26 Chapter Mergers, LBOs, Divestitures, and Holding Companies
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
The BOC questions lead us through a verbal discussion of mergers and merger analysis. This is a useful exercise, but it does not explain the type of quantitative analysis that a financial analyst would need to go through to evaluate a potential merger. For a quantitative analysis, we recommend going through the BOC model. 26-1 Horizontal: In the same business. Example: Exxon merging with Mobil Oil. Vertical: One is a supplier to the other. Example: DuPont buying Conoco to get a supply of oil. Congeneric: The businesses are somewhat related. Example: Citigroup (principally a bank) buying Salomon Smith Barney (an investment banker/stock brokerage operation). Conglomerate: The firms are in unrelated businesses. Example: GE buying NBC. Justice Department intervention would depend on this question: Would the merger be likely to reduce competition materially? Horizontal mergers are the most likely to be blocked, with vertical mergers next. Congeneric mergers are less likely to be attacked, and conglomerate mergers rarely raise antitrust questions. 26-2 Synergy is the situation where two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. Synergy generally results from economies of scale or scope. For example, bank mergers often result in lower costs as duplicate offices are closed and redundant people are laid off. Mergers like that between AOL and Time Warner were supposed to result in increased revenues because Time Warner's media properties were supposed to be delivered can to AOL's huge customer base. Expected synergy is measured either by the expected increase in free cash flow resulting from the merger or by the expected increase in market value of the equity, which depends on the expected increase in cash flow. The expected synergy is allocated by negotiations. If the target firm has many potential suitors, then it will probably capture most of the synergies. On the other hand, if the acquiring firm has many potential acquisitions, then it may be able to offer a low price and capture most of the synergy. Empirical studies indicate that targets get more of the synergies than acquirers, but that result may be more the result of inadequate tests than actual synergy allocations. Since we don't know what cash flows the two firms would have had without the merger, we cannot have full confidence that poor ex post results really indicate a bad merger. For example, AOL Time Warner's market value has gone down since their merger, but the decline might have been even greater absent the merger. Synergies are to a large extent case-specific. Conglomerate mergers would seem to offer little scope for synergies, but the other three types would all have potential for Answers and Solutions: 26 - 1
synergies. Economies of scale could result from horizontal mergers. Cost-reducing efficiencies could result from vertical mergers. Economies of scope, including crossselling and deploying research technology between the firms, could result from congeneric mergers. So, all types of mergers except conglomerate mergers would seem to offer the potential for synergies. Of course, correctly identifying synergistic potential, and then operating so as to capture it, is essential in a good merger. 26-3 The most important factor leading to successful mergers is the existence of good synergies, for without synergistic gains the acquirer cannot afford to pay much of a premium for the target, and the higher the premium, the more likely the merger is to be completed. Other factors include compatibility of the two corporate cultures, and the willingness of one CEO to give up power. Under the multiples approach, metrics like industry average P/E ratios, Price/Book ratios, and Price/EBITDA ratios would be multiplied by the relevant factor for the target company. For example, if the industry average P/E is 15X, and the target company has net income of $10 million, then one application of the market multiple approach would value the company's equity at $150 million. The same procedure could be used on a per share basis, and for items such as EBITDA, book value, sales, number of customers, and the like. This approach is almost always used, either as a basic valuation technique or as a check on a DCF valuation. These are three versions of the DCF method. The corporate valuation method finds the value of the entire corporation and then deducts the value of the debt to find the value of the stock. Here the free cash flows are discounted at the WACC, non-operating assets are added, and then the market value of the debt is subtracted to get the value of the equity. Under the adjusted present value (APV) method, the free cash flows and the interest tax shields are both discounted at the unlevered cost of equity and the value of non-operating assets is added to get the value of the firm. The debt value is then subtracted to find the value of the equity. The equity residual, or free cash flow to equity method discounts the free cash flows to equity at the levered cost of equity to arrive at the value of the equity. The free cash flow to equity is calculated as the free cash flow less after tax interest payments plus any increase in debt. If the capital structure is constant, all three DCF methods will give the same answer if implemented correctly. However, if the capital structure is changing, the APV method should be used. It is, of course, difficult to estimate the values required for the DCF methods. Neither the WACC for use in the corporate valuation model nor the unlevered cost of equity for use in the APV approach can be estimated precisely, and the projected post-merger free cash flows are even harder to estimate. Still, it is necessary to value the target, so analysts do the best they can. Note too that when one sets up an Excel model, inputs can be changed, and different scenarios can be run, to see how sensitive the valuation is to the different variables. This gives decision makers a better idea about the risk inherent in the acquisition, just as similar analyses give an idea about the riskiness of different capital budgeting projects.
26-4
26-5
Answers and Solutions: 26 - 2
26-6
The DCF methods are conceptually better and would normally be given more weight in the valuation process. The market multiples approach is based on the assumption that the target firm is quite similar to the average firm in its industry, and, indeed, that all firms in the industry are relatively similar. That may be incorrect. Also, the multiples approach assumes that all firms are valued properly, i.e., that the market is efficient. We now know that this was not the case, especially for Internet and other tech stocks, during the stock market bubble of the late 1990s. This basic mis-valuation led to many unfortunate mergers, such as that between AOL and Time Warner. Of course, the DCF method could also produce bad valuations, but at least under DCF one can identify the key variables and make judgments as to how accurate or inaccurate they are. As a result, the DCF method is normally given more weight, and the multiples approach is used primarily as a check on the DCF. If the DCF values a company at say $100 million, but the multiples approach values it only at $50 million, then one would want to reexamine the DCF, see why the difference arises, and perhaps modify the inputs.
