21 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Types of mergers Merger analysis Role of investment bankers Corporate alliances, LBOs, divestitures,

21 - 1

Copyright © 2001 by Harcourt, Inc. All rights reserved.

Types of mergers

Merger analysis

Role of investment bankers

Corporate alliances, LBOs, divestitures, and holding companies

CHAPTER 21Mergers, LBOs, Divestitures,

and Holding Companies

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Synergy: Value of the whole exceeds sum of the parts. Could arise from:Operating economiesFinancial economiesDifferential management efficiencyIncreased market powerTaxes (use accumulated losses)

Why do mergers occur?

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Break-up value: Assets would be more valuable if sold to some other company.

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Diversification

Purchase of assets at below replacement cost

Get bigger using debt-financed mergers to help fight off takeovers

What are some questionable reasons for mergers?

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Five Largest completed and proposed mergers, as of January 2000

Buyer

America Online

Vodafone AirTouch

MCI WorldCom

Exxon

Bell Atlantic

Target

Time Warner

Mannesmann

Sprint

Mobil

GTE

Value

$160.0 billion

148.6 billion

128.9 billion

85.2 billion

85.0 billion

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Friendly merger:

The merger is supported by the managements of both firms.

Differentiate between hostile and friendly mergers

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Hostile merger:

Target firm’s management resists the merger.

Acquirer must go directly to the target firm’s stockholders try to get 51% to tender their shares.

Often, mergers that start out hostile end up as friendly when offer price is raised.

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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

Reasons why alliances can make more sense than acquisitions

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Net sales $60.0 $90.0 $112.5 $127.5Cost of goods sold (60%) 36.0 54.0 67.5 76.5Selling/admin. expenses 4.5 6.0 7.5 9.0Interest expense 3.0 4.5 4.5 6.0

EBT $16.5 $25.5 $ 33.0 $ 36.0Taxes (40%) 6.6 10.2 13.2 14.4

Net income $ 9.9 $15.3 $ 19.8 $ 21.6Retentions 0.0 7.5 6.0 4.5Cash flow $ 9.9 $ 7.8 $ 13.8 $ 17.1

Merger Analysis (In Millions)

2001 2002 2003 2004 Cash Flow Statements after Merger Occurs

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Estimated cash flows are residuals which belong to acquirer’s shareholders.

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.

Conceptually, what is the appropriate discount rate to apply to target’s

cash flows?

(More...)

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Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC.

The cash flows reflect the target’s business risk, not the acquiring company’s.

However, the merger will affect the target’s leverage and tax rate, hence its financial risk.

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Terminal Value Calculation

1. First, find the new discount rate:

ks(Target) = kRF + (kM – kRF)bTarget

= 9% + (4%)1.3 = 14.2%.

2. Terminal value =

=

= $221.0 million.

(2004 Cash flow)(1 + g)ks – g

$17.1(1.06) 0.142 – 0.06

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Net Cash Flow Stream Used in Valuation Calculation (In Millions)

2001 2002 2003 2004 Annual cash flow $9.9 $7.8 $13.8 $ 17.1Terminal value 221.0Net cash flow $9.9 $7.8 $13.8 $238.1

Value = + + +

= $163.9 million.

$9.9 (1.142)1

$7.8 (1.142)2

$13.8 (1.142)3

$238.1 (1.142)4

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No. The input estimates would be different, and different synergies would lead to different cash flow forecasts.

Also, a different financing mix or tax rate would change the discount rate.

Would another acquiring company obtain the same value?

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Target firm has 10 million shares outstanding at a price P0 of $9.00 per

share. What should the offeringprice be?

Maximum price =

=

= $16.39/share.

Range = $9 to $16.39/share.

Value of Acquisition Shares Outstanding

$163.9 million10 million

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The offer could range from $9 to $16.39 per share.

At $9 all the merger benefits would go to the acquirer’s shareholders.

At $16.39, all value added would go to the target’s shareholders.

See graph on the next slide.

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0 5 10 15 20

Change in Shareholders’

WealthAcquirer Target

Bargaining Range = Synergy

Price Paid for Target

$9.00 $16.39

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Points About Graph

Nothing magic about crossover price.Actual price would be determined by

bargaining. Higher if target is in better bargaining position, lower if acquirer is.

If target is good fit for many acquirers, other firms will come in, price will be bid up. If not, could be close to $9.

(More...)

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Acquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. Strategy.

Do target’s managers have 51% of stock and want to remain in control?

What kind of personal deal will target’s managers get?

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The evidence strongly suggests:Acquisitions do create value as a

result of economies of scale, other synergies, and/or better management.

Shareholders of target firms reap most of the benefits, i.e., move to right in merger graph (Slide 21-17), because of competitive bids.

Do mergers really create value?

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Arranging mergers

Assisting in defensive tactics

Establishing a fair value

Financing mergers

Risk arbitrage

Functions of Investment Bankers in Mergers

Documents

21 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. Types of mergers Merger analysis Role of investment bankers Corporate alliances, LBOs, divestitures,