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Http Hubcap.clemson.edu ~Kleinr 402 CHAPTER25

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CHAPTER 25 Mergers, LBOs, Divestitures, and Holding Companies


Recent Mergers Reasons for Mergers Types of Mergers Merger Analysis Accounting for Mergers Role of Investment Bankers Corporate Alliances, Leveraged Buyouts, and Divestitures Holding Companies
Finance 402 1

Mergers Announced in 2005 

America West and US Airways
± $1.5 billion - Announced May 19, 2005

Lenovo Goup and IBM PC Division
± $1.25 billion ± Announced April 20th, 2005

Verizon and MCI
± $7.6 billion ± Announced March 29, 2005

Proctor and Gamble and Gillette
± $57 billion ± Announced March 28, 2005

IAC/Interactive and Ask Jeeves
± $1.9 billion ± Announced March 21, 2005

Met Life and Travelers Group
± $11.5 billion ± Announced January 31, 2005
Finance 402 2

Mergers Announced in 2004 

K Mart and Sears Roebuck
± $11 billion ± Announced November 17, 2004

Wachovia and South Trust
± $14.3 billion ± Announced June 21, 2004

May Company and Marshall Field
± Purchased from Target (an Acquisition) ± $3.24 billion ± Announced June 9, 2004 

Wells Fargo and Strong Capital Management
± $400 million (estimated) ± Announced May 27, 2004

Marsh & McLennan ± Kroll, Inc
± $1.96 billion ± Announced May 18, 2004
Finance 402 3

Mergers Announced in 2004 Continued  Sun Trust and National Commerce Financial ± $6. 2004  Cingular J Wireless and AT & T Wireless ± $47 billion ± Announced February 17. 2004 P Morgan Chase and Bank One Finance 402 4 .98 billion ± Announced May 9.

2003  Anthem and Wellpoint ± $16. Paul Companies and Travelers Property Casualty ± $16. 2003  Bank of America and Fleet Boston ± $48 billion ± Announced October 27. 2003 Finance 402 5 .4 billion ± Announced October 27. 2003  Manulife and John Hancock Financial Services ± $10.Mergers Announced in 2003  St.5 billion ± Announced November 17th.4 billion ± Announced November 4.

2003  Manufactured Home and Chateau Communities ± $1. 2003  Viacom and Comedy Central ± $1.Mergers Announced in 2003 -Continued  R. 2003  Oracle and PeopleSoft ± $5.1 billion hostile takeover ± updated in 2004 to $9.S.J.8 billion ± May.2 billion ± April. Reynolds and British American Tobacco PLC ± $3 billion for U. 2003 Finance 402 6 . 2003  Berkshire Hathaway and Clayton Homes ± $1.7 billion ± April. units of British American Tobacco ± Announced October 27.2 billion ± First Announced June 9.

Five Largest Completed Mergers (as of January 2002) BUYER Vodafone AirTouch Pfizer America Online Exxon Glaxo Wellcome TARGET Mannesman Warner-Lambert Time Warner Mobil SmithKline Beecham Finance 402 VALUE (Billion) $161 116 106 81 74 7 .

E.Foreign Acquisitions of U. and Atlantic Richfield Ahold and Giant Food stores. Sohio. Small Appliances 8 Finance 402 . Harris Teeter.S. Goodrich Grand Metropolitan and Pillsbury Thomson and G. Firms          Manulife and John Hancock Financial Services Bridgestone and Firestone Daimler Benz and Chrysler HSBC Holdings and Household International British Petroleum and Amoco. and Price Chopper Michelin and B.F.

Continued          Credit Suisse and First Boston Zurich Insurance and Scudder.Foreign Acquisitions and U.S.) UBS and Paine Webber Bertelsmann and Napster Finance 402 9 . Firms . Stevens Bank of Tokyo-Mitsubishi and UnionBanCal Toronto Dominion Bank and Waterhouse Securities Hong Kong and Shanghai Bank and Marine Midland Matushita and MCA Broken Hill Proprietary and Utah International (from G. E.

