Chapter 25

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Recent Mergers Reasons for Mergers Types of Mergers Merger Analysis Accounting for Mergers Role of Investment Bankers Corporate Alliances, Leveraged Buyouts,

and Divestitures Holding Companies

CHAPTER 25Mergers, LBOs, Divestitures, and

Holding Companies

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Mergers Announced in 2005Mergers Announced in 2005 America West and US Airways

– $1.5 billion - Announced May 19, 2005 Lenovo Goup and IBM PC Division

– $1.25 billion – Announced April 20th, 2005 Verizon and MCI

– $7.6 billion – Announced March 29, 2005 Proctor and Gamble and Gillette

– $57 billion – Announced March 28, 2005 IAC/Interactive and Ask Jeeves

– $1.9 billion – Announced March 21, 2005 Met Life and Travelers Group

– $11.5 billion – Announced January 31, 2005

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Mergers Announced in 2004Mergers Announced in 2004

K Mart and Sears Roebuck– $11 billion – Announced November 17, 2004

Wachovia and South Trust– $14.3 billion – Announced June 21, 2004

May Company and Marshall Field– Purchased from Target (an Acquisition)– $3.24 billion – Announced June 9, 2004

Wells Fargo and Strong Capital Management– $400 million (estimated) – Announced May 27, 2004

Marsh & McLennan – Kroll, Inc– $1.96 billion – Announced May 18, 2004

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Mergers Announced in 2004 - Mergers Announced in 2004 - ContinuedContinued

Sun Trust and National Commerce Financial– $6.98 billion – Announced May 9, 2004

Cingular Wireless and AT & T Wireless– $47 billion – Announced February 17, 2004

J P Morgan Chase and Bank One

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Mergers Announced in 2003Mergers Announced in 2003 St. Paul Companies and Travelers Property Casualty

– $16.5 billion– Announced November 17th, 2003

Bank of America and Fleet Boston– $48 billion– Announced October 27, 2003

Manulife and John Hancock Financial Services– $10.4 billion– Announced November 4, 2003

Anthem and Wellpoint– $16.4 billion– Announced October 27, 2003

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Mergers Announced in 2003 -ContinuedMergers Announced in 2003 -Continued R.J. Reynolds and British American Tobacco PLC

– $3 billion for U.S. units of British American Tobacco– Announced October 27, 2003

Oracle and PeopleSoft– $5.1 billion hostile takeover – updated in 2004 to $9.2 billion– First Announced June 9, 2003

Manufactured Home and Chateau Communities– $1.8 billion– May, 2003

Berkshire Hathaway and Clayton Homes– $1.7 billion– April, 2003

Viacom and Comedy Central– $1.2 billion– April, 2003

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Five Largest Completed Five Largest Completed MergersMergers

(as of January 2002)(as of January 2002)VALUE

BUYER TARGET (Billion)

Vodafone AirTouch Mannesman $161

Pfizer Warner-Lambert 116

America Online Time Warner 106

Exxon Mobil 81

Glaxo Wellcome SmithKline Beecham 74

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Foreign Acquisitions of U.S. Foreign Acquisitions of U.S. FirmsFirms

Manulife and John Hancock Financial Services Bridgestone and Firestone Daimler Benz and Chrysler HSBC Holdings and Household International British Petroleum and Amoco, Sohio, and Atlantic Richfield Ahold and Giant Food stores, Harris Teeter, and Price

Chopper Michelin and B.F. Goodrich Grand Metropolitan and Pillsbury Thomson and G.E. Small Appliances

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Foreign Acquisitions and U.S. Foreign Acquisitions and U.S. Firms - ContinuedFirms - Continued

Credit Suisse and First Boston Zurich Insurance and Scudder, Stevens Bank of Tokyo-Mitsubishi and UnionBanCal Toronto Dominion Bank and Waterhouse Securities Hong Kong and Shanghai Bank and Marine Midland Matushita and MCA Broken Hill Proprietary and Utah International (from G. E.) UBS and Paine Webber Bertelsmann and Napster

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Synergy: Value of the combined firm exceeds the sum of the values of the firms taken separately. Arises from:– Operating economies– Financial economies– Differential management efficiency– Tax Effects (possibly use accumulated losses)

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Which of the reasons that have beenproposed as justification for mergers

are economically justifiable?

