BA 7000-093 Chapter 11

Chapter 11 Mergers and Acquisitions

Key Learning Outcomes
Understanding the potential items to value in M&A and to be able
to assess potential implications o acquirer!s method o payment
A"#asics
$aluation o merger target is rom the perspective o
acquiring company%s shareholders
&et present value o acquisition is the 'value o the
target to acquirer minus the e(ective cost'
#" $alue o target to acquirer
$alue o the target to the acquirer is made up o)
1" *tand alone value o the target plus
+ $alue o improvements at target made by acquirer
management plus
+ $alue o pure synergies bet,een target and
acquirer
C" $aluations must ma-e a capital structure assumption
.he valuations /stand alone0 improvements0 and synergies1 must
ma-e a capital structure assumption
1" 2ACC model or A3$ model
#e careul4
5" .he capital structure assumption should not be re6ective
o the 7nancing used to buy the target per se0 but should
re6ect the degree to ,hich o,ning the target
incrementally a(ects your debt capacity
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BA 7000-093 Chapter 11
8or e9ample0 suppose you bought the target ,ith debt
: you are using 2ACC to value target0 the ,eights
should re6ect the debt capacity o the target0 not 1;;<
debt
: you are using => or A>?0 the ta9 shields should only
re6ect the contribution o the target 7rm to,ards
a(ording those ta9 shields
C" 2hat is the e(ective cost@
1" Acquirer pays cash /A1;;M1
Cash price is the e(ective cost o the acquisition
5" Acquirer must raise the cash /A1;;M1
+ Assume Acquirer must borro, the money rom
government ,ith a subsidiBed rate
Loan is A1;;M0 but 3$ o loan payments is ACDM
3urchase price is A1;;M0 but acquirer ma-es
ADM &3$ on loan" >(ective cost o acquisition is
ACDM
3. Assume Acquirer sells shares o combined 7rm /A1;;M1
+ 3urchase price is A1;;M0 but suppose shares are
actually ,orth AE;M" &3$ on share sale is AF;M"
>(ective cost o acquisition is AE;M"
G"Mergers and Acquisitions oten involve share issues
=esidual earnings valuation cannot be done by
orecasting per+share amounts i shares outstanding are
li-ely to change
Al,ays carry out residual earnings valuations on a
dollar basis0 then divide by current shares
outstanding
Abnormal >arnings ?ro,th /A>?1 valuation can be carried
out by orecasting per+share earnings and dividends
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BA 7000-093 Chapter 11
Ho,ever0 must then ,or- on a levered basis
/requiring changes in the cost o equity capital1
#est to ,or- ,ith operations on a dollar basis
$aluation ,ith an Anticipated Acquisition)
Gealing ,ith $alue :mplicit in >9change =atio
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BA 7000-093 Chapter 11
Question 1. During the early 1990s there was a noticeable increase in mergers and acquisitions
between firms in different countries (termed cross-border acquisitions). What factors
could e!lain this increase" What s!ecial issues can arise in eecuting a cross-
border acquisition and in ultimately meeting your ob#ecti$es for a successful
combination"
Several factors could help explain the increase in er!er and ac"uisition activit# $et%een firs in
different countries& 'hese factors a# include(
=ela9ation o oreign o,nership la,s. As countries have allo%ed !reater
forei!n o%nership of copanies in certain industries )e&!&* $roadcastin!* telephone* steel* autoo$ile+*
forei!n copanies have underta,en er!ers that %ere previousl# prevented due to !overnental
restrictions&
Expansion of regional free trade areas. -nce a re!ional tradin! $loc, is ipleented* it can
$ecoe ore difficult for forei!n firs to export its products to countries %ithin the $loc,& As a
result* a forei!n fir a# purchase a copan# %ithin the $loc, to !uarantee access to the $loc,& .or
exaple* an# Aerican firs rushed to purchase /uropean firs $efore 0anuar# 1* 1991 to assure
continued access to ar,ets of /uropean 2nion e$ers as inte!ration of the /2 ar,ets entered its
next phase& Siilarl#* increased free trade can create ne% opportunities for firs %ithin the $loc, to
expand their ar,ets& Ac"uisitions can provide a %a# of ta,in! advanta!e of these opportunities& .or
exaple* the inte!ration of ar,ets in /urope a# provide opportunities for* sa#* 3eran and 2&4&
$an,s to use cross-$order ac"uisitions to develop into a /uropean $an,&
Globalization of certain industries. -nce a copan# has reached the axiu production in
its hoe ar,et* it a# see, !reater econoies of scale and scope $# purchasin! copetitors in
forei!n ar,ets& B# expandin! its production to the !reatest extent possi$le* the fir hopes to achieve
the ost efficient cost structure& 'his !lo$ali5ation forces the reainin! copanies to consolidate to
achieve the sae level of scale and scope econoies&
Search for new markets. -nce doestic ar,ets for a specific product have atured* a doestic
