Mergers and Acquisitions

Mergers and Acquisitions
Copyright © 2013 CFA Institute

1. Introduction Mergers and acquisitions (M&A) are complex, involving many parties. Mergers and acquisitions involve many issues, including Corporate governance. Form of payment. Legal issues. Contractual issues. Regulatory approval. M&A analysis requires the application of valuation tools to evaluate the M&A decision. Pages 408–409 Introduction Mergers and acquisitions (M&A) are complex, involving many parties. Example 10.1 Guidant Corporation (target) Johnson & Johnson (bidder—unsuccessful) Boston Scientific (bidder—successful) Note: Update on merger—Boston Scientific paid more than a half billion U.S. dollars in 2011 for “improper conduct” by Guidant prior to the merger, with more potential additional claims by the IRS and Department of Justice (DOJ). Mergers and acquisitions involve many issues, including Corporate governance (e.g., role of the board of directors). Form of payment (stock or cash). Legal and contractual issues (e.g., takeover defenses). Regulatory approval (e.g., competition). M&A analysis requires the application of valuation tools to evaluate the M&A decision: Bid and takeover premium. Distribution of gains between acquiring firm and target firm shareholders. Copyright © 2013 CFA Institute

Example of a merger: AMR and U.S. Airways
April 2012 U.S. Airways proposes merger to bankrupt AMR. July 2012 AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone. September 2012 AMR and U.S. Airways begin merger discussions. November 2012 U.S. Airways proposes merger, with its shareholders owning 30% of the new company. February 2013 Details of the merger are worked out. Merger filed with the FTC under Hart-Scott-Rodino Act. LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers. Example of a Merger: AMR and U.S. Airways Issues: AMR, parent of American Airlines, filed for bankruptcy on 29 November 2011. AMR and its unions (pilots, flight attendants) grappled with labor agreements that would be suitable under a merged company (reached agreements December 2012 and January 2013). FTC made a “second request” for a review of the merger in March 2013 under the Hart-Scott-Rodino Act. Parties: AMR US Airways Regulatory authorities: Federal Trade Commission (FTC) DOJ Discussion question: What would be the benefit to U.S. Airways shareholders of a merger with AMR? Copyright © 2013 CFA Institute

2. Mergers and acquisitions Definitions
Merger with Consolidation Acquisition Company A B C Company X Y LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers. Pages 410–411 2. Mergers and Acquisitions Definitions In a consolidation, both companies terminate their legal existence and a new company arises (Company C in the diagram). Example: U.S. Airways + AMR = American Airlines Group Inc. In a statutory merger, often referred to as an acquisition, one company ceases to exist. All of its assets and liabilities are subsumed in the acquiring party (Company X in diagram). Example: Kraft’s 2009 acquisition of Cadbury In a subsidiary merger, the acquired party becomes a subsidiary of the acquiring party (not diagrammed). Example: Textron’s acquisition of Cessna Aircraft Company in 1989 Copyright © 2013 CFA Institute

Mergers and Acquisitions Definitions
Parties to the acquisitions: The target company (or target) is the company being acquired. The acquiring company (or acquirer) is the company acquiring the target. Classified based on endorsement of parties’ management: A hostile takeover is when the target company board of directors objects to a takeover offer. A friendly transaction is when the target company board of directors endorses the merger or acquisition offer. LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers. Pages 410–411 Mergers and Acquisitions Definitions Parties to the acquisitions: The target company (or target) is the company being acquired. The acquiring company (or acquirer) is the company acquiring the target. Note: When you have a merger of equals, there is no clear designation of the target and acquirer. Classified based on endorsement of parties’ management: A hostile takeover is when the target company board of directors objects to a takeover offer. A friendly transaction is when the target company board of directors endorses the merger or acquisition offer. Note: The distinction between a hostile merger and a friendly merger is made later in the chapter in Section 4.3. Copyright © 2013 CFA Institute

Mergers and Acquisitions Definitions
Classified by the relatedness of business activities of the parties to the combination: Type Characteristic Example Horizontal merger Companies are in the same line of business, often competitors. Walt Disney Company buys Lucasfilm (October 2012). Vertical merger Companies are in the same line of production (e.g., supplier–customer). Google acquired Motorola Mobility Holdings (June 2012). Conglomerate merger Companies are in unrelated lines of business. Berkshire Hathaway acquires Lubrizol (2011). LOS: Classify merger and acquisition (M&A) activities based on forms of integration and types of mergers. Pages 410–411 Mergers and Acquisitions Definitions Horizontal merger: Companies are in the same line of business, often competitors—for example, Walt Disney Company buys Lucasfilm (October 2012). Vertical merger: Companies are in the same line of production (e.g., supplier–customer)—Google acquired Motorola Mobility Holdings (June 2012). Conglomerate merger: Companies are in unrelated lines of business. Copyright © 2013 CFA Institute

