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17 .

Merger activity Changes forces and other M&A catalysts Alternative strategies for growth Theories related to M&A Empirical tests of M&A General acquisition programs & processes Sound strategies for M&As 2002 Sales of Hershey

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Acquisition Decision
Strategic Implications Economic Implications Accounting Implications Ultimate Management Decision
Capital Investment Marketing Integration Production Etc., Etc., Etc.

17 .3

Table 17.1 Merger Announcements


Number of Transactions Valued at 2000 $100 GDP Constant Million or $1 Billion Deflator Dollar More or More (2000=100) ($ Billion) 14 0 38.0 $ 31.1 39 0 40.2 49.8 41 1 42.8 51.2 80 0 45.8 74.7 83 3 49.5 87.8 94 113 116 138 200 270 346 301 369 328 181 150 200 242 383 462 640 873 906 1,097 1,150 703 608 654 841 963 4 12 6 11 18 36 27 36 45 35 21 13 18 27 51 74 94 120 158 195 206 121 72 88 134 170 54.0 59.1 62.7 65.2 67.7 69.7 71.3 73.2 75.7 78.6 81.6 84.4 86.4 88.4 90.3 92.1 93.9 95.4 96.5 97.9 100.0 102.4 104.2 106.3 109.1 112.2 82.0 139.7 85.8 112.1 180.6 257.9 242.9 223.6 326.2 281.5 132.6 84.3 111.9 199.6 251.2 386.5 527.4 688.7 1,235.5 1,457.0 1,325.7 683.0 422.9 474.7 688.1 901.1

Year 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Total Dollar Value Paid ($ Billion) $ 11.8 20.0 21.9 34.2 43.5 44.3 82.6 53.8 73.1 122.2 179.8 173.1 163.7 246.9 221.1 108.2 71.2 96.7 176.4 226.7 356.0 495.0 657.1 1,191.9 1,425.9

Number Total 2,297 2,276 2,224 2,106 2,128 1,889 2,395 2,346 2,533 2,543 3,011 3,336 2,032 2,258 2,366 2,074 1,877 2,574 2,663 2,997 3,510 5,848 7,800 7,809 9,278

Percent Change 60.2% 3.0% 45.9% 17.5% -6.6% 70.4% -38.6% 30.7% 61.1% 42.8% -5.8% -7.9% 45.8% -13.7% -52.9% -36.4% 32.8% 78.3% 25.8% 53.9% 36.5% 30.6% 79.4% 17.9% -9.0% -48.5% -38.1% 12.2% 45.0% 31.0%

2000 1,325.7 9,566 2001 699.4 8,290 2002 440.7 7,303 2003 504.6 7,983 2004 750.7 9,783 2005 1,011.0 10,332 Source: Mergerstat Review .

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Table 17.2

Announced World M&A Activity Worldwide M&A Activity ($Billions)


1998 1999 2000 2001 2002 2003 2004 2005

Non-US US Total %US

647 $ 914 $ 1,664 $ 829 $ 647 $ 599 $ 649 $ 1,062 1,374 1,423 1,782 1,156 625 522 857 981 $ 2,020 $ 2,337 $ 3,445 $ 1,985 $ 1,272 $ 1,121 $ 1,506 $ 2,043 68.0% 60.9% 51.7% 58.2% 49.1% 46.5% 56.9% 48.0%

In non-US mergers, a U.S. company is neither a buyer nor target. U.S. mergers include those in which a U.S. firm is either a buyer or a target. Source: SDC data in Mergers & Acquisitions , 2006 Almanac, February 2006.

