Chapter 26
Mergers, LBOs, Divestitures, and Holding Companies
ANSWERS TO END-OF-CHAPTER QUESTIONS
26-1
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. A pooling of interests is, in theory, a merger among equals, and
hence the consolidated balance sheet is constructed by simply adding
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Answers and Solutions: 26 - 1
together the balance sheets of the merged companies. Another way a
merger is handled for accounting purposes is as a purchase. In this
method, the acquiring firm is assumed to have “bought” the acquired
company in much the same way it would buy any capital asset.
g. A white knight is a friendly competing bidder which 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.
26-2
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: 26 - 2
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26-3
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.
26-4
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.
26-5
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.
26-6
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
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Answers and Solutions: 26 - 3
separate companies. In general, it is safe to conclude that one should
be wary of nonsynergistic mergers.
Answers and Solutions: 26 - 4
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SOLUTIONS TO END-OF-CHAPTER PROBLEMS
26-1
D1 = $2.00; g = 5%; b = 0.9; kRF = 5%; RPM = 6%; P0 = ?
ks = kRF + RPM(b)
= 5% + 6%(0.9)
= 10.4%.
P0 =
D1
ks − g
$2.00
0.104 − 0.05
= $37.04.
=
26-2
D1 = $2.00; g = 7%; b = 1.1; kRF = 5%; RPM = 6%; P0 = ?
kS = kRF + RPM(b)
= 5% + 6%(1.1)
= 11.6%.
P0 =
D1
ks − g
$2.00
0.116 − 0.07
= $43.48.
=
26-3
On the basis of the answers in Problems 26-1 and 26-2, the bid for each
share should range between $37.04 and $43.48.
26-4
a. The appropriate discount rate reflects the riskiness of the cash
flows to equity investors.
Thus, it is Vaccaro's cost of equity,
adjusted for leverage effects. Since Apilado's b = 1, its RPM = kM kRF = 14% - 8% = 6%, then:
ks = kRF + (kM - kRF)b = 8% + (14% - 8%)1.5 = 17%.
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Answers and Solutions: 26 - 5
b. The value of Vaccaro is $14.65 million:
0
|
1
|
1.30
17%
2
|
1.50
3
|
1.75
4
5
|
|
g = 6%
2.00
2.12
19.27*
1.11
1.10
1.09
11.35
V = $14.65 million
21.27
CF5 = CF4(1.06) = $2.00(1.06) = $2.12.
Value at t4 of CF5 and all subsequent cash flows is:
*V4 =
CF5
ks − g
=
$2.12
= $19.27.
0.17 − 0.06
Alternatively, input 0, 1.30, 1.50, 1.75, and 21.27(2.00 + 19.27)
into the cash flow register, I = 17, NPV = ? NPV = $14.65.
26-5
0
|
-400,000
1
|
64,000
2
|
64,000
3
|
64,000
• • •
10
|
64,000
CF1 - CF10 = $64,000.
CF0 = -$400,000.
k = 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.
26-6
a. Since the net cash flows are equity returns, the appropriate
discount rate is that cost of equity which reflects the riskiness of
the cash flow stream. This cost is GCC's cost of equity:
ks = kRF + (RPM)b = 8% + (4%)1.50 = 14%.
b. The terminal value is $1,143.4:
Answers and Solutions: 26 - 6
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TV =
$74.8(1.07)
= $1,143.4.
0.14 − 0.07
Annual cash flows are calculated as follows:
Sales
COGS (65%)
Gross profit
Selling/Admin
EBIT
Interest
EBT
Taxes (35%)
Net income
2002
$450.0
(292.5)
$157.5
(45.0)
$112.5
(18.0)
$ 94.5
(33.1)
$ 61.4
2003
$518.0
(336.7)
$181.3
(53.0)
$128.3
(21.0)
$107.3
(37.6)
$ 69.7
2004
$555.0
(360.7)
$194.3
(60.0)
$134.3
(24.0)
$110.3
(38.6)
$ 71.7
2005
$600.0
(390.0)
$210.0
(68.0)
$142.0
(27.0)
$115.0
(40.3)
$ 74.8
The value of GCC to TransWorld's shareholders is the present value
of the cash flows which accrue to the shareholders:
V =
$61.4
$69.7
$71.7
$1,218.2
+
+
+
= $877.2.
