MERGERS AND ACQUISITIONS

The Market for Corporate Control

M&A Activities
Mergers Takeovers LBOs Compensation Spin-offs, etc.

Definitions
Corporate control -- the power to make investment and financing decisions. Corporate governance -- the role of the Board of Directors, shareholder voting, proxy fights, etc. and the actions taken by shareholders to influence corporate decisions. Corporate structure -- the financial organization of the business.

Recent Mergers
Industry Telecoms Pharmaceuticals Pharmaceuticals Banking Banking Telecoms Banking Healthcare Insurance Banking Banking/Consumer Finance Media Acquiring Company Vodafone (UK) Sanofi (France) Pfizer JP Morgan Chase Bank of America Cingular Wireless Mitsubishi Tokyo Financial Group (Japan) Anthem St. Paul Companies Banco santander Central Hispano HSBC Holdings (UK) General Electric Selling Company Mannesmann (germany) Aventis (France/Germany) Pharmacia Bank One FleetBoston Financial Corp. AT&T Wireless Services UFJ Holdings (Japan) Wellpoint Health Networks Travelers property Casualty Abbey (UK) Household International Vivendi Universal Entertainment (France) Payment ($billions) 203.0 64.0 59.5 58.0 49.3 41.0 25.7 16.4 16.1 15.6 15.3 13.7

Sensible Reasons for Mergers

Economies of Scale
A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.

Reduces costs
$

Sensible Reasons for Mergers

Economies of Scope or Vertical Integration Control over suppliers may reduce costs. Over integration can cause the opposite effect.
Pre-integration (less efficient) Company S S S S Post-integration (more efficient) Company

S
S S

Sensible Reasons for Mergers

Combining Complementary Resources Merging may result in each firm filling in the missing pieces of their firm with pieces from the other firm.
Firm A

Firm B

Sensible Reasons for Mergers

Combining Complementary Resources Merging may result in each firm filling in the missing pieces of their firm with pieces from the other firm.
Firm A

Firm B

Sensible Reasons for Mergers

Mergers as a Use for Surplus Funds If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.

Dubious Reasons for Mergers

Diversification
Investors should not pay a premium for diversification since they can do it themselves

Empire Building EPS Game

EX: High PE firm buys Low PE firm -- resulting in higher EPS for merged firm (the bootstrap game)

Dubious Reasons for Mergers

The Bootstrap Game
Selling firm has low P/E ratio (due to low number of shares) After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution.

Dubious Reasons for Mergers

The Bootstrap Game
World Enterprises (before merger) EPS Price per share P/E Ratio Number of shares Total earnings Total market value Current earnings per dollar invested in stock (EP) $ $ 2.00 40.00 20 100,000 200,000 4,000,000 World Enterprises (after buying Muck and Slurry) Muck and Slurry $ 2.00 $ 2.67 $ 20.00 $ 40.00 10 15 100,000 150,000 $ 200,000 $ 400,000 $ 2,000,000 $ 6,000,000

$ $

0.05 $

0.10 $

0.067

Dubious Reasons for Mergers

EP Ratio (log scale)

World Enterprises (after merger)

World Enterprises (before merger) Muck & Slurry

.10 .067 .05 Now Time

Sensible Reasons for Mergers

Unused Tax Shields More Debt Capacity
More Tax Shield Lower BK Costs

Sensible Reasons for Mergers

Inefficient Management (Agency Problems) Management Controls
Capital Markets (mergers, takeovers, LBOs)

Other Managerial Controls

Board of Directors Labor Markets (External & Internal) Compensation Incentives (options)

Board of Directors
Independent? Monitoring Hire/Fire Compensation Strategic Planning

Estimating Merger Gains

Questions
Is there an overall economic gain to the merger? Do the terms of the merger make the company and its shareholders better off?

PV(AB) > PV(A) + PV(B)

Estimating Merger Gains

Economic Gain
Economic Gain = PV(increased earnings) New cash flows from synergies discount rate

Example: Snowbird & Alta

Snowbird is examining the purchase of Alta, which would become a subsidiary of Snowbird if the merger goes through. The projected cash flow statement for Alta (if merged) is shown on the next slide. These cash flows include all synergistic effects. Altas market-determined beta is 1.63. The risk-free rate is 10 percent and the market risk premium is 5 percent. Alta has 10 million shares of stock priced at $6.25. What is the possible economic gain to this merger, if any?