17 .5

Rank 1 2 3 4 5 6 7 8 9 10

Buyer Pfizer Inc.. America Online Inc. Exxon Corp. SBC Communications Inc. Vodafone Group pic - UK Bell Atlantic Corp. Pfizer Inc. Procter & Gamble Co. JPMorgan Chase & Co. Inc. British Petroleum Co. plc - UK

Price Offered Seller ($ Millions) Warner-Lambert Co. $116,705.4 Time Warner Inc. 101,002.5 Mobil Corp. 81,429.8 Ameritech Corp. 75,233.5 Air Touch Communications Inc. 62,768.0 GTE Corp. 60,489.9 Pharmacia Corp. 58,293.8 Gillette Co. 57,920.3 Bank One Corp 57,614.9 Amoco Corp. 56,482.0

Year Announced 1999 2000 1998 1998 1999 1998 2002 2005 2004 1998

Source: Mergerstat

17 .6

Strategic Financial Management: Applications of Corporate Finance Samuel C. Weaver and J. Fred Weston

17 .7

Decision reflects two main forces (neoclassical theory of microeconomics) Timing of merger activity (merger waves) explained by macroeconomic forces
Levels of economic activity (GDP) Stock Price movements Financing conditions Managers want to enhance the long run value of the firm by making positive Net Present Value Investments Change forces may require a firm to make adjustments Multiple activities seek to enhance capabilities Adjustments to shocks Enhancing Capabilities

Value Enhancement

17 .8

1.

2.

3. 4.

5. 6.

Acceleration of the pace of technological change The reduction of costs of communication and transportation Internationalization of markets The expansion of the forms, sources, and intensity of competition Emerging new industries The increase of regulation in some industries and deregulation in others
17 .9

Overriding the change forces are technological change Nations have also adopted international agreements that have resulted in freer trade Impact of economic forces in merger activities
Technological change affects optimal firm size, inducing restructuring Deregulation influences ease of entry in an industry and the scope Changing input costs provide impetus for merger activities
17 .1 0

Change Forces
1. Technology change

Industries
Broadcasting, Entertainment Internet Packaging & Containers Computers Apparels, Textiles Metals & Mining Financial Services Chemical Food Processing Automobile Staffing services Rental equipment Pharmaceuticals Coal, uranium, geothermal Integrated petroleum Oilfield services Air transport Broadcasting, Entertainment Truck & Transport Leasing Pharmaceuticals Petroleum producing Telecommunications Tire & Rubber Retailing Defense Packaging & Containers Tire & Rubber Wireless Pharmaceuticals Toiletries & Cosmetics Integrated steel Facility services Electrical contracting

2. Globalization

3. Commoditization 4. Low growth 5. Chronic excess capacity (consolidation) 6. Fragmentation (rollups) 7. Large capital investment subject to high risks 8. Price volatility

9. Deregulation

Medical services Natural gas Financial Services Computers


17 .1 1

10. Augment Capabilities

Economic rationale for mergers


They can be positive net present value investments If value of combined firms is greater than individual values of entities before the merger, the merger increases value

Synergy of positive net present value investments NVI = VBT (VB + VT)
where: NVI = Net value increase VB = Value of Bidder alone VT = Value of Target alone VBT = Value of firms combined

17 .1 2

Economies of Scale Economies of Scope Extending Technological Capabilities Industry Consolidation Strategies Industry Roll-ups New Capabilities and Managerial Skills First Mover Advantages Customer Relationships Globalization

17 .1 3

Measure of managerial efficiency


Ratio of the market value of the firms debt and equity to the replacement cost of its assets During the late 1970s and early 1980s, the qratio ran between 0.5 and 0.6. In other words, it was cheaper to acquire a firm rather than build additional capacity from scratch.

17 .1 4

Source Operations Financial Market Power

Impact Economies of scale that increase productivity or decrease costs. Lower transaction costs or tax gains Reduced competition Total

% 89.9 5.8 4.3 100.0

Source: Merger Motives and Target Valuation: A Survey of Evidence from CFOs, Mukherjee, Tarun K., Halili Kiymaz, and H. Kent Baker, Journal of Applied Finance, Fall/Winter 2004, Volume 14, Number 2, pp. 7-24.