(1.14)1
(1.14)2
(1.14)3
(1.14)4
Alternatively, input 0, 61.4, 69.7, 71.7, and 1,218.2 into the cash
flow register, I = 14, NPV = ? NPV = $877.2.
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Answers and Solutions: 26 - 7
SOLUTION TO SPREADSHEET PROBLEMS
26-7
The detailed solution
instructor’s resource
Model.xls) and on the
Publishers’ web site,
26-8
a. Under the assumptions given in Part a, the value of the acquisition
would increase to $1,414 (all dollar amounts in thousands).
INPUT DATA:
Net sales
COGS
Sell./adm. exp.
Interest
for the problem is available both on the
CD-ROM (in the file Solution for Ch 26-7 Build a
instructor’s side of the Harcourt College
http://www.harcourtcollege.com/finance/theory10e.
60.00%
2002
$550
330
45
18
2003
$618
371
53
21
2004
$655
393
60
24
2005
$700
420
68
27
Net income
Terminal value of cash flow
Net cash flow to TransWorld
102
0
$102
113
0
$113
116
0
$116
120
1,838
$1,958
Beta after merger
Risk-free rate
Market risk premium
1.5
8%
4%
Debt ratio after merger
Tax rate after merger
Terminal growth rate
50%
35%
7.00%
KEY OUTPUT:
Cost of equity
Terminal value
14.0%
$1,838
Value of acquisition
$1,414
b. Under these assumptions, the value of the acquisition would fall to
$993, but the acquisition should still be undertaken (all dollar
amounts in thousands).
INPUT DATA:
Net sales
COGS
Sell./adm. exp.
Interest
60.00%
2002
$550
330
45
18
2003
$618
371
53
21
2004
$655
393
60
24
2005
$700
420
68
27
Net income
Terminal value of cash flow
Net cash flow to TransWorld
102
0
$102
113
0
$113
116
0
$116
120
1,287
$1,407
Beta after merger
Risk-free rate
Market risk premium
Solution to Spreadsheet Problems: 26 - 8
1.6
9%
5%
Debt ratio after merger
Tax rate after merger
Terminal growth rate
50%
35%
7.00%
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KEY OUTPUT:
Cost of equity
Continuing value
17.0%
$1,287
Value of acquisition
$993
c. If the terminal growth rate increases to 12 percent, the value of
the acquisition would increase to $1,743, while it would fall to
$778 if the terminal growth rate were only 3 percent. Under any of
the situations hypothesized, however, the acquisition would be
profitable and should be pursued (all dollar amounts in thousands).
TERMINAL GROWTH RATE = 12 percent:
INPUT DATA:
Net sales
COGS
Sell./adm. exp.
Interest
60.00%
2002
$550
330
45
18
2003
$618
371
53
21
2004
$655
393
60
24
2005
$700
420
68
27
Net income
Terminal value of cash flow
Net cash flow to TransWorld
102
0
$102
113
0
$113
116
0
$116
120
2,694
$2,814
Beta after merger
Risk-free rate
Market risk premium
1.6
9%
5%
Debt ratio after merger
Tax rate after merger
Terminal growth rate
50%
35%
12.00%
Value of acquisition
$1,743
KEY OUTPUT:
Cost of equity
Terminal value
17.0%
$2,694
TERMINAL GROWTH RATE = 3 percent:
INPUT DATA:
Net sales
COGS
Sell./adm. exp.
Interest
60.00%
2002
$550
330
45
18
2003
$618
371
53
21
2004
$655
393
60
24
2005
$700
420
68
27
Net income
Terminal value of cash flow
Net cash flow to TransWorld
102
0
$102
113
0
$113
116
0
$116
120
885
$1,005
Beta after merger
Risk-free rate
Market risk premium
1.6
9%
5%
Debt ratio after merger
Tax rate after merger
Terminal growth rate
50%
35%
3.00%
KEY OUTPUT:
Cost of equity
Continuing value
17.0%
$885
Value of acquisition
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$778
Solution to Spreadsheet Problems: 26 - 9
CYBERPROBLEM
26-9
The detailed solution for the cyberproblem is available on the
instructor’s side of the Harcourt College Publishers’ web site,
http://www.harcourtcollege.com/finance/theory10e.
Solution to Cyberproblem: 26 - 10
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Mini Case: 26 - 11