competition
materially?
Horizontal mergers are the most likely to be blocked, with vertical
mergers next.
Congeneric mergers are less likely to be attacked, and
conglomerate mergers rarely raise antitrust questions.
25-2
Synergy is the situation where two firms merge and the merged firm has
higher cash flows than the sum of the cash flows from the two merger
partners. Synergy generally results from economies of scale or scope.
For example, bank mergers often result in lower costs as duplicate
offices are closed and redundant people are laid off.
Mergers like
that between AOL and Time Warner were supposed to result in increased
revenues because Time Warner’s media properties were supposed to be
delivered can to AOL’s huge customer base.
Expected synergy is measured either by the expected increase in free
cash flow resulting from the merger or by the expected increase in
market value of the equity, which depends on the expected increase in
cash flow.
The expected synergy is allocated by negotiations.
If the target
firm has many potential suitors, then it will probably capture most of
the synergies.
On the other hand, if the acquiring firm has many
potential acquisitions, then it may be able to offer a low price and
capture most of the synergy.
Empirical studies indicate that targets
get more of the synergies than acquirers, but that result may be more
the result of inadequate tests than actual synergy allocations. Since
we don’t know what cash flows the two firms would have had without the
merger, we cannot have full confidence that poor ex post results really
indicate a bad merger. For example, AOL Time Warner’s market value has
gone down since their merger, but the decline might have been even
greater absent the merger.
Synergies are to a large extent case-specific. Conglomerate mergers
would seem to offer little scope for synergies, but the other three
types would all have potential for synergies. Economies of scale could
result from horizontal mergers.
Cost-reducing efficiencies could
Answers and Solutions: 25 - 1
result from
selling and
result from
conglomerate
Of course,
operating so
vertical mergers.
Economies of scope, including crossdeploying research technology between the firms, could
congeneric mergers.
So, all types of mergers except
mergers would seem to offer the potential for synergies.
correctly identifying synergistic potential, and then
as to capture it, is essential in a good merger.
25-3
The most important factor leading to successful mergers is the
existence of good synergies, for without synergistic gains the acquirer
cannot afford to pay much of a premium for the target, and the higher
the premium, the more likely the merger is to be completed.
Other
factors include compatibility of the two corporate cultures, and the
willingness of one CEO to give up power.
25-4
Under the multiples approach, metrics like industry average P/E ratios,
Price/Book ratios, and Price/EBITDA ratios would be multiplied by the
relevant factor for the target company.
For example, if the industry
average P/E is 15X, and the target company has net income of $10
million, then one application of the market multiple approach would
value the company’s equity at $150 million.
The same procedure could
be used on a per share basis, and for items such as EBITDA, book value,
sales, number of customers, and the like.
This approach is almost
always used, either as a basic valuation technique or as a check on a
DCF valuation.
25-5
These are two versions of the DCF method.
The corporate valuation
method finds the value of the entire corporation and then deducts the
value of the debt to find the value of the stock. Here the free cash
flows are discounted at the WACC, non-operating assets are added, and
then the market value of the debt is subtracted to get the value of the
equity.
Under the adjusted present value (APV) method, the free cash
flows plus the interest tax shields are discounted at the unleveraged
cost of equity, and then the debt value is subtracted to find the value
of the equity.
Generally, under the APV approach, the corporate
valuation model is used to find the PV of cash flows once cash flows
begin to grow at a stable, constant rate.
Under the DCF method, one could either use free cash flows
discounted at the acquired firm’s WACC or the equity residual method,
where the cash flows would be the flows to the equity discounted at the
risk-adjusted cost of equity for the target.
The two DCF procedures
should produce the same or quite similar valuations, assuming the
inputs used in the methods are consistent.
Both DCF methods should
lead to the same valuation, but it is difficult to implement the
corporate valuation method if the capital structure is changing, as it
often is in the years following a merger.
It is, of course, difficult to estimate the values required for
either DCF method. Neither the WACC for use in the corporate valuation
model nor the leverage-free cost of equity for use in the APV approach
can be estimated precisely, and the projected post-merger free cash
flows are even harder to estimate. Still, it is necessary to value the
target, so analysts do the best they can. Note too that when one sets
up an Excel model, inputs can be changed, and different scenarios can
be run, to see how sensitive the valuation is to the different
variables.
This gives decision makers a better idea about the risk
Answers and Solutions: 25 - 2
inherent in the acquisition, just as similar analyses give an idea
about the riskiness of different capital budgeting projects.
25-6
The DCF methods are conceptually better and would normally be given
more weight in the valuation process. The market multiples approach is
based on the assumption that the target firm is quite similar to the
average firm in its industry, and, indeed, that all firms in the
industry are relatively similar.
That may be incorrect.
Also, the
multiples approach assumes that all firms are valued properly, i.e.,
that the market is efficient. We now know that this was not the case,
especially for Internet and other tech stocks, during the stock market
bubble of the late 1990s.
This basic mis-valuation led to many
unfortunate mergers, such as that between AOL and Time Warner.
Of course, the DCF method could also produce bad valuations, but at
least under DCF one can identify the key variables and make judgments
as to how accurate or inaccurate they are.
As a result, the DCF method is normally given more weight, and the
multiples approach is used primarily as a check on the DCF. If the DCF
values a company at say $100 million, but the multiples approach values
it only at $50 million, then one would want to reexamine the DCF, see
why the difference arises, and perhaps modify the inputs.
25-7
Note:
Everything said in this answer to Question 7 pertains to
financial accounting only.
The tax accounting treatment is totally
separate and quite different.
See the answer to Question 8 for a
discussion of tax implications of mergers.
With purchase accounting, the target’s assets are appraised and are
then put on the acquirer’s books at their appraised value. Often, the
actual price paid exceeds the appraised value of the target’s assets,
in which case there is apparently some intangible asset called
“goodwill” that gives rise to high earnings and the merger premium.
For example, the target might have assets with a book value of $100
million, an appraised value of $200, and a market value of $500 million
due to its very high rate of return on assets. Goodwill is calculated
(in essence) as the difference between the price paid and the appraised
value of the acquired assets, in this case $300 million, and it is then
shown on the acquirer’s balance sheet as an asset.
An alternative treatment that was permitted until 2001 was pooling
of interests.
Under pooling, the target firm’s asset and liability
accounts were simply added to those of the acquiring firm, regardless
of how much was actually paid for the target. In a pooling, the $400
million premium paid over book would simply be disregarded.
When companies could choose between pooling and purchase, most
choose pooling, because under purchase accounting they were required to
amortize (write off) the goodwill that was created by mergers over a
period that could not exceed 40 years. That write-off lowered reported
profits and perhaps had a negative influence on stock prices.
In 2001, the SEC and the accounting profession stopped allowing
pooling and began requiring firms to use purchase accounting. However,
there is no longer an annual charge for goodwill. Rather, goodwill is
allowed to stay on the books, except if it is determined that the value
of the purchased assets has declined, then a flash cut write-off equal
Answers and Solutions: 25 - 3
to the estimated value decline must be taken.
There is no
corresponding upward valuation if the merger produced more goodwill
than was reflected in the premium paid for the target.
Many companies created huge amounts of goodwill in mergers during
the market bubble of the late 1990s, and they are now having to take
equally huge write-offs. For example, AOL Time Warner recently took a
hit of over $50 billion.
25-8
Taxes in mergers are quite complicated, so we can only provide a rough
outline of the tax situation.
Here are answers to the tax treatment
under the 4 situations described in the question.
To answer these
questions, we traced through the chart provided in ch25BOC-model.xls.
a. Acquirer pays $100 million in cash for the target’s stock in a
tender offer. Acquirer records assets at their book value.
(Note:
This could be done on the company’s tax books but not on the books
used for stockholder reporting.)
Go down left side of chart to Taxable, because cash rather than
stock is paid. Then go to the right stock is bought. Then continue
to right because assets are recorded at book rather than appraised
value. In the final box, we see that:




Target’s stockholders would receive the entire $100 million from
the acquirer when they surrendered their stock, and then each
individual stockholder would pay taxes depending on how long they
had held the stock and their cost basis.