3. Motives for merger Creating Value Synergy Growth
Increasing market power Acquiring unique capabilities or resources Unlocking hidden value Cross-Border Mergers Exploiting market imperfections Overcoming adverse government policy Technology transfer Product differentiation Following clients Dubious Motives Diversification Bootstrapping earnings Managers’ personal incentives Tax considerations LOS: Explain common motivations behind M&A activity. Pages 413–417 3. Motives for Merger Creating value (that is, mergers with these motives have the potential to add value): Synergy (Note: > 2) Economies of scale Cross-product selling Growth External growth (may be less risky than organic growth) Increasing market power Horizontal or vertical integration to increase strength in the industry Note: Regulatory authorities in some countries may limit this as a benefit (e.g., FTC in the United States). Acquiring unique capabilities or resources Resources include patents, technology, trademarks, or raw materials Unlocking hidden value Improve management, reorganize structure, breakups, or liquidations Cross-border mergers: Exploiting market imperfections Cheaper labor in one market Lower-cost raw materials Overcoming adverse government policy Circumvent tariffs Circumvent barriers to trade Technology transfer Facilitate entry into a country’s market Gain access to new technology or resources Product differentiation Enhance product line Expand into a country’s market “Buy” reputation for entry into a market Following clients Make sure that the business of clients do not go to another company once the client expands to another country. Dubious motives: Diversification Investors can diversify in their own portfolios, so there is generally no value to companies to diversify. Bootstrapping earnings (see Example 10-3) Occurs if the acquirer’s shares trade at a higher P/E than the targets Managers’ personal incentives Compensation (often tied to size of the firm/earnings—part of managerialism theories) Decrease their personal employment risk Tax considerations Most jurisdictions do not allow “buying” tax losses. Discussion question: Is there any economic justification for diversification as a motive to merge? Copyright © 2013 CFA Institute

Bootstrapping The short-run increase in earnings per share which occurs in a share for share exchange when a company trading on a higher price to earnings ratio acquires a company trading on a lower price to earnings ratio. The bootstrap effect only occur when Acquirer's P/E ratio is higher than Target's and Acquirer's P/E post merger does not decline. Copyright © 2013 CFA Institute

Example: Financial and Market Data for Acquirer and Target
Financial/Price Data Acquirer Target Sales $400 million $105 million Net income $80 million $22 million Cash flow $140 million $42 million Book value $320 million $72 million Number of common shares outstanding 50 million 20 million Current market price of common stock $30.50 $20.00 Recent market price range $34-26 $22-18 Copyright © 2013 CFA Institute

(Question) If Acquirer issues common stock at the current market price and uses the proceeds to acquire Target's outstanding common stock, the bootstrap earnings effect on post merger earnings would most likely occur if Target's acquisition price: A. is $20 or lower. B. is $20 or higher. C. is $20 or lower and Acquirer's post merger P/E remains at the current level. Copyright © 2013 CFA Institute

Example: Bootstrapping earnings
Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the market’s use of the pre-merger P/E to value post-merger EPS. Assumptions: Exchange ratio: One share of Company One for two shares of Company Two Market applies pre-merger P/E of Company One to post-merger earnings. Company One Company Two Company One Post-Acquisition Earnings $100 million $50 million $150 million Number of shares 100 million 50 million 125 million Earnings per share $1 $1.20 P/E 20 10 Price per share $20 $10 $24 Market value of stock $2,000 million $500 million $3,000 million LOS: Explain how earnings per share (EPS) bootstrapping works and calculate a company’s post-merger EPS. Pages 415–416 Example: Bootstrapping Earnings Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the market’s use of the pre-merger P/E to value post-merger EPS. In this example, we first assume that the market is imperfect and incorrectly applies the pre-merger P/E of Company One to the merged company. In the next slide, we assume that the market correctly values the post-merger company using a weighted average P/E. Example 10-3 provides an example of the bootstrapping effect. Discussion question: In an efficient market, would bootstrapping exist? Copyright © 2013 CFA Institute

Example: Bootstrapping earnings
Weighted P E = $100 $150 × $50 $150 × 10 = 16.67 Assumptions: Exchange ratio: One share of Company One for two shares of Company Two Market applies weighted average P/E to the post-merger company. Company One Company Two Company One Post-Acquisition Earnings $100 million $50 million $150 million Number of shares 100 million 50 million 125 million Earnings per share $1 $1.20 P/E 20 10 16.67 Price per share $20 $10 Market value of stock $2,000 million $500 million $2,500 million LOS: Explain how earnings per share (EPS) bootstrapping works and calculate a company’s post-merger EPS. Example: Bootstrapping Earnings The correct valuation, assuming no synergistic effects not reflected in the pre-merger values of the company, uses a weighted P/E, in which the weights are the contributions to earnings: Weighted P/E = $100 $150 × $50 $150 × 10 = 16.67 Copyright © 2013 CFA Institute

Motives and the Industry’s Life Cycle
The motives for a merger are influenced, in part, by the industry’s stage in its life cycle. Factors include Need for capital. Need for resources. Degree of competition and the number of competitors. Growth opportunities (organic vs. external). Opportunities for synergy. LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles. Pages 417–418 Motives and the Industry’s Life Cycle The motives for a merger are influenced, in part, by the industry’s stage in its life cycle (Example 10-4). Factors include Need for capital (e.g., startups may merge with larger firms to have access to capital). Need for resources (e.g., need for raw materials in a competitive market). Degree of competition and the number of competitors (e.g., survival for a mature company with few growth opportunities). Growth opportunities (organic vs. external)—for example, mature companies may seek out external growth as organic opportunities wane. Opportunities for synergy (e.g., mature companies may need to merge to gain economics of scale to produce growth). Copyright © 2013 CFA Institute

Mergers and the Industry Life Cycle
Industry Life Cycle Stage Industry Description Motives for Merger Types of Mergers Pioneering development Industry exhibits substantial development costs and has low, but slowly increasing, sales growth. Younger, smaller companies may sell themselves to larger companies in mature or declining industries and look for ways to enter into a new growth industry. Young companies may look to merge with companies that allow them to pool management and capital resources. Conglomerate Horizontal Rapid accelerating growth Industry exhibits high profit margins caused by few participants in the market. Explosive growth in sales may require large capital requirements to expand existing capacity. LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles. Pages 417–418 Mergers and the Industry Life Cycle From Example 10-4 in the text. Copyright © 2013 CFA Institute

