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FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
Copyright © 2014 by Nelson Education Ltd.
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Chapter 24
MERGERS, ACQUISITIONS,
AND RESTRUCTURING
CHAPTER 24 OUTLINE
•
•
•
•
•
•
•
Rationale for Mergers
Types of Mergers
Level of Merger Activity
Hostile versus Friendly Takeovers
Overview of Merger Analysis
The Free Cash Flow to Equity (FCFE) Approach
Illustration of the Two Valuation Approaches for a
Constant Capital Structure
• Setting the Bid Price
Copyright © 2014 by Nelson Education Ltd.
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CHAPTER 24 OUTLINE (cont’d)
•
•
•
•
•
•
•
•
Taxes and the Structure of the Takeover Bid
Financial Reporting for Mergers
Analysis for a “True Consolidation”
Role of Investment Bankers
Who Wins: The Empirical Evidence
Corporate Alliances
Leveraged Buyouts
Divestitures
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Rationale for Mergers
• Synergy: VA+B > VA + VB; arise from
–
–
–
–
–
•
•
•
•
operating economies
financial economies
tax effects
differential efficiency
increased market power
Tax considerations
Purchase of assets below replacement cost
Diversification
Managers’ personal incentives
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Rationale for Mergers (cont’d)
• Break-up value: Assets would be more
valuable if broken up and sold to other
companies.
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Types of Mergers
• Horizontal
– Same line of business (e.g., TSX-Montreal
Exchange merger)
• Vertical
– Producer-supplier relationship
• Congeneric
– Related but not horizontal or vertical
• Conglomerate (unrelated)
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Level of Merger Activity: Five Largest
Completed Mergers (as of December 2007)
BUYER
TARGET
VALUE
(Billion)
Vodafone
AirTouch
Mannesman
Pfizer
Warner-Lambert
116
America Online
Time Warner
106
Consortium led
by Royal Bank
of Scotland
ABN Amro
Holding
95
Exxon
Mobil
81
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$161
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Hostile Versus Friendly Takeovers
• Friendly merger:
– Supported by both firms’ managements
• 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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Overview of Merger Analysis
• To answer two questions:
– Value of the target after being incorporated into the
acquirer
– Price offered by the acquirer to the target
• Two basic approaches
–
–
–
–
Discounted cash flow (DCF) technique
Corporate valuation (free cash flow, FCF) method
Equity residual (free cash flow to equity, FCFE) method
Market multiple analysis
Copyright © 2014 by Nelson Education Ltd.
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Free Cash Flow to Equity (FCFE)
Approach
0
1
2
N
N+1
∞
|--------------|----------------|--------------------------|------------------|--------------------------------|
FCFE1
FCFE2
FCFEN
FCFEN+1
FCFE∞
N
N+1
N+2
∞
|-----------------|---------------|-----------------|
HVFCFEN
FCFEN+1 FCFEN+2 FCFE∞
0
1
2
N
N+1
∞
|---------------|-----------------|--------------------------|-----------------|-------------------------------|
FCFE1
FCFE2
FCFEN
FCFEN+1
FCFE∞
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Illustration of the Two Valuation Approaches
for a Constant Capital Structure
• Determining the discount rate
• Projecting post-merger cash flows
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Discount Rate Calculations
Target’s data: rRF = 7%, RPM = 5%,
beta = 1.2, wd =30.17%, rd = 9%
rsL = rRF + (RPM)bTarget
= 7% + 1.2(5%) = 13%
WACC= wd (1 – T) rd + ws rsL
= 0.3017(0.6)(9%) + 0.6983(13%)
= 10.707%
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Financial Data
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Projecting Post-Merger
Cash Flows
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Valuation Using the Corporate
Valuation Model
(FCF2016)(1+g)
Horizon Value Operations, 2016 =
WACC – g
= $6,800(1.06)
0.10707 – 0.06
= $153.1 million
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Valuation Using the Corporate
Valuation Model (cont’d)
VOper
$3.2
$5.6
$3.2
+
+
+ $6.4
+ $6.8+$153.1
=
(1.10707)1 (1.10707)2 (1.10707)3
(1.10707)4
(1.10707)5
= $110.1
With no nonoperating assets, the value of equity =
Voperations – Value of debt = $110.1 – $27 = $83.1 million
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Valuation Using the FCFE Model
Horizon Value FCFE, 2016
(FCFE2016)(1+g)
=
rsL – g
= $7.06(1.06)
0.13 – 0.06
= $106.9 million
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Valuation Using the FCFE Model (cont’d)
VFCFE =$6.2 + $ 4.0 + $ 4.1
(1.13)1
(1.13)2
+ $ 6.0
(1.13)3
+
$ 6.7
(1.13)4
+ $7.1+$106.9
(1.13)5
= $83.1 million
With no nonoperating assets, the total value of equity is
equal to VFCFE. Both models arrive at an equity value of
$83.1 million > $62.5 million, the current market value.