Target’s shareholders would get nothing from the target firm
itself.
The target firm itself would pay no taxes on gains because it
received nothing from the merger. Only its stockholders received
a payment from the acquirer, so only the stockholders face a
potential tax liability.
The acquirer would depreciate the acquired assets exactly like
they would have been depreciated without the merger.
Note that the acquiring firm would own the target company, and it
would inherit any environmental or product liability claims against
the company.
This situation has bankrupted many companies that
acquired firms involved with asbestos.
b. Same as a, but Acquirer records assets at their appraised value.
Now we go to the lower middle box. The target’s stockholders get
the same $100 million and pay the same taxes as before.
However,
the target firm itself, which really means the acquiring firm
because it now owns the target, must immediately pay a tax on the
$50 million difference between the $50 million book value and the
$100 million purchase price. At a 35% rate, the immediately payable
tax would be $50(0.35) = $17.5 million.
Taxes are at the normal
corporate tax rate, because corporations do not have a lower capital
gains tax rate. The acquirer could write up depreciable assets from
$50 million to the $80 million appraised value, and it could record
the $20 million difference between the $100 million price and the
$80 million appraised value as goodwill, so it would be able to
write off the entire $100 million, either as depreciation or as
Answers and Solutions: 25 - 4
amortization.
This would save it $35 million in taxes, but that
saving would occur over time.
One would have to compare the PV of the tax savings to the
immediate $17.5 tax, but unless the acquirer has some offsetting
losses elsewhere, it would probably not be good to choose this
method, because the PV would probably be both lower and less certain
than the immediate tax payment.
Therefore, this procedure is not
used very often in practice.
c. Acquirer gives stock with a market value of $100 million in exchange
for the target’s stock.
Now in the chart move across the top to the right. We now have
an exchange of stock, which results in a non-taxable merger.
The
target’s stockholders would receive the $100 million of stock in the
acquirer, but they would not have to pay taxes until they sold that
stock. Their basis would be the same as their basis in the target
firm.
Assets would not be written up, goodwill would not be
created, and tax depreciation for the Target subsidiary would be the
same as before the merger.
Note that this procedure amounts to a pooling of interests, which
is allowed for tax purposes but is no longer permitted for
accounting purposes.
Thus, there is a major difference in
bookkeeping for tax and book purposes for nontaxable mergers.
d. Acquirer pays $100 million in cash to the target for its assets.
This takes us to the lower left section of the chart. We would
have a taxable merger.
Assets would be written up to their
appraised value ($80 million), and $20 million of goodwill would be
created. The target company itself would have to pay taxes on the
$50 million of gains, and the tax would be at the normal corporate
tax rate, so it would amount to $17.5 million.
The funds after
taxes (presumably $100 million minus the $17.5 million tax on the
$50 million gain) would then be distributed to the target’s
stockholders as a liquidating dividend. The difference between the
liquidating dividend and a stockholder’s basis would be treated as a
capital gains and taxed as such in the year the dividend was paid.
Answers and Solutions: 25 - 5
ANSWERS TO END-OF-CHAPTER QUESTIONS
25-1
a. Synergy occurs when the whole is greater than the sum of its parts.
When applied to mergers, a synergistic merger occurs when the
postmerger earnings exceed the sum of the separate companies'
premerger earnings. A merger is the joining of two firms to form a
single firm.
b. A horizontal merger is a merger between two companies in the same
line of business. In a vertical merger, a company acquires another
firm that is "upstream" or "downstream"; for example, an automobile
manufacturer acquires a steel producer. A congeneric merger involves
firms that are interrelated, but not identical, lines of business.
One example is Prudential's acquisition of Bache & Company. In a
conglomerate merger, unrelated enterprises combine, such as Mobil
Oil and Montgomery Ward.
c. A friendly merger occurs when the target company's management agrees
to the merger and recommends that shareholders approve the deal. In
a hostile merger, the management of the target company resists the
offer. A defensive merger occurs when one company acquires another
to help ward off a hostile merger attempt.
A tender offer is the
offer of one firm to buy the stock of another by going directly to
the stockholders, frequently over the opposition of the target
company’s management.
A target company is a firm that another
company seeks to acquire. Breakup value is a firm’s value if its
assets are sold off in pieces. An acquiring company is a company
that seeks to acquire another firm.
d. An operating merger occurs when the operations of two companies are
integrated with the expectation of obtaining synergistic gains.
These may occur due to economies of scale, management efficiency, or
a host of other reasons. In a pure financial merger, the companies
will not be operated as a single unit, and no operating economies
are expected.
e. The discounted cash flow (DCF) method to valuing a business involves
the application of capital budgeting procedures to an entire firm
rather than to a single project. The market multiple method applies
a market-determined multiple to net income, earnings per share,
sales, book value, or number of subscribers, and is a less precise
method than DCF.
f. Under purchase accounting, the acquiring firm is assumed to have
“bought” the acquired company in much the same way it would buy any
capital asset. Any excess of the purchase price over the book value
of assets is added to goodwill, which may be expensed for Federal
income tax purposes, but may not be expensed for shareholder
reporting.
Answers and Solutions: 25 - 6
g. A white knight is a friendly competing bidder that a target
management likes better than the company making a hostile offer, and
the target solicits a merger with the white knight as a preferable
alternative.
A poison pill is a deliberate action that a company takes which
makes it a less attractive takeover target. A golden parachute is a
payment made to executives that are forced out when a merger takes
place.
A proxy fight is an attempt to gain control of a firm by
soliciting stockholders to vote for a new management team.
h. A joint venture involves the joining together of parts of companies
to accomplish specific, limited objectives. Joint ventures are
controlled by the combined management of the two (or more) parent
companies. A corporate or strategic alliance is a cooperative deal
that stops short of a merger.
i. A divestiture is the opposite of an acquisition. That is, a company
sells a portion of its assets, often a whole division, to another
firm or individual. In a spin-off, a holding company distributes the
stock of one of the operating companies to its shareholders. Thus,
control passes from the holding company to the shareholders
directly.
A leveraged buyout is a transaction in which a firm's
publicly owned stock is acquired in a mostly debt-financed tender
offer, and a privately owned, highly leveraged firm results. Often,
the firm's own management initiates the LBO.
j. A holding company is a corporation formed for the sole purpose of
owning stocks in other companies. A holding company differs from a
stock mutual fund in that holding companies own sufficient stock in
their operating companies to exercise effective working control. An
operating company is a company controlled by a holding company. A
parent company is another name for a holding company. A parent
company will often have control over many subsidiaries.
k. Arbitrage is the simultaneous buying and selling of the same
commodity or security in two different markets at different prices,
and pocketing a risk-free return.
In the context of mergers, risk
arbitrage refers to the practice of purchasing stock in companies
that may become takeover targets.
25-2
Horizontal and vertical mergers are most likely to result in
governmental intervention, but mergers of this type are also most
likely to result in operating synergy. Conglomerate and congeneric
mergers are attacked by the government less often, but they also are
less likely to provide any synergistic benefits.
Answers and Solutions: 25 - 7
25-3
A tender offer might be used. Although many tender offers are made by
surprise and over the opposition of the target firm's management,
tender offers can and often are made on a "friendly" basis. In this
case, management (the board of directors) of the target company
endorses the tender offer and recommends that shareholders tender their
shares.
25-4
An operating merger involves integrating the company's operations in
hopes of obtaining synergistic benefits, while a pure financial merger
generally does not involve integrating the merged company's operations.
25-5
Disney's management could (and did) argue that its stock was worth more
than $4.22 per share, and that if Steinberg had taken control, the
remaining stockholders would be out in the cold and exploited by
Steinberg.
Perhaps so, but most nonmanagement stockholders (1) would
prefer $4.22 to $2.875, (2) were upset at having management give away
$60 million of their value to Steinberg, (3) believed that by no means
could Steinberg treat them worse than did the current management, and
(4) were more than a little suspicious that management's primary motive
was to keep their jobs and perks.
Personally, we regarded the Disney affair as a flagrant abuse of
outside stockholders by a management desperate to keep control.
However, we must note that Disney's stock is selling for $112.875 in
June 1998, so perhaps management was right. Also, though, Disney's old
management is largely gone, and a new and perhaps better group now has
control.
