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##### CHAPTER 26

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**CHAPTER 26**Mergers, LBOs, Divestitures, and Holding Companies**Topics in Chapter**• Types of mergers • Merger analysis • Role of investment bankers • LBOs, divestitures, and holding companies**What are some valid economicjustifications for mergers?**• Synergy: Value of the whole exceeds sum of the parts. Could arise from: • Operating economies • Financial economies • Differential management efficiency • Taxes (use accumulated losses) (More...)**Valid Reasons (Continued)**• Break-up value: Assets would be more valuable if broken up and sold to other companies.**What are some questionablereasons for mergers?**• Diversification • Purchase of assets at below replacement cost • Acquire other firms to increase size, thus making it more difficult to be acquired**Differentiate between hostile and friendly mergers**• Friendly merger: • The merger is supported by the managements of both firms. (More...)**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 offer price is raised.**Reasons why alliances can make more sense than acquisitions**• Access to new markets and technologies • Multiple parties share risks and expenses • Rivals can often work together harmoniously • Antitrust laws can shelter cooperative R&D activities**Reason for APV**• 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.**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. The APV Model (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 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 is easier than APV to use 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.**Steps in APV Valuation**• 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.**Steps in APV Valuation**Value of operations + Value of any non-operating assets = Total value of the firm - Value of debt (pre-merger) = Value of equity**2006**2007 2008 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 11.70 10.50 APV Valuation Analysis (In Millions) Based on Post-Acquisition Cash Flows**2009**2010 2011 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 Cash flows… continued**2006**2007 2008 Interest expense 5.00 6.50 Tax savings from interest $ 2.00 $ 2.60 2009 2010 2011 Interest expense 6.50 7.00 8.16 Tax savings from interest $ 2.60 $ 2.80 $ 3.26 Interest Tax Savings after Merger 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**rsL = rRF + (rM - rRF)bTarget = 7% + (4%)1.3 = 12.2% rsU = wdrd + wsrsL = 0.20(9%) + 0.80(12.2%) = 11.56%**(FCF2011)(1+g)**Unlevered Horizon Value = rsU - g = $21.94(1.06) 0.1156 – 0.06 = $418.3 million. Unlevered Horizon Value**$10.5**$16.5 $11.7 $20.7 $440.2 VUL = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $298.9 million. Unlevered Value**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.**(TS2011)(1+g)**Tax Shield Horizon Value = rsU - g = $3.26(1.06) 0.1156 – 0.06 = $62.2 million. Tax Shield Horizon Value**$ 2.6**$ 2.6 $ 2.0 $ 2.8 $ 65.5 VTS = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $45.5 million. Tax Shield Value 2007 2008 2009 2010 2011 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**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 = 298.9 + 45.5 = $344.4 million**What is the value of the Target’sequity?**• 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.**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 0 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 2010 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 2011 will change. • Interest2011 = 0.10(221.6) = $22.16 million • Tax Shield2011 = 22.16(0.40) = $8.864 million**(TS2011)(1+g)**Tax Shield Horizon Value = rsU - g = $8.864(1.06) 0.1156 – 0.06 = $169.0 million. New Tax Shield Horizon Value Calculation**2007**2008 2009 2010 2011 Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 8.864 Tax shield horizon value $ 169.0 Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 177.9 $ 2.6 $ 2.6 $ 2.0 $ 2.8 $177.9 VTS = + + + + (1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5 = $110.5 million. New Tax Shield Value**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 = 298.9 + 110.5 = $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.**Do mergers really create value?**• 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.**What method is used to account for mergers?**• Pooling of interests is GONE. Only purchase accounting may be used now.**Purchase Accounting**• 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.**Goodwill Amortization**• Goodwill 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. • Goodwill is still amortized for Federal Tax purposes.