26-7
Note: Everything said in this answer to Question 7 pertains to financial accounting only. The tax accounting treatment is totally separate and quite different. See the answer to Question 8 for a discussion of tax implications of mergers. With purchase accounting, the target's assets are appraised and are then put on the acquirer's books at their appraised value. Often, the actual price paid exceeds the appraised value of the target's assets, in which case there is apparently some intangible asset called goodwill that gives rise to high earnings and the merger premium. For example, the target might have assets with a book value of $100 million, an appraised value of $200, and a market value of $500 million due to its very high rate of return on assets. Goodwill is calculated (in essence) as the difference between the price paid and the appraised value of the acquired assets, in this case $300 million, and it is then shown on the acquirer's balance sheet as an asset. An alternative treatment that was permitted until 2001 was pooling of interests. Under pooling, the target firm's asset and liability accounts were simply added to those of the acquiring firm, regardless of how much was actually paid for the target. In a pooling, the $400 million premium paid over book would simply be disregarded. When companies could choose between pooling and purchase, most choose pooling, because under purchase accounting they were required to amortize (write off) the goodwill that was created by mergers over a period that could not exceed 40 years. That write-off lowered reported profits and perhaps had a negative influence on stock prices. In 2001, the SEC and the accounting profession stopped allowing pooling and began requiring firms to use purchase accounting. However, there is no longer an annual charge for goodwill. Rather, goodwill is allowed to stay on the books, except if it is determined that the value of the purchased assets has declined, then a flash cut write-off equal to the
Answers and Solutions: 26 - 3
estimated value decline must be taken. There is no corresponding upward valuation if the merger produced more goodwill than was reflected in the premium paid for the target. Many companies created huge amounts of goodwill in mergers during the market bubble of the late 1990s, and they are now having to take equally huge write-offs. For example, in the mid 2000s AOL Time Warner recently took a hit of over $50 billion because the value of the investment in AOL declined so dramatically. 26-8 Taxes in mergers are quite complicated, so we can only provide a rough outline of the tax situation. Here are answers to the tax treatment under the 4 situations described in the question. To answer these questions, we traced through the chart provided in ch25BOCmodel.xls. a. Acquirer pays $100 million in cash for the target's stock in a tender offer. Acquirer records assets at their book value. (Note: This could be done on the company's tax books but not on the books used for stockholder reporting.) Go down left side of chart to Taxable, because cash rather than stock is paid. Then go to the right stock is bought. Then continue to right because assets are recorded at book rather than appraised value. In the final box, we see that: Target's stockholders would receive the entire $100 million from the acquirer when they surrendered their stock, and then each individual stockholder would pay taxes depending on how long they had held the stock and their cost basis. Target's shareholders would get nothing from the target firm itself. The target firm itself would pay no taxes on gains because it received nothing from the merger. Only its stockholders received a payment from the acquirer, so only the stockholders face a potential tax liability. The acquirer would depreciate the acquired assets exactly like they would have been depreciated without the merger. Note that the acquiring firm would own the target company, and it would inherit any environmental or product liability claims against the company. This situation has bankrupted many companies that acquired firms involved with asbestos. b. Same as a, but Acquirer records assets at their appraised value. Now we go to the lower middle box. The target's stockholders get the same $100 million and pay the same taxes as before. However, the target firm itself, which really means the acquiring firm because it now owns the target, must immediately pay a tax on the $50 million difference between the $50 million book value and the $100 million purchase price. At a 35% rate, the immediately payable tax would be $50(0.35) = $17.5 million. Taxes are at the normal corporate tax rate, because corporations do not have a lower capital gains tax rate. The acquirer could write up depreciable assets from $50 million to the $80 million appraised value, and it could record the $20 million difference between the $100 million price and the $80 million appraised value as goodwill, so it would be able to write off the entire $100 million, Answers and Solutions: 26 - 4
either as depreciation or as amortization. This would save it $35 million in taxes, but that saving would occur over time. One would have to compare the PV of the tax savings to the immediate $17.5 tax, but unless the acquirer has some offsetting losses elsewhere, it would probably not be good to choose this method, because the PV would probably be both lower and less certain than the immediate tax payment. Therefore, this procedure is not used very often in practice. c. Acquirer gives stock with a market value of $100 million in exchange for the target's stock. Now in the chart move across the top to the right. We now have an exchange of stock, which results in a non-taxable merger. The target's stockholders would receive the $100 million of stock in the acquirer, but they would not have to pay taxes until they sold that stock. Their basis would be the same as their basis in the target firm. Assets would not be written up, goodwill would not be created, and tax depreciation for the Target subsidiary would be the same as before the merger. Note that this procedure amounts to a pooling of interests, which is allowed for tax purposes but is no longer permitted for accounting purposes. Thus, there is a major difference in bookkeeping for tax and book purposes for nontaxable mergers. d. Acquirer pays $100 million in cash to the target for its assets. This takes us to the lower left section of the chart. We would have a taxable merger. Assets would be written up to their appraised value ($80 million), and $20 million of goodwill would be created. The target company itself would have to pay taxes on the $50 million of gains, and the tax would be at the normal corporate tax rate, so it would amount to $17.5 million. The funds after taxes (presumably $100 million minus the $17.5 million tax on the $50 million gain) would then be distributed to the target's stockholders as a liquidating dividend. The difference between the liquidating dividend and a stockholder's basis would be treated as a capital gains and taxed as such in the year the dividend was paid.