Industry Life Cycle Stage Industry Description Motives for Merger Types of Mergers Mature growth Industry experiences a drop in the entry of new competitors, but growth potential remains. Mergers may be undertaken to achieve economies of scale, savings, and operational efficiencies. Horizontal Vertical Stabilization and market maturity Industry faces increasing competition and capacity constraints. Mergers may be undertaken to achieve economies of scale in research, production, and marketing to match the low cost and price performance of other companies (domestic and foreign). Large companies may acquire smaller companies to improve management and provide a broader financial base. LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles. Pages 417–418 Mergers and the Industry Life Cycle From Example 10-4 in the text. Copyright © 2013 CFA Institute

Industry Life Cycle Stage Industry Description Motives for Merger Types of Mergers Deceleration of growth and decline Industry faces overcapacity and eroding profit margins. Horizontal mergers may be undertaken to ensure survival. Vertical mergers may be carried out to increase efficiency and profit margins. Companies in related industries may merge to exploit synergy. Companies in this industry may acquire companies in young industries. Horizontal Vertical Conglomerate LOS: Explain the relationship among merger motivations and types of mergers based on industry life cycles. Pages 417–418 Mergers and the Industry Life Cycle From Example 10-4 in the text. Copyright © 2013 CFA Institute

4. Transaction characteristics
Form of the Transaction Stock purchase Asset purchase Method of Payment Cash Securities Combination of cash and securities Attitude of Management Hostile Friendly LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management. Pages 418–423 4. Transaction Characteristics Form of the transaction Stock purchase Asset purchase Method of payment Cash Securities Combination of cash and securities Attitude of management Hostile Friendly Copyright © 2013 CFA Institute

Form of an Acquisition In a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm. A stock purchase needs shareholder approval. Target shareholders are taxed on any gain. Acquirer assumes target’s liabilities. In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. An asset purchase may not need shareholder approval. Acquirer likely avoids assumption of liabilities. LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management. Pages 419–420 Form of an Acquisition In a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm. A stock purchase needs shareholder approval. Target shareholders are taxed on any gain. Acquirer assumes target’s liabilities. In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. An asset purchase may not need shareholder approval. Acquirer likely avoids assumption of liabilities. Copyright © 2013 CFA Institute

Method of Payment Cash offering
Cash offering may be cash from existing acquirer balances or from a debt issue. Securities offering Target shareholders receive shares of common stock, preferred stock, or debt of the acquirer. The exchange ratio determines the number of securities received in exchange for a share of target stock. Factors influencing method of payment: Sharing of risk among the acquirer and target shareholders. Signaling by the acquiring firm. Capital structure of the acquiring firm. LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management. Pages 420–422 Method of Payment Cash offering Cash offering may be cash from existing acquirer balances or from a debt issue. Securities offering Target shareholders receive shares of common stock, preferred stock, or debt of the acquirer. The exchange ratio determines the number of securities received in exchange for a share of target stock. Factors influencing method of payment: Sharing of risk among the acquirer and target shareholders. Signaling by the acquiring firm. Capital structure of the acquiring firm. Based on data from Mergerstat Review, FactSet Mergerstat, LLC ( Copyright © 2013 CFA Institute

Mindset of Managers Friendly merger: Offer made through the target’s board of directors Hostile merger: Offer made directly to the target shareholders Shareholders and regulators approve. Enter into a definitive merger agreement. Perform due diligence. Enter into merger discussions. Approach target management. Types Bear hug Tender offer Proxy fight LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management. Pages 422–423 Mindset of Managers Friendly merger: Offer made through the target’s board of directors Process: Approach target management. Enter into merger discussions. Perform due diligence. Enter into a definitive merger agreement. Shareholders and regulators approve. Hostile merger: Offer made directly to target shareholders Bear hug Informal offer directly to target shareholders Tender offer Formal offer made directly to the shareholders of the target firm Shareholders must tender their shares—that is, accept the offer. Proxy fight Acquiring party solicits proxies (votes). Acquiring party, with sufficient proxies, has representatives elected to the target company board of directors. Copyright © 2013 CFA Institute

Hostile vs. Friendly mergers
The classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company. A friendly merger is one in which the board negotiates and accepts an offer. A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful. LOS: Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management. Pages 422–423 Hostile vs. Friendly Mergers The classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company. A friendly merger is one in which the board negotiates and accepts an offer. A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful. Note: A hostile merger offer can become a friendly merger if the board of the target acquiesces. Example: In 2012, Martin Marietta Materials (MLM) made a bid for Vulcan Materials (VMC). Discussion question: If you are a target firm shareholder and there is a bid for the stock that exceeds the target share price pre-bid, what action, if any, would you want the board of directors of the target firm to take? Copyright © 2013 CFA Institute

5. Takeovers Takeover defenses are intended to either prevent the transaction from taking place or to increase the offer. Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive. Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirer’s power gained from its ownership interest in the target. LOS: Distinguish among pre-offer and post-offer takeover defense mechanisms. Pages 424–429 5. Takeovers Takeover defenses are intended to either prevent the transaction from taking place, or to increase the offer. Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive. Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirer’s power gained from its ownership interest in the target. Copyright © 2013 CFA Institute