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Setting the Bid Price
•
•
•
•
Estimate of target’s value = $83.1 million
Target’s current value
= $62.5 million
Synergistic benefits
= $20.6 million
Presumably, the target’s value is increased by
$20.6 million due to merger synergies,
although realizing such synergies has been
problematic in many mergers.
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Setting the Bid Price (cont’d)
• The offer could range from $62.5 million to
$83.1 million.
• At $62.5 million, all merger benefits would go
to the acquiring firm’s shareholders.
• At $83.1 million, all value added would go to
the target firm’s shareholders.
• The graph on the next slide summarizes the
situation.
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Change in Shareholders’ Wealth
Target
Acquirer
$62.5 million
0
35
$83.1 million
60
85
110
Price Paid
for Target
Bargaining Range = Synergy
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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 $62.5 million.
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Points About Graph (cont’d)
• Acquirer might want to make high
“preemptive” bid to ward off other bidders,
or low bid and then plan to go up. Strategy is
important.
• 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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Taxes and Structure of the
Takeover Bid
• A merger can be structured as
– asset purchase
– share purchase
• Payment can be offered in the form of
– cash (the deal is taxable)
– stock of the acquiring firm (the deal is nontaxable)
– debt of the acquiring firm
– some combination of the above
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Financial Reporting for Mergers
• Acquisition accounting may be used now.
– The assets of the acquired firm are “written up”
to reflect purchase price if it is greater than the
net asset value.
– Goodwill is often created, which appears as an
asset on the balance sheet.
– Common equity account is increased to balance
assets and claims.
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Goodwill Amortization
• Goodwill is NO LONGER amortized over time
for shareholder reporting.
• Goodwill is subject to an annual “impairment
test.” If its fair market value has declined,
then goodwill is reduced. Otherwise it is not.
• Goodwill is still amortized for federal tax
purposes.
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Acquisition Method: An Illustration
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Income Statement Effects
• The acquiring firm must expense any transaction
costs related to the merger (e.g., professional
fees and organizational costs).
• The acquisition differential (i.e., the fair values
exceed the book values) may lead to higher
depreciation charges.
• The decline in the fair value of goodwill as a
result of annual impairment test must be charged
to earnings but not the gain.
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Income Statement Effects:
An Illustration
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Analysis for a “True Consolidation”
• Step 1: Estimate the value of the combined
firm, reflecting any synergies, tax effects, or
capital structure changes.
• Step 2: Allocate the new company’s stock
(especially the synergistic-induced value)
between the two sets of old shareholders.
– One basis can be the relative pre-announcement
values of the two companies.
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The Role of Investment Bankers
•
•
•
•
•
Arranging mergers
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
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Who Wins?: The Empirical Evidence
• According to empirical evidence, 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; that is, the final price is close to full
value.
– Target management can always say no.
– Competing bidders often push up prices.
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Corporate Alliances
REASONS WHY THEY MAKE MORE SENSE
THAN MERGERS
•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.
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Leveraged Buyouts
• In a leveraged buyout (LBO), a small group of
investors, normally including management,
buys all of the publicly held stock, and hence
takes the firm private.
• The purchase is often financed with debt.
• After operating privately for a number of
years, investors take the firm public to “cash
out.”
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What are the Pros and Cons of
Going Private?
• Advantages:
– Administrative cost savings
– Increased managerial incentives
– Increased managerial flexibility
– Increased shareholder participation
• Disadvantages:
– Limited access to equity capital
– No way to capture return on investment
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Divestitures
MAJOR TYPES
• Sale of an entire subsidiary to another firm
• Spinning off a corporate subsidiary by giving the
stock to existing shareholders
• Carving out a corporate subsidiary by selling a
minority interest
• Outright liquidation of assets
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What Motivates Firms to
Divest Assets?
• Subsidiary worth more to buyer than when
operated by current owner
• To settle antitrust issues
• Subsidiary’s value increased if it operates
independently
• To change strategic direction
• To shed money losers
• To get needed cash when distressed
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