Answers and Solutions: 26 - 5
ANSWERS TO END-OF-CHAPTER QUESTIONS
26-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to mergers, a synergistic merger occurs when the postmerger free cash flows exceed the sum of the separate companies' premerger free cash flows. A merger is the joining of two firms to form a single firm. b. A horizontal merger is a merger between two companies in the same line of business. In a vertical merger, a company acquires another firm that is "upstream" or "downstream"; for example, an automobile manufacturer acquires a steel producer. A congeneric merger involves firms that are interrelated, but not identical, lines of business. One example is Prudential's acquisition of Bache & Company. In a conglomerate merger, unrelated enterprises combine, such as Mobil Oil and Montgomery Ward. c. A friendly merger occurs when the target company's management agrees to the merger and recommends that shareholders approve the deal. In a hostile merger, the management of the target company resists the offer. A defensive merger occurs when one company acquires another to help ward off a hostile merger attempt. A tender offer is the offer of one firm to buy the stock of another by going directly to the stockholders, frequently over the opposition of the target company's management. A target company is a firm that another company seeks to acquire. Breakup value is a firm's value if its assets are sold off in pieces. An acquiring company is a company that seeks to acquire another firm. d. An operating merger occurs when the operations of two companies are integrated with the expectation of obtaining synergistic gains. These may occur due to economies of scale, management efficiency, or a host of other reasons. In a pure financial merger, the companies will not be operated as a single unit, and no operating economies are expected. e. The adjusted present value model discounts projected free cash flows and interest tax shields at the unlevered cost of equity to arrive at the value of operations. You add in the value of non-operating assets to get the value of the entire firm (both debt and equity). To get the value of equity, subtract off the value of the debt. This model is especially useful when the acquirer will change the target's capital structure after the acquisition because it separately values the interest tax shields and the unlevered value of the firm.
Answers and Solutions: 26 - 6
f. The free cash flow to equity model, or also called the residual dividend model, first calculates FCFE, which is the free cash flow payable to shareholders. FCFE is free cash flow less interest expense plus the interest tax shield. It then discounts the FCFEs at the levered cost of equity to arrive at the value of equity in operations. You add in the value of non-operating assets and you get the value of the equity. To get the value of operations you then add in the value of the debt. g. Under purchase accounting, the acquiring firm is assumed to have bought the acquired company in much the same way it would buy any capital asset. Any excess of the purchase price over the book value of assets is added to goodwill, which may be expensed for Federal income tax purposes, but may not be expensed for shareholder reporting. h. A white knight is a friendly competing bidder that a target management likes better than the company making a hostile offer, and the target solicits a merger with the white knight as a preferable alternative. A poison pill is a deliberate action that a company takes which makes it a less attractive takeover target. A golden parachute is a payment made to executives that are forced out when a merger takes place. A proxy fight is an attempt to gain control of a firm by soliciting stockholders to vote for a new management team. i. A joint venture involves the joining together of parts of companies to accomplish specific, limited objectives. Joint ventures are controlled by the combined management of the two (or more) parent companies. A corporate or strategic alliance is a cooperative deal that stops short of a merger. A divestiture is the opposite of an acquisition. That is, a company sells a portion of its assets, often a whole division, to another firm or individual. In a spin-off, a holding company distributes the stock of one of the operating companies to its shareholders. Thus, control passes from the holding company to the shareholders directly. A leveraged buyout is a transaction in which a firm's publicly owned stock is acquired in a mostly debt-financed tender offer, and a privately owned, highly leveraged firm results. Often, the firm's own management initiates the LBO.
j.
k. A holding company is a corporation formed for the sole purpose of owning stocks in other companies. A holding company differs from a stock mutual fund in that holding companies own sufficient stock in their operating companies to exercise effective working control. An operating company is a company controlled by a holding company. A parent company is another name for a holding company. A parent company will often have control over many subsidiaries. l. Arbitrage is the simultaneous buying and selling of the same commodity or security in two different markets at different prices, and pocketing a risk-free return. In the context of mergers, risk arbitrage refers to the practice of purchasing stock in companies that may become takeover targets. Answers and Solutions: 26 - 7
26-2
Horizontal and vertical mergers are most likely to result in governmental intervention, but mergers of this type are also most likely to result in operating synergy. Conglomerate and congeneric mergers are attacked by the government less often, but they also are less likely to provide any synergistic benefits. A tender offer might be used. Although many tender offers are made by surprise and over the opposition of the target firm's management, tender offers can and often are made on a "friendly" basis. In this case, management (the board of directors) of the target company endorses the tender offer and recommends that shareholders tender their shares. An operating merger involves integrating the company's operations in hopes of obtaining synergistic benefits, while a pure financial merger generally does not involve integrating the merged company's operations. The three models--APV, FCFE and corporate valuation (CV) all do the same thing. They value a firm's operations and its equity. When implemented under a scenario that is consistent with the assumptions of all three models, they will all give the same answer. The CV model discounts free cash flows at the WACC to obtain the value of operations. You then add non-operating assets and subtract out debt to arrive at the value of equity. In this case the value of the interest tax shield is incorporated because the WACC is used to discount the cash flows; the WACC has a reduction in the cost of debt to account for its tax shield. The APV model treats the free cash flows and the interest tax shields separately, discounting both of them at the unlevered cost of equity. The result is the value of operations. You add in the value of non-operating assets to get the value of the firm, and subtract out the value of the debt to get the value of the equity. The FCFE model calculates free cash flows to equity as FCF interest expense + interest tax shield. The model then discounts these FCFEs at the levered cost of equity to get the value of equity in operations. You add in the value of non-operating assets to get the value of equity, and then add in the value of the debt to get the value of the entire firm.
26-3
26-4
26-5
Answers and Solutions: 26 - 8
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
26-1
FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; r RF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ? rs = rRF + RPM(b) = 5% + 6%(1.4) = 13.4%. WACC = wdrd(1-T) + wsrs = 0.30(8%)(0.60) + 0.70(13.4%) = 10.82% Vops =
FCF0 (1 g) WACC g $2.1 = 0.1082 0.05 = $36.08 million
VS = Vops debt = 36.08 10.82 = $25.26 million Price = 25.26 million / 1 million shares = $25.26 / share. 26-2 FCF1 = $2.5 million, FCF2 = $2.9 million, FCF3 = $3.4 million, and FCF4 = 3.57 million; Interest in the 4th year = $1.472 million. g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T = 40%; rd = 8% Vops = ? P0 = ? rsU = wdrd + wsrsL Note: rs was calculated in problem 1 to be 13.4% = 0.30(8%) + 0.70(13.4%) = 11.78% WACC was calculated in problem 1 to be 10.82%. Since the horizon capital structure is the same as in problem 1, the WACC is the same, although we don't need WACC to apply the APV. Tax shields are TS1 = TS2 = TS3 = Interest x T = 600,000, and TS4 = 1,472,000 x T = 588,800.