Takeover defenses Pre-Offer Takeover Defense Mechanisms
Poison pills (flip-in pill and flip-over pill) Poison puts Incorporation in a state with restrictive takeover laws Staggered board of directors Restricted voting rights Supermajority voting provisions Fair price amendments Golden parachutes Post-Offer Takeover Defense Mechanisms “Just say no” defense Litigation Greenmail Share repurchase Leveraged recapitalization “Crown jewels” defenses “Pac-Man” defense White knight defense White squire defense LOS: Distinguish among pre-offer and post-offer takeover defense mechanisms. Pages 424–428 Takeover Defenses Pre-offer takeover defense mechanisms: Poison pills Any device that makes it more expensive for the acquirer to take control of the target without the target board’s approval Triggered by a change in control; can be rescinded if the offer becomes friendly Flip-in pill: Target shareholders have the right to buy shares of the target at a discount. Flip-over pill: Target shareholders have the right to buy shares of the acquirer at a discount. Poison puts Allows the bondholders of the target to put the shares back to the target company Intended to reduce the cash stores of the target company Incorporation in a state with restrictive takeover laws (United States) Some states give target companies more power to fend off an unwanted takeover (e.g., Ohio and Pennsylvania). Staggered board of directors By having board terms staggered through time, it takes longer to get control through a proxy fight. Restricted voting rights Provision that prevents shareholders who have recently acquired large blocks of shares (objective: hostile acquirer) from voting Supermajority voting provisions Require a percentage of votes larger than simply a majority for change of control votes Fair price amendments Specify the minimum price in an acquisition May be relative to trading values at a point or range in time Golden parachutes Compensation agreement between the target firm and executives of the target firm in which these employees receive substantial payments if there is a change in control Post-offer takeover defense mechanisms “Just say no” defense Board of directors rejects offer. If bear hug, the board would make the case for a higher bid. Litigation Lawsuit based on violation of securities laws or on anticompetitive grounds is filed. Greenmail The target repurchases shares from the party attempting to acquire the target. Share repurchase Perform a stock repurchase, which may raise the price of the stock. Could buy all shares in a leveraged buyout Leveraged recapitalization Borrow heavily to finance a share repurchase, which makes the target more levered and, hence, unattractive. “Crown jewels” defenses Sell an asset, division, or subsidiary that is attractive to the acquiring company. “Pac-Man” defense Offer to buy acquirer. White knight defense Find a friendly third party to buy the target. White squire defense Find a friendly third party to buy a minority (yet substantial) interest in the target. Copyright © 2013 CFA Institute

Regulation of Mergers and Acquisitions
Antitrust Law Securities Law Pages 429–434 6. Regulation Regulation of M&A takes two forms: antitrust laws and securities law. Antitrust pertains to the effect of the M&A activity on competition. Securities laws pertain to the M&A process and disclosures. Copyright © 2013 CFA Institute

Antitrust Law: United States
Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegal Sherman Antitrust Act (1890) Outlawed specific business practices Clayton Antitrust Act (1914) Closed loopholes in the Clayton Act Celler–Kefauver Act (1950) Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance Hart–Scott–Rodino Antitrust Improvements Act (1976) Pages 430–431 Antitrust Law: United States Sherman Antitrust Act (1890) Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegal Clayton Antitrust Act (1914) Outlawed specific business practices Celler–Kefauver Act (1950) Closed loopholes in the Clayton Act Hart–Scott–Rodino Antitrust Improvements Act (1976) Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance Copyright © 2013 CFA Institute

Antitrust The European Commission reviews combinations for antitrust issues. Regulatory bodies besides the FTC may review combinations (e.g., U.S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions). If the combination involves companies in different countries, it may require approvals by all countries’ regulatory bodies. Pages 430–431 Antitrust The European Commission reviews combinations for antitrust issues. Regulatory bodies besides the FTC may review combinations (e.g., U.S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions). If the combination involves companies in different countries, it may require approvals by all countries’ regulatory bodies. Copyright © 2013 CFA Institute

HHI Concentration Level and Possible Government Action
The HHI The Herfindalhl–Hirschman Index (HHI) is a measure of concentration within an industry and is often used by regulators to evaluate the effects of a merger. The HHI is constructed as the sum of the squared market shares of the firms in the industry: HHI = i n Output of firm i Total sales or output of the market × HHI Concentration Level and Possible Government Action Post-Merger HHI Concentration Change in HHI Government Action Less than 1,000 Not concentrated Any amount No action Between 1,000 and 1,800 Moderately concentrated 100 or more Possible challenge More than 1,800 Highly concentrated 50 or more Challenge LOS: Calculate the Herfindahl–Hirschman Index (HHI) and evaluate the likelihood of an antitrust challenge for a given business combination. Pages 431–433 The HHI The Herfindalhl–Hirschman Index (HHI) is a measure of concentration within an industry and is often used by regulators to evaluate the effects of a merger. It requires knowledge of the market shares of the companies in the industry. The HHI is constructed as the sum of the squared market shares of the firms in the industry: HHI = i n Output of firm i Total sales or output of the market × Table from Exhibit 10-2 in the text. Key to regulation: Both the level of the HHI and the change in HHI resulting from the merger are important. Copyright © 2013 CFA Institute

Example: HHI Consider an industry that has six companies. Their respective market shares are as follows: What is the likely government action, if any, if Companies E and F combined? Company Market Share A 25% B 15% C D E F 100% LOS: Calculate the Herfindahl–Hirschman Index (HHI) and evaluate the likelihood of an antitrust challenge for a given business combination. Pages 431–433 Example: HHI Note: This example is similar, but not identical, to Example 10-7. Consider an industry that has six companies and their respective market shares: Company Market share A 25% B 15% C 15% D 15% E 15% F 15% 100% What is the likely government action, if any, if Companies E and F combined? Copyright © 2013 CFA Institute