Arises from: ± Operating economies ± Financial economies ± Differential management efficiency ± Tax Effects (possibly use accumulated losses) (More..) Finance 402 10 .Which of the reasons that have been proposed as justification for mergers are economically justifiable?  Synergy: Value of the combined firm exceeds the sum of the values of the firms taken separately..

± Increased Market Power: Due to reduced competition  Corporate Focus  World Wide Competition (Globalization)  Acquire Technological Skills Finance 402 11 .

Finance 402 12 .BreakBreak-up Value  Break-up value: A company¶s assets would be more valuable if sold to and then operated by some other company or spun off.

What are some questionable reasons for mergers?  Diversification ± Stockholders can achieve diversification at lower cost than firms ± Transfers wealth from stockholders to debt holders ± No synergistic effects  Purchase of assets at below replacement cost (more) Finance 402 13 .

What are some questionable reasons for mergers? continued  Retention of control ± Acquire other firms to increase size. thus making it more difficult to be acquired  Managers¶ personal incentives Finance 402 14 .

Types of Mergers  Horizontal ± First Union and Wachovia  Vertical ± DuPont and Conoco  Congeric .Related Enterprises ± Duke Power and Pan Energy  Conglomerate ± Mobil Oil and Montgomery Ward Finance 402 15 .

Finance 402 16 . ± This merger is supported by the management of both firms.Differentiate between hostile and friendly mergers  Friendly merger: ± Management of one firm (acquirer) agrees to buy another firm (target).

± Acquirer must go directly to the target firm¶s stockholders. ± Tender offer ± Proxy fights Finance 402 17 . Hostile merger: ± Target firm¶s management resists the merger. try to get 51% to tender their shares. when the offer price is raised. ± Often. mergers that start out hostile end up as friendly.

Merger Regulation . Finance 402 .The Williams Act of 1968  Acquirers must disclose their current holdings within 10 days of amassing 5% of company¶s stock  Acquirers must disclose source of funds to be used in the acquisition  Target firm¶s SH must be allowed at least 20 days to tender their shares  If the acquiring firm increases the offer price. all SH who tendered must receive the 18 higher price.

M & A ³Terms´  Poison Put  Poison Pill  White Knight  Shark Repellent  Greenmail  Golden Parachute  Super Majority  ESOP Finance 402 19 .

 It is hard to incorporate year-to-year changes in WACC in the corporate valuation model. Finance 402 20 .Reason for Adjusted Present Value (APV) Merger Analysis  Often in a merger the capital structure changes rapidly over the first several years.  This causes the WACC to change from year to year.

The Adjusted Present Value (APV) Model Value of firm if it had no debt + Value of tax savings due to debt = Value of operations First term is called the unlevered value of the firm. The second term is called the value of the interest tax shield... (More.) Finance 402 21 .

Interest tax savings = Interest(tax rate) = TSt . Value of interest tax shield = PV of interest tax savings at unlevered cost of equity.APV Model Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity. Finance 402 22 . rsU.

Finance 402 23 .Note to APV  APV is the best model to use when the capital structure is changing.  The Corporate Valuation model is easier than APV to use when the capital structure is constant²such as at the horizon.

2. Calculate WACC at horizon. horizon growth rate. Finance 402 24 . 5. all discounted at rsU. Calculate Vops as PV of FCFt. Calculate the unlevered cost of equity. TSt . TSt and horizon value. 3. rsU. Project FCFt . 4. and horizon capital structure.Steps in APV Valuation 1. Calculate horizon value using constant growth corporate valuation model.

7 0.5 10.0 37.0 16.5 25.0 $112.5 7.0 11.APV Valuation Analysis (In Millions) Free Cash Flows after Merger Occurs Net sales Cost of goods sold (60%) Selling/admin.0 15.0 22.8 18.5 76.5 9.5 16. expenses EBIT Taxes on EBIT (40%) NOPAT Net Retentions Free Cash Flow 2004 $60.8 11.0 7.7 25 From Mini Case in Chapter 25 Finance 402 .5 6.5 54.5 42.0 4.0 67.0 30.7 2005 2006 2007 $90.2 7.5 19.0 4.5 20.0 36.5 6.0 12.5 $127.