Answers and Solutions: 26 - 9
Tax shield horizon value = TS4(1+g)/(rsU-g) = 0.588 (1.05)/(0.1178-0.05) = 9.12 0.600 0.600 0.600 0.600 9.12 Value of tax shields = 2 3 1.1178 (1.1178) (1.1178) (1.1178) 4 = $7.67 million. Unlevered horizon value = FCF4(1+g)/(rsU-g) = 3.57(1.05)/(0.1178-0.05) = 55.29 2.5 2.9 3.4 3.57 55.29 Unlevered Vops = 2 3 1.1178 (1.1178) (1.1178) (1.1178) 4 = $44.69 Value of operations = unlevered Vops + value of tax shields = 44.69 + 7.67 = 52.36 million Equity value to Harrison = Vops Debt = 52.36 million - 10.82 million = 41.54 million or $41.54 per share since there are 1 million shares outstanding. Note: Since the capital structure isn't changing and the company has reached its target capital structure by the horizon, you could have just used the corporate valuation model to calculate the value of operations. In the corporate valuation model you discount the FCFs at the WACC to get the value of operations: Corporate Valuation Model Horizon Value = FCF4(1+g)/(WACC-g) = 3.57(1.05)/(0.1082 0.05) = 3.7485/(0.0582) = $64.41 million 2.5 2.9 3.4 3.57 64.41 Value of operations = 2 3 1.1082 (1.1082) (1.1082) (1.1082) 4 = $52.19 million which is the same as the value of operations calculated above, except for rounding differences (the answer above was $52.36 million). 26-3 On the basis of the answers in Problems 26-1 and 26-2, the bid for each share should range between $25.26 and $41.54.
Answers and Solutions: 26 - 10
26-4
The difference between this problem and problem 26-2 is the tax shield in year 4, which reflects the 45% debt capital structure. TS4 = (new debt level)(interest rate on debt)(tax rate) = 30.6(0.085)(0.40) = $1.04 million. rsU = 11.78% was calculated in the earlier problems. The tax shield horizon value is = HVTS4 = TS5/(rsU g) = TS4(1+g)/(rsU-g) = 1.04(1.05)/(0.1178-0.05) = $16.11 million Value of tax shields =
0.600 0.600 1.1178 (1.1178) 2 = $12.43 million
0.600 (1.1178) 3
1.04 16.11 (1.1178) 4
The unlevered horizon value and the unlevered value of operations is the same as in problem 3: Unlevered horizon value = FCF4(1+g)/(rsU-g) = 3.57(1.05)/(0.1178-0.05) = $55.29 million 2.5 2.9 3.4 3.57 55.29 Unlevered Vops = 2 3 1.1178 (1.1178) (1.1178) (1.1178) 4 = $44.69 The new value of operations is Value of operations = unlevered Vops + value of tax shields = 44.69 + 12.43 = 57.13 million Equity value to Hastings = Vops Debt = 57.13 million - 10.82 million = $46.31 million or $46.31 per share since there are 1 million shares outstanding. Although not necessary for the problem, you could calculate the new WACC that will prevail after the 45% target capital structure is reached. rsL = rsU + (rsU rd)(D/S) = 11.78% + (11.78% - 8.5%)(0.45/0.55) = 14.46% WACC = wdrd(1-T) + wsrs = 0.45(8.5%)(1-0.40) + 0.55(14.46%) = 10.25%
Answers and Solutions: 26 - 11
26-5
a. The appropriate discount rate reflects the riskiness of the cash flows. Thus, it is Conroy's unlevered cost of equity that should be used to discount the free cash flows and tax shields in years 1-5 and at the horizon. The horizon value should be calculated using Conroy's tax shields at the stable target capital structure, which are provided for Year 5. Since Conroy's beta = 1.3, its current cost of equity, r sL = 6% + 1.3(4.5%) = 11.85%. Since its percentage of debt is 25% and the rate on its debt is 9%, its unlevered cost of equity is rsU = wdrd + wsrsL = 0.25(9%) + 0.75 (11.85%) = 11.14% Interest5 = Debt4 (9.5%) = 2.116 TS5 = Interest5(Tax rate) = 2.116(0.35%) = 0.7405 (You must use the post merger tax rate) In the other years, the tax shield is equal to the interest expense multiplied by the tax rate: TS1 = 1.2(0.35) = 0.42, TS2 = 0.595, TS3 = 0.98, TS4 = 0.735 HVTS5 = TS6/(rsU g) = TS5(1 + g)/(rsU g) = 0.7405(1.06)/(0.1114 0.06) = $15.28 million The value of the tax shields = 0.42 0.595 0.980 2 1.1114 (1.1114) (1.1114) 3
0.735 (1.1114) 4
0.741 15.28 = $11.50 million (1.1114) 5
The unlevered horizon value is HVUL5 = FCF5(1+g)/(rsU g) = 2.12(1.06)/(0.1115-0.06) = $43.74 million The unlevered value of operations is 1.3 1.5 1.75 2 1.1114 (1.1114) (1.1114) 3
2.0 (1.1114) 4
2.12 43.74 = $32.02 million (1.1114) 5
b. The value of operations is the sum of the interest tax shields and the unlevered value = 11.50 + 32.02 = $43.52 million. The value of the equity is the value of operations (plus any non-operating assets, which are zero in this case) less debt: Equity = 43.52 10.00 = $33.52 million. This is the maximum amount that Marston should pay for Conroy.
