Lecture 9 Mergers and Acquisitions

Lecture 9 Mergers and Acquisitions
THE INTRODUCTION

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.

Example of a merger: AMR and U.S. Airways
U.S. Airways proposes merger to bankrupt AMR. April 2012 AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone. July 2012 AMR and U.S. Airways begin merger discussions. September 2012 U.S. Airways proposes merger, with its shareholders owning 30% of the new company. November 2012 Details of the merger are worked out. Merger filed with the FTC under Hart-Scott-Rodino Act. February 2013

2. Mergers and acquisitions Definitions
Merger with Consolidation Acquisition Company A B C Company X Y

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.

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).

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

Creation of Synergy Motive for M&As

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

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

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 (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).

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.

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.

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

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

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.

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 (

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

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.

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.

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.

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

Poison puts 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

Staggered board of directors
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.

Leveraged recapitalization
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.

Regulation of Mergers and Acquisitions
Antitrust Law Securities Law

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)

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.

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.

Estimating Free Cash Flow (FCF)
Calculate FCF NOPLAT + Noncash charges – Change in working capital – Capital expenditures Calculate NOPLAT Unlevered net income + Change in deferred taxes Calculate Unlevered Net Income Net income + Net interest after tax Calculate Net Interest after Tax (Interest expense – Interest income) × (1 – Tax rate)

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 Tax rate = 45% What is ABC’s free cash flow?

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

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.

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.

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

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

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 Estimated takeover price of the XYZ Company = $237.5 million × 1.2 = $285 million

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

Comparable Transaction Analysis
Collect Information on Recent Takeover Transactions of Comparable Companies Calculate Multiples for Comparable Companies Estimate Takeover Value Based on Multiples

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 Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each.

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

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

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.

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

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?

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

Reason to Use APV in Merger Valuation
Often in a merger the capital structure changes rapidly over the first several years. This causes the WACC to change from year to year. It is hard to incorporate year-to-year changes in WACC in the corporate valuation model.

The APV Model Value of firm if it had no debt
+ Value of tax savings due to debt = Value of operations First term is called the unlevered value of the firm. The second term is called the value of the interest tax shield. (More...)

APV Model Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity, rsU. Value of interest tax shield = PV of interest tax savings discounted at unlevered cost of equity. Interest tax savings = Interest(tax rate) = TSt.

Note to APV APV is the best model to use when the capital structure is changing. The Corporate Valuation model (i.e., discount FCF at WACC) is easier to use than APV when the capital structure is constant.

Steps in APV Valuation Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter. Project horizon growth rate. Calculate the unlevered cost of equity, rsU. Calculate horizon value of tax shields using constant growth formula and TSN. Calculate horizon value of unlevered firm using constant growth formula and FCFN. (More...)

Steps in APV Valuation (Continued)
Calculate unlevered value of firm as PV of unlevered horizon value and FCFt Calculate value of tax shields as PV of tax shield horizon value and TSt Calculate Vops as sum of unlevered value and tax shield value.

Estimating the Value of Equity
Value of operations + Value of any non-operating assets = Total value of the firm - Value of debt (pre-merger) = Value of equity

APV Valuation Analysis (In Millions) Based on Post-Acquisition Cash Flows
2010 2011 2012 Net sales 60.00 $ 90.00 Cost of goods sold (60%) 36.00 54.00 Selling/administrative expense 4.50 6.00 EBIT 19.50 30.00 Taxes on EBIT (40%) 7.80 12.00 NOPAT 11.70 18.00 Total net operating capital 150.0 150.00 157.50 Investment in net operating capital 0.00 7.50 Free Cash Flow 10.50

Cash flows… continued 2013 2014 2015 Net sales 112.50 $ 127.50 139.70
Cost of goods sold (60%) 67.50 76.50 83.80 Selling/administrative expense 7.50 9.00 11.00 EBIT 37.50 42.00 44.90 Taxes on EBIT (40%) 15.00 16.80 17.96 NOPAT 22.50 25.20 26.94 Total net operating capital 163.50 168.00 173.00 Investment in net operating capital 6.00 4.50 5.00 Free Cash Flow 16.50 20.70 21.94

