This preview shows page 1. Sign up to view the full content.
Unformatted text preview: TBS 907 AUTUMN 2005 LECTURE 6 COMPANY RESTRUCTURING MERGERS AND ACQUISITIONS Topics Covered Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs The Mechanics of a Merger Mergers and the Economy Takeover Battles and Tactics Recent Mergers
Industry Telecoms Pharmaceuticals Pharmaceuticals Banking Banking Telecoms Banking Healthcare Insurance Banking Banking/Consumer Finance Media Acquiring Company Vodafone (UK) Sanofi (France) Pfizer JP Morgan Chase Bank of America Cingular Wireless Mitsubishi Tokyo Financial Group (Japan) Anthem St. Paul Companies Banco santander Central Hispano HSBC Holdings (UK) General Electric Selling Company Mannesmann (germany) Aventis (France/Germany) Pharmacia Bank One FleetBoston Financial Corp. AT&T Wireless Services UFJ Holdings (Japan) Wellpoint Health Networks Travelers property Casualty Abbey (UK) Household International Vivendi Universal Entertainment (France) Payment ($billions) 203.0 64.0 59.5 58.0 49.3 41.0 25.7 16.4 16.1 15.6 15.3 13.7 Key Terms Merger The union of two or more commercial interests or corporations Acquisition One company gaining the possession of another corporation Combination The merger of separate entities into a new firm or the acquisition of one firm by another MERGER TYPES Horizontal takeover: takeover of a target Vertical takeover: takeover of a target company operating in the same line of business as the acquiring company. company that is either a supplier of goods to, or a consumer of goods produced by, the acquiring company. Conglomerate takeover: takeover of a target company in an unrelated type of business. What are the motives that prompt executives to acquire or merge with another organization? Motives for Combinations Opportunistic Defensive Move Increase ability to handle change Attain strategic goals more quickly and inexpensively POSITIVE MOTIVES Decrease Competition Enter New Markets Cut Costs Economies of Scale Horizontal Tax Considerations Surplus Funds Economies of resource Vertical NEGATIVE MOTIVES Diversification Leveraging Investment of Surplus Funds Financial Instrument Tinkering These include capturing economies of scale or of vertical integration, combining complementary resources, making better use of tax shields or tax loss carryforwards, shifting surplus funds from one firm to another firm that will use the funds more profitably or distribute them to shareholders, and eliminating inefficiencies. Sensible REASONS for mergers Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units. $ Reduces costs $ $ Sensible Reasons for Mergers
Economies of Vertical Integration Control over suppliers "may" reduce costs. Over integration can cause the opposite effect. Post-integration
Pre-integration (less efficient) Company S S (more efficient) Company S S S S S S Vertical integration reduces cost by increasing efficiency. "Vertical" integration can be either up or down, that is, suppliers or distributors. Over integration may increase costs. There are several suppliers or distributors, before integration, to foster competition, but after the merger, they can all be integrated into one more efficient supplier or distributor. Combining Complementary Resources Merging may results in each firm filling in the "missing pieces" of their firm with pieces from the other firm. Firm A and B are odd shaped as shown in the diagram. They form a perfect rectangle after the merger. That is, they complement each other and thereby improve profits. Firm A Sensible Reasons for Mergers Firm B Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds. Firms with excess funds might want to acquire other firms. Many times paying out high dividends might be better. Some dubious reasons for mergers Mergers are sometimes justified by diversification, for example. Then there's the bootstrap game, in which mergers increase earnings per share, but only at the expense of future growth. The ability of merged firms to borrow at a lower interest rate is another commonly cited motive, but it is not a real benefit, in general. Dubious Reasons for Mergers Diversification The most dubious reason for a merger is diversification. Full diversification can easily be achieved by forming portfolios. Investors should not pay a premium for diversification since they can do it themselves. Dubious Reasons for Mergers
The Bootstrap Game
Acquiring Firm has high P/E ratio Selling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution. Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises (before merger) EPS Price per share P/E Ratio Number of shares Total earnings Total market value Current earnings per dollar invested in stock $ $ $ $ 2.00 40.00 20 100,000 200,000 4,000,000 World Enterprises (after buying Muck and Slurry) Muck and Slurry $ 2.00 $ 2.67 $ 20.00 $ 40.00 10 15 100,000 150,000 $ 200,000 $ 400,000 $ 2,000,000 $ 6,000,000 $ 0.05 $ 0.10 $ 0.067 Dubious Reasons for Mergers
Earnings per dollar invested (log scale) World Enterprises (after merger) World Enterprises (before merger) Muck & Slurry .10 .067 .05 Now Time Estimating merger gains and costs Mergers are worth more together than apart. Thus, the gain to a merger is the present value of the merged firms minus the sum of their separate present values. The cost of the merger to your firm is that part of the gain which the other firm captures. Estimating merger gains and costs
