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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. Economic Justifications for Mergers. Synergy = Value of the whole exceeds sum of the parts

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chapter 26


Mergers, LBOs, Divestitures, and Holding Companies

topics in chapter
Topics in Chapter
  • Types of mergers
  • Merger analysis
  • Role of investment bankers
  • LBOs, divestitures, and holding companies
economic justifications for mergers
Economic Justifications for Mergers
  • Synergy = Value of the whole exceeds sum of the parts
    • Operating economies
    • Financial economies
    • Differential management efficiency
    • Taxes (use accumulated losses)
  • Break-up value = Assets more valuable broken up and sold
questionable reasons for mergers
QuestionableReasons for Mergers
  • Diversification
  • Purchase of assets below replacement cost
  • Acquire other firms to increase size, thus making it more difficult to be acquired
merger types
Merger Types
  • Horizontal
  • Vertical
  • Congeneric
    • Related but not same industry
  • Conglomerate
    • Unrelated enterprises
friendly hostile mergers
Friendly & Hostile Mergers
  • Friendly merger:
    • Supported by management of both firms
  • Hostile merger:
    • Target firm’s management resists the merger
    • Acquirer must go directly to the target firm’s stockholders – “tender offer” - try to get 51% to tender their shares.
    • Often, mergers that start out hostile end up as friendly, when offer price is raised
merger analysis
Merger Analysis
  • DCF Analysis
    • Corporate Valuation (Ch 11)
    • Adjusted Present Value Method (Ch 26.7)
    • Equity Residual Model (Ch 26.8)
      • = Free Cash Flow to Equity Method
  • Market Multiples Analysis
    • Provides a “benchmark”
the apv model
Value of firm if it had no debt

+ Value of tax savings due to debt

= Value of operations

First term = unlevered value of the firm

Second term = value of the interest tax shield

The APV Model
the apv model1
The APV Model







apv model
APV Model
  • VU = Unlevered value of firm

= PV of FCFs discounted at unlevered cost of equity, rsU

  • VTS = Value of interest tax shield

= PV of interest tax savings discounted at unlevered cost of equity, rsU

Interest tax savings = Interest * (tax rate) = TSt

apv vs corporate valuation
APV vs. Corporate Valuation
  • Best model when capital structure is changing
    • Merger often causes capital structure changes over the first several years
    • Causes WACC to change from year to year
    • Hard to incorporate year-to-year WACC changes in the corporate valuation model
  • Corporate Valuation (i.e., discount FCF at WACC) = easier than APV when capital structure is constant
steps in apv valuation
Steps in APV Valuation
  • Calculate unlevered cost of equity, rsU
  • Project FCFt ,TSt until company is at its target capital structure for one year and is expected to grow at a constant rate thereafter.




steps in apv valuation1
Steps in APV Valuation
  • Project horizon growth rate, g
    • Calculate horizon value of unlevered firm using constant growth formula and FCFN
    • Calculate horizon value of tax shields using constant growth formula and TSN



steps in apv valuation2
Steps in APV Valuation
  • Calculate Value of Operations
    • 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



steps in apv valuation3
Steps in APV Valuation
  • Calculate Value of Operations
    • Calculate Vop as sum of unlevered value and tax shield value
  • Find total value of the firm


the fcfe approach
The FCFE Approach
  • FCFE = Free Cash Flow to Equity
    • Cash flow available for distribution to common shareholders


fcfe approach
FCFE Approach
  • Value of Equity =
  • Assuming constant growth:





valuation examples
Valuation Examples
  • Caldwell Inc’s acquisition of Tutwiler
  • Tutwiler
    • Market value of equity = $62.5 m
    • Debt = $27 m
    • Total market value = $89.5 m
    • % Debt = 30.17%
    • Cost of debt, rd = 9%
    • 10 million shares outstanding
tutwiler acquisition
Tutwiler Acquisition
  • Tutwiler’s pre-merger beta = 1.20
  • Risk-free rate = 7%
  • Market risk premium = 5%
    • CAPM rsL= 13%
tutwiler acquisition1
Tutwiler Acquisition
  • Both firms = 40% tax rate
  • Post-horizon g= 6%
  • Caldwell will issue debt to maintain constant capital structure:
    • $6.2 m debt increase at merger
tutwiler apv approach
Tutwiler – APV Approach

Estimate Tutwiler’s Unlevered Cost of Equity:

tutwiler value recap
Tutwiler Value Recap

Tutwiler is worth more as part of Caldwell than stand-alone

the bid price caldwell s bid for tutwiler
The Bid PriceCaldwell’s Bid for Tutwiler
  • Caldwell will assume Tutwiler’s debt
    • Added short-term debt for acquisition
  • Analysis shows Tutwiler worth $83.1m to Caldwell
    • If Caldwell pays more Caldwell value diluted
  • How much should Caldwell offer?
caldwell s bid for tutwiler
Caldwell’s Bid for Tutwiler
  • Target’s Estimated value = $83.1 million
  • Target’s current value = $62.5 million
  • Merger premium = $20.6 million
  •  “Synergistic Benefits” = $20.6 million
  • Realizing synergies has been problematic in many mergers
caldwell s bid
Caldwell’s Bid
  • Offer range = $62.5m to $83.1m
    • $62.5m → merger benefits would go to the acquiring firm’s shareholders
    • $83.1m →all value added would go to the target firm’s shareholders
bid strategy issues
Bid Strategy Issues
  • High “preemptive” bid to ward off other bidders
  • Low bid and then plan to go up
  • Do target’s managers have 51% of stock and want to remain in control?
  • What kind of personal deal will target’s managers get?
do mergers really create value
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.
  • Target firm shareholders reap most of the benefits
    • Final price close to full value
    • Target management can always say no
    • Competing bidders often push up prices
acquisition with permanent change in capital structure
Acquisition with Permanent Change in Capital Structure
  • Tutwiler currently:
    • $62.5m value of equity
    • $27m debt = 30.17% debt
  • Caldwell’s plan
    • Increase debt to 50%
    • Maintain level from 2012 on
    • New rate on debt = 9.5%
      • Tax shield, WACC and bid price will change
change in tax shield
Change in Tax Shield

