CHAPTER 26
Merger Analysis
1

Justifications for Mergers


Valid justifications:
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
Break-up value exceeds value as going concern
Synergy
Questionable justifications:


Diversification
Increase firm size
2

Types of Mergers


Friendly vs. Hostile merger
Cash vs. stock swap
3

Analysis of mergers

Discounted cash flow approach to merger valuation requires:


Estimation of cash flows
Determine the discount rate
4

Analysis of mergers


The correct cash flows and discount rate depend on the evaluation technique used.
We will use the “Corporate Valuation
Model” (from Chapter 11) based on
Free Cash Flows, discounted at the
WACC
5

Corporate Valuation Model:
Discount Rate

To use the corporate valuation model to value a merger target, we must estimate the post-merger WACC of the target firm.
6

Free Cash Flow Valuation


The FCF approach estimates the total firm value, rather than the value of equity or per share value directly.
The value of equity (& per share value) can be obtained from the total value of assets by netting out other claims.
7

Corporate Valuation

A company owns two types of assets:


Nonoperating assets (securities)
Operating assets
Net Operating Capital equals Net Fixed
Assets plus Net Operating Working Capital
8

Applying the Corporate
Valuation Model

Free cash flow is the cash flow available for distribution to investors after all necessary additions to operating assets:
FCF = NOPAT – net investment in operating assets
NOPAT = EBIT (1 – tax rate)
9

Corporate value


The PV of their expected future free cash flows, discounted at the WACC, is the value of operations (V
OP
).
Total corporate value is sum of:
Value of operations
Value of nonoperating assets
10

Steps in Corporate Valuation
Model (nonconstant growth)
3.
4.
1.
2.
Identify a planning period of t years.
Project FCF for years 1 thru t.
Estimate the horizon growth rate.
Calculate the post-merger r
SL
WACC of target firm.
and
11

Steps in Corporate Valuation
Model (Cont.)
5.
6.
7.
Calculate horizon value using constant growth corporate valuation model and
WACC.
Calculate V ops as PV of FCFs years 1 thru t and horizon value, all discounted at postmerger WACC.
Calculate the value of equity by adding financial assets, subtracting existing pref. stock & debt from the value of operations.
12

Alternative valuation techniques

Another method of estimating firm value is based valuation multiples.
Examples include value as a multiple of:



Earnings (P/E)
Book value
Sales revenue
13

Merger winners & losers
Target firm shareholders receive an average premium of:
Friendly merger 20%
Hostile takeover 30%
14

Merger winners & losers
Long-run (five year) stock performance of acquiring firms:
Cash acquisitions
Stock swaps
Abnormal returns
18.5%
-24.2%
15

Leveraged buyout (LB0)



In an LBO, a small group of investors, normally including management, buys all of the publicly held stock, and takes the firm private.
Purchase often financed with debt.
After operating privately for a number of years, investors take the firm public to “cash out.”
16

Major types of divestitures




Sale of an entire subsidiary to another firm.
Spinning off a corporate subsidiary by giving the stock to existing shareholders.
Carving out a corporate subsidiary by selling a minority interest.
Outright liquidation of assets.
17

Motivation to divest assets






Subsidiary worth more to buyer than when operated by current owner.
To settle antitrust issues.
Subsidiary’s value increased if it operates independently.
To change strategic direction.
To shed money losers.
To get needed cash when distressed.
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