The cost of a merger is the premium the buyer pays for the selling firm over its value as a separate entity. This cost is sometimes tricky to calculate; for example, when the selling firm's stockholders acquire a share of the two merging firms, thus acquiring a share of the economic gain to the merger. Estimating Merger Gains Questions Is there an overall economic gain to the merger? Do the terms of the merger make the company and its shareholders better off? Synergy in mergers is the situation where the performance, and therefore the value, of a combined entity exceeds those of the previously separate components: VAT > VA + VT where VAT = the value of the assets of the combined company VA = the value of Company A operating independently VT = the value of Company T operating independently VALUATION OF SHARES Bases for Valuation Income Based Present Value Dividend Valuation P/E Ratio Asset Based Book Value Replacement Cost Break Up Value Additionally, methods based on a mixture of `assets' and `income' may be used Present Value Approach Present Value Approach In theory, the value of any asset is the value of its future earnings discounted at a rate which reflects the systematic risk of these earnings. The gain from the takeover can be defined as the difference between the value of the combined company and the sum of their values as independent entities: Gain = VAT (VA + VT) Assuming that cash is used to buy Company T, the net cost is defined as: Net cost = cash VT Present Value Approach Present Value Approach (Contd) Cost is considered in terms of the premium paid over T's value as an independent entity. The takeover will have a positive NPV for Company A's shareholders only if the gain exceeds the net cost: NPVA = gain net cost = gain cash + VT > 0 Present Value Approach Present Value Approach (Contd)
If NPVA is equal to zero, then the above equation can be used to find the value of Company T to Company A, VT(A), which is the maximum price A should pay for the target: VT(A) = cash = gain + VT Present Value Approach Present Value Approach (Contd) It is necessary to focus on the incremental cash flow effects of the takeover: Incremental inflows sales revenue proceeds from disposal of surplus assets Incremental outflows operating costs capital investments to upgrade existing assets or acquire new assets Comparing Gains and Costs Comparing Gains and Costs The amount of the cash consideration determines how the total gain is divided between the two sets of shareholders: every additional dollar paid to the target's shareholders means a dollar less for the acquirer's shareholders. Comparing Gains and Costs Comparing Gains and Costs (cont.) Note that the possible gains from a takeover may already be impounded into the target's market price. Management should therefore check that the share price of a proposed target has not already been increased by takeover rumours. Management should also keep its takeover intentions completely confidential until formally announcing the bid. Estimating Cost for a Share Estimating Cost for a Share Exchange Takeover
Shareexchange takeover: the acquiring company issues shares in exchange for the target's shares. The cost will depend on the post takeover price of the acquiring company's shares. Estimating Cost for a Share Estimating Cost for a Share Exchange Takeover (cont.) In general, the estimated cost of a share exchange takeover is: Net cost = b VAT VT where b = the fraction of the combined company that will be owned by the former shareholders of the target company For a cash offer, the net cost is independent of the takeover gain, whereas for a shareexchange offer, the cost depends on the takeover gain. Present Value Approach Although from a theoretical point of view, the only sustainable model is that which is based on the net present value of future earnings, this model is generally impossible to apply because of the practical difficulties associated with estimating future earnings streams, choosing an appropriate discount rate, etc. Therefore, in practice the other methods are considered as surrogates for the one theoretically sound method Dividend Valuation Method Assuming no Growth Constant Growth Situation Where D P= k
0 0 E P0 = Price of Shares (exdiv) D1 = Next Period's Dividend P0 = Ke = Required Return or Cost of Equity Capital g = growth rate in dividends k D
E 1 -g Dividend Valuation Method Assumptions: The dividend stream is usually estimated by calculating past patterns in dividends. Shareholders' required rate of return (ke) is normally estimated by taking the cost of equity of a similarly quoted company or may be obtained by using the capital asset pricing model. Comparability is important here and we must ensure that the quoted company is of a similar size and involved in the same line of business ( i.e. it carries the same level of systematic risk). Adjustments are often made to reflect the nonmarketability of unquoted shares ( shareholders could accept a lower return from quoted companies due to easier disposal of shares. Dividend Valuation Method Comparability Problems Quoted companies are more diversified therefore may not be an exact proxy for private company. Gearing Levels may differ. Difference in Risk due to larger diversification Difference in Dividend Yields Earnings Yield or P/E Ratio The P/E ratio is another figure which is published in the financial press and is widely regarded as an important measure. It is defined as P/E Ratio = Price per Share Earnings per share ( EPS) This formula is then turned around to value shares in unquoted companies: Value per share = EPS X Suitable P/E Ratio Calculated value may then be reduced to take into account the nonmarketability of the shares Value per share = EPS X Suitable P/E Ratio The basic choice for a suitable P/E ratio will be that of a quoted company of comparable size in the same industry There is a tendency for dividends to be more stable than earnings. Since share prices are broadly based on expected future earnings, a P/E ratio based on a single year's reported earnings may be very different for companies in the same sector, carrying the same systematic risk. The main difficulty in trying to apply the model is finding a similar company, with similar growth prospects. It is important to ensure that earnings in the victim company reflect future earnings prospects as it would be unwise to value a company on freakishly high ( or low) earnings. In spite of these shortcomings , the P/E ratio is regarded as an important measure by investment analysts, it is a broad brush measure and should be treated accordingly to value shares. Asset Based Measures