Example: HHI Company Market Share HHI Before HHI After A 25% 625 B 15%
225 C D E E+F 30% 900 F Total 100% 1125 1575 LOS: Calculate the Herfindahl–Hirschman Index (HHI) and evaluate the likelihood of an antitrust challenge for a given business combination. Pages 431–433 Example: HHI (continued) For example: Company A: (25% x 100)2 = 625 Use the total HHI post-merger and the change in the total pre- to post-merger, and compare these results with Exhibit 10-2 (page 431). The industry would be considered moderately concentrated before and after the combination of E and F, and The change in the HHI is 450, which may result in a government challenge. The industry would be considered moderately concentrated before and after the combination of E and F, and The change in the HHI is 450, which may result in a government challenge. Copyright © 2013 CFA Institute

Securities Laws: United States
Williams Act (1968): Requires public disclosure when a party acquires 5% or more of a target’s common stock. Specifies rules and restrictions pertaining to a tender offer. Pages 433–434 Securities Laws: United States Williams Act (1968): Requires public disclosure when a party acquires 5% or more of a target’s common stock. Specifies rules and restrictions pertaining to a tender offer. Copyright © 2013 CFA Institute

7. Merger analysis The discounted cash flow (DCF) method is often used in the valuation of the target company. The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern. The goal is to estimate future FCF. We can use pro forma financial statements to estimate FCF We use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future. LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Pages 434–450 7. Merger Analysis The discounted cash flow (DCF) method is often used in the valuation of the target company. The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern. The goal is to estimate future FCF. We can use pro forma financial statements to estimate FCF. We use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future. Copyright © 2013 CFA Institute

Estimating Free Cash Flow (FCF)
Calculate Net Interest after Tax (Interest expense – Interest income) × (1 – Tax rate) Calculate Unlevered Net Income Net income + Net interest after tax Calculate NOPLAT Unlevered net income + Change in deferred taxes Calculate FCF NOPLAT + Noncash charges – Change in working capital – Capital expenditures LOS: Calculate free cash flows for a target company and estimate the company’s intrinsic value based on discounted cash flow analysis. Pages 434–438 Estimating Free Cash Flow Process Net interest after tax = (Interest expense – Interest income) × (1 – Tax rate) Unlevered net income = Net income + Net interest after tax NOPLAT = Unleveraged net income + Change in deferred taxes (NOPLAT is net operating profit less adjusted taxes) FCF = NOPLAT + Noncash charges – Change in working capital – Capital expenditures Copyright © 2013 CFA Institute

Example: FCF for the ABC Company
Suppose analysts have constructed pro forma financial statements for the ABC Company and report the following: From the pro forma income statement From the pro forma income statement Net income $40 Interest expense $5 Interest income $2 Change in deferred taxes $3 Depreciation $10 Change in working capital $6 Capital expenditures $20 Assumed LOS: Calculate free cash flows for a target company and estimate the company’s intrinsic value based on discounted cash flow analysis. Pages 434–438 Example: Calculating FCF This example focuses on the calculation of a given year’s FCF so that we can demonstrate the FCF calculation. The information needed for this calculation comes from two pro forma sources: the income statement and the statement of cash flows. Tax rate = 45% What is ABC’s free cash flow? Copyright © 2013 CFA Institute

Example: FCF Net income $40.00 Plus Net interest after tax 1.65 Equals
Unlevered net income $41.65 Change in deferred taxes 3.00 Net operating profit minus adjusted taxes $44.65 Depreciation 10.00 Minus Change in working capital 6.00 Capital expenditures 20.00 Free cash flow $28.65 LOS: Calculate free cash flows for a target company and estimate the company’s intrinsic value based on discounted cash flow analysis. Pages 434–438 Example: FCF Net income $40.00 Plus Net interest after tax Equals Unlevered net income $41.65 Plus Change in deferred taxes Equals Net operating profit less adjusted taxes $44.65 Plus Depreciation Minus Change in working capital Minus Capital expenditures Equals Free cash flow $28.65 Copyright © 2013 CFA Institute

Discounted Cash Flow (DCF) and the Terminal Value
We can estimate the terminal value: Assuming a constant growth after the initial few years or Assuming a multiple (based on comparables) of pro forma FCF for the last estimated year. LOS: Calculate free cash flows for a target company and estimate the company’s intrinsic value based on discounted cash flow analysis. Pages 438–439 DCF and the Terminal Value We can estimate the terminal value: Assuming a constant growth after the initial few years or Assuming a multiple (based on comparables) of pro forma FCF for the last estimated year. Copyright © 2013 CFA Institute

The DCF method Advantages of using the DCF method:
The model allows for changes in cash flows in the future. The cash flows and estimated value are based on forecasted fundamentals. The model can be adapted for different situations. Disadvantages of using the DCF method: For a rapidly growing company, the FCF and net income may be misaligned (e.g., higher-than-normal capital expenditure). Estimating future cash flows is difficult because of the uncertainty. Estimating discount rates is difficult, and these rates may change over time. The terminal value estimate is sensitive to the assumptions and model used. LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Page 440 The DCF method Advantages and disadvantages Advantages of using the DCF method The model allows for changes in cash flows in the future. The cash flows and estimated value are based on forecasted fundamentals. The model can be adapted for different situations. Disadvantages of using the DCF method For a rapidly growing company, the FCF and net income may be misaligned (e.g., higher than normal capital expenditure). Estimating future cash flows is difficult because of the uncertainty. Estimating discount rates is difficult, and these rates may change over time. The terminal value estimate is sensitive to the assumptions and model used. Copyright © 2013 CFA Institute