Perhaps Steinberg was right about the value of the assets,
and perhaps his actions forced a desirable management change.
Still,
and if so, Disney's stockholders paid a steep price ($60 million) to
get the management change.
Legislation might be desirable, but there is a danger that
legislation will help incompetent managers fight off legitimate and
desirable efforts to put corporate assets into more effective hands.
Markets work reasonably well, but the Disney situation does make it
clear that a manager really can threaten to commit corporate suicide
and use this tactic to fend off proposed takeovers. Still, a balanced
package of legislation would, in our judgment, do more good than harm
in preserving the efficiency of our capital markets.
Answers and Solutions: 25 - 8
25-6
Academicians have long argued that conglomerate mergers which produce
no synergy are not economically efficient because (1) overhead costs
are incurred in managing the combined enterprise, thus lowering
earnings; and (2) relevant risk is not reduced, because the combined
firm's beta is a weighted average of the betas of the merged firms. In
other words, investors could, individually, get whatever benefits of
diversification there are by buying the stocks of the two firms,
without incurring unnecessary overhead. The recent rash of corporate
divestitures attests to the merits of this position. The only logical
rationale for nonsynergistic conglomerate mergers is that debt capacity
may be increased by lowering the risk of bankruptcy. This would
increase the value of the merged company because of the debt tax
effect: TD, and D, could now be larger than the sum of the D's of the
separate companies. In general, it is safe to conclude that one should
be wary of nonsynergistic mergers.
Answers and Solutions: 25 - 9
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
25-1
FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd
= 30%; T = 40%; rd = 8% Vops = ? P0 = ?
rs
=
=
=
WACC =
=
=
Vops
=
=
=
=
=
Price =
=
VS
25-2
rRF + RPM(b)
5% + 6%(1.4)
13.4%.
wdrd(1-T) + wsrs
0.30(8%)(0.60) + 0.70(13.4%)
10.82%
FCF0(1  g)
WACC  g
$2.1
0.1082  0.05
$36.08 million
Vops – debt
36.08 – 10.82 = $25.26 million
25.26 million / 1 million shares
$25.26 / share.
FCF1 = $2.5 million, FCF2 = $2.9 million and FCF3 = $3.4 million; g = 5%;
b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ?
WACC was calculated in problem 1 to be 10.82%.
Since the horizon
capital structure is the same as in problem 1, the WACC is the same.
Horizon Value3 = FCF3(1+g)/(WACC – g)
= 3.4 (1.05)/(.1082 – 0.05)
= $61.34 million
Tax shields in years 1 through 3 are:
TS1 = TS2 = TS3 = Interest x T
= 1,500,000 x 0.40
= 600,000
FCF + Tax Shield + Horizon Value
Year 1: 2.5 million + 600,000 =
Year 2: 2.9 million + 600,000 =
Year 3: 3.4 million + 600,000 +
Answers and Solutions: 25 - 10
=
3.1 million
3.5 million
61.34 million = 65.34 million
The unlevered cost of equity based on the pre-merger required rate of
return and pre-merger capital structure is:
rsU = wdrd + wsrsL Note: rs was calculated in problem 1 to be 13.4%
= 0.30(8%) + 0.70(13.4%)
= 11.78%
The present value of the FCFs, the tax shields, and the horizon value
at the unlevered cost of equity is:
3.1
3.5
65.34


1.1178 (1.1178)2
(1.1178)3
= $52.36 million
Vops =
Equity value to Harrison = Vops – Debt
= 52.36 million - 10.82 million
= 41.54 million
or $41.54 per share since there are 1 million shares outstanding.
25-3
On the basis of the answers in Problems 25-1 and 25-2, the bid for each
share should range between $25.26 and $41.54.
25-4
The difference between this problem and problem 25-2 is the discount
rate used at the horizon. Since rsU = 11.78%, rsL with 45% debt and an
8.5% cost of debt is:
rsL
=
=
=
WACC =
=
=
rsU + (rsU –rd)(D/S)
11.78% + (11.78% - 8.5%)(0.45/0.55)
14.46%
wdrd(1-T) + wsrs
0.45(8.5%)(1-0.40) + 0.55(14.46%)
10.25%
The new horizon value at this WACC is:
Horizon Value3 = FCF3(1+g)/(WACC – g)
= 3.4 (1.05)/(.1025 – 0.05)
= $68.0 million
The new present value is:
3.1
3.5
3.4  0.6  68


Vops =
1.1178 (1.1178)2
(1.1178)3
= $57.13 million
The value of the equity is $57.13 million – 10.82 = 46.31 million, or
$43.61 per share.
Answers and Solutions: 25 - 11
25-5
a. The appropriate discount rate reflects the riskiness of the cash
flows. Thus, it is Conroy’s unlevered cost of equity that should be
used to discount the free cash flows and tax shields in years 1-4.
The horizon value should be calculated using Conroy’s WACC,
adjusting for the increased leverage.
Since Conroy’s b = 1.3, its
current cost of equity, rsL = 6% + 1.3(4.5%) = 11.85%.
Since its
percentage of debt is 25% and the rate on its debt is 9%, its
unlevered cost of equity is
rsU = wdrd + wsrsL
= 0.25(9%) + 0.75 (11.85%)
= 11.14%
At the new capital structure of 40 percent debt with a rate of 9.5
percent, the new levered cost of equity and WACC will be:
rsL
=
=
=
=
=
=
WACC
rsU + (rsU –rd)(D/S)
11.14% + (11.14% - 9.5%)(0.40/0.60)
12.23%
wdrd(1-T) + wsrs
0.40(9.5%)(1-0.35) + 0.60(12.23%)
9.81%
b. The horizon value is:
Horizon Value4 = FCF4(1+g)/(WACC – g)
= 2.0 (1.06)/(0.0981 – 0.06)
= $55.64 million
The interest tax shields are calculated as interest payment x Tax
rate. These tax shields, free cash flows, and horizon value are to
be discounted at the unlevered cost of equity:
Year
1
2
3
4
5
|--------|---------|---------|---------|---------|
Tax Shield
1.2(.35) 1.7(.35) 2.8(.35) 2.1(.35)
Free Cash Flow
1.3
1.5
1.75
2.0
Horizon Value
55.64
Total
1.72
2.10
2.73
58.38
The present value of these cash flows is the value of operations:
1.72
2.10
2.73
58.38



1.1114 (1.1114)2
(1.1114)3
(1.1114)4
= $43.50 million
Vops =
Equity = Vops – debt
= $43.5 – 10 = $33.5 million is the maximum amount to pay.
Answers and Solutions: 25 - 12
25-6
0
|
-400,000
1
|
64,000
2
|
64,000
3
|
64,000
  
10
|
64,000
CF1 - CF10 = $64,000.
CF0 = -$400,000.
r = 10%.
Using a financial calculator, the PV of the future cash flows is:
N=10
I=10
PMT = -64000
FV = 0; PV = $393,252.295.
NPV = $393,252.295 - $400,000 = -$6,747.71.
Alternatively, input -400,000 and 64,000 (10) into the cash flow
register, I = 10, NPV = ?
NPV = -$6,747.71.
Since the NPV of the
investment is negative, Stanley should not make the purchase.
Answers and Solutions: 25 - 13
25-7
a. The horizon value should be calculated using BCC’s WACC based on its
new capital structure.
The intermediate free cash flows, tax
shields, and the horizon value should be discounted at BCC’s
unlevered cost of equity. To calculate all of these items: First,
find BCC's pre-merger cost of equity and unlevered cost of equity:
rsL = rRF + (RPM)b = 6% + (4%)1.40 = 11.6%.
rsU = wdrd + wsrsL = 0.40(10%) + 0.60(11.6%) = 10.96%
after the merger, BCC will have 50 percent of debt costing 10%, so
its levered cost of equity and WACC will be:
rsL
WACC
=
=
=
=
=
=
rsU + (rsU –rd)(D/S)
10.96% + (10.96% - 10%)(0.50/0.50)
11.92%
wdrd(1-T) + wsrs
0.5(10%)(1-0.35) + 0.5(11.92%)
9.21%
b. The free cash flows are NOPAT - net retentions = (Sales – CGS –
selling expenses)(1-T) – net retentions. CGS is 65% of sales:
Net sales
Cost of Goods Sold
Selling and
administrative expense
EBIT
Taxes on EBIT (35%)
NOPAT
Net Retentions
FCF
2004
$450
293
2005
$518
337
2006
$555
361
45
112
39
73
60
23
53
136
48
88
80
8
60
149
52
97
75
22
2007
$600
390
68
165
58
107
70
37.25*
since the horizon value is based on the last projected free cash
flow, we carried the calculation out two more decimal places.
