Lecture: 8 - Mergers and Restructuring I.Reasons for Merging a. Increased Combined Value of Firms synergy, economies of scale in management, distribution,

Lecture: 8 - Mergers and RestructuringLecture: 8 - Mergers and Restructuring

I. Reasons for Merging

a. Increased Combined Value of Firms

synergy, economies of scale in management,

distribution, production or research.

b. “Dubious Reasons”

diversification, buy growth, and EPS Rise

II. How to Decide to Merge - Like Any Investment, NPV

NPVMerger = ValueTarget + ValueMerged Firm - Price Paid

III. Steps to Calculating NPVMerger

a. ValueTarget= Market Value of Securities = Shr x P

to get P, you can use P= D/(k - g) or P = P/E x EPS

b. Value =

c. CF = CFBT(1 - T) + Depr(T) - Additional

Outlays + Gain/Loss From Sale of Assets

t

ntt

CF

k 1 1( )


III. Steps to Calculating NPVMerger - Continued

d. Get k Commensurate with Risk

e. Get Costs Which are Clear for Cash Offers

f. Cost for Stock Offers - Calculate % of Bidding Firm Owned by Target Shareholders After

Merger

W = Shares Held by Target in Merged Firm Total Shares in Merged Firm

ValueMerged firm = ValueTarget + ValueAcquirer

+ ValueMerged Firm

Cost = W x (Value of Merged Firm)

g. If DCF’s have Infinite Life Then Use

Constant Growth Model or Infinite Annuity


Example: Consider the following incremental cash flows, depreciation and investments from a merger.

Year CFBT Depr Investment

0 0 0 100,000

1 200,000 400,000 1,200,000

2 400,000 500,000 300,000

3 500,000 200,000 200,000

4 - 800,000 50,000 200,000

If the corporate tax rate is .35, the cost of capital is 20%, the present market value of the target is $1,000,000 and the bidder’s market value is $4,500,000, should the target be acquired if the bidder will have to give the target shareholders 25% of the combined firm’s shares as payment to complete the acquisition?

Year CFBT + Depr - Investment = CF

0 0 0 100,000 -100,000

1 200,000(.65) 400,000(.35) 1,200,000 -930,000

2 400,000(.65) 500,000(.35) 300,000 135,000

3 500,000(.65) 200,000(.35) 200,000 195,000

4 - 800,000(.65) 50,000(.35) 200,000 337,500

PV at time 3 of CF’s for year 4 and after = 337,500/.20

= 1,687,500

ValueMerged Firm = -100,000 - 930,000[PV.20,1] +

135,000 [PV.20,2] + 195,000 [PV.20,3] +

1,687,500 [PV.20,3]

= 308,159

ValueMerged Firm = 4,500,000 + 1,000,000 + 308,159

= 5,808,159

Cost of purchase = .25(5,808,159) = 1,452,040

NPV = 1,000,000 + 308,159 - 1,452,040 = -143,881


IV. Market Value Exchange Ratio

Market Value of Cash and Securities Offered by

Acquiring Firm/Market Value of Target’s Stock

Guideline: Usually 125 - 150%

V. EPS (Earnings Per Share) “Illusion” - Continued

c. For Cash Payment -> EPS = E/Nx

d. For Shares Payment -> Post Merger

EPS = E/[Nx + PyNy/Px]

where, E = Total Earnings of Combined Firm

Nx = # Old Shares of Acquiring Firm X

Ny = # of Shares of Target Firm Y

Px = Share Price of Acquiring Company

Py = Share Price Offered for Target

VI. Who Benefits From Mergers

a. Target Usually Benefits

b. Acquirer Usually Loses or Gains Very Little

c. Investment Bankers Make a Fortune



VIII. Tax Implications of a Merger - Tax Free if:

a. Consolidation - No Tax Motivations and

Continuity of Organization

b. Acquisition of Whole Firm - Uses Voting Stock

& Acquires at least 80% of Target’s Stock

c. Acquisition of Assets - Target Shareholders

Must be Shareholders in Combined Firm

IX. Accounting Treatment of a Merger

X. Balance Sheet Effects of a Merger

XI. Income Sheet Effects of a Merger

XII. Successful Mergers Focus on Fixed Assets

XIII. Financing Alternatives of a Merger

a. Junk Bonds

b. Bonds Used for LBOs (Leveraged Buyouts)

c. Divestiture of Parts of Firm to Pay for LBO

d. Finance Through ESOP (Employee Stock

Ownership Plan)


XIV. Terminology

a. Greenmail or Repurchase Standstill Agreements

b. Golden Parachutes

c. Golden Handcuffs

XV. Defensive Tactics

a. Staggered Board of Directors

b. Super Majority

c. Super Common Stock

d. Poison Pills

e. Scorched Earth

f. Leverage

g. Restructure

h. White Squire

i. White Knight

j. Pac Man

k. Nancy Reagan - Just Say No!

l. Bear Hug


XVI. Divestiture

a. Difficult Decision for Business Managers

b. Sell Off Assets Worth More to Others

c. Focus on Assets Best Managed by Present

Managers

XVII.Steps to Decide on Divestiture - getting Merger NPV

a. Estimate Operating CFs of the Division

b. Get the After Tax Discount Rate k for the Division

c. Calculate PV of CFs

d. Subtract Liabilities Associated with Division

NPV = - Market Value of Liabilities

This assumes that the acquirer assumes the target’s liabilities (e.g., you own a $120,000 home with a

$100,000 mortgage - sell for $20,000 or more if buyer assumes the mortgage.)

e. Compare NPV with Net After Tax Proceeds

if After Tax Proceeds > NPV then sell.

t

ntCF

1 (1 + k) t


XVII.Steps to Decide on Divestiture - Continued

f. If Acquirer Does Not Accept Liabilities, Adjust

Offer Downward by Liabilities Value

Note: Process is exactly the reverse of the decision to merge process.

XVIII. Abandonment

a. Check NPV Periodically

b. Salvage Value After Tax > PV of Remaining

CFs => Abandon Project, Else, Keep

Example: SIV Products can sell a product line for $50,000 after tax or it can keep the product line which will earn $17,500 each year for the next 4 years. If its cost of capital is 14 percent, should SIV divest the product line? How about if the product line has $3000 in liabilities that will be assumed by the purchaser?

a.NPVkeep = 17,500[PVA.14,4] - 50,000 = 990

Keep, do not divest.

b. NPVkeep = 17,500[PVA.14,4] - 50,000 - $3000 = -2010

Now you should divest.


XIX. Financial Distress

a. Out of Court Options

1. Extensions

2. Composition

3. Assignment

b. In Court Options /Bankruptcy Reform Act 1978

1. Debtor Files - Voluntary

2. Creditor Files - Involuntary

3. Chapter 7 - Liquidation

XX. Reorganization

a. Trustee can Reorganize or Run it Himself

b. Creditors Vote to Accept/Reject Trustee’s Plan

for Reorganization

XXI. Decision to Liquidate or Reorganize

Calculation of:

NPVliq. > NPVreorg. => Liquidate

NPVreorg. > NPVliq. => Reorganize

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Lecture: 8 - Mergers and Restructuring I.Reasons for Merging a. Increased Combined Value of Firms synergy, economies of scale in management, distribution,