Answers and Solutions: 26 - 12
Although not required for the value calculation, the WACC at the new capital structure can be calculated. At the new capital structure of 40 percent debt with a rate 9.5 of percent, the new levered cost of equity and WACC will be: rsL = rsU + (rsU rd)(D/S) = 11.14% + (11.14% - 9.5%)(0.40/0.60) = 12.23% WACC = wdrd(1-T) + wsrs = 0.40(9.5%)(1-0.35) + 0.60(12.23%) = 9.81% 26-6 a. BCC's unlevered cost of equity depends on its pre-merger cost of equity and its premerger capital structure: rsL = rRF + (RPM)b = 6% + (4%)1.40 = 11.6%. rsU = wdrd + wsrsL = 0.40(10%) + 0.60(11.6%) = 10.96% b. The free cash flows are NOPAT investment in net operating capital = (Sales CGS selling expenses)(1-T) investment in net operating capital. CGS is 65% of sales: 2006 Net sales Cost of Goods Sold SGA EBIT Taxes on EBIT (35%) NOPAT Total Operating Cap. Inv. in Op. Capital FCF 2007 $450.00 $292.50 $45.00 $112.50 $39.38 $73.12 $850.00 $50.00 $23.12 2008 $518.00 $336.70 $53.00 $128.30 $44.90 $83.40 $930.00 $80.00 $3.40 2009 $555.00 $360.75 $60.00 $134.25 $46.99 $87.26 $1,005 $75.00 $12.26 2010 $600.00 $390.00 $68.00 $142.00 $49.70 $92.30 $1,075 $70.00 $22.30 2011 $643.00 $417.95 $73.00 $152.05 $53.22 $98.83 $1,150 $75.00 $23.83
$800
TSn = Interestn(Tax rate) TS1 = 40(0.35) = 14.00, TS2 = 45(0.35) = 15.75, TS3 = 47(0.35) = 16.45, TS4 = 52(0.35) = 18.20, TS5 = 54(0.35) = 18.90 c. Horizon value of tax shields = TS5(1+g)/(rsU g) = 18.9(1.07)/(0.1096-0.07) = $510.70 Unlevered horizon value = FCF5(1+g)/(rsU g) = 23.83(1.07)/(0.1096-0.07) = $644.0
Answers and Solutions: 26 - 13
d. Value of tax shields = PV of tax shields and the PV of the horizon value of the tax shields at rsU. The unlevered value of operations = PV of the FCFs and the PV of the unlevered horizon value at rsU. The cash flows for both are summarized below: 2007 $14.00 $14.00 $23.13 $23.13 2008 $15.75 $15.75 $3.40 $3.40 2009 $16.45 $16.45 $12.26 $12.26 2010 $18.20 $18.20 $22.30 $22.30 2010 $18.9 $510.7 $529.6 $23.83 $644.00 $667.8
Tax shield TSHV Sum of TS FCF FCF HV Sum of FCF
The NPV of the sum of the TS row at 10.96% is $364.3, which is the value of the tax shields. The NPV of the sum of the FCF row is $444.3, which is the unlevered value of operations. The sum of the value of the tax shields and the unlevered value of operations is the value of operations: 364.3 + 444.3 = $808.6 Less the value of debt, $300, is the value of equity: 808.6 300 = $508.6 million. Although we don't need this calculation for the valuation, after the merger, BCC will have 50 percent of debt costing 10%, so its levered cost of equity and WACC will be: rsL = rsU + (rsU rd)(D/S) = 10.96% + (10.96% - 10%)(0.50/0.50) = 11.92% WACC = wdrd(1-T) + wsrs = 0.5(10%)(1-0.35) + 0.5(11.92%) = 9.21%
Answers and Solutions: 26 - 14
SOLUTION TO SPREADSHEET PROBLEMS
26-7
The detailed solution for the problem is available both on the instructor's resource CDROM (in the file Solution to IFM9 Ch 26 P07 Build a Model.xls) and on the instructor's side of the accompanying book site, http://now.swlearning.com/brigham.
Answers and Solutions: 26 - 15
MINI CASE Note to Instructors: Some instructors choose to assign the Mini Case as homework. Therefore, the PowerPoint slides for the mini case, IFM9 Ch 26 Show.ppt, and the accompanying Excel file, IFM9 Ch 26 Mini Case.xls, are not included for the students on ThomsonNOW. However, many instructors, including us, want students to have copies of class notes. Therefore, we make the PowerPoint slides and Excel worksheets available to our students by posting them to our password-protected Web site. We encourage you to do the same if you would like for your students to have these files. Hager's Home Repair Company, a regional hardware chain that specializes in do-it-yourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative uses for the excess funds is an acquisition. Doug Zona, Hager's treasurer and your boss, has been asked to place a value on a potential target, Lyons' Lighting (LL), a chain that operates in several adjacent states, and he has enlisted your help. The table below indicates Zona's estimates of LL's earnings potential if it came under Hager's management (in millions of dollars). The interest expense listed here includes the interest (1) on LL's existing debt, which is $55 million at a rate of 9 percent, and (2) on new debt expected to be issued over time to help finance expansion within the new L division, the code name given to the target firm. If acquired, LL will face a 40 percent tax rate. Security analysts estimate LL's beta to be 1.3. The acquisition would not change Lyons' capital structure, which is 20 percent debt. Zona realizes that Lyons' Lighting's business plan also requires certain levels of operating capital and that the annual investment could be significant. The required levels of total net operating capital are listed below. Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also estimates that free cash flows after 2011 will grow at a constant rate of 6 percent. Following are projections for sales and other items. 2007 Net sales $60.00 Cost of goods sold (60%) 36.00 Selling/administrative expense 4.50 Interest expense 5.00 Total net operating capital 150.00 150.00 2006 2008 2009 2010 2011 $90.00 $112.50 $127.50 $139.70 54.00 67.50 76.50 83.80 6.00 7.50 9.00 11.00 6.50 6.50 7.00 8.16 157.50 163.50 168.00 173.0
Hager's management is new to the merger game, so Zona has been asked to answer some basic questions about mergers as well as to perform the merger analysis. To structure the task, Zona has developed the following questions, which you must answer and then defend to Hager's board.
Mini Case: 26- 16
a.
Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain. The economically justifiable rationales for mergers are synergy and tax consequences. Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. (if synergy exists, then the whole is greater than the sum of the parts, and hence synergy is also called the "2 + 2 = 5" effect.) A synergistic merger creates value, which must be apportioned between the stockholders of the merging companies. Synergy can arise from four sources: (1) operating economies of scale in management, production, marketing, or distribution; (2) financial economies, which could include higher debt capacity, lower transactions costs, or better coverage by securities' analysts which can lead to higher demand and, hence, higher prices; (3) differential management efficiency, which implies that new management can increase the value of a firm's assets; and (4) increased market power due to reduced competition. Operating and financial economies are socially desirable, as are mergers that increase managerial efficiency, but mergers that reduce competition are both undesirable and illegal. Another valid rationale behind mergers is tax considerations. For example, a firm which is highly profitable and consequently in the highest corporate tax bracket could acquire a company with large accumulated tax losses, and immediately use those losses to shelter its current and future income. Without the merger, the carryforwards might eventually be used, but their value would be higher if used now rather than in the future. The motives that are generally less supportable on economic grounds are risk reduction, purchase of assets at below replacement cost, control, and globalization. Managers often state that diversification helps to stabilize a firm's earnings stream and thus reduces total risk, and hence benefits shareholders. Stabilization of earnings is certainly beneficial to a firm's employees, suppliers, customers, and managers. However, if a stock investor is concerned about earnings variability, he or she can diversify more easily than can the firm. Why should firm a and firm b merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing? Further, we know that well-diversified shareholders are more concerned with a stock's market risk than its stand-alone risk, and higher earnings instability does not necessarily translate into higher market risk. Sometimes a firm will be touted as a possible acquisition candidate because the replacement value of its assets is considerably higher than its market value. For example, in the early 1980s, oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. However, the value of an asset stems from its expected cash flows, not from its cost. Thus, paying $1
Answer:
Mini Case: 26- 17
million for a slide rule plant that would cost $2 million to build from scratch is not a good deal if no one uses slide rules. In recent years, many hostile takeovers have occurred. To keep their companies independent, and also to protect their jobs, managers sometimes engineer defensive mergers, which make their firms more difficult to "digest." Also, such defensive mergers are usually debt-financed, which makes it harder for a potential acquirer to use debt financing to finance the acquisition. In general, defensive mergers appear to be designed more for the benefit of managers than for that of the stockholders. An increased desire to become globalized has resulted in many mergers. To merge just to become international is not an economically justified reason for a merger; however, increased globalization has led to increased economies of scale. Thus, synergies often result--which is an economically justifiable reason for mergers. Synergy appears to be the reason for this merger.
b. Answer:
Briefly describe the differences between a hostile merger and a friendly merger. In a friendly merger, the management of one firm (the acquirer) agrees to buy another firm (the target). In most cases, the action is initiated by the acquiring firm, but in some situations the target may initiate the merger. The managements of both firms get together and work out terms which they believe to be beneficial to both sets of shareholders. Then they issue statements to their stockholders recommending that they agree to the merger. Of course, the shareholders of the target firm normally must vote on the merger, but management's support generally assures that the votes will be favorable. If a target firm's management resists the merger, then the acquiring firm's advances are said to be hostile rather than friendly. In this case, the acquirer, if it chooses to, must make a direct appeal to the target firm's shareholders. This takes the form of a tender offer, whereby the target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stock, bonds, or some combination of the three. If 51 percent or more of the target firm's shareholders tender their shares, then the merger will be completed over management's objection.
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c. Answer:
What are the steps in valuing a merger? When the capital structure is changing rapidly, as in many mergers, the WACC changes from year-to-year and it is difficult to apply the corporate valuation model in these cases. The APV model works better when the capital structure is changing. The steps are: 1. Project FCFt ,TSt until the target is at its target capital structure for one year and and is expected to grow thereafter at a constant growth rate. 2. Project the horizon growth rate. 3. Calculate the unlevered cost of equity, rsu. 4. Calculate horizon value of tax shields using the constant growth formula and TSN. 5. Calculate the horizon value of the unlevered firm using the constant growth formula and FCFN. 6. Calculate the unlevered firm value as the present value of the unlevered horizon value and the FCFs at the unlevered cost of equity. 7. Calculate the value of the tax shields as the present value of the tax shield horizon value and the individual tax shields. 8. Calculate Vops as the sum of the unlevered value and the tax shield value.
d.
