Mergers and Acquisitions Finance 7311

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Mergers and AcquisitionsFinance 7311
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Terminology

• Target
• Potential takeover candidate
• Acquirer (Bidder)
• Firm doing the taking over
• Merger
• Friendly combination of two firms
• Tender Offer (Hostile Takeover)
• Opposed by target management

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Leveraged Buyout

• Takeover in a highly leveraged transaction
• Advantages
• Concentrates ownership in fewer hands
• Takes cash out of managements hands debt as
  discipline
• Tax advantage of debt
• Disadvantages
• Effect of economic downturn?
• Loss of financial flexibility

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Terminology, cont.

• Management Buyout
• Same as LBO, except existing management is major
  shareholder
• Proxy Contest
• Voting by S/H on major corporate transactions
• Restructuring
• Significant change in allocation of corporate
  resources
• Current management stays on

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Selecting and Valuing a Target

• Business Plan or Objective ? should drive the
  process!!
• Vertical Integration
• Excess Capacity
• Product gt Distribution
• Pepsi Taco Bell
• Distribution gt Product
• (Time Warner Paramount)
• Strategic Enter a new market for example
• Diversification (Later)

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Valuation

• PVt PV of target (stand alone)
• PVa PV of acquiring firm (stand alone)
• PVc PV of combined firm
• TP tender price

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Synergy

• Synergy is the value created by the proposed
  merger/acquisition
• PVc - (PVa PVt) Total Synergy
• Value of combined firm sum of stand-alone firm
  value

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Net Present Value

• NPV of acquisition to acquiring firm
• PVc - (PVa PVt) - (TP - PVt)
• Total synergy - synergy to target
• Synergy to target goes to target S/H

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Synergy

• Sources of Synergy?
• Economies of Scale in
• Production
• Distribution
• Management/Administration
• Strategic
• Management better allocation of resources

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Synergy

• Financial Viewpoint
• Revenue Enhancement
• Cost reduction
• Combination of both
• More specifically, what impact on the inputs to
  value?
• EBIT, Capital Spending

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Calculation of Synergy

• Estimate combined cash flows and subtract sum
  of the parts
• PVc - (Pva PVt) ? usually most difficult
• Estimate the change in cash flows
• Or change in target value if only changes occur
  there
• Must identify the source of value
• Revenue enhancement
• Cost reduction

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Acquisition

• What is already reflected in Targets current
  share price? (assuming publicly traded)
• Value as is
• Value with expected changes (current mgmt)
• Value in play
• How much of a change in control premium is
  already reflected in price? (is company already
  in play?)

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Acquisition

• Acquirer must offer a Premium to induce S/H to
  tender
• Must bid less than target stand-alone value plus
  synergy (Neg NPV)
• Do other Bidders exist? Is source of value
  generic or specific?
• Provision of information to market
• If value highest to you, you can win

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Acquisition, cont.

• Strategy Bid high enough to deter potential
  bidders, but low enough to retain value
• Avoid Winners Curse
• Target
• Defensive Tactics

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Defensive Tactics

• Methods used by target management to avoid being
  taken over
• Poison Pill
• White Knight
• Greenmail
• Classified Boards
• Fair-price amendment
• Supermajority Voting
• Courts, ok if only one bidder

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Motives/Reasons

• Corporate Raiding
• Raider buying company for less than value
• Premiums average 30
• Creation of Monopoly Power
• Hard to test others should benefit
• Wealth Transfer from other parties
• Not much evidence
• Taxes May support economics

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Motives/Reasons

• Market Inefficiency
• Firm is Undervalued by Market
• Information to market
• Unsuccessful takeovers
• Target value goes back to preoffer price
• No perm. Reevaluation of firm
• Value created in combination

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Diversification

• Reduce Risk - may obtain better terms and/or
  better relationships from
• Employees
• Suppliers
• Customers
• Analogous to too much debt before
• Management - much human risk and human capital
  tied up in firm S/H?