Asset based measures are generally considered appropriate when shareholdings of greater than 50% are being valued. Such shareholding gives the right to control acquisition and disposal of underlying assets. There are several possible asset based measures: Problems associated with Asset Valuation: Historic Data Subjective Service Industry vs. Goods Industry Replacement Cost Break Up Value Market Value Book Value Maximum and Minimum Values Application of the methods discussed above might result in differing results. Based on this: What is the maximum the bidder should pay What is the minimum the seller will accept. The maximum is the present value of the victim company's earnings plus or minus any synergistic effects. Another approach is to calculate how much a similar company would cost. This can be estimated by using replacement costs of assets plus an allowance for goodwill. Valuation of Shares Conclusion
It is important to appreciate that valuation is not an exact science. In a merger and takeover situation, the final price paid will often depend on how badly the owners wish to sell and the bidders wish to buy. Other factors relevant to Valuation Background of Industry and Market Information regarding the shares. Nature of the industry Who are the main competitors Are there any competitors to the bidder in terms of takeover Who are the key sales customers and suppliers of the company? Are there any plans for diversification of activities in the future, technological knowhow? Size of the shareholding to be acquired Details of other shareholders Rights attaching to the shares Possible restrictions on transfer Steps in the Takeover of a Quoted Company Appointment of Advisors Hostile or Friendly Takeover Possible acquisition of shares in the market in conjunction with the bid. Stages of the offer itself: Offer Document Closing Date Withdrawal of acceptances Revision Lapsing Response to Takeover Action Every company is subject to a takeover and there will be a price at which the shareholders may be induced to sell their shares. Problem arises when there diverse shareholders, and there is a predatory bid made at less than fair value. Management Motives in defending a bid strongly: Personal Shareholders Interest Monopoly Employee Interests Reasons for Predatory Bid Current Share price of the victim is depressed The group's prospects are better than anticipated. Strong position of the group in one or more market Corporate Defence The purpose of a corporate defence is to either obtain a full and satisfactory price from an unwelcome bidder, or to ward off the bid, and remain independent. National Economic Interest Employee Interest Strategic Defence The principal aim of strategic defence is to try and eliminate as far as possible, the attractions of the group to a wouldbe predator. Maximise Share Price Existence of a Group Strategy Communication Dividend Policy Strategic Shareholdings Acquisitions by the target company Good Housekeeping Anti Takeover Mechanisms Many companies in an effort to remain independent to win time to analyse effectively a takeover bid, have implemented antitakeover mechanisms. For Example: Poison Pills FlipIn Pills Back End Rights Pac Man Disposal of the Crown Jewels/Scorched Earth Fatman Golden Parachutes Other Forms of Corporate Restructuring Divestments It is the withdrawal of investment in a business. Reasons for Divestment Goal Incongruence Not part of the Strategy Careful Study of the financial impact of the divestment. Demerger A group is split into two or more separate parts of roughly comparable size which are large enough to carry on independently after the split. Management BuyOuts Another aspect of Mergers and Acquistions Purchasers of the company are the company's current management. Different Types of MBO's: Management Buyout Leveraged Buyout Employee Buyout Management Buyin Spinout Advantages of Buyouts Advantages to the disposing company If the subsidiary is loss making, sale to the management will often be better financially than liquidation and closure costs. There is a known buyer. Better publicity by preserving employee's jobs Better current management than competitors Advantages of Buyouts Advantages to the acquiring management Preservation of jobs Significant equity participation Quicker than starting a business from scratch No shareholder control, free rein to management Sources of Finance for an MBO In an MBO, unlike a corporatebacked takeover, the acquiring group usually lack the financial resources to fund the acquisition. Pension Funds, Insurance Companies, merchant banks and other such institutions specialize in MBO financing. Viability of an MBO Why do the current owners want to sell? Proposed Management Team fully capable? Reliable business plan, cash flow projections Proposal Purchase Price Financing Method Sources of Finance for an MBO The Form of Finance Duration of the Finance Ongoing Support Syndication The Involvment of the Institution Why do fewer than one quarter of mergers and acquisitions achieve their financial and strategic objectives? Failure to Meet Goals Buying the wrong company Paying the wrong price for the company Making the deal at the wrong time Failure to Meet Goals Cont'd Failing at the combination process Financial tunnel vision Poor planning and preparation Implicit contracts open to interpretation and misunderstanding Wrong motives ...
View Full Document
This note was uploaded on 07/10/2009 for the course FIN FIN taught by Professor Dr. during the Spring '09 term at Baptist College of Health Sciences.
- Spring '09