fir %ill often tr# to continue its expansion in forei!n ar,ets& -ften* the easiest %a# to enter a
forei!n ar,et is to purchase a copan# alread# operatin! in that ar,et& 6t !uarantees iediate
ar,et share and instant nae reco!nition %ith local consuers&
6nternational er!ers %ill create special issues that %ill ultiatel# affect the success of the er!er&
'hese special issues a# include valuin! a forei!n copan# that operates and prepares its financial
reports under different accountin! rules& 7ifferences in accountin! rules a# include(
'reatent of intan!i$les* such as 897 expenses* $rand naes* !ood%ill* patents* etc&
'reatent of inflation&: .orei!n exchan!e exposure&: ;ed!in! ac"uisition price&
;ed!in! future cash flo%s fro the forei!n fir&: 8e!ulator# considerations&
.orei!n !overnent investent approvals&: .orei!n !overnent antitrust approvals&
A$ilit# to expatriate earnin!s fro the forei!n countr#&
7ifferences in la%s* re!ulations* and rules !overnin! personnel and huan resources areas&
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BA 7000-093 Chapter 11
7ifferences in the operations of forei!n ar,ets and copanies* includin! differences in
ana!eent practices* %or,er nors and expectations* roles of !overnent in the econo#* and
corruption in the $usiness and political environents of the econo#&
=ana!eent and coordination of doestic and forei!n operations&
Question %. &ou ha$e been hired by '( )n$estment *an+ to wor+ in the merger de!artment. ,he
analysis required for all !otential acquisitions includes an eamination of the target
for any off-balance-sheet assets or liabilities that ha$e to be factored into the
$aluation. -re!are a chec+list for your eamination.
Off-Balance Sheet Liabilities
/xecutor# contracts: Contin!ent o$li!ations: -peratin! leases:
>ia$ilities under environental re!ulations
Off-Balance Sheet ssets!7ependin! on the specific circustance* these assets a# alread# $e
included on the $alance sheet& 'hese assets are either valued )e&!&* intan!i$le assets+ or revalued )e&!&*
land held for sale+ once the# have $een purchased $# another copan#&
8esearch and developent expenditures
?atents* tradear,s* and other intellectual propert#
Brand naes: 3ood%ill: >and held for sale
Question .. / leading oil e!loration com!any decides to acquire an )nternet com!any at a %0
!ercent !remium. ,he acquirer argues that this mo$e creates $alue for its own
stoc+holders because it can use its ecess cash flows from the oil business to hel!
finance growth in the new )nternet segment. 0$aluate the economic merits of this
claim.
'he oil copan# is ar!uin! that a er!er could create value $# providin! lo%-cost financin! to a
financiall#-constrained electronics fir& 'his ar!uent is $ased on the idea that capital ar,et
iperfections have prevented the electronics copan# fro investin! in all of its !ro%th
opportunities& 'hese iperfections a# have developed as a result of inforation as#etries
$et%een ana!eent and outside investors& 6f the electronics fir has to rel# on outside investors to
finance its !ro%th* capital ar,et constraints could prevent it fro underta,in! %orth%hile pro@ects
$ecause pu$lic capital ar,ets %ould pro$a$l# $e a costl# source of funds for the fir& ;o%ever* $#
purchasin! the electronics copan#* the oil copan# can help it overcoe the capital ar,et
iperfections and ena$le the electronics fir to invest in all of its !ro%th opportunities&
'he erits of the oil copan#As ar!uent for $u#in! the electronics copan# depend on t%o
conditions& .irst* financial constraints ust $e preventin! the electronics fir fro underta,in! soe
profita$le pro@ects& 6f the electronics fir is not financiall#-constrained or does not have a set of
unfunded $ut profita$le pro@ects* then havin! access to the additional capital of the oil copan# %ill
not create value& 'he onl# pro@ects the fir %ould have left %ould $e unprofita$le ones& Second* the
financial constraints ust $e due to capital ar,et iperfections& 6t is plausi$le that the electronics
fir could face capital ar,et iperfections due to inforation as#etries& 6nforation pro$les
are li,el# to $e severe for ne%l#-fored* hi!h-!ro%th copanies* a description t#pical of an#
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BA 7000-093 Chapter 11
electronics firs& 6f inforation pro$les a,e it difficult for outside investors to value the
electronics fir $ecause of its short trac, record or $ecause its financial stateents provide little
insi!ht a$out the value of its !ro%th opportunities* then outside investors could $e an expensive
source of funds&
Gigital >quipment Company $aluations)
*tand Alone $aluation) Gigital + *tatus Iuo
Digital had earning before interest and taxes of $391.38
million in 1997, which translated into a
A pretax operating margin of 3! on its re"en#es of $13,$%&
million
An aftertax ret#rn on capital of 8.'1!