*
c. Horizon value = 37.25(1.07)/(0.921-0.07) = $1,804
d. Vops = PV of FCF, Tax shield, and Horizon value at the unlevered
cost of equity. The tax shields are interest x tax rate:
Interest
Tax shield
FCF
Horizon Value
Total CF
2004
40
14
23
2005
45
16
8
2006
47
16
22
37
24
38
2007
52
18
37
1,803
1,859
NPV at unlevered cost of equity, 10.96%, = Vops = $1,308 = $1.3
million.
Value of BCC’s equity = Vops – Debt = 1.308 million –
300,000 = $1.08 million.
Solution to Cyberproblem: 26 - 14
SOLUTION TO SPREADSHEET PROBLEMS
25-8
The detailed solution for the problem is available both on the
instructor’s resource CD-ROM (in the file Solution to Ch 25-8 Build a
Model.xls) and on the instructor’s side of the accompanying book site,
http://brigham.swcollege.com.
Solution to Cyberproblem: 25 - 15
MINI CASE
HAGER’S HOME REPAIR COMPANY, A REGIONAL HARDWARE CHAIN, WHICH SPECIALIZES IN
“DO-IT-YOURSELF” MATERIALS AND EQUIPMENT RENTALS, IS CASH RICH BECAUSE OF
SEVERAL CONSECUTIVE GOOD YEARS.
FUNDS IS AN ACQUISITION.
ONE OF THE ALTERNATIVE USES FOR THE EXCESS
DOUG ZONA, HAGER’S TREASURER AND YOUR BOSS, HAS
BEEN ASKED TO PLACE A VALUE ON A POTENTIAL TARGET, LYONS’ LIGHTING, A SMALL
CHAIN WHICH OPERATES IN AN ADJACENT STATE, AND HE HAS ENLISTED YOUR HELP.
THE TABLE BELOW INDICATES ZONA’S ESTIMATES OF LYONS’ EARNINGS POTENTIAL
IF IT CAME UNDER HAGER’S MANAGEMENT (IN MILLIONS OF DOLLARS). THE INTEREST
EXPENSE LISTED HERE INCLUDES THE INTEREST (1) ON LYONS’ EXISTING DEBT, WHICH
IS $55 MILLION AT A RATE OF 9%, AND (2) ON NEW DEBT EXPECTED TO BE ISSUED
OVER TIME TO HELP FINANCE EXPANSION WITHIN THE NEW “L DIVISION,” THE CODE
NAME GIVEN TO THE TARGET FIRM.
IF ACQUIRED, LYONS' LIGHTING WILL FACE A 40%
TAX RATE.
SECURITY ANALYSTS ESTIMATE THAT LYONS’ BETA IS 1.3. THE ACQUISITION
WOULD NOT CHANGE LYONS’ CAPITAL STRUCTURE. ZONA REALIZES THAT LYONS’ LIGHTING
ALSO GENERATES DEPRECIATION CASH FLOWS, ALL OF WHICH MUST BE REINVESTED IN
THE DIVISION TO REPLACE WORN-OUT EQUIPMENT.
THE NET RETENTIONS IN THE TABLE
BELOW ARE REQUIRED REINVESTMENT IN ADDITION TO THESE DEPRECIATION CASH FLOWS.
ZONA ESTIMATES THE RISK-FREE RATE TO BE 9 PERCENT AND THE MARKET RISK
PREMIUM TO BE 4 PERCENT. HE ALSO ESTIMATES THAT FREE CASH FLOWS AFTER 2007
WILL GROW AT A CONSTANT RATE OF 6 PERCENT. FOLLOWING ARE PROJECTIONS FOR
SALES AND OTHER ITEMS.
2004
NET SALES
$60.0
COST OF GOODS SOLD (60%)
2005
2006
2007
$90.0 $112.5
$127.5
36.0
54.0
67.5
76.5
SELLING/ADMINISTRATIVE EXPENSE
4.5
6.0
7.5
9.0
INTEREST EXPENSE
5.0
6.5
6.5
7.0
REQUIRED NET RETENTIONS
0.0
7.5
6.0
4.5
HAGER’ MANAGEMENT IS NEW TO THE MERGER GAME, SO ZONA HAS BEEN ASKED TO
ANSWER SOME BASIC QUESTIONS ABOUT MERGERS AS WELL AS TO PERFORM THE MERGER
ANALYSIS.
TO STRUCTURE THE TASK, ZONA HAS DEVELOPED THE FOLLOWING QUESTIONS,
WHICH YOU MUST ANSWER AND THEN DEFEND TO HAGER’S BOARD.
Mini Case: 25- 16
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,
(5)
SYNERGY, AND (6) GLOBALIZATION.
IN GENERAL, WHICH OF THE REASONS
ARE
WHICH
ECONOMICALLY
JUSTIFIABLE?
ARE
NOT?
WHICH
FIT
THE
SITUATION AT HAND? EXPLAIN.
ANSWER:
THE ECONOMICALLY JUSTIFIABLE RATIONALES FOR MERGERS ARE SYNERGY AND
TAX CONSEQUENCES.
SYNERGY OCCURS WHEN THE VALUE OF THE COMBINED
FIRM EXCEEDS THE SUM OF THE VALUES OF THE FIRMS TAKEN SEPARATELY.
(IF SYNERGY EXISTS, THEN THE WHOLE IS GREATER THAN THE SUM OF THE
PARTS, AND HENCE SYNERGY IS ALSO CALLED THE "2 + 2 = 5" EFFECT.)
A SYNERGISTIC MERGER CREATES VALUE, WHICH MUST BE APPORTIONED
BETWEEN
ARISE
THE
STOCKHOLDERS
FROM
FOUR
OF
THE
SOURCES:
MANAGEMENT,
PRODUCTION,
ECONOMIES,
WHICH
(1)
MERGING
OPERATING
MARKETING,
COULD
OR
INCLUDE
COMPANIES.
SYNERGY
ECONOMIES
DISTRIBUTION;
HIGHER
DEBT
OF
CAN
SCALE
(2)
IN
FINANCIAL
CAPACITY,
LOWER
TRANSACTIONS COSTS, OR BETTER COVERAGE BY SECURITIES' ANALYSTS WHICH
CAN
LEAD
TO
DIFFERENTIAL
MANAGEMENT
HIGHER
DEMAND
MANAGEMENT
CAN
INCREASE
AND,
HENCE,
EFFICIENCY,
THE
VALUE
OF
HIGHER
WHICH
A
ECONOMIES
ARE
SOCIALLY
FIRM'S
DESIRABLE,
(3)
THAT
NEW
IMPLIES
ASSETS;
INCREASED MARKET POWER DUE TO REDUCED COMPETITION.
FINANCIAL
PRICES;
AS
AND
(4)
OPERATING AND
ARE
MERGERS
THAT
INCREASE MANAGERIAL EFFICIENCY, BUT MERGERS THAT REDUCE COMPETITION
ARE BOTH UNDESIRABLE AND ILLEGAL.
ANOTHER
VALID
RATIONALE
BEHIND
MERGERS
IS
TAX
CONSIDERATIONS.
FOR EXAMPLE, A FIRM WHICH IS HIGHLY PROFITABLE AND CONSEQUENTLY IN
THE HIGHEST CORPORATE TAX BRACKET COULD ACQUIRE A COMPANY WITH LARGE
ACCUMULATED TAX LOSSES, AND IMMEDIATELY USE THOSE LOSSES TO SHELTER
ITS
CURRENT
AND
FUTURE
INCOME.