Interest Tax Savings after Merger
2010 2011 2012 Interest expense 5.00 6.50 Tax savings from interest 2.00 $ 2.60 2013 2014 2015 Interest expense 6.50 7.00 8.16 Tax savings from interest 2.60 $ 2.80 3.26 Note: Tax savings = interest expense (Tax rate). The tax rate is 40%

What is investment in net operating capital?
Recall that firms must reinvest in order to replace worn out assets and grow. Investment in net operating capital = change in total net operating capital. This is equivalent to gross investment in operating capital minus depreciation

Non-Operating Assets Short-term investments and marketable securities are non-operating assets. The Target has none of these.

What is the appropriate discount rate to apply to the target’s cash flows?
After acquisition, the free cash flows belong to the remaining debtholders in the target and the various investors in the acquiring firm: their debtholders, stockholders, and others such as preferred stockholders. These cash flows can be redeployed within the acquiring firm. (More...)

Discount rate… Free cash flow is the cash flow that would occur if the firm had no debt, so it should be discounted at the unlevered cost of equity, rsU The interest tax shields are also discounted at the unlevered cost of equity, rsU

Note: Comparison of APV with Corporate Valuation Model
APV discounts FCF at rsU and also the tax shields at rsU; the value of the tax savings is incorporated explicitly. Corp. Val. Model discounts FCF at WACC, which has a (1-T) factor to account for the value of the tax shield. Both models give same answer if the capital structure is constant. But if the capital structure is changing, then APV should be used.

Discount Rate for Horizon Value
The last year of projections must be at the target capital structure with constant growth thereafter. Discount the FCFs using the constant growth formula to find the unlevered horizon value. Discount the tax shields using the constant growth formula to find the horizon value of the tax shields.

Discount Rate Calculations
Target’s data: rRF = 7%; RPM = 4%, beta = 1.3, wd =20%, rd = 9%. rsL = rRF + (RPM)bTarget = 7% + (4%)1.3 = 12.2% rsU = wdrd + wsrsL = 0.20(9%) (12.2%)= 11.56% 10

Unlevered Horizon Value (Constant growth of 6%)
(FCF2015)(1+g) rsU - g = $21.94(1.06) – 0.06 = $418.3 million.

Unlevered Value VUL = = $298.9 million. 2011 2012 2013 2014 2015
Free Cash Flow 11.7 $ 10.5 16.5 20.7 21.94 Unlevered Horizon Value 418.3 Total 440.2 VUL = $11.7 (1.1156)1 $10.5 (1.1156)2 + $16.5 (1.1156)3 $20.7 (1.1156)4 = $298.9 million. $440.2 (1.1156)5

Unlevered Value The unlevered value is the value of the firm’s operations if it had no debt. In this case Lyons’ operations would be worth $298.9 million if it were financed with 100% equity.

Tax Shield Horizon Value
(TS2015)(1+g) rsU - g = $3.26(1.06) – 0.06 = $62.2 million.

Tax Shield Value VTS = = $45.5 million. 2011 2012 2013 2014 2015
Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 3.264 Tax shield horizon value $ 62.2 Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 65.5 VTS = $ 2.0 (1.1156)1 $ 2.6 (1.1156)2 + (1.1156)3 $ 2.8 (1.1156)4 = $45.5 million. $ 65.5 (1.1156)5

What Is the value of the Target Firm’s operations to the Acquiring Firm? (In Millions)
Value of operations = unlevered value + value of tax shield = = $344.4 million

What is the value of the Target’s equity?
The Target has $55 million in debt. Vops + non-operating assets – debt = equity 344.4 million + 0 – 55 million = $289.4 million = equity value of target to the acquirer.

Would another potential acquirer obtain the same value?
No. The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies. Further, a different beta estimate, financing mix, or tax rate would change the discount rate.

The Bid Price Assume the target company has
20 million shares outstanding. The stock last traded at $11 per share, which reflects the target’s value on a stand-alone basis. How much should the acquiring firm offer?

Estimate of target’s value = $289.4 million
Target’s current value = $220.0 million Merger premium = $ 69.4 million Presumably, the target’s value is increased by $69.4 million due to merger synergies, although realizing such synergies has been problematic in many mergers. (More...)