Comparable Company Analysis
Select Comparable Companies Publicly traded companies that are similar to the subject company Same or similar industry Calculate Relative Value Measures Enterprise value multiples Price multiples Apply Metrics to Target Judgment needed to select appropriate metric Estimate Takeover Price Takeover premium added LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Pages 440–444 Comparable Company Analysis Process: Select comparable companies Publicly traded companies that are similar to the subject company Same or similar industry Calculate relative value measures Enterprise value multiples Price multiples Apply metrics to target Judgment needed to select appropriate metric Estimate takeover price Takeover premium added Copyright © 2013 CFA Institute

Example: Comparable Company Analysis
Suppose an analyst has gathered the following information on the target company, the XYZ Company: If the typical takeover premium is 20%, what is the XYZ Company’s value in a merger using the comparable company approach? XYZ Company Average of Comparables Earnings $10 million P/E of comparables 30 times Cash flow $12 million P/CF of comparables 25 times Book value of equity $50 million P/BV of comparables 2 times Sales $100 million P/S of comparables 2.5 times LOS: Estimate the value of a target company using comparable company and comparable transaction analyses. Pages 440–444 Example: Comparable Company Analysis Suppose an analyst has gathered the following information on the target company, the XYZ Company: XYZ Company Average of comparables Earnings $10 million P/E of comparables 30 times Cash flow $12 million P/CF of comparables 25 times Book value of equity $50 million P/BV of comparables 2 times Sales $100 million P/S of comparables 2.5 times If the typical takeover premium is 20%, what is the XYZ Company’s value in a merger using the comparable company approach? Note: This example does not require calculating the mean of the comparables and makes the assumption, as does Example 10-8, that the arithmetic average of the comparables multiple and resultant values is the most appropriate. Discussion question: If there is a wide dispersion among the multiples of the comparables, is an arithmetic mean of these multiples most appropriate? Copyright © 2013 CFA Institute

Example: Comparable Company Analysis
Assuming that the average of the values from the different multiples is most appropriate: Comparables’ Multiples Estimated Stock Value Earnings $10 million × 30 $300 million Cash flow $12 million 25 Book value of equity $50 million 2 $100 million Sales 2.5 $250 million Average = $237.5 million LOS: Estimate the value of a target company using comparable company and comparable transaction analyses. Pages 440–444 Example: Comparable Company Analysis Assuming that the average of the values from the different multiples is most appropriate: Using comparables’ multiples Estimated stock value Earnings $10 million × 30 $300 million Cash flow $12 million × 25 $300 million Book value of equity $50 million × 2 $100 million Sales $100 million × 2.5 $250 million Average = $237.5 million Estimated takeover price of the XYZ Company = $237.5 million × 1.2 = $285 million Note: The multiplier of 1.2 is from the takeover premium: = 1.2 Estimated takeover price of the XYZ Company = $237.5 million × 1.2 = $285 million Copyright © 2013 CFA Institute

Comparable Company Analysis
Advantages Provides reasonable estimate of the target company’s value Readily available inputs Estimates based on market’s value of company attributes Disadvantages Sensitive to market mispricing Sensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergers Does not consider specific changes that may be made in the target post- merger LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Pages 443–444 Comparable Company Analysis Advantages and disadvantages Advantages Provides reasonable estimate of the target company’s value Readily available inputs Estimates based on market’s value of company attributes Disadvantages Sensitive to market mispricing Sensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergers Does not consider specific changes that may be made in the target post-merger Copyright © 2013 CFA Institute

Comparable Transaction Analysis
Collect Information on Recent Takeover Transactions of Comparable Companies Calculate Multiples for Comparable Companies Estimate Takeover Value Based on Multiples LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Pages 444–445 Comparable Transaction Analysis Process Collect information on recent takeover transactions of comparable companies. Calculate multiples for comparable companies (e.g., P/E, P/CF). Estimate takeover value based on multiples. Copyright © 2013 CFA Institute

Example: Comparable Transaction Analysis
Suppose an analyst has gathered the following information on the target company, the MNO Company: MNO Company Average of Multiples of Comparable Transactions Earnings $10 million P/E of comparables 15 times Cash flow $12 million P/CF of comparables 20 times Book value of equity $50 million P/BV of comparables 5 times Sales $100 million P/S of comparables 3 times LOS: Estimate the value of a target company using comparable company and comparable transaction analyses. Pages 444–445 Example: Comparable Transaction Analysis Suppose an analyst has gathered the following information on the target company, the MNO Company: MNO Company Average of comparables Earnings $10 million P/E of comparables 15 times Cash flow $12 million P/CF of comparables 20 times Book value of equity $50 million P/BV of comparables 5 times Sales $100 million P/S of comparables 3 times Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. Note: What is the difference between the comparable transaction analysis and the comparable company analysis? The company analysis uses comparables that are similar but that may or may not be involved in M&A. The comparable transaction analysis uses multiples only of recent transactions of comparable companies. Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. Copyright © 2013 CFA Institute

Example: Comparable Transaction Analysis
Comparables’ Transaction Multiples Estimated Stock Value Earnings $10 million × 15 $150 million Cash flow $12 million 20 $240 million Book value of equity $50 million 5 $250 million Sales $100 million 3 $300 million Value of MNO = 0.7 × $ × $ × $ × $300 Value = $238 million LOS: Estimate the value of a target company using comparable company and comparable transaction analyses. Pages 444–445 Example: Comparable Transaction Analysis Comparables’ transaction multiples Estimated stock value Earnings $10 million × 15 $150 million Cash flow $12 million × 20 $240 million Book value of equity $50 million × 5 $250 million Sales $100 million × 3 $300 million Value of MNO = 0.7 × $ × $ × $ × $300 Value = $238 million Copyright © 2013 CFA Institute