WITHOUT
THE
MERGER,
THE
CARRY-
FORWARDS MIGHT EVENTUALLY BE USED, BUT THEIR VALUE WOULD BE HIGHER
IF USED NOW RATHER THAN IN THE FUTURE.
THE
MOTIVES
THAT
ARE
GENERALLY
LESS
SUPPORTABLE
ON
ECONOMIC
GROUNDS ARE RISK REDUCTION, PURCHASE OF ASSETS AT BELOW REPLACEMENT
COST,
CONTROL,
AND
GLOBALIZATION.
MANAGERS
OFTEN
STATE
THAT
DIVERSIFICATION HELPS TO STABILIZE A FIRM'S EARNINGS STREAM AND THUS
REDUCES TOTAL RISK, AND HENCE BENEFITS SHAREHOLDERS.
Mini Case: 25- 17
STABILIZATION
OF
EARNINGS
IS
CERTAINLY
BENEFICIAL
EMPLOYEES, SUPPLIERS, CUSTOMERS, AND MANAGERS.
INVESTOR
IS
CONCERNED
ABOUT
EARNINGS
A
FIRM'S
HOWEVER, IF A STOCK
VARIABILITY,
DIVERSIFY MORE EASILY THAN CAN THE FIRM.
TO
HE
OR
SHE
CAN
WHY SHOULD FIRM A AND FIRM
B MERGE TO STABILIZE EARNINGS WHEN STOCKHOLDERS CAN MERELY PURCHASE
BOTH STOCKS AND ACCOMPLISH THE SAME THING?
WELL-DIVERSIFIED
MARKET
RISK
SHAREHOLDERS
THAN
ITS
ARE
MORE
STAND-ALONE
FURTHER, WE KNOW THAT
CONCERNED
RISK,
WITH
AND
A
HIGHER
STOCK'S
EARNINGS
INSTABILITY DOES NOT NECESSARILY TRANSLATE INTO HIGHER MARKET RISK.
SOMETIMES
CANDIDATE
A
FIRM
BECAUSE
WILL
THE
BE
TOUTED
AS
REPLACEMENT
A
POSSIBLE
ACQUISITION
OF
ASSETS
VALUE
CONSIDERABLY HIGHER THAN ITS MARKET VALUE.
ITS
IS
FOR EXAMPLE, IN THE
EARLY 1980s, OIL COMPANIES COULD ACQUIRE RESERVES MORE CHEAPLY BY
BUYING
OUT
OTHER
OIL
COMPANIES
THAN
BY
EXPLORATORY
DRILLING.
HOWEVER, THE VALUE OF AN ASSET STEMS FROM ITS EXPECTED CASH FLOWS,
NOT FROM ITS COST.
THUS, PAYING $1 MILLION FOR A SLIDE RULE PLANT
THAT WOULD COST $2 MILLION TO BUILD FROM SCRATCH IS NOT A GOOD DEAL
IF NO ONE USES SLIDE RULES.
IN RECENT YEARS, MANY HOSTILE TAKEOVERS HAVE OCCURRED.
THEIR
COMPANIES
MANAGERS
INDEPENDENT,
SOMETIMES
ENGINEER
AND
DEFENSIVE
FIRMS MORE DIFFICULT TO "DIGEST."
USUALLY
DEBT-FINANCED,
ACQUIRER
TO
USE
DEBT
GENERAL,
DEFENSIVE
WHICH
TO
PROTECT
MERGERS,
THEIR
JOBS,
MAKE
THEIR
WHICH
ALSO, SUCH DEFENSIVE MERGERS ARE
MAKES
FINANCING
MERGERS
ALSO
TO KEEP
TO
APPEAR
IT
HARDER
FINANCE
TO
BE
THE
FOR
A
POTENTIAL
ACQUISITION.
DESIGNED
MORE
IN
FOR
THE
BENEFIT OF MANAGERS THAN FOR THAT OF THE STOCKHOLDERS.
AN INCREASED DESIRE TO BECOME GLOBALIZED HAS RESULTED IN MANY
MERGERS.
TO
ECONOMICALLY
GLOBALIZATION
MERGE
JUSTIFIED
HAS
LED
JUST
TO
REASON
TO
BECOME
FOR
INCREASED
A
INTERNATIONAL
MERGER;
ECONOMIES
IS
HOWEVER,
OF
NOT
AN
INCREASED
SCALE.
THUS,
SYNERGIES OFTEN RESULT--WHICH IS AN ECONOMICALLY JUSTIFIABLE REASON
FOR MERGERS.
Mini Case: 25- 18
SYNERGY APPEARS TO BE THE REASON FOR THIS MERGER.
B.
BRIEFLY
DESCRIBE
THE
DIFFERENCES
BETWEEN
A
HOSTILE
MERGER
AND
A
FRIENDLY MERGER.
ANSWER:
IN A FRIENDLY MERGER, THE MANAGEMENT OF ONE FIRM (THE ACQUIRER)
AGREES TO BUY ANOTHER FIRM (THE TARGET).
IS
INITIATED
BY
THE
ACQUIRING
FIRM,
TARGET MAY INITIATE THE MERGER.
IN MOST CASES, THE ACTION
BUT
IN
SOME
SITUATIONS
THE
THE MANAGEMENTS OF BOTH FIRMS GET
TOGETHER AND WORK OUT TERMS WHICH THEY BELIEVE TO BE BENEFICIAL TO
BOTH SETS OF SHAREHOLDERS.
THEN THEY ISSUE STATEMENTS TO THEIR
STOCKHOLDERS RECOMMENDING THAT THEY AGREE TO THE MERGER.
THE
SHAREHOLDERS
OF
THE
TARGET
FIRM
NORMALLY
MUST
OF COURSE,
VOTE
ON
THE
MERGER, BUT MANAGEMENT'S SUPPORT GENERALLY ASSURES THAT THE VOTES
WILL BE FAVORABLE.
IF
A
TARGET
FIRM'S
MANAGEMENT
ADVANCES
ARE
RESISTS
SAID
TO
THE
BE
MERGER,
HOSTILE
THEN
ACQUIRING
FIRM'S
FRIENDLY.
IN THIS CASE, THE ACQUIRER, IF IT CHOOSES TO, MUST MAKE A
DIRECT APPEAL TO THE TARGET FIRM'S SHAREHOLDERS.
RATHER
THE
THAN
THIS TAKES THE
FORM OF A TENDER OFFER, WHEREBY THE TARGET FIRM'S SHAREHOLDERS ARE
ASKED TO "TENDER" THEIR SHARES TO THE ACQUIRING FIRM IN EXCHANGE FOR
CASH, STOCK, BONDS, OR SOME COMBINATION OF THE THREE.
IF 51 PERCENT
OR MORE OF THE TARGET FIRM'S SHAREHOLDERS TENDER THEIR SHARES, THEN
THE MERGER WILL BE COMPLETED OVER MANAGEMENT'S OBJECTION.
C.
WHAT ARE THE STEPS IN VALUING A MERGER?
ANSWER:
WHEN THE CAPITAL STRUCTURE IS CHANGING RAPIDLY, AS IN MANY MERGERS,
THE WACC CHANGES FROM YEAR-TO-YEAR AND IT IS DIFFICULT TO APPLY THE
CORPORATE
VALUATION
MODEL
IN
THESE
CASES.
BETTER WHEN THE CAPITAL STRUCTURE IS CHANGING.
THE
APV
MODEL
WORKS
THE STEPS ARE:
1. PROJECT FCFT ,TST , HORIZON GROWTH RATE, AND HORIZON CAPITAL
STRUCTURE.
2. CALCULATE THE UNLEVERED COST OF EQUITY, RSU.
3. CALCULATE WACC AT HORIZON.
4. CALCULATE HORIZON VALUE USING CONSTANT GROWTH CORPORATE VALUATION
MODEL.
5. CALCULATE VOPS AS PV OF FCFT, TST AND HORIZON VALUE, ALL
DISCOUNTED AT RSU.
Mini Case: 25- 19
D.
USE THE DATA DEVELOPED IN THE TABLE TO CONSTRUCT THE L DIVISION'S
FREE CASH FLOWS FOR 2004 THROUGH 2007.