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– Increased Market Power: Due to reduced competition

Corporate FocusWorld Wide Competition (Globalization)Acquire Technological Skills

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Break-up ValueBreak-up Value

Break-up value: A company’s assets would be more valuable if sold to and then operated by some other company or spun off.

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Diversification– Stockholders can achieve diversification at

lower cost than firms– Transfers wealth from stockholders to debt

holders– No synergistic effects

Purchase of assets at below replacement cost

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What are some questionablereasons for mergers?

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What are some questionableWhat are some questionablereasons for mergers? - reasons for mergers? -

continuedcontinuedRetention of control

– Acquire other firms to increase size, thus making it more difficult to be acquired

Managers’ personal incentives

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Types of MergersTypes of Mergers

Horizontal– First Union and Wachovia

Vertical– DuPont and Conoco

Congeric - Related Enterprises– Duke Power and Pan Energy

Conglomerate– Mobil Oil and Montgomery Ward

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Friendly merger: – Management of one firm (acquirer)

agrees to buy another firm (target).– This merger is supported by the

management of both firms.

Differentiate betweenhostile and friendly mergers

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Hostile merger:– Target firm’s management resists the

merger.– Acquirer must go directly to the target

firm’s stockholders, try to get 51% to tender their shares.

– Often, mergers that start out hostile end up as friendly, when the offer price is raised.

– Tender offer– Proxy fights

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Merger Regulation - The Merger Regulation - The Williams Act of 1968Williams Act of 1968

Acquirers must disclose their current holdings within 10 days of amassing 5% of company’s stock

Acquirers must disclose source of funds to be used in the acquisition

Target firm’s SH must be allowed at least 20 days to tender their shares

If the acquiring firm increases the offer price, all SH who tendered must receive the higher price.

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M & A “Terms”M & A “Terms”

Poison PutPoison PillWhite KnightShark RepellentGreenmailGolden ParachuteSuper MajorityESOP

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Reason for Adjusted Present Reason for Adjusted Present Value (APV) Merger AnalysisValue (APV) Merger Analysis

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.

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The Adjusted Present Value The Adjusted Present Value (APV) Model(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.

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APV ModelAPV 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 at unlevered cost of equity. Interest tax savings =

Interest(tax rate) = TSt .

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Note to APVNote to APV

APV is the best model to use when the capital structure is changing.

The Corporate Valuation model is easier than APV to use when the capital structure is constant—such as at the horizon.

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Steps in APV ValuationSteps in APV Valuation

1. Project FCFt , TSt , horizon growth rate, and horizon capital structure.

2. Calculate the unlevered cost of equity, rsU.3. Calculate WACC at horizon.4. Calculate horizon value using constant

growth corporate valuation model.

5. Calculate Vops as PV of FCFt, TSt and horizon value, all discounted at rsU.

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Net sales $60.0 $90.0 $112.5 $127.5Cost of goods sold (60%) 36.0 54.0 67.5 76.5Selling/admin. expenses 4.5 6.0 7.5 9.0EBIT 19.5 30.0 37.5 42.0Taxes on EBIT (40%) 7.8 12.0 15.0 16.8NOPAT 11.7 18.0 22.5 25.2Net Retentions 0.0 7.5 6.0 4.5Free Cash Flow 11.7 10.5 16.5 20.7

APV Valuation Analysis (In Millions)

2004 2005 2006 2007 Free Cash Flows after Merger Occurs

From Mini Case in Chapter 25

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Interest Tax Savings after Interest Tax Savings after MergerMerger

Interest expense 5.0 6.5 6.5 7.0

Interest tax savings 2.0 2.6 2.6 2.8

Interest tax savings are calculated as

interest(T). T = 40%

2004 2005 2006 2007

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What are the net retentions?What are the net retentions?

Recall that firms must reinvest in order to replace worn out assets and grow.

Net retentions = gross retentions – depreciation.

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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.

Conceptually, what is the appropriate discount rate to apply to the

target’s cash flows?

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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.

The interest tax shields are also discounted at the unlevered cost of equity.

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Note: Comparison of APV with Note: Comparison of APV with Corporate Valuation ModelCorporate Valuation Model

APV discounts FCF at rsU and adds in present value of the tax shields—the value of the tax savings are 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 carefully done. BUT it is difficult to apply the Corp. Val. Model when WACC is changing from year-to-year.

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Discount rate for Horizon Discount rate for Horizon ValueValue

At the horizon the capital structure is constant, so the corporate valuation model can be used, so discount FCFs at WACC.

