CORPORATE
FINANCIAL
THEORY
Lecture 9
Megers & Acquisitions
Three Areas of Study
1.
Determining if a Merger creates value (then
developing an offer price)
2.
Evaluating M&A offers in the market place (your case
analysis assignment)
3.
M&A Strategies (biggest area of “talk”)
Today - Cover both
Part 1 & 3 via lecture
Part 2 via example
Recent Mergers
Bank of America Family Tree
Note: Ironically, MBNA was once owned by a previous version of Bank of
America, which sold it in an IPO.
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
Number of deals
Mergers (1962-2013)
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by using
excess capacity or spreading fixed costs across more units.
Reduces costs
$
$
$
Sensible Reasons for Mergers
Economies of Vertical Integration
 Control
over suppliers “may” reduce costs.
 Over integration can cause the opposite effect.
Pre-integration
(less efficient)
Post-integration
(more efficient)
Company
S
S
S
S
S
Company
S
S
S
Sensible Reasons for Mergers
Combining Complementary Resources
Merging may results in each firm filling in the
“missing pieces” of their firm with pieces from the
other firm.
Firm A
Firm B
Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if any,
positive NPV projects available, acquisition may be the
best use of your funds.
Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low
number of shares)
After merger, acquiring firm has short term
EPS rise
Long term, acquirer will have slower than
normal EPS growth due to share dilution.
Dubious Reasons for Mergers

Boot Strap Game

Diversification
 Investors
should not pay a premium for diversification
since they can do it themselves.

Excuse to change capital structure
Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises
(before merger)
EPS
Price per share
P/E Ratio
Number of shares
Total earnings
Total market value
Current earnings
per dollar invested
in stock
$
$
$
$
$
2.00
40.00
20
100,000
200,000
4,000,000
World Enterprises
(after buying Muck
and Slurry)
Muck and Slurry
$
2.00 $
2.67
$
20.00 $
40.00
10
15
100,000
150,000
$
200,000 $
400,000
$
2,000,000 $
6,000,000
0.05 $
0.10 $
0.067
Dubious Reasons for Mergers
Earnings per
dollar invested
(log scale)
World Enterprises (after merger)
World Enterprises (before merger)
Muck & Slurry
.10
.067
.05
Now
Time
Other People’s Money
Additivity Principle
Estimating Merger Gains
Economic Gain = PV(increased earnings)
=
New cash flows from synergies
discount rate
Q: If M&A creates value, Why?
A:
Synergies
-Admin
-Dup services
-lower COC
Estimating Merger Gains

Questions
 Is
there an overall economic gain to the merger?
 Do the terms of the merger make the company and its
shareholders better off?
????
PV(AB) > PV(A) + PV(B)
Estimating Merger Gains
Gain  PV AB  ( PV A  PVB )  PV AB
Cost  Cash paid  PVB
NPV  gain  lost
 PV AB  ( cash  PVB )
Estimating Merger Gains
Example – Two firms merge creating $25 million
in synergies. If A buys B for $65 million, the cost is
$15 million.
PVA  $200
PVB  $50
Gain  PVAB  $25
PVAB  $275million
Cost  Cash paid  PVB
 65  50  $15million
Estimating Merger Gains
Example – The NPV to A will be the difference
between the gain and the cost.
NPVA  25  15  $10million
NPVA  wealth wit h merger - wealth wi thout merger
 ( PVAB  Cash)  PVA
 (275  65)  200
 $10million
Estimating Merger Gains
Q: How Much Should A Firm Pay in a M&A?
A: Theory
Gain = PVAB - (PVA + PVB)
A must pay B part of the gain
A: Reality
A usually pays B all of the gain, plus more.
Why?
Premium Paid by A = (Cash - MVB) + (MVB - PVB)
Other People’s Money
Board Meeting
Takeover Methods
Type of Takeovers
• Hostile
• Friendly
• LBO
• Going Private
• Greenmail
• White Knight
Takeover Methods
Tools Used To Acquire Companies
Proxy Contest
Tender Offer
Acquisition
Leveraged
Buy-Out
Merger
Management
Buy-Out
Takeover Defenses
White Knight - Friendly potential acquirer sought by a target
company threatened by an unwelcome suitor.
Shark Repellent - Amendments to a company charter made to
forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoid acquisition;
for example, the right for existing shareholders to buy
additional shares at an attractive price if a bidder acquires a
large holding.
Takeover Defenses
Wall Street
Board Meeting
M&A