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Alternative Business Arrangements

17 .1 6

1. Internal projects Investment expansions developed within the firm. 2. Mergers Any transaction that forms one economic unit from two or more previous units. The equity or ownership stock of the target is acquired. All of the liabilities of ownership carry over to the acquiring firm. 3. Joint ventures A combination of subsets of assets contributed by two (or more) business entities for a specific business purpose and a limited duration 4. Alliances More informal inter-business relations 5. Licensing Developing proprietary technology for rent to others 6. Minority investments A small fraction, usually less than 5%, of the equity of the target is acquired. This gives the acquiring firm increased knowledge of the activities of the relatively new area represented by the investment. 7. Share Repurchase An announcement of a repurchase of the firms own shares generally in the open market.
17 .1 7

Separate business entity Limited in scope and duration Objectives achieved through joint venture
Opportunity to share risks Reduce Investment costs Enjoy benefits of economies of scale, critical mass Allow firms the opportunity to gain and share knowledge

Advantageous in international setting Serve as interim step before a firm buys a segment of another firm
Gives selling firm opportunity to demonstrate knowledge Determine a price which was uncertain before the join venture Minimizes employee turnover Avoids impairment of supplier and distribution networks
17 .1 8

Combine assets without violating acquisition regulations of local governments Used to circumvent international trade barriers

Less formal than joint ventures May involve multiple partners where mutual trust is required Speed of change in relationship may be rapid Advantages: Characteristics
No new entity or formal contract

Provide flexibility because of informality Provide firms with access to new markets and technologies with relatively small investments Difficult to predict the way relationship will evolve Initial understandings may have to focus on adaptability to change rather than future success
17 .1 9

Table 21.8 Acquisitions vs. Joint Ventures vs. Strategic Alliances


Acquisition Allows 100% control No need for inter-firm consensus Less flexible Larger commitment of resources Risky Often acquire more than is needed May cause upheaval in corporate culture May require accommodating different management systems Requires combining, harmonizing information systems Requires combining different corporate cultures Requires rapid, effective integration Remedy for strategic miscalculations Most cost-cutting possible Can have partial investments as an interim step Can be across borders Joint Venture Firms intersect over narrow, well-defined segments Exploit distinctive or narrow opportunities Generally only two firms involved Limited risk Joint production of single products Combines known resources Require high level management interaction Rarely used in new markets or technologies Can be used to reduce risk in a merger transaction Often across borders Tensions: Your firm wants to learn as much as possible, but not to convey too much Strategic Alliance Useful for creation of complex systems between multiple firms Blurs corporate boundaries Partner is usually larger than in JVs (10/1 vs. 5/1) Allows firms to focus on fewer core competencies Less clear contributions and benefits Difficult to anticipate consequences Gives firms access to people who would not work directly for them Often small resource commitment Limited time duration Must be managed actively by senior executives The relationship is likely to evolve in directions not initially planned Managing over time requires adaptability to change and new knowledge Especially useful across borders Replacement for government prohibited cross border mergers

17 .2 0

Benefits Learn new areas Combine best practices Increase demand for products Add capabilities Add products Add markets Speed Costs known Avoid antitrust Clarity

Internal L L L L L L L L H H

Merger H H M H H H H M L M

JV H M M H M M M H H L

Alliance H M L M L M M M H L

Licensing H L L L L H H L H H

Investment H M H M L L M H M M

*Strength of benefit: High, Medium, Low

17 .2 1

17 .2 2

Winners Curse
When there are many bidders, a wide range of bids is likely to result The winning bidder will be the highest bidder and will typically pay in excess of the expected value. Thus, the winner is cursed. Excessive self confidence of the bidders A factor that causes the winners curse phenomenon to occur The competition of other bidders could cause the winning bidder to pay too much

Hubris

17 .2 3

Theory of Mergers
Shleifer and Vishny
Theory based on overvaluation of bidders and undervaluation of targets Financial markets are inefficient, but bidders and targets have perfect information

Roll
Financial markets are efficient, but bidders are irrational (winners curse)

Neo-classical theory
M&As exist to help firms adjust to change or extend their capabilities Firms are rewarded when the merger makes economic sense and punished if not

17 .2 4

Agency problems arise because managers are only a fraction of the ownership of the firms Compensation arrangements and market for managers may mitigate the agency problem
Compensation is tied to good performance The importance of a good reputation for managers May work less vigorously Consume more perquisites