This last debt level is consistent with the assumed long-term capital structure

The last interest payment is consistent with the long-term capital structure

effect on the bid price
Effect on the Bid Price

Horizon value of Tax Shields is larger due to increased debt level.

merger payment
Merger Payment
  • Cash
  • Shares in acquiring firm
  • Debt of the acquiring firm
  • Combination
bid structure effects
Bid Structure Effects
  • Capital structure of post-merger firm
  • Tax treatment of shareholders
  • Ability of target shareholders to benefit from post merger gains
  • Federal & state regulations applied to acquiring firm
tax consequences shareholders
Tax Consequences Shareholders
  • Taxable Offer
    • Payment = primarily cash or bonds
    • IRS views as a “sale”
    • Target shareholders taxed on gain
      • Original purchase price vs. Offer price
      • Taxed in year of merger
tax consequences shareholders1
Tax Consequences Shareholders
  • Non-taxable Offer
    • Payment = primarily stock
    • IRS views as an “exchange”
    • Target shareholder pay no taxes at time of merger
    • Taxed at time of stock sale
    • Preferred by shareholders
tax consequences firms
Tax Consequences Firms
  • Non-taxable offer
    • Simple merger of balance sheets
    • Continue depreciating target’s assets as previously
  • Taxable offer – depends on offer type
    • Offer for target’s assets
    • Offer for target’s stock
tax consequences firms1
Tax Consequences Firms
  • Taxable Offer for Target’s assets
    • Acquirer pays gain on offer – asset value
    • Acquirer records target’s assets at appraised value
      • Depreciation based on new valuation
    • “Goodwill” = offer – new valuation
      • Amortized over 15 years/straight line
tax consequences firms2
Tax Consequences Firms
  • Taxable Offer for Target’s Stock
    • 2 Choices of tax treatment

1. Record acquired assets at book value and continue depreciating on current schedule

2. Record acquired assets at appraised value and generate goodwill

purchase accounting
Purchase Accounting
  • Purchase:
    • Assets of acquired firm are “written up or down” to reflect purchase price relative to net asset value
    • Goodwill often created
      • An asset on the balance sheet
    • Common equity account increased to balance assets and claims
goodwill amortization
Goodwill Amortization
  • Goodwill amortization:
    • No longer amortized over time for shareholder reporting
    • Still amortized for Federal Tax purposes
  • Goodwill subject to annual “impairment test”
    • If fair market value has declined, then goodwill is reduced
the role of investment bankers
The Role of Investment Bankers
  • Arranging mergers
    • Identifying targets
  • Developing defensive tactics
  • Establishing a fair value
  • Financing mergers
  • Arbitrage operations
defensive tactics
Defensive Tactics
  • “Super Majority”
    • 1/3 of Directors elected each year
    • 75% approval for merger versus simple majority
  • Convince target price is too low
  • Raising anti-trust issues
  • Open market repurchase of stock to push price up
  • Finding a “White Knight”
  • Finding a “White Squire”
  • Taking a “Poison Pill”
  • ESOP plans
poison pills
Poison Pills
  • Any technique used to discourage hostile takeovers
    • Borrowing on terms that require immediate repayment if acquired
    • Selling desirable assets at low prices
    • Granting lucrative “golden parachutes”
    • Allowing current shareholders to buy shares at reduced prices
risk arbitrage
Risk Arbitrage
  • “Arbitrageurs” or “arbs”
  • Speculation in likely takeover targets
  • Insider trading scandals
    • Ivan Boesky
who wins
Who Wins?
  • Takeovers increase the wealth of target firm shareholders
  • Benefit to acquiring firm debatable
  • “Event Studies” – Target stock price
    •  30% for hostile tender offers
    •  20% for friendly mergers
alliances versus acquisitions
Alliances versus 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
leveraged buyout lb0
Leveraged Buyout (LB0)
  • Small group of investors buys all publicly held stock
    • Takes the firm private
    • Group usually includes management
  • Purchase often financed with large amounts of high-yield debt
  • Investors take firm public to “cash out”
advantages and disadvantages of going private
Advantages and Disadvantages of Going Private
  • 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
types of divestitures
Types of Divestitures
  • Sale of entire subsidiary to another firm
  • “Spin-off”
    • Spinning off a corporate subsidiary by giving the stock to existing shareholders
  • “Carve-out”
    • Selling a minority interest in a subsidiary
  • Outright liquidation of assets
motivation for divestitures
Motivation for Divestitures
  • Subsidiary worth more to buyer than when operated by current owner
  • Settle antitrust issues
  • Subsidiary’s value increased operated independently
  • Change strategic direction
  • Shed money losers
  • Get needed cash when distressed
holding companies
Holding Companies
  • Corporation formed for sole purpose of owning the stocks of other companies
  • Typically, subsidiary companies:
    • Issue their own debt
    • Equity held by the holding company
    • Holding company sells stock to individual investors
advantages and disadvantages of holding companies
Advantages and Disadvantages of Holding Companies
  • Advantages:
    • Control with fractional ownership
    • Isolation of risks
  • Disadvantages:
    • Partial multiple taxation
    • Ease of enforced dissolution