Who Usually Benefits from M&A?
Shareholders of B
Lawyers & Brokers
Execs in A
Who Usually Losses in M&A?
Shareholders of A
Execs in B
Employees
M&A Analysis
Steps for M&A Market Analysis
• Briefly describe the financial & strategic history of the
company
• Determine pre-announcement value
• Describe M&A offer
• Determine merged value (examine synergies)
• Compare values, offer, & market prices
• Predict success of M&A
• Recommend a strategy for investors and shareholders
• Provide a summary analysis
M&A Analysis







History - News, Annual Report, 10k, etc.
(Library & My Web page)
(use spreadsheets to present financial facts)
(reference your sources)
(present both original & summary data)
(remember to annualize data)
Submit electronically


Excel file only
Named: Last Name in File Name
Disney / Cap Cities Deal

•
•
•
Announcement of Offer
Disney offers to acquire Cap Cities/ABC.
Disney will exchange each share of Cap Cities for
one share of Disney plus $65 cash.
Disney will issue $10bil in new debt to finance the
deal.
Fact Sheet
Disney
CC \ ABC
.EPS(curre nt) $
2.60
5.10
.7/31 sh Price ($)
57.38
96.13
.8/1 sh Price ($)
58.63
116.25
PE ratio
22
# Shares
19
New Firm
2.33 * *
58.63
25
520 mil
154 mil
EPS Growth Rate
20. %
14. %
.Assets ($)
32.40 bil
15.30 bil
52.60 bil
47.70 bil
2.60 bil
0.50 bil
13.10 bil
3.10 bil
29.80 bil
14.80 bil
39.50 bil
44.60 bil
EBIT
1.88 bil
1.28 bil
3.18 bil
.Debt Service ($)
0.19 bil
0.04 bil
1.05 bil
.Operating Inc ($)
1.69 bil
1.24 bil
2.13 bil
.Taxes ($)
0.59 bil
0.43 bil
0.75 bil
.Net Earnings ($)
1.10 bil
0.81 bil
1.38 bil
.Debt ($ MV)
.Equity ($ MV)
674 mil
?
Comb Sep
**
Disney
Market
Forecasted N.E. @ 14% growth rate
Rd
7.25%
8.0 %
Forecasted N.E. @ EPSx#New Shares
EPS
$ 2.50
$ 2.33
Disney Proforma Forecast (,000s)
Perpetual discount rate = 11.36%
Perpetual Avg Growth = 4%
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
$1,031,202
165,458
110,697
1,307,357
$1,198,772
191,600
116,232
1,506,605
$1,393,573
221,873
122,043
1,737,489
$1,620,028
256,929
128,146
2,005,103
$1,883,283
297,524
134,553
2,315,360
$2,189,317
344,533
141,281
2,675,130
$2,545,080
398,969
148,345
3,092,394
$2,958,656
462,006
155,762
3,576,424
$3,439,438
535,003
163,550
4,137,991
$3,998,346
619,534
171,727
4,789,607
$4,648,078
717,420
180,314
5,545,811
$5,403,390
830,772
189,329
6,423,492
959,018
164,776
58,116
1,181,910
1,114,858
190,811
61,022
1,366,691
1,296,023
220,959
64,073
1,581,055
1,506,626
255,871
67,276
1,829,774
1,751,453
296,298
70,640
2,118,392
2,036,064
343,113
74,172
2,453,350
2,366,925
397,325
77,881
2,842,131
2,751,550
460,103
81,775
3,293,428
3,198,677
532,799
85,864
3,817,340
3,718,462
616,981
90,157
4,425,600
4,322,712
714,464
94,665
5,131,841
206,240
23,164
55,349
284,753
239,754
26,824
58,116
324,694
278,715
31,062
61,022
370,799
324,006
35,970
64,073
424,049
376,657
41,653
67,276
485,586
437,863
48,235
70,640
556,738
509,016
55,856
74,172
639,044
591,731
64,681
77,881
734,293
687,888
74,900
81,775
844,563
799,669
86,735
85,864
972,268
929,616
100,439
90,157
1,120,211
1,080,678
116,308
94,665
1,291,651
8,543
9,741
11,124
12,721
14,568
16,702
19,171
22,029
25,337
29,168
33,606
38,750
276,210
314,954
359,675
411,327
471,019
540,036
619,873
712,264
819,226
943,100
1,086,605
1,252,901
Revenues
Theme parks (exh 11)
Motion pictures (exh 8)
Consumer products (exh 12)
Total revenues
Costs & expenses of operations
Theme Parks (80%)
Motion pictures (86%)
Consumer products (50%)
Total costs & expenses
824,962
142,294
55,349
1,022,604
Operating income before corporate
Entertainment & recreation
Motion pictures
Consumer products & other
Total operating income
Corporate Expenses
G&A, Int, etc (3%)
Income
Taxes @ 43%
Net Income
118,770
135,430
154,660
176,871