(ased #pon its beta of 1.1', an aftertax cost of borrowing of
'! and a debt ratio of approximatel) 1$!, the cost of capital
for Digital in 1997 was
*ost of +,#it) - &! . 1.1' /'.'!0 - 11.33!
*ost of *apital - 11.33! /.90 . '! /.10 - 11.'9!
Digital had capital expendit#res of $%7' million, depreciation
of $ %&1 million and wor2ing capital was 1'! of re"en#es.
3perating income, net cap ex and re"en#es are expected to
grow &! a )ear for the next ' )ears, and '! thereafter.
Cear .C.. 'erinal Dalue ?D
1 E133&21 E119&<2
2 E1<1&2B E113&<3
3 E1<9&73 E107&7B
< E1BF&71 E102&3B
B E11F&2< E2*717&3B E1*117&<7
'erinal Cear E1B1&2B
.ir Dalue G "#$%%&.'%
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BA 7000-093 Chapter 11
4he capital expendit#res are ass#med to be 11$! of
re"en#es in stable growth5 wor2ing capital remains 1'!5
Debt ratio remains at 1$!, b#t aftertax cost of debt
drops to %!. (eta declines to 1.
Gigital) Change in Control
Digital will raise its debt ratio to 1$!. 4he beta will increase,
b#t the cost of capital will decrease.
6ew (eta - 1.1' /7nle"ered (eta - 1.$75 Debt8+,#it) 9atio -
1'!0
*ost of +,#it) - &! . 1.1' /'.'!0 - 11.88!
6ew Aftertax *ost of Debt - '.1'!
*ost of *apital - 11.88! /$.80 . '.1'! /$.10 - 11.3'!
Digital will raise its ret#rn on capital to 11.3'!, which is its
cost of capital. /:retax 3perating margin will go #p to %!0
4he rein"estment rate remains #nchanged, b#t the increase
in the ret#rn on capital will increase the expected growth rate
in the next ' )ears to 1$!.
After )ear ', the beta will drop to 1, and the aftertax cost of
debt will decline to %!.
7i!ital Daluation( Chan!e in Control
Cear .C.. 'erinal Dalue ?D
1 E1B1&29 E1<0&31
2 E171&91 E13F&1B
3 E1F9&11 E131&97
< E20F&02 E13B&31
B E22F&F2 E1*BF<&12 E3*9F0&29
'erinal Cear E329&23
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BA 7000-093 Chapter 11
Dalue of the .ir( %ith Control Chan!e G " '$()% million
Dalue of the .ir( Status Huo G " #$%%& million
Dalue of Control G "#$'#% million
;)nerg) +<ects in =al#ation >np#ts
If synergy is Valuation Inputs that will be afected
are
+conomies of ;cale Operating Margin of combined ?rm will be
greater than the re"en#eweighted operating
margin of indi"id#al ?rms.
@rowth ;)nerg) Aore proBectsCHigher Reinvestment Rate
/9etention0
(etter proBectsC Higher Return on Capital
/93+0
Longer rowth !eriod
Again, these inp#ts will be estimated for the
combined ?rm.
=al#ing ;)nerg)C *ompa, and Digital
>n 1997, *ompa, ac,#ired Digital for $ 3$ per share . $.9%'
*ompa, shares for e"er) Digital share. /$ '3&$ per share0
4he ac,#isition was moti"ated b) the belief that the
combined ?rm wo#ld be able to ?nd in"estment opport#nities
and compete better than the ?rms indi"id#all) co#ld.