WHY ARE WE IDENTIFYING
INTEREST EXPENSE SEPARATELY SINCE IT IS NOT NORMALLY INCLUDED IN
CALCULATING
ANALYSIS?
FREE
CASH
FLOW
OR
IN
A
CAPITAL
BUDGETING
CASH
FLOW
WHY ARE NET RETENTIONS DEDUCTED IN CALCUATING FREE CASH
FLOW?
ANSWER:
THE EASIEST APPROACH HERE IS TO CALCULATE THE FREE CASH FLOWS FOR
THE L DIVISION, ASSUMING THAT THE ACQUISITION IS MADE (IN MILLIONS
OF DOLLARS).
NET SALES
COST OF GOODS SOLD (60%)
SELLING/ADMIN. EXPENSES
EBIT
TAXES ON EBIT(40%)
NOPAT
NET RETENTIONS
FREE CASH FLOW
2004
$60.0
36.0
4.5
19.5
7.8
11.7
0.0
11.7
2005
$90.0
54.0
6.0
30.0
12.0
18.0
7.5
10.5
2006
$112.5
67.5
7.5
37.5
15.0
22.5
6.0
16.5
2007
$127.5
76.5
9.0
42.0
16.8
25.2
4.5
20.7
5.0
2.0
6.5
2.6
6.5
2.6
7.0
2.8
INTEREST EXPENSE
INTEREST TAX SAVINGS
NOTE THAT THESE FREE CASH FLOWS ARE IDENTICAL TO WHAT YOU WOULD
CONSTRUCT TO USE THE CORPORATE VALUATION MODEL OR TO USE STANDARD
CAPITAL
BUDGETING
PROCEDURES,
EXCEPT
THAT
WE
HAVE
ALSO
INCLUDED
SEPARATE LINES FOR THE INTEREST EXPENSE AND INTEREST TAX SAVINGS
(WHICH ARE CALCUATED AS INTEREST X TAX RATE AND ARE ALSO CALLED
INTEREST TAX SHIELDS).
IN MANY MERGER ANALYSES THE DEBT LEVELS
CHANGE SO DRAMATICALLY THAT USING THE CORPORATE VALUE MODEL WOULD
REQUIRE RE-ESTIMATING THE WACC EVERY YEAR.
INSTEAD, THE APV MODEL
BREAKS UP THE VALUE OF OPERATIONS INTO TWO COMPONENTS:
VOPERATIONS = VUNLEVERED + VTAX
THE
FREE
CASH
FLOWS
AND
INTEREST
SHIELD
TAX
SEPARATELY AT THE UNLEVERED COST OF EQUITY.
.
SAVINGS
ARE
DISCOUNTED
THIS IS MORE CONVENIENT
TO USE THAN THE CORPORATE VALUE MODEL BECAUSE THE UNLEVERED COST OF
EQUITY CAN BE USED EVEN WHEN THE CAPITAL STRUCTURE IS CHANGING.
Mini Case: 25- 20
ALSO, IN STRAIGHT CAPITAL BUDGETING AND THE SIMPLEST APPLICATION
OF THE CORPORATE VALUE MODEL ALL DEBT INVOLVED IS NEW DEBT, WHICH IS
ISSUED TO FUND THE ASSET ADDITIONS. HENCE, THE DEBT INVOLVED ALL
COSTS THE SAME, rd, AND THIS COST IS ACCOUNTED FOR BY DISCOUNTING THE
CASH FLOWS AT THE FIRM'S WACC. HOWEVER, IN A MERGER THE ACQUIRING
FIRM USUALLY BOTH ASSUMES THE EXISTING DEBT OF THE TARGET AND ISSUES
NEW DEBT TO HELP FINANCE THE TAKEOVER.
THUS, THE DEBT INVOLVED HAS
DIFFERENT COSTS, AND HENCE CANNOT BE ACCOUNTED FOR AS A SINGLE COST
IN THE WACC.
THE EASIEST SOLUTION IS TO EXPLICITLY INCLUDE THE
INTEREST TAX SHIELD AND USE THE APV.
IN
REGARDS
TO
RETENTIONS,
ALL
OF
THE
CASH
FLOWS
FROM
AN
INDIVIDUAL PROJECT ARE AVAILABLE FOR USE THROUGHOUT THE FIRM, SINCE
CAPITAL EXPENDITURES ARE EXPLICITLY ACCOUNTED FOR.
SIMILARLY, WE
ACCOUNT FOR CAPITAL EXPENDITURES WITHIN THE ACQUIRED FIRM WHEN WE
CALCULATE
FREE
CASH
FLOW.
THERE
ARE
TWO
EQUIVALENT
WAYS
TO
CALCULATE FREE CASH FLOW:
NOPAT
+ DEPRECIATION
= OPERATING CASH FLOW
- GROSS RETENTIONS
= FREE CASH FLOW
OR:
NOPAT
- NET RETENTIONS
= FREE CASH FLOW
WHERE NET RETENTIONS = GROSS RETENTIONS – DEPRECIATION.
THE INTEREST TAX SAVINGS ARE CASH FLOWS THAT ARE ALSO AVAILABLE
TO PAY INTEREST, PRINCIPAL, OR FOR OTHER USE WITHIN THE FIRM.
THE
CORPORATE
VALUATION
MODEL
(WHICH
ASSUMED
A
STABLE
IN
CAPITAL
STRUCUTURE) WE ACCOUNTED FOR THE VALUE OF THESE TAX SAVINGS BY USING
A LOWER COST OF CAPITAL--THE DEBT COMPONENT OF THE WACC IS REDUCED
BY THE FACTOR (1-T).
IN THE APV WE DISCOUNT AT THE HIGHER UNLEVERED
COST OF EQUITY AND TAKE THESE TAX SAVINGS INTO ACCOUNT EXPLICITLY.
Mini Case: 25- 21
NOTE
THAT
IN
MANY
CASES,
AND
IN
THIS
CASE,
THE
CORPORATE
VALUATION MODEL CAN BE USED AT THE HORIZON TO CALCULATE THE HORIZON
VALUE.
THIS IS BECAUSE IN MANY CASES THE FIRM IS AT A STABLE
CAPITAL STRUCTURE BY THE HORIZON AND IN THIS CASE THE CORPORATE
VALUATION MODEL IS EASIER TO APPLY.
SO THE STEPS ARE:
(1) APPLY CORPORATE VALUATION MODEL AT HORIZON TO GET THE HORIZON
VALUE (2) DISCOUNT THE FREE CASH FLOWS AND TAX SHIELDS BEFORE THE
HORIZON, ALONG WITH THE HORIZON VALUE, AT THE UNLEVERED COST OF
EQUITY.
THIS GIVES THE VALUE OF OPERATIONS.
(3) SUBTRACT THE
CURRENT LEVEL OF DEBT TO GET THE CURRENT EQUITY VALUE.
E.
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?
ANSWER:
AS DISCUSSED ABOVE, THE FREE CASH FLOWS, TAX SHIELDS AND HORIZON
VALUE SHOULD ALL BE DISCOUNTED AT THE UNLEVERED COST OF EQUITY.
THIS COST SHOULD BE CALCULATED BASED ON THE TARGET’S RISK, NOT THE
ACQUIRER’S
RISK.
HAGER’S
INVESTMENT
BANKERS
LYONS’ LIGHTING’S BETA IS CURRENTLY 1.3.
HAVE
ESTIMATED
THAT
THE HORIZON VALUE SHOULD
BE CALCULATED USING LYONS’ WACC, WHICH IS BASED ON THE COSTS OF DEBT
AND EQUITY AFTER ANY CHANGE IN LEVERAGE.
TO OBTAIN THE UNLEVERED REQUIRED RATE OF RETURN WE FIRST NEED THE
LEVERED REQUIRED RATE OF RETURN.
NOTE THAT rRF = 7% AND RPM = 4%.
THUS, THE L DIVISION'S LEVERED REQUIRED RATE OF RETURN ON EQUITY IS:
rs(LYONS’
LIGHTING)
= rRF + (rM - rRF)bLYONS’
LIGHTING
= 7% + (4%)1.3 = 12.2%.