5 2. T = 40% Finance 402 26 .0 2.Interest Tax Savings after Merger 2004 2005 2006 2007 Interest expense Interest tax savings 5.6 6.0 2.6 7.5 2.8 Interest tax savings are calculated as interest(T).0 6.

Finance 402 27 .  Net retentions = gross retentions ± depreciation.What are the net retentions?  Recall that firms must reinvest in order to replace worn out assets and grow.

what is the appropriate discount rate to apply to the target¶s cash flows?  After acquisition. stockholders. (More. and others such as preferred stockholders.Conceptually. the free cash flows belong to the remaining debtholders in the target and the various investors in the acquiring firm: their debtholders...) Finance 402 28  These . cash flows can be redeployed within the acquiring firm.

 Free cash flow is the cash flow that would occur if the firm had no debt. interest tax shields are also discounted at the unlevered cost of equity.  The Finance 402 29 . so it should be discounted at the unlevered cost of equity.

Model when WACC is changing from year-to-year. Finance 402 30 . Val. Corp. Val. Model discounts FCF at WACC. which has a (1-T) factor to account for the value of the tax shield. Both models give same answer IF carefully done.Note: Comparison of APV with Corporate Valuation Model    APV discounts FCF at rsU and adds in present value of the tax shields²the value of the tax savings are incorporated explicitly. BUT it is difficult to apply the Corp.

so discount FCFs at WACC. so the corporate valuation model can be used.Discount rate for Horizon Value  At the horizon the capital structure is constant. Finance 402 31 .

84% Finance 402 32 .80(12.20(0.80(12.20(9%) + 0.Discount Rate Calculations rsL = rRF + (rM .2%) = 11.3 = 12.2%) = 10.2% rsU = wdrd + wsrsL = 0.rRF)bTarget = 7% + (4%)1.56% WACC = wd(1-T)rd + wsrsL =0.60)9% + 0.

7(1.3 million. or Continuing.06 = $453.1084  0. Finance 402 33 . Value (FCF2007 )(1  g) = WACC  g Horizon value = $20.06) 0.Horizon.

0 Total $13.3 2.8 $19.4 million.1156)1 + (1.1 $13.7 $13.7 Horizon value 453.8 Interest tax shield 2.1 = (1.6 2.5 $16.6 2.7 $476.1156)3 + (1.5 $ 20.1 $476.8 VOps $13.1156)4 = $344.7 $10.What Is the value of the Target Firm¶s operations to the Acquiring Firm? (In Millions) 2004 2005 2006 2007 Free Cash Flow $11.1156)2 + (1.1 $19. Finance 402 34 .

4 million = equity value of target to the acquirer.4 million ± 55 million = $289.  Vops ± debt = equity  344. Finance 402 35 .What is the value of the Target¶s equity?  The Target has $55 million in debt.

The cash flow estimates would be different. both due to forecasting inaccuracies and to differential synergies.Would another potential acquirer obtain the same value?  No. a different beta estimate.  Additionally. a different estimating procedure could result in a different discount rate. or tax rate would change the discount rate. financing mix.  Further. Finance 402 36 .

. the target¶s value is increased by $69.) Finance 402 37 .0million Merger premium = $ 69.4 million Presumably. although realizing such synergies has been problematic in many mergers..4 million due to merger synergies.4 million Target¶s current value = $220.Estimate of target¶s value = $289. (More.

The stock last traded at $11 per share.Assume the target company has 20 million shares outstanding. which reflects the target¶s value on a stand-alone basis. How much should the acquiring firm offer? Finance 402 38 .

At $14. The graph on the next slide summarizes the situation.4/20 = $14. Finance 402 39 . all merger benefits would go to the acquiring firm¶s shareholders. At $11.47 per share.    The offer could range from $11 to $289.47. all value added would go to the target firm¶s shareholders.