Market takeovers provides an external control device of last resort


Takeover through a tender offer or proxy fight enables outside managers to gain control
17 .2 5

Free Cash Flow Hypothesis (FCFH)


Definition: cash flow in excess of the amounts required to fund all projects that have positive net present values when discounted at their applicable costs of capital FCF must be paid out to shareholders if the firm is to be efficient and to maximize its share price
This reduces the amount of resources under the control of managers, thereby reducing their power

It is important for managers to bond their promise to pay out future cash flows
This is more effective than any divided policy

17 .2 6

Before their merger announcement, each of the two individual companies was $333 billion (January 10, 2000) By August 1, 2003 their combined market value was $70 billion The AOL segment performed poorly following the merger because its business model had become obsolete

Faced similar situation to that of AOL following the collapse of internet advertising in 2000 Yahoos stock had fallen from $215 to $9 by September 2001 Yahoo brought in Terry Semel to become CEO who revitalized Yahoo! and brought its stock back over $37

Yahoo! used a combination of methods AOL sought a big merger to address its difficulties a. Revitalizing advertising with new approaches b. Migrating services it had provided for free to enhanced pay services c. Acquisitions in Key Areas
17 .2 7

Acquisition Scorecard

17 .2 8

Success or Failure?
With So Much on the Line, With Everyone Doing It, With All of the Scrutiny, With All of the Money, Time, Energy, and Effort,

How Successful Are Acquisitions??


17 .2 9

17 .3 0

* Cumulative abnormal returns represent the stocks daily returns (less the return of the overall
market). These daily abnormal returns are then accumulated or the period of time.
17 .3 1

* Cumulative abnormal returns represent the stocks daily returns (less the return of the overall
market). These daily abnormal returns are then accumulated or the period of time.
17 .3 2

Pattern of Gains Related to Takeover Theories


(1) Total Value + 0 (2) Gains to Target + + + (3) Gains to Acquirer +

Type I. Efficiency or synergy II. Hubris (winner's curse, overpay) III. Agency problems or mistakes
Source: Berkovitch and Narayanan, 1993.

17 .3 3

Event returns
Stock for stock mergers: target firms gain on average about 15%-20% Cash mergers: abnormal returns to targets 25%-30-40% On average bidders have zero abnormal returns which implies that they earn only their cost of capital. Combined event returns are positivethe combinations are value increasing.

Longer Run Performance Studies


Reliability of event studies is questioned because its longer term results that matter However, event returns represents the markets best judgment of long run prospects. Healy, Palepu, and Ruback (1992): 50 large mergers, industry adjusted performance measures were improved in the long run. Initial event returns were consistent with the longer term accounting performance.

17 .3 4

Buyer Size and Target Ownership Form


Harding and Rovit (2004)
There is a positive relation between annual returns and experience. Integration problems are greater in combining larger firms

Analysis of Frequency Distribution of Returns


Hazelkorn, Zenner, and Shivdasani (2004) study
There exist winners and losers, even though the average return is zero Acquisitions outperform that of public companies Focused acquisition outperform diversification Foreign acquisitions yielded higher returns that domestic Returns higher for smaller transactions
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17 .3 6

Discounted cash flow at targets cost of capital Value is driven by:


Sales growth Margins Tax rate Working capital investment Fixed capital investment Cost of capital Residual value

17 .3 7

DCF Model introduced in Chapter 12 Comparables


Price to sales Price to earnings Price to book value Price to EBITDA Numerous other general and industry metrics

Must always be considered within the context of the industry.