202,538
232,215
266,545
306,274
352,267
405,533
467,240
538,748
----------------------- --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------157,440
179,524
205,015
234,456
268,481
307,821
353,327
405,991
466,959
537,567
619,365
714,154
----------------------- --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Term Value=
10,091,303
Cash Flow
179,524
205,015
'NPV @ 19.82% =
$2,713,269
Price per share =
$78.65
# shares =
34.5
*Capital Investments are assumed to equal depreciation
$71.72
37.83
$64.48
42.08
234,456
268,481
307,821
353,327
405,991
466,959
537,567
619,365
10,805,457
Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Pretax cost savings, constant dollars
Expected inflation rate
Growth rate of FCF (nominal), in perpetuity
Discount rate
Ongoing investment / savings (year 3+)
Pretax cost savings, current dollars
Tax expense (@ 40%)
After-tax cost savings
Less: investment necessary to realize the savings
Plus: disinvestment associated with the savings
Subtotal
Terminal value
Free cash flow
14 Net Present Value of Cost Savings
1
2
3
4
$1,500 $3,000 $3,000 $3,000
2%
2%
2%
2%
5
$3,000
2%
2%
14%
0%
$1,530 $3,121 $3,184 $3,247
(612) (1,248) (1,273) (1,299)
918 1,873 1,910 1,948
0
0
0
0
0
0
0
0
918 1,873 1,910 1,948
$0
$14,495
$3,312
(1,325)
1,987
0
0
1,987
16,892
$918 $1,873 $1,910 $1,948 $18,880
Assumptions:
Growth rate
WACC
Tax rate
4.0%
10.2%
40%
TSE Free Cash Flow
2000e
Notes
$2,187,208
2001e
2002e
2003e
2004e
Sales
$2,329,373 $2,480,785 $2,642,037 $2,813,769 $2,996,658
Cost of goods sold
1,910,086
2,034,244
2,166,470
2,307,291
2,457,260
Gross profit
419,287
446,541
475,567
506,478
539,398
Selling, general, & admin. (SG&A) expenses
125,786
131,482
140,028
146,316
155,826
Earnings before interest and taxes (EBIT)
293,501
315,060
335,539
360,162
383,572
Taxes
117,400
126,024
134,215
144,065
153,429
Net income
176,101
189,036
201,323
216,097
230,143
+ Depreciation
27,950
29,770
31,700
33,170
35,960
- Capital expenditures (CAPEX)
=1.1 times dep.
(30,745)
(32,747)
(34,870)
(36,487)
(39,556)
- increase in WC (as % change in sales)
1%
(45,166)
(48,102)
(51,228)
(54,558)
(58,104)
Free Cash Flow
128,140
137,957
146,925
158,222
168,443
Terminal value
2,828,362
Total Free Cash Flow
$128,140
$137,957
$146,925
$158,222 $2,996,805
Dividends
$128,140
$137,957
$146,925
$158,222 $2,996,805
Enterprise value
Less debt
Equity value
Number of shares
Value per share (DCF)
Current price per share
FCF Approach
$2,291,497
$155,795
$2,135,702
64,417
$33.15
$21.98
Earnings before interest and taxes
Less taxes
Net operating profit after tax
Less increse in net working capital
Less capital expenditures
Plus depreciation and amortization
Free cash flow
Terminal value
Free cash flow with terminal value
2000
23,863
10,207
13,657
1,270
(1,582)
835
14,803
2001
27,503
12,240
15,263
1,461
1,161
900
13,541
2002
31,689
14,584
17,105
1,680
1,275
975
15,124
2003
33,614
15,811
17,803
773
1,148
1,010
16,892
2004
35,655
17,322
18,333
819
1,193
1,046
17,367
2005
37,818
18,934
18,884
868
1,240
1,085
17,861
2006
40,111
20,652
19,459
921
1,291
1,126
18,374
14,803
13,541
15,124
16,892
17,367
17,861
18,374
2007
42,542
22,584
19,958
976 14% of sales change
1,344
1,170
18,808
249,210
6% growth
268,018
Discount rate
14%
Enterprise value 162,070
Less debt (46,000)
Equity value 116,070
Lira/euro exchange rate
1,936
Equity value in EUR
59.95

Probabilistic Analysis: Monte Carlo Simulation
Suppose we allow several assumptions to vary. What is the
resulting distribution of the DCF value of equity?









Sales growth years 1–3: 14%–17%
Sales growth years 4–7: 5%–7%
Operating cost/sales: 41%–49%
Personnel cost/sales: 13%–17%
Receivables/sales: 15%–18%
Accounts payable/sales: 15%–18%
Other payables/sales: 15/18%