THE UNLEVERED COST OF EQUITY, BASED ON A 20% DEBT RATIO, COST OF
DEBT OF 9%, AND A LEVERED COST OF EQUITY OF 12.2% IS:
rsU = wdrd + wsrsL
= 0.20(9%) + 0.80(12.2%) = 11.56%
SINCE HAGER’S WILL MAINTAIN LYONS’ CURRENT CAPITAL STRUCTURE OF 20%
DEBT AT THE HORIZON, THE WACC TO BE USED IN THE HORIZON VALUE
CALCULATION CAN BE BASED ON THE LEVERED COST OF EQUITY CALCULATED
Mini Case: 25- 22
ABOVE.
IF, AS WE DISCUSS IN A LATER PART TO THIS MINI-CASE, LYONS’
CAPITAL STRUCTURE IS TO BE CHANGED, THEN A NEW LEVERED COST OF
EQUITY MUST BE CALCULATED BASED ON THIS NEW CAPITAL STRUCTURE, AND
THE WACC CALCULATION BASED ON THIS NEW LEVERED COST OF EQUITY.
WACC = wdrd(1 – T) + wsrsL
= 0.20(9%)(1 – 0.40) + 0.80(12.2%) = 10.84%
F.
WHAT
IS
THE
ACQUISITION;
ESTIMATED
THAT
IS,
HORIZON,
WHAT
IS
DIVISION'S CASH FLOWS BEYOND 2007?
SHAREHOLDERS?
THE
CONTINUING,
ESTIMATED
VALUE
VALUE
OF
OF
THE
THE
L
WHAT IS LYONS’ VALUE TO HAGER’S
SUPPOSE ANOTHER FIRM WERE EVALUATING LYONS’ AS AN
ACQUISITION CANDIDATE.
ANSWER:
OR
WOULD THEY OBTAIN THE SAME VALUE? EXPLAIN.
THE 2007 CASH FLOW IS $20.7 MILLION, AND IT IS EXPECTED TO GROW AT A
6 PERCENT CONSTANT GROWTH RATE IN 2008 AND BEYOND.
WITH A CONSTANT
GROWTH RATE AND STABLE CAPITAL STRUCUTURE, THE CORPORATE VALUE MODEL
CAN BE USED TO VALUE THE CASH FLOWS BEYOND 2007:
HORIZON VALUE =
(2007 CASH FLOW)(1  g)
WACC  g
$20.7(1.06)
=
0.1084  0.06
= $453.3 MILLION.
ADDING THE HORIZON VALUE, THE TOTAL CASH FLOW STREAM LOOKS LIKE
THIS (IN MILLIONS OF DOLLARS):
2004
ANNUAL FREE CASH FLOW $11.7
HORIZON VALUE
INTEREST TAX SHIELD
2.0
TOTAL CASH FLOW
$13.7
2005
$10.5
2006
$16.5
2.6
$13.1
2.6
$19.1
2007
$ 20.7
453.3
2.8
$476.8
NOW, THE VALUE OF LYONS’ OPERATIONS IS THE PRESENT VALUE OF THIS
STREAM, DISCOUNTED AT ITS UNLEVERED COST OF EQUITY, 11.6%.
THE
PRESENT VALUE IS $344.4 MILLION.
THE VALUE OF LYONS’ EQUITY IS THIS VALUE OF OPERATIONS LESS ITS
CURRENT DEBT OF $55 MILLION, FOR AN EQUITY VALUE OF $289.4 MILLION.
IF ANOTHER FIRM WERE VALUING LYONS’, THEY WOULD PROBABLY OBTAIN AN
ESTIMATE
DIFFERENT
FROM
$289.4
MILLION.
MOST
IMPORTANT,
THE
Mini Case: 25- 23
SYNERGIES INVOLVED WOULD LIKELY BE DIFFERENT, AND HENCE THE CASH
FLOW ESTIMATES WOULD DIFFER.
ALSO, ANOTHER POTENTIAL ACQUIRER MIGHT
USE DIFFERENT FINANCING, OR HAVE A DIFFERENT TAX RATE, AND HENCE
ESTIMATE A DIFFERENT DISCOUNT RATE AT THE HORIZON AND HAVE DIFFERENT
INTEREST TAX SHIELDS.
G.
ASSUME THAT LYONS’ HAS 20 MILLION SHARES OUTSTANDING.
THESE SHARES
ARE TRADED RELATIVELY INFREQUENTLY, BUT THE LAST TRADE, MADE SEVERAL
WEEKS AGO, WAS AT A PRICE OF $11 PER SHARE.
OFFER FOR LYONS’?
ANSWER:
WITH
A
CURRENT
SHOULD HAGER’S MAKE AN
IF SO, HOW MUCH SHOULD IT OFFER PER SHARE?
PRICE
OF
$11
PER
SHARE
AND
20
MILLION
SHARES
OUTSTANDING, LYONS’ CURRENT MARKET VALUE IS $11(20) = $220 MILLION.
SINCE LYONS’ EXPECTED VALUE TO HAGER’S IS $289.4 MILLION, IT APPEARS
THAT THE MERGER WOULD BE BENEFICIAL TO BOTH SETS OF STOCKHOLDERS.
THE DIFFERENCE, $289.4 - $220.0 = $69.4 MILLION, IS THE ADDED VALUE
TO BE APPORTIONED BETWEEN THE STOCKHOLDERS OF BOTH FIRMS.
THE OFFERING RANGE IS FROM $11 PER SHARE TO $289.4/20 = $14.47
PER SHARE.
AT $11, ALL OF THE BENEFIT OF THE MERGER GOES TO HAGER’S
SHAREHOLDERS, WHILE AT $14.47, ALL OF THE VALUE CREATED GOES TO
LYONS’ SHAREHOLDERS.
IF HAGER’S OFFERS MORE THAN $14.47 PER SHARE,
THEN WEALTH WOULD BE TRANSFERRED FROM HAGER’S STOCKHOLDERS TO LYONS’
STOCKHOLDERS.
AS TO THE ACTUAL OFFERING PRICE, HAGER’S SHOULD MAKE THE OFFER AS
LOW
AS
POSSIBLE,
YET
ACCEPTABLE
TO
LYONS’
SHAREHOLDERS.
A
LOW
INITIAL OFFER, SAY $11.50 PER SHARE, WOULD PROBABLY BE REJECTED AND
THE EFFORT WASTED.
SUITORS
HAGER’S.
TO
FURTHER, THE OFFER MAY INFLUENCE OTHER POTENTIAL
CONSIDER
LYONS’,
AND
THEY
COULD
END
UP
OUTBIDDING
CONVERSELY, A HIGH PRICE, SAY $14, PASSES ALMOST ALL OF
THE GAIN TO LYONS’ STOCKHOLDERS, AND HAGER’S MANAGERS SHOULD RETAIN
AS
MUCH
OF
THE
SYNERGISTIC
VALUE
AS
POSSIBLE
FOR
THEIR
OWN
SHAREHOLDERS.
NOTE THAT THIS DISCUSSION ASSUMES THAT LYONS’ $11 PRICE IS A
"FAIR," EQUILIBRIUM VALUE IN THE ABSENCE OF A MERGER.
SINCE THE
STOCK TRADES INFREQUENTLY, THE $11 PRICE MAY NOT REPRESENT A FAIR
MINIMUM PRICE. LYONS’ MANAGEMENT SHOULD MAKE AN EVALUATION (OR HIRE
Mini Case: 25- 24
SOMEONE
TO
MAKE
THE
EVALUATION)
OF
A
FAIR
PRICE
AND
USE
THIS
INFORMATION IN ITS NEGOTIATIONS WITH HAGER’S.
H.
HOW
WOULD
THE
ANALYSIS
BE
DIFFERENT
IF
HAGER’S
INTENDED
TO
RECAPITALIZE LYONS’ WITH 40% DEBT COSTING 10% AT THE END OF FOUR
YEARS?
ANSWER:
THE FREE CASH FLOWS AND THE UNLEVERED COST OF EQUITY WOULD BE
UNCHANGED.