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Diversification Evidence

• Comment Jarrell (95 JFE)
• Firm performance is increasing in firm focus
• Lang Stulz (94 JPE)
• Firms diversify when growth opportunities within
  industry exhausted
• Such diversification does not benefit S/H

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Diversification Evidence

• Berger Ofek (95 JFE)
• Compare stand-alone value of diversified firm
  segments to specialized firms
• Diversified firm worth 13 - 15 less than sum of
  stand alone components

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Diversification Evidence

• Day (95 JFE)
• Examines motives for risk reduction
• Firms pursue equity variance reducing activities
• Higher levels of personal wealth in firm
• More years invested w/ firm
• The poorer previous performance
• CEO specialists invest in similar specialties

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Performance Changes

• Dennis Denis (95 JFE)
• Turnover
• Forced
• Normal
• Forced Operating Income/Assets decreases in 3
  years prior increases following
• Normal Little difference prior small
  improvement afterward

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Dennis Dennis, cont.

• Forced resignations are rare
• 68 preceded by active monitoring by large S/H,
  B/H or potential acquirers
• 56 are the target of some form of control
  activity
• Boards not so effective in isolation
• Modern Trend Outside Directors

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Example Pre-acquisition assumptions

• Assume the following projected FCFs on a
  stand-alone basis for the target.
• Long-run growth after 2008 is 4
• The firm currently has 100 million in 8 debt
  O/S. Capital structure is 1/3 Debt and 2/3
  equity
• Tax rate 40

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Calculation of Re

• Beta 1.38
• Rf 5.0 (20 yr T-Bond)
• Market Risk Premium 5.5 (Ibbotson)
• Re Rf B(Rm Rf)
• Re 5 1.38(5.5)
• Re 12.6

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Calculation of WACC

• WACC Re E/(DE) Rd(1-t)D/(DE)
• WACC 12.6 x 2/3 8 x (1-40) x 1/3
• WACC 8.4 1.6
• WACC 10

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Target Cash Flows Before Acquisition (Millions)
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Target Cash Flows Before Acquisition (Millions)
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Pro-Forma Balance Sheet and Income Statement
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Post Acquisition Assumptions(Should specifically
identify)

• Transition Costs 40 million in first year,
  declining by 10 million per year
• Severance pay
• Disruption Learning curve Cultural change
• Additional Capital Spending 10 million first
  year then 5 million thereafter
• Depreciation 5 million more/yr
• Change in NWC 18 in 06 8 in 07 and 9 in
  08

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Post Acquisition Assumptions(Should specifically
identify)

• Margins constant sales 60 higher in years
  05-08
• Long-run growth increased to 5
• Capital Structure constant
• Beta unchanged

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Acquisition Effect on EBIT
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Target Cash Flows After Acquisition (Millions)
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Target Cash Flows After Acquisition (Millions)
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Reasonableness Implied Market Multiples

• Firm Value/EBITDA 514/70 7.34
• (note the above is a firm value)
• P/E 414/25.2 16.4
• (note the above is an equity value)
• Compare these to similar company multiples

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Synergy

• Equity Firm
• Post Acquisition Value 413.8 513.8
• Pre-Acquisition Value 362.2 462.2
• Total Synergy 51.6 51.6

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Net Present Value

• Assume Acquirer offers a 10 premium on Equity
  Value
• Offers 400 for equity
• Total synergy 51.6
• Synergy to target S/H 37.8 (400 362.2)
• NPV 13.8

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Alternatively Change in FCF

• Assuming Existing Estimated FCF stream of target
  is fairly
• valued ? we can Examine the Change in FCF as a
• Capital Budgeting Project

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Projecting Combined I/S B/S

• Why?
• Financing Needs consolidated
• Benchmark
• Impact on Financial ratios
• Short-run v. Long-run effect
• Negative short-run
• Positive long-run

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Target

• Assume Pre-acquisition value is appraised value
  with
• Difference reflected in Net Fixed Assets

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Goodwill

• Goodwill is the difference between the purchase
  price and the appraised value of the assets at
  time of acquisition
• Ex 400 360.2 39.8
• Amortization of goodwill is not deductible for
  tax purposes

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Combined Balance Sheet at Acquisition

• Assuming Purchase Assets for 500 100 cash 400
  debt