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BA 7000-093 Chapter 11
(ac2gro#nd Data /$ in Aillions0
Compa" #igital$ Opt
Mgd
*#rrent +(>4 $ 1,987 $ '11
*#rrent 9e"en#es $1',%8% $13,$%&
*apital +xpendit#res Depreciation $ 18% $ 1%
/o<set0
+xpected growth rate next ' )ears 1$! 1$!
+xpected growth rate after )ear ' '! '!
Debt 8/Debt . +,#it)0 1$! 1$!
Aftertax cost of debt '! '.1'!
(eta for e,#it) next ' )ears 1.1' 1.1'
(eta for e,#it) after )ear ' 1.$$ 1.$
Dor2ing *apital89e"en#es 1'! 1'!
4ax rate is 3&! for both companies
=al#ing *ompa,
Eear F*FF 4erminal =al#e :=
1 $1,'18.19 $1,3'%.%7
1 $1,&7$.$1 $1,319.1%
3 $1,837.$1 $1,3$%.%9
% $1,$1$.71 $1,18$.19
' $1,111.78 $'&,&'%.81 $33,178.'3
4erminal Eear $1,831.7% $38,'%&.91
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BA 7000-093 Chapter 11
=al#e of *ompa, - $ 38,'%7 million
After )ear ', capital expendit#res will be 11$! of
depreciation.
*ombined Firm =al#ation
1. 4he *ombined ?rm will ha"e some economies of scale,
allowing it to increase its c#rrent aftertax operating
margin slightl). 4he dollar sa"ings will be approximatel) $
1$$ million.
*#rrent 3perating Aargin - /1987.'1108/1'%8%.13$%&0 -
9.11!
6ew 3perating Aargin - /1987.'11.1$$08/1'%8%.13$%&0 -
9.3&!
1. 4he combined ?rm will also ha"e a slightl) higher growth
rate of 1$.'$! o"er the next ' )ears, beca#se of operating
s)nergies.
3. 4he beta of the combined ?rm is comp#ted in two stepsC
DigitalGs 7nle"ered (eta - 1.$75 *ompa,Gs 7nle"ered (eta-1.17
DigitalGs Firm =al#e - %.'5 *ompa,Gs Firm =al#e - 38.&
7nle"ered (eta - 1.$7 H /%.'8%3.10 . 1.17 /38.&8%3.10 - 1.1&
*ombined FirmGs Debt8+,#it) 9atio - 13.&%!
6ew Ie"ered (eta - 1.1& /1./1$.3&0/.13&%00 - 1.1&
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BA 7000-093 Chapter 11
*ost of *apital - 11.93! /.880 . '! /.110 - 11.98!
*ombined Firm =al#ation
Eear F*FF 4erminal =al#e :=
1 $1,71&.&' $1,'%1.9'
1 $1,9$7.9' $1,'11.'9
3 $1,1$8.18 $1,'$1.'$
% $1,319.&' $1,%81.&8
' $1,'7%.1& $&&,9$7.'1
$39,%&3.87
4erminal Eear $3,3%'.38
=al#e of *ombined Firm - A FD0D11
4he =al#e of ;)nerg)
=al#e of *ombined Firm with ;)nerg) - $%','11
million
=al#e of *ompa, . =al#e of Digital
- 38,'%7 . %'31 - $ %%,$79
million
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BA 7000-093 Chapter 11
.otal $alue o *ynergy J A 10FK5
million
DigitalC =al#ation (loc2s
$alue o 8irm + *tatus Iuo J A 5011; million
. =al#e of *ontrol - $ 1,'11 million
$alue o 8irm + Change o Control J A F0DK1 million
. =al#e of ;)nerg) - $ 1,%31 million
.otal $alue o Gigital ,ith *ynergy J A D0CEK million
+"al#ating *ompa,Gs 3<er
=al#e of Digital with ;)nerg) - $',9&3 mil
=al#e of *ash paid in deal - $ 3$ H 1%&.789 mil shares - $%,%$3
mil
DigitalGs 3#tstanding Debt /ass#med b) *ompa,0 $1,$$&
mil
9emaining =al#e $ ''% mil
8 n#mber of ;hares o#tstanding 8 1%&.789
- 9emaining =al#e per ;hare $ 3.77
*ompa,Gs price per share at time of +xchange 3<er $ 17
Appropriate +xchange 9atio - 3.77817 - $.1% *ompa, shares8Digital
share
Act#al +xchange 9atio - $.9%' *ompa, shares8Digital ;hare
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BA 7000-093 Chapter 11
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