IF WE ASSUME THAT THE INTEREST PAYMENTS IN THE FIRST 4
YEARS ARE UNCHANGED, AND THE INTENTION IS TO USE 40 PERCENT DEBT AT
THE HORIZON, THEN THE HORIZON LEVERED COST OF EQUITY WOULD INCREASE,
AND THE LEVERED WACC WOULD DECREASE.
NEW LEVERED COST OF EQUITY = rsL = rU + (ru – rd)(D/S)
= 11.6% + (11.6% - 10%)(0.40/0.60)
= 12.6%
NEW WACC = wdrd(1 – T) + wsrsL
= 0.40(10%)(1 – 0.40) + 0.60(12.6%) = 9.96%
THE NEW HORIZON VALUE IS BASED ON THIS NEW WACC:
(2007 CASH FLOW)(1  g)
WACC  g
$20.7(1.06)
=
0.0996  0.06
= $554.1 MILLION.
NEW HORIZON VALUE =
ASSUMING HAGER’S WILL KEEP THE SAME DEBT LEVEL FOR THE FIRST FOUR
YEARS AS ASSUMED AND THEN TARGET A 40% DEBT LEVEL IN THE HORIZON,
THE NEW VALUE OF OPERATIONS IS THE PV OF THE FREE CASH FLOWS, TAX
SHIELDS FROM BEFORE, BUT USING THIS NEW HORIZON VALUE:
NEW VOPS = $409.5 MILLION
LESS DEBT OF $55 MILLION LEAVES EQUITY OF $354.5 MILLION. THIS IS
$65.0 MILLION, OR $3.25 PER SHARE, MORE THAN AT A 20% DEBT LEVEL.
THE DIFFERENCE IN VALUE IS DUE TO THE ADDED INTEREST TAX SHIELD AT
THE HIGHER DEBT LEVEL.
Mini Case: 25- 25
I.
THERE HAS BEEN CONSIDERABLE RESEARCH UNDERTAKEN TO DETERMINE WHETHER
MERGERS REALLY CREATE VALUE AND, IF SO, HOW THIS VALUE IS SHARED
BETWEEN
THE
PARTIES
INVOLVED.
WHAT
ARE
THE
RESULTS
OF
THIS
RESEARCH?
ANSWER:
MOST RESEARCHERS AGREE THAT TAKEOVERS INCREASE THE WEALTH OF THE
SHAREHOLDERS OF TARGET FIRMS, FOR OTHERWISE THEY WOULD NOT AGREE TO
THE OFFER.
HOWEVER, THERE IS A DEBATE AS TO WHETHER MERGERS BENEFIT
THE ACQUIRING FIRM’S SHAREHOLDERS.
THE RESULTS OF THESE STUDIES
HAVE SHOWN, ON AVERAGE, THE STOCK PRICES OF TARGET FIRMS INCREASE BY
ABOUT 30 PERCENT IN HOSTILE TENDER OFFERS, WHILE IN FRIENDLY MERGERS
THE AVERAGE INCREASE IS ABOUT 20 PERCENT.
HOWEVER, FOR BOTH HOSTILE
AND FRIENDLY DEALS, THE STOCK PRICES OF ACQUIRING FIRMS, ON AVERAGE,
REMAIN CONSTANT.
CREATE
VALUE,
THUS, ONE CAN CONCLUDE THAT (1) ACQUISITIONS DO
BUT
(2)
THAT
SHAREHOLDERS
OF
TARGET
FIRMS
REAP
VIRTUALLY ALL THE BENEFITS.
J.
WHAT METHOD IS USED TO ACCOUNT FOR MERGERS?
ANSWER:
MERGERS MUST BE ACCOUNTED FOR USING PURCHASE ACCOUNTING, IN WHICH
THE ACQUIRED COMPANY IS TREATED AS ANY OTHER CAPITAL ASSET PURCHASE.
THE OLD METHOD CALLED “POOLING ACCOUNTING” HAS BEEN ELIMINATED.
K.
WHAT MERGER-RELATED ACTIVITIES ARE UNDERTAKEN BY INVESTMENT BANKERS?
ANSWER:
THE
INVESTMENT
BANKING
COMMUNITY
IS
INVOLVED
WITH
MERGERS
IN
A
NUMBER OF WAYS.
SEVERAL OF THESE ACTIVITIES ARE:
(1) HELPING TO
ARRANGE
(2)
DEVELOPING
MERGERS,
IMPLEMENTING
DEFENSIVE
AIDING
TARGET
TACTICS,
COMPANIES
(3)
IN
HELPING
TO
VALUE
AND
TARGET
COMPANIES, (4) HELPING TO FINANCE MERGERS, AND (5) RISK ARBITRAGE-SPECULATING
TARGETS.
Mini Case: 25- 26
IN
THE
STOCKS
OF
COMPANIES
THAT
ARE
LIKELY
TAKEOVER
HOPEFULLY, INVESTMENT BANKERS ARE NOT GIVING KICKBACKS TO COMPANY
EXECUTIVES WHO GIVE THEM BUSINESS, OR PROVIDING FRAUDULENT ANALYST
REPORTS TO PUMP UP THE STOCKS OF COMPANIES THEY WOULD LIKE TO DO
BUSINESS WITH.
L.
WHAT IS A LEVERAGED BUYOUT (LBO)?
WHAT ARE SOME OF THE ADVANTAGES
AND DISADVANTAGES OF GOING PRIVATE?
ANSWER:
A
LEVERAGED
BUYOUT
IS
A
SITUATION
IN
WHICH
HEAVILY TO BUY ALL THE SHARES OF A COMPANY.
PRIVATE
INCLUDE
ADMINISTRATIVE
COST
SAVINGS,
A
SMALL
GROUP
OF
ADVANTAGES TO GOING
INCREASED
MANAGERIAL
INCENTIVES, INCREASED MANAGERIAL FLEXIBILITY, INCREASED SHAREHOLDER
PARTICIPATION,
AND
INCREASED
FINANCIAL
LEVERAGE.
THE
MAIN
DISADVANTAGE OF GOING PRIVATE IS NOT HAVING ACCESS TO THE LARGE
AMOUNTS
M.
OF
CAPITAL
AVAILABLE
IN
THE
EQUITY
WHAT ARE THE MAJOR TYPES OF DIVESTITURES?
MARKET,
MAKING
IT
WHAT MOTIVATES FIRMS TO
DIVEST ASSETS?
ANSWER:
THE THREE PRIMARY TYPES OF DIVESTITURES ARE (1) THE SALE OF 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
ASSETS.
THE
STOCKHOLDERS,
REASONS
FOR
AND
(3)
DIVESTITURES
OUTRIGHT
VARY
LIQUIDATION
WIDELY.
OF
SOMETIMES
COMPANIES NEED CASH EITHER TO FINANCE EXPANSION IN THEIR PRIMARY
BUSINESS LINES OR TO REDUCE A LARGE DEBT BURDEN.
SOMETIMES FIRMS
DIVEST TO UNLOAD LOSING ASSETS THAT WOULD OTHERWISE DRAG THE COMPANY
DOWN, OR DIVESTING MAY BE THE RESULT OF AN ANTITRUST SETTLEMENT,
WHERE THE GOVERNMENT REQUIRES A BREAKUP.
Mini Case: 25- 27
N.
WHAT
ARE
HOLDING
COMPANIES?
WHAT
ARE
THEIR
ADVANTAGES
AND
DISADVANTAGES?
ANSWER:
HOLDING COMPANIES ARE CORPORATIONS FORMED FOR THE SOLE PURPOSE OF
OWNING THE STOCKS OF OTHER COMPANIES.
THE ADVANTAGES INCLUDE THE
ABILITY TO CONTROL A COMPANY WITHOUT OWNING ALL ITS STOCKS AND THE
ABILITY
TAXATION
TO
OF
ISOLATE
EARNINGS
RISKS.
AT
BOTH
DISADVANTAGES
THE
INCLUDE
SUBSIDIARY
AND
THE
PARENT
HOLDING COMPANIES CAN ALSO BE EASILY DISSOLVED BY REGULATORS.
Mini Case: 25- 28
POSSIBLE
LEVELS.
Mini Case: 25- 29