17 .3 8

Valuation Approaches
Valuation of continuing operations Valuation of combined businesses
Synergies
Operational benefits as a result of the combination

Synergies that accrue to the target Synergies that accrue to the buyer

Consideration of alternatives

17 .3 9

Table 17.8 (also Table 12.4)

Comprehensive Valuation Model


Including Terminal Year ($ Millions)

Year 1 2006

Year 2 2007

Year 3 2008

Year 4 2009

Year 5 2010

Year 6 2011

Year 7 2012

Year 8 2013

Panel A - Projected Free Cash Flow


Net Reveneue Cost of sales (excluding depreciation) Selling, marketing, and administrative Depreciation Operating Income Taxes After Tax Operating Income % of Sales Depreciation Working Capital Investment Capital Expenditures Free Cash Flow % of Sales Terminal Value Present Value $ 5,025.4 8-Year Total 9,936.5 Terminal Value $ 14,961.9 Value of the Operations $ 717.8 $ 659.3 $ 661.2 $ 631.4 $ 616.4 $ 604.0 $ 582.7 $ $ 5,077.8 2,894.3 949.5 204.4 1,029.6 381.0 648.6 12.8% 204.4 108.7 (185.0) 776.7 $ 15.3% $ 5,331.7 3,017.7 986.4 218.1 1,109.5 410.5 699.0 13.1% 218.1 44.7 (190.0) 771.8 $ 14.5% $ 5,571.6 3,136.8 1,019.6 232.6 1,182.6 437.6 745.0 13.4% 232.6 60.0 (200.0) 837.6 $ 15.0% $ 5,794.5 3,244.9 1,048.8 247.6 1,253.2 463.7 789.5 13.6% 247.6 28.3 (200.0) 865.4 $ 14.9% $ 6,026.3 3,356.6 1,078.7 263.1 1,327.9 491.3 836.6 13.9% 263.1 24.4 (210.0) 914.1 $ 15.2% $ 6,207.1 3,444.9 1,098.7 279.1 1,384.4 512.2 872.2 14.1% 279.1 27.8 (210.0) $ 6,362.3 3,512.0 1,113.4 295.6 1,441.3 533.3 908.0 14.3% 295.6 28.1 (220.0) $ 6,521.4 3,599.8 1,141.2 312.6 1,467.8 543.1 924.7 14.2% 312.6 20.7 (220.0)

969.1 $ 1,011.7 $ 1,038.0 15.6% 15.9% 15.9% $ 18,665.8 $ 552.6 $ 9,936.5

Panel B - Valuation Model Relationships


Year 0 Revenue Revenue growth Tax rate % of Sales Cost of sales (excluding depreciation) Selling, marketing, and administrative Expenses excluding depreciation Operating margin before depreciation Fixed capital investment Depreciation (% of Sales) Net, fixed investment Working capital (dis) investment Cost of Capital $ 4,836.0
5.00% 37.00% 57.00% 18.70% 75.70% 5.00% 37.00% 56.60% 18.50% 75.10% 4.50% 37.00% 56.30% 18.30% 74.60% 4.00% 37.00% 56.00% 18.10% 74.10% 4.00% 37.00% 55.70% 17.90% 73.60% 3.00% 37.00% 55.50% 17.70% 73.20% 2.50% 37.00% 55.20% 17.50% 72.70% 2.50% 37.00% 55.20% 17.50% 72.70%

24.30% 3.64% 4.03% 0.38% -2.14% 8.20%

24.90% 3.56% 4.09% 0.53% -0.84%

25.40% 3.59% 4.17% 0.59% -1.08%

25.90% 3.45% 4.27% 0.82% -0.49%

26.40% 3.48% 4.37% 0.88% -0.40%

26.80% 3.38% 4.50% 1.11% -0.45%

27.30% 3.46% 4.65% 1.19% -0.44%

27.30% 3.37% 4.79% 1.42% -0.32%

17 .4 0

In order to justify a 40% premium on Hershey, the bidder would have to assume:
Increased sales growth:
Sales Growth Original Revised 2006 5.0% 10.0 2007 5.0% 12.0 2008 4.5% 8.0 2009 4.0% 6.0

Reduced expenses (SG&A) 3% points per year Realize $67.2 million reduction in other expenses of the combined entity.