Snowbird & Alta

Projected Post-Merger Cash Flows for the Alta Subsidiary as of December 31 Net Sales Cost of Goods Sold Selling and Admin. Expense Depreciation EBIT Interest EBT Taxes (40%) Net Income Add Back Depreciation Cash Flow from Operations Less Retentions Need for Growth Add TERMINAL VALUE Net Cash Flow
$ 2002 2003 2004 2005 2006 105.0 $ 126.0 $ 151.0 $ 174.0 $ 191.0 (75.0) (89.0) (106.0) (122.0) (132.0) (10.0) (12.0) (13.0) (15.0) (16.0) (8.0) (8.0) (9.0) (9.0) (10.0) 12.0 17.0 23.0 28.0 33.0 (8.0) (9.0) (10.0) (11.0) (11.0) 4.0 8.0 13.0 17.0 22.0 (1.6) (3.2) (5.2) (6.8) (8.8) 2.4 4.8 7.8 10.2 13.2 8.0 10.4 (4.0) 6.4 8.0 12.8 (4.0) 8.8 9.0 16.8 (7.0) 9.8 9.0 19.2 (9.0) 10.2 10.0 23.2 (12.0) 150.2 161.4

Snowbird & Alta

Discount Rate

r r (rm r ) f f .10 1.63 (.05) .182

Snowbird & Alta

Terminal Value

Assume: terminal growth rate of 10%

CF CF (1 g ) 2007 2006 V 2006 rg rg (23.2 12.0)(1.10) .182 .10 150.2

Snowbird & Alta

Total Firm Value

2001

$92.8

$6.4 $8.8 $9.8 (1.182)1 (1.182)2 (1.182)3 $ 10 . 2 $ 161 . 4 (1.182)4 (1.182)5

Snowbird & Alta

Possible Economic Gain = Merger Value - Pre-merger Value

= $92.8 - $6.25 x 10,000,000

= $92.8 - $62.5

= $30.3 million

Snowbird & Alta

Change in

Stockholders
Wealth

Snowbird (Acquirer)

Alta (Target)

Bargaining Range

$62.5

= Synergy

$92.8

Price Paid for Target

Takeover Methods
Tools Used To Acquire Companies
Proxy Contest Tender Offer

Acquisition

Merger

Leveraged Buy-Out

Management Buy-Out

Takeover Defenses
White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor. Shark Repellent - Amendments to a company charter made to forestall takeover attempts. Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

Leveraged Buyouts
The difference between leveraged buyouts and ordinary acquisitions:
1. A large fraction of the purchase price is debt financed. 2. The LBO goes private, and its share is no longer trade on the open market.

Leveraged Buyouts
The three main characteristics of LBOs:
1. 2. 3. High debt Incentives Private ownership

Leveraged Buyouts
10 Largest LBOs in 1980s and 1997/98 examples
Acquirer KKR KKR KKR Thompson Co. KKR Wings Holdings TF Investments Macy Acquisitions Corp. Carlyle Group & Welsh, Carson, Anderson and Stowe Quest Dex TRW Automotive Blackstone Group Holdings KKR PanAmSat Texas Pacific group, Bain Capital. & Goldman Sachs. Burger King Target RJR Nabisco Beatrice Safeway Southland (7-11) Owens-Illinios NWA, Inc. Industry Food, tobacco Food Supermarkets Convenience stores Glass Airlines Hospitals Department stores Yellow pages Auto parts Satellites Fast food Year 1989 1986 1986 1987 1987 1989 1989 1986 2002 2002 2004 2002 Value ($mil) 24,720 6,250 4,240 4,000 4,680 3,690 3,600 3,500 7,050 4,700 4,380 2,260

Phillips Petroleum Case

Philips balance sheet was dramatically changed by its leveraged restructuring (figures in $billions).
1984 Balance Sheet (Before LBO) Net Working Capital (0.7) 5.1 Fixed Assets 12.4 6.6 Total assets 11.7 11.7

Debt Equity Total liabilities

1985 Balance Sheet (After LBO) Net Working Capital 0.0 9.3 Fixed Assets 10.9 1.6 Total assets 10.9 10.9

Debt Equity Total liabilities

Spin-offs, etc.
Spin off -- debut independent company created by detaching part of a parent company's assets and operations. Carve-outs-- similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering. Asset Sales-- the sale of the assets of a division to other firms .

EXIT (Overcapacity)
1. 2. 3. 4. Capital Markets Internal Control Mechanisms Regulation and Legal System Product and Factor Markets
(Michael Jensens arguments)

Is M&A good or bad for economic efficiency?

Summary
M&A is Corporate Control Activity Many Sensible Reasons for Mergers Measure the Gains to Merger
New cash flows from synergies Discount rate DCF Analysis

Other M&A Activities The Role of M&A Activity for the Economy