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 - 1 - 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 - 2 - 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 $alue :mplicit in >9change =atio - 3 - BA 7000-093 Chapter 11 Question 1. During the early 1990s there was a noticeable increase in mergers and acquisitions between firms in different countries (termed cross-border acquisitions). What factors could e!lain this increase" What s!ecial issues can arise in eecuting a cross- border acquisition and in ultimately meeting your ob#ecti$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& - < - 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 $e severe for ne%l#-fored* hi!h-!ro%th copanies* a description t#pical of an# - B - BA 7000-093 Chapter 11 electronics firs& 6f inforation pro$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 "#$%%&.'% - 1 - BA 7000-093 Chapter 11 4he capital expendit#res are ass#med to be 11$! 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 - 7 - 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. - F - 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.$$ 1.$ Dor2ing *apital89e"en#es 1'! 1'! 4ax rate is 3&! for both companies =al#ing *ompa, Eear F*FF 4erminal =al#e := 1 $1,'18.19 $1,3'%.%7 1 $1,&7$.$1 $1,319.1% 3 $1,837.$1 $1,3$%.%9 % $1,$1$.71 $1,18$.19 ' $1,111.78 $'&,&'%.81 $33,178.'3 4erminal Eear $1,831.7% $38,'%&.91 - 9 - BA 7000-093 Chapter 11 =al#e of *ompa, - $ 38,'%7 million After )ear ', capital expendit#res will be 11$! of depreciation. *ombined Firm =al#ation 1. 4he *ombined ?rm will ha"e some economies of scale, allowing it to increase its c#rrent aftertax operating margin slightl). 4he dollar sa"ings will be approximatel) $ 1$$ million. *#rrent 3perating Aargin - /1987.'1108/1'%8%.13$%&0 - 9.11! 6ew 3perating Aargin - /1987.'11.1$$08/1'%8%.13$%&0 - 9.3&! 1. 4he combined ?rm will also ha"e a slightl) higher growth rate of 1$.'$! o"er the next ' )ears, beca#se of operating s)nergies. 3. 4he beta of the combined ?rm is comp#ted in two stepsC DigitalGs 7nle"ered (eta - 1.$75 *ompa,Gs 7nle"ered (eta-1.17 DigitalGs Firm =al#e - %.'5 *ompa,Gs Firm =al#e - 38.& 7nle"ered (eta - 1.$7 H /%.'8%3.10 . 1.17 /38.&8%3.10 - 1.1& *ombined FirmGs Debt8+,#it) 9atio - 13.&%! 6ew Ie"ered (eta - 1.1& /1./1$.3&0/.13&%00 - 1.1& - 10 - BA 7000-093 Chapter 11 *ost of *apital - 11.93! /.880 . '! /.110 - 11.98! *ombined Firm =al#ation Eear F*FF 4erminal =al#e := 1 $1,71&.&' $1,'%1.9' 1 $1,9$7.9' $1,'11.'9 3 $1,1$8.18 $1,'$1.'$ % $1,319.&' $1,%81.&8 ' $1,'7%.1& $&&,9$7.'1 $39,%&3.87 4erminal Eear $3,3%'.38 =al#e of *ombined Firm - A FD0D11 4he =al#e of ;)nerg) =al#e of *ombined Firm with ;)nerg) - $%','11 million =al#e of *ompa, . =al#e of Digital - 38,'%7 . %'31 - $ %%,$79 million - 11 - BA 7000-093 Chapter 11 .otal $alue o *ynergy J A 10FK5 million DigitalC =al#ation (loc2s $alue o 8irm + *tatus Iuo J A 5011; million . =al#e of *ontrol - $ 1,'11 million $alue o 8irm + Change o Control J A F0DK1 million . =al#e of ;)nerg) - $ 1,%31 million .otal $alue o Gigital ,ith *ynergy J A D0CEK million +"al#ating *ompa,Gs 3<er =al#e of Digital with ;)nerg) - $',9&3 mil =al#e of *ash paid in deal - $ 3$ H 1%&.789 mil shares - $%,%$3 mil DigitalGs 3#tstanding Debt /ass#med b) *ompa,0 $1,$$& 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 - 12 - BA 7000-093 Chapter 11 - 13 -