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Discount Rate Calculations

rsL = rRF + (rM - rRF)bTarget

= 7% + (4%)1.3 = 12.2%

rsU = wdrd + wsrsL

= 0.20(9%) + 0.80(12.2%) = 11.56%

WACC = wd(1-T)rd + wsrsL

=0.20(0.60)9% + 0.80(12.2%)

= 10.84%

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Horizon value =

=

= $453.3 million.

Horizon, or Continuing, Value

g WACC

g))(1(FCF2007

06.01084.0

)06.1(7.20$

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What Is the value of the Target What Is the value of the Target Firm’s operations to the Firm’s operations to the

Acquiring Firm? (In Millions)Acquiring Firm? (In Millions) 2004 2005 2006 2007

Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 453.3Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $476.8

VOps = + + +

= $344.4 million.

$13.7 (1.1156)1

$13.1 (1.1156)2

$19.1 (1.1156)3

$476.8 (1.1156)4

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What is the value of the What is the value of the Target’s equity?Target’s equity?

The Target has $55 million in debt.Vops – debt = equity344.4 million – 55 million = $289.4 million

= equity value of target to the acquirer.

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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.

Additionally, a different estimating procedure could result in a different discount rate.

Would another potential acquirer obtain the same value?

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Estimate of target’s value = $289.4 million

Target’s current value = $220.0million

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.

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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?

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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.

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0 5 10 15 20

Change in Shareholders’

Wealth

Acquirer Target

Bargaining Range = Synergy

Price Paid for Target

$11.00 $14.47

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Points About GraphPoints 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. Most of the time the target’s stockholders receive the vast majority of the benefits.

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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 What if the Acquirer intended to increase the debt level in the increase the debt level in the Target to 40% with an interest Target to 40% with an interest

rate of 10%?rate of 10%?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)

Long term rsLwill change, so horizon WACC will change, so horizon value will change.

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New WACC CalculationNew WACC Calculation

New rsL = rsU + (rsU – rd)(D/S)= 11.56% + (11.56% - 10%)(0.4/0.6) = 12.60%

New WACC = wdrd(1-T) + wsrsL

= 0.4(10%)(1-0.4) + 0.6(12.6%)= 9.96%

All data are from the mini case.

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New Horizon Value New Horizon Value CalculationCalculation

Horizon value =

=

= $554.1 million.

g WACC

g))(1(FCF2007

06.00996.0

)06.1(7.20$

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New VNew Vopsops and V and Vequityequity

2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7Horizon value 554.1Interest tax shield 2.0 2.6 2.6 2.8Total $13.7 $13.1 $19.1 $577.6

VOps = + + +

= $409.5 million.

$13.7 (1.1156)1

$13.1 (1.1156)2

$19.1 (1.1156)3

$577.6 (1.1156)4

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New Equity ValueNew Equity Value

$409.5 million - 55 million = $354.5 million

This is $65.1 million, or $3.26 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.

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Pooling of interests is GONE. Only purchase accounting may be used now.

What method is used to account for for mergers?

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Purchase:

– The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value.

– Goodwill is often created, which appears as an asset on the balance sheet.

– Common equity account is increased to balance assets and claims.

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Goodwill AmortizationGoodwill AmortizationGoodwill is NO LONGER amortized over

time for shareholder reporting.Goodwill is subject to an annual “impairment

test.” If its fair market value has declined, then goodwill is reduced. Otherwise it is not.– AOL Time Warner wrote down $54 billion of

goodwill in 2002 because of “impairment test.”Goodwill is still amortized for Federal Tax

purposes. Can amortize goodwill over 15 years using straight-line method.

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Corporate CultureCorporate Culture

Should also consider factors other than cash flows, such as Corporate Culture, marketing philosophies, and personnel policies.

Merger talks often collapse because of “social issues” and “chemistry.”– Who will run the combined company?– What will be the name of the combined firm?– Where will the headquarters be located?

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Analysis for a “True Analysis for a “True Consolidation” - Merger of EqualsConsolidation” - Merger of Equals Steps:

– Develop pro forma financial statements for the consolidated corporation. Determine the projected consolidated free cash flows available to stockholders.

– Estimate the new company’s unlevered cost of equity, and use that rate to discount the free cash flows and interest tax shields of the consolidated company.