Use the data developed in the table to construct the L division's free cash flows for 2007 through 2011. Why are we identifying interest expense separately since it is not normally included in calculating free cash flow or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating free cash flow? The easiest approach here is to calculate the free cash flows for the L division, assuming that the acquisition is made (in millions of dollars). 2006 2007 2008 2009 2010 2011 Net sales $60.0 $90.0 $112.5 $127.5 $139.70 Cost of goods sold (60%) 36.0 54.0 67.5 76.5 83.80 Selling/admin. Expenses 4.5 6.0 7.5 9.0 11.0 EBIT 19.5 30.0 37.5 42.0 44.9 Taxes on EBIT(40%) 7.8 12.0 15.0 16.8 18.0 NOPAT 11.7 18.0 22.5 25.2 26.9 Total net operating capital 150.0 150.0 157.5 163.5 168.0 173.0 Investment in net operating capital 0.0 7.5 6.0 4.5 5.0 Free cash flow 11.7 10.5 16.5 20.7 21.94 Interest expense Interest tax savings 5.0 2.0 6.5 2.6 6.5 2.6 7.0 2.8 8.2 3.264
Answer:
Note that these free cash flows are identical to what you would construct to use the corporate valuation model or to use standard capital budgeting procedures, except Mini Case: 26- 19
that we have also included separate lines for the interest expense and interest tax savings (which are calculated as interest x tax rate and are also called interest tax shields). In many merger analyses the debt levels change so dramatically that using the corporate value model would require re-estimating the WACC every year. Instead, the APV model breaks up the value of operations into two components: Voperations = Vunlevered + Vtax shield . The free cash flows and interest tax savings are discounted separately at the unlevered cost of equity. This is more convenient to use than the corporate value model because the unlevered cost of equity can be used even when the capital structure is changing. Also, in straight capital budgeting and the simplest application of the corporate value model all debt involved is new debt, which is issued to fund the asset additions. Hence, the debt involved all costs the same, rd, and this cost is accounted for by discounting the cash flows at the firm's WACC. However, in a merger the acquiring firm usually both assumes the existing debt of the target and issues new debt to help finance the takeover. Thus, the debt involved has different costs, and hence cannot be accounted for as a single cost in the WACC. The easiest solution is to explicitly include the interest tax shield and use the APV. In regards to retentions, all of the cash flows from an individual project are available for use throughout the firm, since capital expenditures are explicitly accounted for. Similarly, we account for capital expenditures within the acquired firm when we calculate free cash flow. There are two equivalent ways to calculate free cash flow: NOPAT + Depreciation = Operating Cash Flow - Gross investment in operating capital = Free Cash Flow OR: NOPAT - Investment in net operating capital = Free Cash Flow Where investment in net operating capital = Gross investment in operating capital Depreciation. The interest tax savings are cash flows that are also available to pay interest, principal, or for other use within the firm. In the corporate valuation model (which assumed a stable capital structure) we accounted for the value of these tax savings by using a lower cost of capital--the debt component of the WACC is reduced by the factor (1-t). In the APV we discount at the higher unlevered cost of equity and take these tax savings into account explicitly. The steps to apply the APV model are:
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(1) Calculate the unlevered cost of equity, r sU, using the pre-merger levered cost of equity and the pre-merger capital structure; (2) calculate the horizon value of the unlevered firm as the present value of the free cash flows after the horizon discounted at rsU; (3) calculate the horizon value of the tax shields as the present value of the interest tax shields after the horizon discounted at r sU; (4) calculate the value of the unlevered firm as the present value of the horizon value of the unlevered firm plus the present value of the free cash flows until the horizon, discounted at r sU; (5) calculate the value of the tax shields as the present value of the horizon value of the tax shields plus the present value of the tax shields until the horizon, discounted at r sU; (6) add the value of the unlevered firm to the value of the tax shields to get the value of operations; (7) add any the value of any non-operating assets and subtract the value of all debt to get the current equity value. Note that the Extension to this chapter discusses how the final interest expense projections are made and shows that in many cases, and in this case, the corporate valuation model can be used at the horizon to calculate the horizon value rather than calculating separately the horizon value of the tax shield and the unlevered horizon value. This is because in many cases the firm is at a stable capital structure by the horizon and in this case the corporate valuation model is easier to apply.
e.
Conceptually, what is the appropriate discount rate to apply to the cash flows developed in part c? What is your actual estimate of this discount rate? As discussed above, the free cash flows, tax shields and horizon value should all be discounted at the unlevered cost of equity. This cost should be calculated based on the target's risk, not the acquirer's risk. Hager's investment bankers have estimated that Lyons' Lighting's beta is currently 1.3. The horizon value should be calculated using Lyons' WACC, which is based on the costs of debt and equity after any change in leverage. To obtain the unlevered required rate of return we first need the levered required rate of return. Note that rrf = 7% and rpm = 4%. Thus, the l division's levered required rate of return on equity is: rs(Lyons' Lighting) = rrf + (rm - rrf)bLyons' Lighting = 7% + (4%)1.3 = 12.2%. The unlevered cost of equity, based on a 20% debt ratio, cost of debt of 9%, and a levered cost of equity of 12.2% is: rsu = wdrd + wsrsl = 0.20(9%) + 0.80(12.2%) = 11.56%
Answer:
Mini Case: 26- 21
f.
What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated value of the L division's cash flows beyond 2011? What is Lyons' value to Hager's shareholders? Suppose another firm were evaluating Lyons' as an acquisition candidate. Would they obtain the same value? Explain. The 2011 cash flow is $20.7 million, and it is expected to grow at a 6 percent constant growth rate in 2011 and beyond. We will find the unlevered horizon value and the horizon value of the tax shields: Unlevered horizon value =
Answer:
(2011Free Cash Flow)(1 g) rsU g $21.94(1.06) = 0.1156 0.06 = $418.3 million. (2011Tax Shield)(1 g) rsU g $3.264(1.06) = 0.1156 0.06 = $62.2 million.
Tax Shield horizon value =
To calculate the unlevered value of the firm, find the present value of the unlevered horizon value and the free cash flows at the unlevered cost of equity (in millions of dollars): 2007 Annual free cash flow $11.7 Unlevered horizon value Total $11.7 2008 $10.5 $10.5 2009 $16.5 $16.5 2010 $ 20.7 2011 $21.9 418.3 $20.7 $440.2
The present value of these cash flows at the unlevered cost of equity, 11.56%, is $298.9 million. This is the unlevered value of operations. The value of the interest tax shields is calculated similarly: 2007 Annual tax shield $2.0 Horizon value of tax shield Total $2.0 2008 $2.6 $2.6 2009 $2.6 $2.6 2010 $2.8 $2.8 2011 $3.3 62.2 $65.5
The present value of this stream of cash flows at the unlevered cost of equity, 11.56%, is $45.5 million. Mini Case: 26- 22
Now, the value of Lyons operations is the sum of the unlevered value and the value of the tax shields: Value of operations = Unlevered value of operations + value of tax shields = $298.9 million + 45.5 million = $344.4 million The value of Lyons' equity is this value of operations less its current debt of $55 million, for an equity value of $289.4 million. If another firm were valuing Lyons', they would probably obtain an estimate different from $289.4 million. Most important, the synergies involved would likely be different, and hence the cash flow estimates would differ. Also, another potential acquirer might use different financing, or have a different tax rate, and hence estimate a different discount rate at the horizon and have different interest tax shields.