The offer could range from $11 to $289.4/20 = $14.47 per share.
At $11, all merger benefits would go to the acquiring firm’s shareholders. At $14.47, all value added would go to the target firm’s shareholders. The graph on the next slide summarizes the situation.

Change in Shareholders’ Wealth
Acquirer Target $11.00 $14.47 Price Paid for Target 5 10 15 20 Bargaining Range = Synergy

Points About Graph Nothing magic about crossover price.
Actual price would be determined by bargaining. Higher if target is in better bargaining position, lower if acquirer is. If target is good fit for many acquirers, other firms will come in, price will be bid up. If not, could be close to $11. (More...)

Acquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. Strategy is important. Do target’s managers have 51% of stock and want to remain in control? What kind of personal deal will target’s managers get?

What if the Acquirer intended to increase the debt level in the Target to 40% with an interest rate of 10%? Assume debt at the end of 2014 will be $221.6 million. Free cash flows wouldn’t change Assume interest payments in short term won’t change (if they did, it is easy to incorporate that difference). Interest in 2015 will change. Interest2015 = 0.10(221.6) = $22.16 million Tax Shield2015 = 22.16(0.40) = $8.864 million

New Tax Shield Horizon Value Calculation
(TS2015)(1+g) rsU - g = $8.864(1.06) – 0.06 = $169.0 million.

New Tax Shield Value VTS = = $110.5 million. 2011 2012 2013 2014 2015
Interest tax shield 2.0 $ 2.6 2.8 8.864 Tax shield horizon value 169.0 Total 177.9 VTS = $ 2.0 (1.1156)1 $ 2.6 (1.1156)2 + (1.1156)3 $ 2.8 (1.1156)4 = $110.5 million. $177.9 (1.1156)5

Increase in Tax Shield The old tax shield value was $45.5 million when the company was financed with 20% debt. When the company is financed with 40% debt, the tax shield value increases to $110.5 million. The increase is due to the larger interest deductions.

New Vops and Vequity Value of operations
= unlevered value + value of tax shield = = $409.4 million Value of equity = Value of operations + non-operating assets – debt

New Equity Value $409.4 million - $55 million = $354.4 million
This is $65 million, or $3.25 per share more than if the horizon capital structure is 20% debt. The added value is the value of the additional tax shield from the increased debt.

How to finance acquisition?

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.

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. .

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.

Examples Cash offers Stock offers Stock and 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)

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

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

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. 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) Another name of a spin-off: Hive-off or hived-off Liquidation: Breaking up the entity and selling off its assets piecemeal

What are holding companies?
A holding company is a corporation formed for the sole purpose of owning the stocks of other companies. In a typical holding company, the subsidiary companies issue their own debt, but their equity is held by the holding company, which, in turn, sells stock to individual investors.

Advantages and Disadvantages of Holding Companies
Control with fractional ownership. Isolation of risks. Disadvantages: Partial multiple taxation. Ease of enforced dissolution.

What is a leveraged buyout (LB0)?
In an LBO, a small group of investors, normally including management, buys all of the publicly held stock, and hence 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.”

CASE EXAMPLE

vs The Battle of Takeover TARGET ACQUIRER
It is emblematic of the New Europe and it is taking shape with the launch of the common currency and the globalization of industry

The Battle of Takeover After a series of unrest,GUCCI successful revival LVMH acquisition the shares and ttempted takeover GUCCI GUCCI thinning the shares of shareholders Cooperate with PPR ,grabbing GUCCI form LVMH's cloutches “The White Knight” Successful stop the hostile takeover of LVMH “The Poison Pill”

GUCCI GROUP N.V. Gucci is a well-known brand in Italy, has always been famous to high-grade, luxurious and sexy . GUCCI was founded in 1923 by Guccio Gucci. However, in1993 after a decade of turmoil and scandal,the GUCCI family have to sold their cmpany. Then, Investcorp become the GUCCI's owner.