Comparable Transaction Analysis
Advantages Does not require specific estimation of a takeover premium Based on recent market transactions, so information is current and observed Reduces litigation risk Disadvantages Depends on takeover transactions being correct valuations There may not be sufficient transactions to observe the valuations Does not include value of changes to be made in target LOS: Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each. Page 446 Comparable Transaction Analysis Advantages and disadvantages Advantages Does not require specific estimation of a takeover premium Based on recent market transactions, so information is current and observed Reduces litigation risk Disadvantages Depends on takeover transactions to be correct valuations There may not be sufficient transactions to observe the valuations Does not include value of changes to be made in target Copyright © 2013 CFA Institute

Evaluating Bids The acquiring firm shareholders want to minimize the amount paid to target shareholders, not paying more than the pre-merger value of the target plus the value of the synergies. The target shareholders want to maximize the gain, accepting nothing below the pre-merger market value. LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders. Pages 446–450 Evaluating Bids The acquiring firm shareholders want to minimize the amount paid to target shareholders, not paying more than the pre-merger value of the target plus the value of the synergies. The target shareholders want to maximize the gain, accepting nothing below the pre-merger market value. Copyright © 2013 CFA Institute

Evaluating bids: Formulas
Target shareholders’ gain = Premium = PT – VT (10-7) where PT = price paid for the target company VT = pre-merger value of the target company Acquirer’s gain = Synergies – Premium = S – (PT – VT) (10-8) S = synergies created by the business combination VA* = VA + VT + S – C (10-9) VA* = post-merger value of the combined companies VA = pre-merger value of the acquirer C = cash paid to target shareholders LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders. Pages 446–447 Evaluating Bids: Formulas Key: Estimating the value added from synergy Copyright © 2013 CFA Institute

Example: Evaluating Bids
Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger? What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger? LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders. Pages 446–450 Example: Evaluating Bids Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. What are the synergistic gains from this merger? What parties, if any, share in these gains? What is the estimated value of the Big Company post-merger? Copyright © 2013 CFA Institute

Example: Evaluating Bids
Synergistic gains = $2 million  0.10 = $20 million Division of gains: First calculate the gains for each party and then evaluate the division. Target shareholders gain = $18 million – $15 million = $3 million Acquirer’s gain = $20 million – 3 million = $17 million Little shareholders get $3 million  $20 million = 15% of the gain Big shareholders get $17 million  $20 million = 85% of the gain Value of Big Company post-merger = $400 million + $15 million + $20 million – $18 million = $417 million LOS: Evaluate a merger bid, calculate the estimated post-merger value of an acquirer, and calculate the gains accrued to the target shareholders versus the acquirer shareholders. Pages 446–450 Example: Evaluating Bids Synergistic gains = $2 million  0.10 = $20 million (valued as a perpetuity) Division of gains: First calculate the gains for each party and then evaluate the division. Target shareholders gain = $18 million – $15 million= $3 million Acquirer’s gain = $20 million – 3 million = $17 million Little shareholders get $3 million  $20 million = 15% of the gain Big shareholders get $17 million  $20 million = 85% of the gain Value of Big Company post-merger = $400 million + $15 million + $20 million – $18 million = $417 million Copyright © 2013 CFA Institute

Effects of Price and Payment Method
The more confidence in the realization of synergies, the greater the chance that the acquiring firm will pay cash and the more the target company shareholders will prefer stock. The greater the use of stock in a deal, the greater the burden of the risks borne by the target shareholders and the greater the potential benefits accrue to the target shareholders. The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash. LOS: Explain the effects of price and payment method on the distribution of risks and benefits in a merger transaction Page 450 Effects of Price and Payment Method The more confidence in the realization of synergies, the greater the chance that the acquiring firm will pay cash and the more that the target company shareholders will prefer stock. The greater the use of stock in a deal, the greater the burden of the risks borne by the target shareholders and the greater the potential benefits accrue to the target shareholders. The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash. Examples Cash offers InBev’s acquisition of the remaining 50% interest in Grupo Modelo (2012) Stock offers Office Depot and Office Max (2013, in process) Stock and cash offers Kraft’s acquisition of Cadbury (2010) ICE acquisition of NYSE Euronext (2012) Copyright © 2013 CFA Institute

8. Who benefits from Mergers?
Mergers create value for the target company shareholders in the short run. Acquirers tend to overpay in merger bids. The transfer of wealth is from acquirer to target company shareholders. Roll: Overpayment results from “hubris.” Acquirers tend to underperform in the long run. They are unable to fully capture any synergies or other benefit from the merger. LOS: Describe empirical evidence related to the distribution of benefits in a merger. Pages 450–451 8. Who Benefits from Mergers? Mergers create value for the target company shareholders in the short run. Acquirers tend to overpay in merger bids. The transfer of wealth is from acquirer to target company shareholders. Roll: Overpayment results from “hubris.” Note: Winner’s curse Acquirers tend to underperform in the long run. They are unable to fully capture any synergies or other benefit from the merger. Copyright © 2013 CFA Institute

Mergers that create value
Buyer is strong. Transaction premiums are relatively low. Number of bidders is low. Initial market reaction to the news is favorable. LOS: Describe empirical evidence related to the distribution of benefits in a merger. Page 451 Mergers that Create Value Buyer is strong. Transaction premiums are relatively low. Number of bidders is low. Initial market reaction to the news is favorable. Copyright © 2013 CFA Institute

