21 1 CHAPTER 21 Mergers LBOs Divestitures and

21 - 1 CHAPTER 21 Mergers, LBOs, Divestitures, and Holding Companies n Types of mergers n Merger analysis n Role of investment bankers n Corporate alliances, LBOs, divestitures, and holding companies Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 2 Why do mergers occur? n Synergy: Value of the whole exceeds sum of the parts. Could arise from: l. Operating economies l. Financial economies l. Differential management efficiency l. Increased market power l. Taxes (use accumulated losses) Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 3 n Break-up value: Assets would be more valuable if sold to

21 - 4 What are some questionable reasons for mergers? n Diversification n Purchase of assets at below replacement cost n Get bigger using debt-financed mergers to help fight off takeovers Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 5 Five Largest completed and proposed mergers, as of January 2000 Buyer Target Value America Online Time Warner $160. 0 billion Vodafone Air. Touch Mannesmann 148. 6 billion MCI World. Com Sprint 128. 9 billion Exxon Mobil 85. 2 billion Bell Atlantic GTE 85. 0 billion Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 6 Differentiate between hostile and friendly mergers n Friendly merger: l. The

21 - 7 n Hostile merger: l. Target firm’s management resists the merger. l. Acquirer must go directly to the target firm’s stockholders try to get 51% to tender their shares. l. Often, mergers that start out hostile end up as friendly when offer price is raised. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 8 Reasons why alliances can make more sense than acquisitions n Access to new markets and technologies n Multiple parties share risks and expenses n Rivals can often work together harmoniously n Antitrust laws can shelter cooperative R&D activities Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 9 Merger Analysis (In Millions) Cash Flow Statements after Merger Occurs 2001 Net sales $60. 0 $90. 0 $112. 5 Cost of goods sold (60%) 36. 0 Selling/admin. expenses 4. 5 Interest expense 3. 0 4. 5 6. 0 EBT $16. 5 $25. 5 $ Taxes (40%) 6. 6 10. 2 13. 2 Net income $ 9. 9 $15. 3 $ Retentions 0. 0 7. 5 6. 0 Cash flow $ 9. 9 $ 7. 8 $ 13. 8 Copyright © 2001 by Harcourt, Inc. 2002 2003 2004 $127. 5 54. 0 67. 5 76. 5 6. 0 7. 5 9. 0 4. 5 33. 0 $ 36. 0 14. 4 19. 8 $ 21. 6 4. 5 $ 17. 1 All rights reserved.

21 - 10 Conceptually, what is the appropriate discount rate to apply to target’s cash flows? n Estimated cash flows are residuals which belong to acquirer’s shareholders. n They are riskier than the typical capital budgeting cash flows. Because fixed interest charges are deducted, this increases the volatility of the residual cash flows. (More. . . ) Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 11 n Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC. n The cash flows reflect the target’s business risk, not the acquiring company’s. n However, the merger will affect the target’s leverage and tax rate, hence its financial risk. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 12 Terminal Value Calculation 1. First, find the new discount rate: ks(Target) = k. RF + (k. M – k. RF)b. Target = 9% + (4%)1. 3 = 14. 2%. (2004 Cash flow)(1 + g) 2. Terminal value = ks – g $17. 1(1. 06) = 0. 142 – 0. 06 = $221. 0 million. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 13 Net Cash Flow Stream Used in Valuation Calculation (In Millions) Annual cash flow Terminal value Net cash flow Value = $9. 9 (1. 142)1 2002 $9. 9 $7. 8 $13. 8 $ 17. 1 221. 0 $7. 8 $13. 8 $238. 1 $9. 9 + $7. 8 (1. 142)2 + 2003 $13. 8 (1. 142)3 + 2004 $238. 1 (1. 142)4 = $163. 9 million. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 14 Would another acquiring company obtain the same value? n No. The input estimates would be different, and different synergies would lead to different cash flow forecasts. n Also, a different financing mix or tax rate would change the discount rate. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 15 Target firm has 10 million shares outstanding at a price P 0 of $9. 00 per share. What should the offering price be? Maximum price = Value of Acquisition Shares Outstanding million = $163. 9 10 million = $16. 39/share. Range = $9 to $16. 39/share. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 16 n The offer could range from $9 to $16. 39 per share. n At $9 all the merger benefits would go to the acquirer’s shareholders. n At $16. 39, all value added would go to the target’s shareholders. n See graph on the next slide. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 17 Change in Shareholders’ Wealth Acquirer Target $9. 00 0 5 Copyright

21 - 18 Points About Graph n Nothing magic about crossover price. n Actual price would be determined by bargaining. Higher if target is in better bargaining position, lower if acquirer is. n If target is good fit for many acquirers, other firms will come in, price will be bid up. If not, could be (More. . . ) close to $9. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 19 n Acquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. Strategy. n Do target’s managers have 51% of stock and want to remain in control? n What kind of personal deal will target’s managers get? Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 20 Do mergers really create value? n The evidence strongly suggests: l. Acquisitions do create value as a result of economies of scale, other synergies, and/or better management. l. Shareholders of target firms reap most of the benefits, i. e. , move to right in merger graph (Slide 21 -17), because of competitive bids. Copyright © 2001 by Harcourt, Inc. All rights reserved.

21 - 21 Functions of Investment Bankers in Mergers n Arranging mergers n Assisting in defensive tactics n Establishing a fair value n Financing mergers n Risk arbitrage Copyright © 2001 by Harcourt, Inc. All rights reserved.