Mini Case: 26- 23
g.
Assume that Lyons' has 20 million shares outstanding. These shares are traded relatively infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should Hager's make an offer for Lyons'? If so, how much should it offer per share? With a current price of $11 per share and 20 million shares outstanding, Lyons' current market value is $11(20) = $220 million. Since Lyons' expected value to Hager's is $289.4 million, it appears that the merger would be beneficial to both sets of stockholders. The difference, $289.4 - $220.0 = $69.4 million, is the added value to be apportioned between the stockholders of both firms. The offering range is from $11 per share to $289.4/20 = $14.47 per share. At $11, all of the benefit of the merger goes to Hager's shareholders, while at $14.47 all of the value created goes to Lyons' shareholders. If Hager's offers more than $14.47 per share, then wealth would be transferred from Hager's stockholders to Lyons' stockholders. As to the actual offering price, Hager's should make the offer as low as possible, yet acceptable to Lyons' shareholders. A low initial offer, say $11.50 per share, would probably be rejected and the effort wasted. Further, the offer may influence other potential suitors to consider Lyons', and they could end up outbidding Hager's. Conversely, a high price, say $14, passes almost all of the gain to Lyons' stockholders, and Hager's managers should retain as much of the synergistic value as possible for their own shareholders. Note that this discussion assumes that Lyons' $11 price is a "fair," equilibrium value in the absence of a merger. Since the stock trades infrequently, the $11 price may not represent a fair minimum price. Lyons' management should make an evaluation (or hire someone to make the evaluation) of a fair price and use this information in its negotiations with Hager's.
Answer:
Mini Case: 26- 24
h.
How would the analysis be different if Hager's intended to recapitalize Lyons' with 40% debt costing 10% at the end of four years? This amounts to $221.6 million in debt as of the end of 2010. The free cash flows and the unlevered cost of equity would be unchanged. Thus the unlevered horizon value and the unlevered value of operations will remain the same. If we assume that the interest payments in the first 4 years are unchanged, and the intention is to use 40 percent debt costing 10 percent throughout 2011 and thereafter at the horizon, then the horizon tax shield will be larger, as will the tax shield in 2011: New 2011 interest = Debt2010 x New interest rate = $221.6 (10%) = $22.16 million New 2011 Tax shield = New 2011 interest x Tax rate = $22.16(40%) = $8.864 million New Tax Shield horizon value =
Answer:
(New 2011Tax Shield)(1 g) rsU g $8.864(1.06) = 0.1156 0.06 = $169.0 million.
2008 $2.6 $2.6 2009 $2.6 $2.6 2010 $2.8 2011 $3.3 169.0 $2.8 $177.9
2007 Annual tax shield $2.0 Horizon value of tax shield Total $2.0
The present value of this stream of cash flows at the unlevered cost of equity, 11.56%, is $110.5 million. Since the unlevered value of operations doesn't change, then the value of operations is now the unlevered value of operations calculated earlier plus the new value of the tax shields: New Value of operations = Unlevered value of operations + value of tax shields = $298.9 million + 110.5 million = $409.4 million Less debt of $55 million leaves equity of $354.4 million. This is $65.0 million, or $3.25 per share, more than at a 20% debt level. The difference in value is due to the added interest tax shield at the higher debt level.
Mini Case: 26- 25
i.
There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research? Most researchers agree that takeovers increase the wealth of the shareholders of target firms, for otherwise they would not agree to the offer. However, there is a debate as to whether mergers benefit the acquiring firm's shareholders. The results of these studies have shown, on average, the stock prices of target firms increase by about 30 percent in hostile tender offers, while in friendly mergers the average increase is about 20 percent. However, for both hostile and friendly deals, the stock prices of acquiring firms, on average, remain constant. Thus, one can conclude that (1) acquisitions do create value, but (2) that shareholders of target firms reap virtually all the benefits.
Answer:
j. Answer:
What method is used to account for mergers? Mergers must be accounted for using purchase accounting, in which the acquired company is treated as any other capital asset purchase. The old method called pooling accounting has been eliminated.
k. Answer:
What merger-related activities are undertaken by investment bankers? The investment banking community is involved with mergers in a number of ways. Several of these activities are: (1) helping to arrange mergers, (2) aiding target companies in developing and implementing defensive tactics, (3) helping to value target companies, (4) helping to finance mergers, and (5) risk arbitrage--speculating in the stocks of companies that are likely takeover targets. Hopefully, investment bankers are not giving kickbacks to company executives who give them business, or providing fraudulent analyst reports to pump up the stocks of companies they would like to do business with.
Mini Case: 26- 26
l.
What is a leveraged buyout (LBO)? disadvantages of going private?
What are some of the advantages and
Answer:
A leveraged buyout is a situation in which a small group of investors (which usually include the firm's managers) borrows heavily to buy all the shares of a company. Advantages to going private include administrative cost savings, increased managerial incentives, increased managerial flexibility, increased shareholder participation, and increased financial leverage. The main disadvantage of going private is not having access to the large amounts of capital available in the equity market, making it difficult to fund a firm's projects.
m. Answer:
What are the major types of divestitures? What motivates firms to divest assets? The three primary types of divestitures are (1) the sale of an operating unit to another firm, (2) setting up the business to be divested as a separate corporation and then spinning it off to the divesting firm's stockholders, and (3) outright liquidation of assets. The reasons for divestitures vary widely. Sometimes companies need cash either to finance expansion in their primary business lines or to reduce a large debt burden. Sometimes firms divest to unload losing assets that would otherwise drag the company down, or divesting may be the result of an antitrust settlement, where the government requires a breakup.
n. Answer:
What are holding companies? What are their advantages and disadvantages? Holding companies are corporations formed for the sole purpose of owning the stocks of other companies. The advantages include the ability to control a company without owning all its stocks and the ability to isolate risks. Disadvantages include the possible taxation of earnings at both the subsidiary and parent levels. Holding companies can also be easily dissolved by regulators.
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