00 0 5 10 15 $14.Change in Shareholders¶ Wealth Acquirer Target $11.47 20 Price Paid for Target 40 Bargaining Range = Synergy Finance 402 .

Most of the time the target¶s stockholders receive the vast (More. other firms will come in. price will be bid up. is good fit for many acquirers. Higher if target is in better bargaining position.Points About Graph  Nothing  Actual magic about crossover price. Finance 402 41  If target . lower if acquirer is.. price would be determined by bargaining. could be close to $11. If not.) majority of the benefits..

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? Finance 402 42 . or low bid and then plan to go up.Acquirer might want to make high ³preemptive´ bid to ward off other bidders.

it is easy to incorporate that difference)  Long term rsLwill change. so horizon value will change. .What if the Acquirer intended to increase the debt level in the Target to 40% with an interest rate of 10%?  Free cash flows wouldn¶t change  Assume interest payments in short term won¶t change (if they did. so horizon WACC will change.

6(12.6%) = 9.10%)(0.New WACC Calculation New rsL = rsU + (rsU ± rd)(D/S) = 11.56% + (11.4/0.96% All data are from the mini case. Finance 402 44 .4) + 0.4(10%)(1-0.60% New WACC = wdrd(1-T) + wsrsL = 0.56% .6) = 12.

06 = $554.0996  0.7(1.1 million. Finance 402 45 .New Horizon Value Calculation Horizon value (FCF2007 )(1  g) = WACC  g = $20.06) 0.

8 Interest tax shield 2.6 2.7 $10.5 million.1156)1 + (1.5 $ 20.0 Total $13.6 $19.6 VOps $13.1 $577.7 $13.5 $16.1156)2 + (1.1 = (1.New Vops and Vequity 2004 2005 2006 2007 Free Cash Flow $11.1156)3 + (1.7 Horizon value 554.6 2.1 $13.1156)4 = $409.1 2.7 $577.1 $19. Finance 402 46 .

1 million.New Equity Value  $409.  The added value is the value of the additional tax shield from the increased debt. or $3.5 million .55 million = $354.5 million  This is $65. Finance 402 47 .26 per share more than if the horizon capital structure is 20% debt.

. Only purchase accounting may be used now.) Finance 402 48 . (More.What method is used to account for for mergers?  Pooling of interests is GONE..

± Goodwill is often created. ± Common equity account is increased to balance assets and claims. Finance 402 49 . which appears as an asset on the balance sheet. Purchase: ± The assets of the acquired firm are ³written up´ to reflect purchase price if it is greater than the net asset value.

± AOL Time Warner wrote down $54 billion of goodwill in 2002 because of ³impairment test. Otherwise it is not.  Goodwill is subject to an annual ³impairment test.´  Goodwill is still amortized for Federal Tax purposes. Can amortize goodwill over 15 years using straight-line method.Goodwill Amortization  Goodwill is NO LONGER amortized over time for shareholder reporting. Finance 402 50 .´ If its fair market value has declined. then goodwill is reduced.

such as Corporate Culture.´ ± Who will run the combined company? ± What will be the name of the combined firm? ± Where will the headquarters be located? Finance 402 51 . marketing philosophies.Corporate Culture  Should also consider factors other than cash flows. and personnel policies.  Merger talks often collapse because of ³social issues´ and ³chemistry.

Merger of Equals  Steps: ± Develop pro forma financial statements for the consolidated corporation. Finance 402 52 .Analysis for a ³True Consolidation´ . and use that rate to discount the free cash flows and interest tax shields of the consolidated company. ± Decide how to allocate the new company¶s stock between the two sets of old stockholders. ± Estimate the new company¶s unlevered cost of equity. Determine the projected consolidated free cash flows available to stockholders.

What merger-related activities are undertaken by investment bankers?         Identify targets Help arrange mergers ± No ³parked stock´ Develop defensive tactics Value target companies Help finance mergers Invest in stocks of potential merger candidates Arbitrage operations Trend is away from using investment bankers. especially for smaller deals Finance 402 53 .