9. Corporate restructuring
A divestiture is the sale, liquidation, or spin-off of a division or subsidiary. Parent company Equity Carve-Out Spin-Off Split-Off Divestiture Liquidation LOS: Distinguish among divestitures, equity carve-outs, spin-offs, split-offs, and liquidation. Pages 451–452 9. Corporate Restructuring Copyright © 2013 CFA Institute

Reasons for Restructuring
Companies generally increase in size with a merger or acquisition. Restructuring, which includes divestitures, generally follows periods of merger and acquisitions. Reasons for restructuring: Change in strategic focus Poor fit Reverse synergy Financial or cash flow needs LOS: Explain major reasons for divestitures. Page 452 Reasons for Restructuring Companies generally increase in size with a merger or acquisition. Restructuring, which includes divestitures, generally follows periods of merger and acquisitions. Reasons for restructuring: Change in strategic focus Poor fit Reverse synergy Financial or cash flow needs Copyright © 2013 CFA Institute

Forms of divestiture Sale to another company: Direct sale of assets
Creation of a separate entity and the sale of interests in that entity (i.e., an equity carve-out) Spin-off: Parent company’s shareholders receive shares of stock Split-offs are similar to a spin-off, but only some shareholders receive shares in the new entity in exchange for shares in the parent company’s stock. Liquidation: Breaking up the entity and selling off its assets piecemeal LOS: Distinguish among divestitures, equity carve-outs, spin-offs, split-offs, and liquidation. Page 452 Forms of Divestiture Sale to another company: Direct sale of assets Example of sale of assets: November 2012 of McGraw-Hill’s education unit to Apollo Global Management Creation of a separate entity and the sale of interests in that entity (i.e., an equity carve-out) Example of an equity carve out: August 2012 carve-out of E. I. DuPont de Nemours and Co. (ticker: DD) auto paint business by Carlyle Group (ticker: CG) Spin-off: Parent company’s shareholders receive shares of stock in the spun-off company Example of a spin-off: April 2012 spin-off of Phillips 66 (ticker: PSX) from ConocoPhillips (ticker: COP) Example of a spin-off: December 2011 spin-off of TripAdvisor (ticker: TRIP) from Expedia (ticker: EXPE) Split-offs are similar to a spin-off, but only some shareholders receive shares in the new entity in exchange for shares in the parent company’s stock. Another name of a spin-off: Hive-off or hived-off Variation: Split-up, in which shareholders get stock in two companies in exchange for stock in parent Examples: McGraw Hill (2012), Marathon Oil (2012) Liquidation: Breaking up the entity and selling off its assets piecemeal Copyright © 2013 CFA Institute

10. Summary An acquisition is the purchase of some portion of one company by another, whereas a merger represents the absorption of one company by another. Mergers may be a statutory merger, a subsidiary merger, or a consolidation. Horizontal mergers occur among peer companies engaged in the same kind of business, vertical mergers occur among companies along a given value chain, and conglomerates are formed by companies in unrelated businesses. Merger activity has historically occurred in waves. Waves have typically coincided with a strong economy and buoyant stock market activity. Merger activity tends to be concentrated in a few industries, usually those undergoing changes. There are number of motives for a merger or acquisition; some are justified, some are dubious. 10. Summary Copyright © 2013 CFA Institute

Summary (continued) A merger transaction may take the form of a stock purchase or an asset purchase. The decision of which approach to take will affect other aspects of the transaction. The method of payment for a merger may be cash, securities, or a mixed offering with some of both. Hostile transactions are those opposed by target managers, whereas friendly transactions are endorsed by the target company’s managers. There are a variety of both pre- and post-offer defenses a target can use to ward off an unwanted takeover bid. 10. Summary Copyright © 2013 CFA Institute

Summary (continued) Pre-offer defense mechanisms include poison pills and puts, incorporation in a jurisdiction with restrictive takeover laws, staggered boards of directors, restricted voting rights, supermajority voting provisions, fair price amendments, and golden parachutes. Post-offer defenses include “just say no” defense, litigation, greenmail, share repurchases, leveraged recapitalization, “crown jewel” defense, “Pac-Man” defense, or finding a white knight or a white squire. Antitrust legislation prohibits mergers and acquisitions that impede competition. The Federal Trade Commission and Department of Justice review mergers for antitrust concerns in the United States. The European Commission reviews transactions in the European Union. The Herfindahl–Hirschman Index (HHI) is a measure of market power based on the sum of the squared market shares for each company in an industry. The Williams Act is the cornerstone of securities legislation for M&A activities in the United States. 10. Summary Copyright © 2013 CFA Institute

Summary (continued) Three major tools for valuing a target company are discounted cash flow analysis, comparable company analysis, and comparable transaction analysis. In a merger bid, the gain to target shareholders is the takeover premium. The acquirer gain is the value of any synergies created by the merger, minus the premium paid to target shareholders. The empirical evidence suggests that merger transactions create value for target company shareholders, yet acquirers tend to accrue value in the years following a merger. A divestiture is a transaction in which a company sells, liquidates, or spins off a division or a subsidiary. A company may divest assets using a sale to another company, a spin-off to shareholders, or a liquidation. 10. Summary Copyright © 2013 CFA Institute

Mergers and Acquisitions

Similar presentations

Presentation on theme: "Mergers and Acquisitions"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Mergers and Acquisitions

Similar presentations

Presentation on theme: "Mergers and Acquisitions"— Presentation transcript:

Similar presentations

About project

Feedback