GUCCI Development trajectory Before Acquisition
1987 1992 1993 1994 GUCCI is in Family Power Crisis Investcorp buy the shares of GUCCI GUCCI lost more than $40 million and almost went bankrupt Investcorp control the shares of GUCCI Tom Ford was appointed creative director Domenico De Sole become the CEO to head GUCCI International successfullly tranformed

First round Creeping Acquisition
There are three steps in the battle bewteen GUCCI and LVMH

Step 1. U.S Securities and Exchange Commission Regulation WHY On January 6, 1999, LVMH conglomerate announced that it had passed 5% shareholding level in Gucci Group. MUST post public notification of a firm taking a 5% or more stake in another poblicly traded company

Step 2. Six days later(in Juanuary 12,1999), LVMH annouced that it had acquired 9.5% from Prada Thus, now LVMH have more than 14.5% stake in Gucci

exploit loophole of U.S law----not acquire to launch a general tender once any company achived 33% shares,but French not. Step 3. On juanuary 26, LVMH confirmed that it total had 34.4% stake in Gucci .

FIRST ROUND LVMH WINS

Second round Poison Pill
It's really useful to avoid hostile acquisition

1 2 Solution of Gucci Employee trust On February 18,1999
LVMH responded for that situation. ESOP didn't dilute the earnings. implement A new employee stock ownership plan structure Because ESOP shares were issued to a trust, the share carried no dividend rights. Employee trust 1 2 stipulate that the shares couldn't be transferred to any third part

countermeasure of LVMH
On February 25, 1999. LVMH seeked an injunction from Amsterdam's Court strip the newly issued employee trust share voting rights bar Gucci's management from issuing new shares. One week later, Amsterdam's Court postponed any decision of Gucci's defense untill May. And stated that the suspension of LVMH's voting rights was based on the company not acting as responsible shareholder

WINS SECOND ROUND Gucci
Both of them claimed victory ,hower, Gucci protected itself from LVMH's hostile acquisition. SECOND ROUND Gucci WINS

WHITE KNIGHT Contact Francois Pinault is the president&CEO of Pinnault-Printemps-Redoute(PPR). He undertook the acquisition of Sanofi Beaute which owned the Yves Saint Laurent brand. Gucci retained Morgan Stanley to contact Mr.Fancois Pinault and starting discussing&negotiations on the Gucci’s emerging strategy.

Eliminate hostile Plan
After discussion, Pinault intended to buy the division & resell the business to Gucci. MARCH 19 Gucci announced the entry of Francois Pinault as a role of white knight(friendly business investor) Gucci would issue 39 million news shares to PPR for US$75 OR 40% stake LVMH’s share in Gucci falling to 21% LVMH go to Amsterdam courts for asking injections to stop the capital infusion by PPR

MAY 29: Court’s Decision ACCEPT DENY RESULT Result
PPR’s upholding investment in GUCCI ACCEPT Poison – Pill (Employee Trust) DENY LVMH owned only 20% of GUCCI Group RESULT PPR approved by 80% of GUCCI’s shareholders for 4 years

Conflict of Interest 40% 20% PPR want LVMH out
LVMH want to gain their invest Other shareholders will get premium when change the owner

Bidding War

Tom Ford and De Sole secretly granted Gucci stock.
Court Tom Ford and De Sole secretly granted Gucci stock.

PPR buy Gucci share = Change minority
Amsterdam Enterprise Court PPR buy Gucci share = Change minority Free Float 65% Free Float 39%

Court Agree to investigate
Amsterdam Enterprise Court Court Agree to investigate PPR buy Gucci share = Change minority Free Float 65% Free Float 39%

If worst case happen, PPR sell share in Gucci
PPR Share Fell 3% Why ???? If worst case happen, PPR sell share in Gucci

LVMH cash out with profit.
Solving : All Parties Gain LVMH cash out with profit. Free Float get premium. PPR pay !

How Much PPR Pay ? 8.6 million shares (from LVMH) with $94/share
($2 premium) Another 12% share buy at $101.5/share

Pay dividend $7/share to minority except PPR
How Much PPR Pay ? Pay dividend $7/share to minority except PPR

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

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

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

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

Lecture 9 Mergers and Acquisitions

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Lecture 9 Mergers and Acquisitions

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