Do mergers really create value? 

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. 

Finance 402


± Studies show stock price of target firms

increase by 30% in hostile tender offers, while in friendly tender offers, the increase is 20%.

Finance 402


Merger Failures 
61% of

buyers destroyed their own shareholder¶s wealth  In April 2002, AOL Time Warner took a $54 billion charge  17 out of the 21 ³winners´ in the merger spring of 1998 were a ³bust´ for investors who owned the shares
Finance 402 56

damaging the business and losing key personnel Finance 402 57 .Reasons for Merger Failure  Overpay by a sizeable premium  Overestimate likely cost savings and synergies  Delay over integrating operations after merger  Emphasis on cost-cutting.

Other Failure Results  TYCO ± Paid $11.7 billion)       WorldCom AT&T Vivendi Cisco Systems Conseco First Union Corp Finance 402 58 .6 billion in July 2002 (loss of 6.3 billion for CIT in June 2001 and completed an IPO for $4.

Reasons why alliances can make more sense than acquisitions  Joint Venture  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 Finance 402 59 .

Can be a subsidiary of a public company. usually including current management.  Purchase often financed mostly with debt. acquires a firm in a transaction financed largely by borrowing.´  Very prevalent during the 1980s 60 Finance 402 .´ Typically buy publicly held stock.  After operating privately for a number of years. They ³go private.Leveraged Buyout (LBO)  A small group of equity investors. investors might take the firm public to ³cash out.

2003 ± DuPont sold its Invista textiles unit to Koch Industries for $4. Nov.4 billion Finance 402 61 . 2003 ± Investor Group purchased Aladdin Resort & Casino for $500 million Nov. LBOs accounted for almost 10% of all mergers & acquisitions. 17. LBOs were up 50% vs.73 Billion April. 2002 ± Northrop Grumman Corp. sold TRW Automotive Business to Blackstone for $4. 2002. 19. their largest share since 1989. In the third quarter of 2002.Leverage Buyout (LBO) Continued     Between January 2002 and November 6. the same period the previous year to $20 billion.

What are are the advantages and disadvantages 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  How to exit an LBO ± Go Public ± Sell to another company ± Another LBO Finance 402 62 .

so the parent gains new equity financing yet retains control Philip Morris and Kraft  Outright liquidation  of assets 63 Woolworth Finance 402 .Types of Divestitures  Sale of  an entire subsidiary to another firm Target and Marshall Field Spinning off a corporate subsidiary by giving stock to existing shareholders AT&T and Lucent Technologies  Spin-Off    Carve  Out  A minority interest in a corporate subsidiary is sold to new shareholders.

 To get needed cash when distressed.  To change strategic direction. Finance 402 64 .What motivates firms to divest assets?  Subsidiary worth more to buyer than when operated by current owner.  Subsidiary¶s value increased if it operates independently.  To settle antitrust issues.  To shed money losers.

one purchaser at a time  Have to decide what it is worth to someone else  Typically an admission of failure  Hurts the Balance Sheet and benefits the Income Statement  Risks and Returns are different Finance 402 65 . Acquisitions  Not the ³opposite side of a coin´ of an acquisition  Like selling a house.Divestitures vs.

typical holding company.What are holding companies? A holding company is a corporation formed for the sole purpose of owning the stocks of other companies. sells stock to individual investors. which. the subsidiary companies issue their own debt. Finance 402 66  In a . in turn. but their equity is held by the holding company.

Holding Companies Advantages and Disadvantages  Advantages  Disadvantages ± Control with ± Partial Multiple fractional ownership ± Isolation of risks (but often the parent is still responsible) Finance 402 Taxation ± Ease of enforced dissolution 67 .

Conclusion         Merger Trends Reasons for Mergers Types of Mergers Merger Analysis Accounting for Mergers Leveraged Buyouts Divestitures Holding Companies Finance 402 68 .

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