– Decide how to allocate the new company’s stock between the two sets of old stockholders.

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Identify targets Help arrange mergers

– No “parked stock” Develop defensive tactics Value target companies Help finance mergers Invest in stocks of potential merger candidates Arbitrage operations Trend is away from using investment bankers,

especially for smaller deals

What merger-related activities are undertaken by investment bankers?

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According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management.

Shareholders of target firms reap most of the benefits, that is, the final price is close to full value.– Target management can always say no.

– Competing bidders often push up prices.

Do mergers really create value?

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– Studies show stock price of target firms increase by 30% in hostile tender offers, while in friendly tender offers, the increase is 20%.

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Merger FailuresMerger Failures

61% of buyers destroyed their own shareholder’s wealth

In April 2002, AOL Time Warner took a $54 billion charge

17 out of the 21 “winners” in the merger spring of 1998 were a “bust” for investors who owned the shares

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Reasons for Merger FailureReasons for Merger Failure

Overpay by a sizeable premiumOverestimate likely cost savings and

synergiesDelay over integrating operations after

mergerEmphasis on cost-cutting, damaging the

business and losing key personnel

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Other Failure ResultsOther Failure Results TYCO

– Paid $11.3 billion for CIT in June 2001 and completed an IPO for $4.6 billion in July 2002 (loss of 6.7 billion)

WorldCom AT&T Vivendi Cisco Systems Conseco First Union Corp

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Joint VentureAccess to new markets and technologiesMultiple parties share risks and expensesRivals can often work together

harmoniouslyAntitrust laws can shelter cooperative

R&D activities

Reasons why alliances can make more sense than acquisitions

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Leveraged Buyout (LBO)Leveraged Buyout (LBO)

A small group of equity investors, usually including current management, acquires a firm in a transaction financed largely by borrowing. They “go private.” Typically buy publicly held stock. Can be a subsidiary of a public company.

Purchase often financed mostly with debt.After operating privately for a number of years,

investors might take the firm public to “cash out.” Very prevalent during the 1980s

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Leverage Buyout (LBO) ContinuedLeverage Buyout (LBO) Continued Between January 2002 and November 6, 2002, LBOs

were up 50% vs. the same period the previous year to $20 billion. In the third quarter of 2002, LBOs accounted for almost 10% of all mergers & acquisitions, their largest share since 1989.

Nov. 19, 2002 – Northrop Grumman Corp. sold TRW Automotive Business to Blackstone for $4.73 Billion

April, 2003 – Investor Group purchased Aladdin Resort & Casino for $500 million

Nov. 17, 2003 – DuPont sold its Invista textiles unit to Koch Industries for $4.4 billion

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Advantages:– Administrative cost savings– Increased managerial incentives– Increased managerial flexibility– Increased shareholder participation

Disadvantages:– Limited access to equity capital– No way to capture return on investment

How to exit an LBO– Go Public– Sell to another company– Another LBO

What are are the advantages and disadvantages of going private?

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Types of DivestituresTypes of DivestituresSale of an entire subsidiary to another firm

Target and Marshall Field

Spin-Off Spinning off a corporate subsidiary by giving stock to existing

shareholders AT&T and Lucent Technologies

Carve Out A minority interest in a corporate subsidiary is sold to new

shareholders, so the parent gains new equity financing yet retains control

Philip Morris and Kraft

Outright liquidation of assets Woolworth

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Subsidiary worth more to buyer than when operated by current owner.

To settle antitrust issues.Subsidiary’s value increased if it operates

independently.To change strategic direction.To shed money losers.To get needed cash when distressed.

What motivates firms to divest assets?

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Divestitures vs. AcquisitionsDivestitures vs. AcquisitionsNot the “opposite side of a coin” of an acquisitionLike selling a house, one purchaser at a timeHave to decide what it is worth to someone elseTypically an admission of failureHurts the Balance Sheet and benefits the Income

StatementRisks and Returns are different

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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.

What are holding companies?

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Holding Companies - Holding Companies - Advantages and DisadvantagesAdvantages and Disadvantages

Advantages– Control with

fractional ownership

– Isolation of risks (but often the parent is still responsible)

Disadvantages– Partial Multiple

Taxation– Ease of enforced

dissolution

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ConclusionConclusion

Merger Trends Reasons for Mergers Types of Mergers Merger Analysis Accounting for Mergers Leveraged Buyouts Divestitures Holding Companies