17 .4 1

Table 17.9

Comprehensive Valuation Model


Including Terminal Year ($ Millions)

Year 1 2006

Year 2 2007

Year 3 2008

Year 4 2009

Year 5 2010

Year 6 2011

Year 7 2012

Year 8 2013

Panel A - Projected Free Cash Flow


Net Reveneue Cost of sales (excluding depreciation) Selling, marketing, and administrative Depreciation Acquirer's synergies - additional expense reductions Operating Income Taxes After Tax Operating Income % of Sales Depreciation Working Capital Investment Capital Expenditures Free Cash Flow % of Sales Terminal Value Present Value $ 6,724.2 8-Year Total 13,490.0 Terminal Value $ 20,214.1 Value of the Operations $ 884.0 $ 869.1 $ 893.1 $ 868.2 $ 844.4 $ 823.3 $ 791.9 $ $ 5,319.6 3,032.2 835.2 214.1 (67.2) 1,305.3 483.0 822.3 15.5% 214.1 113.9 (193.8) $ 5,958.0 3,372.2 923.5 243.7 (67.2) 1,485.8 549.7 936.1 15.7% 243.7 50.0 (212.3) $ 6,434.6 3,622.7 984.5 268.6 (67.2) 1,626.0 601.6 1,024.4 15.9% 268.6 69.3 (231.0) $ 6,820.7 3,819.6 1,029.9 291.4 (67.2) 1,747.0 646.4 1,100.6 16.1% 291.4 33.3 (235.4) $ 7,093.5 3,951.1 1,056.9 309.7 (67.2) 1,843.0 681.9 1,161.1 16.4% 309.7 28.7 (247.2) $ 7,306.3 4,055.0 1,074.0 328.5 (67.2) 1,916.0 708.9 1,207.1 16.5% 328.5 32.7 (247.2) $ 7,489.0 4,133.9 1,085.9 347.9 (67.2) 1,988.5 735.7 1,252.8 16.7% 347.9 33.1 (259.0) $ 7,676.2 4,237.3 1,113.0 368.0 (67.2) 2,025.1 749.3 1,275.8 16.6% 368.0 24.4 (259.0)

956.5 $ 1,017.5 $ 1,131.3 $ 1,189.9 $ 1,252.3 $ 1,321.1 $ 1,374.8 $ 1,409.2 18.0% 17.1% 17.6% 17.4% 17.7% 18.1% 18.4% 18.4% $ 25,340.9 $ 750.2 $ 13,490.0

Panel B - Valuation Model Relationships


Year 0 Revenue Acquirer's Synergies Revenue growth Tax rate % of Sales Cost of sales (excluding depreciation) Selling, marketing, and administrative Expenses excluding depreciation Operating margin before depreciation Fixed capital investment Depreciation (% of Sales) Net, fixed investment Working capital (dis) investment Cost of Capital $ 4,836.0 $ 67.2
10.00% 37.00% 57.00% 15.70% 72.70%

67.2
12.00% 37.00% 56.60% 15.50% 72.10%

67.2
8.00% 37.00% 56.30% 15.30% 71.60%

67.2
6.00% 37.00% 56.00% 15.10% 71.10%

67.2
4.00% 37.00% 55.70% 14.90% 70.60%

67.2
3.00% 37.00% 55.50% 14.70% 70.20%

67.2
2.50% 37.00% 55.20% 14.50% 69.70%

67.2
2.50% 37.00% 55.20% 14.50% 69.70%

24.30% 3.64% 4.03% 0.38% -2.14% 8.20%

24.90% 3.56% 4.09% 0.53% -0.84%

25.40% 3.59% 4.17% 0.59% -1.08%

25.90% 3.45% 4.27% 0.82% -0.49%

26.40% 3.48% 4.37% 0.88% -0.40%

26.80% 3.38% 4.50% 1.11% -0.45%

27.30% 3.46% 4.65% 1.19% -0.44%

27.30% 3.37% 4.79% 1.42% -0.32%

17 .4 2

Present Value
($mms)

Explicit Period Terminal Value Enterprise Value

$ $

6,724.2 13,490.0 20,214.2 20,214.2 67.2 (1,762.0) 18,519.4 240.5 77.00


17 .4 3

Add: Less:

Value of the Operations $ Cash and equivalents Interest bearing debt Value of the Equity $ Shares outstanding Value per share

Valuation Methodology Valuation of publicly traded targets Discounted cash flow (DCF) approach DCF along with market multiples Market multiples only Other Total Valuation of private targets Discounted cash flow approach Industry price-to-earnings approach Industry price-to-book approach Other Total

% 49.3 33.3 12.0 5.4 100.0 48.4 31.3 6.3 14.1 100.0
17 .4 4

Source: Merger Motives and Target Valuation: A Survey of Evidence from CFOs, Mukherjee, Tarun K., Halili Kiymaz, and H. Kent Baker, Journal of Applied Finance, Fall/Winter 2004, Volume 14, Number 2, pp. 7-24.
Strategic Financial Management:

When you acquire a business:


Say, you pay $100mm for a business Get assets valued at $60mm and liabilities of $15mm or in total net assets of $45mm. Paid $100mm so the remaining $55mm is Goodwill Goodwill is formally called, Intangibles Resulting from Business Acquisitions

Amortization or expensing
Old approach: Amortized the Goodwill over 40 years (straightline) New approach:
Revalue the business every year If no change in fair value no expense. If the fair value falls below $100mm to say $80mm, then $20mm of asset impairment must be expensed.
17 .4 5

General Acquisition Programs

17 .4 6

Acquisition Process
Hit List Companies that are reviewed on a continuous basis in case the company gets put in play Suitor Courting a company for an extended period of time Sealed bid offer (most common)

Valuation Focused

17 .4 7

Most acquisitions (90%) are of privately held companies, divisions, or brands A Bidder receives an initial contact from sellers investment bank
Initial level of interest Offering document Preliminary non-binding indication of value (6 weeks) Top 3 indication of value bidders move on to Round 2 Plants visits Discussion with management Data room provided for due diligence Final value, binding, sealed bid 4 weeks later

Round 2

17 .4 8

40-70 Pages Company history and overview Discussion of business


Major products, markets, customers, suppliers

Discussion of management team Discussion of production facilities


Location Employees including union status

Financials
Generally limited historical data for 2-5 years
17 .4 9

Presentation to Senior Management and the Board of Directors Focus on strategic rationale and financial valuation
Joint presentation Operation managers
Present, review, discuss, and agree to assumptions

Finance
Base case valuation with sensitivity analysis Financing

17 .5 0

17 .5 1

A conceptual framework for sound strategic M&A decisions include a number of principles
1. 2. 3. 4. 5. Successful M&As must take place within the framework of a firms strategic planning processes. M&As encompass the use of multiple methods of adjustments: merger, divest, ally, invest, share repurchases, LBOs. The multiple adjustments are made repeatedly over extended time periods. M&As alone cannot create a strong firm. To achieve higher returns to shareholders than its comparison firms requires an effective organization and strong portfolio of growth opportunities and effective organization. The firm must have strength in markets in which its core capabilities give it a competitive advantage. In each market area the firm must achieve competitive leadership or divest the segment.
17 .5 2

6. 7.

A conceptual framework for sound strategic M&A decisions include a number of principles (continued)
8. The combination of internal programs and M&As are required for continued leadership. 9. The firm must have a group of officers that develop experience in all forms of M&As and continuously react with the top executive. 10.All segments of the firm must recognize its multiple strategies and make contributions to overall results based on boundaryless intersections. 11.Continuous reviews of managers based on their plans, programs, and executions must be conducted by the top executives. 12.Managers who do not execute must be replaced. 13.Executive compensation must be based on performance meaningfully measured. 14.The chairman and/or president needs to interact continuously to provide inspiration and executive development. 15.The system must select and develop managers with dedication, passion, and leadership.
17 .5 3

1. 2. 3. 4. 5. 6. 7. 8. 9.

Diversification destroys value; focus conserves value. Expected synergies are important drivers of value creation. Value acquiring pays; glamour acquiring does not. M&A to build market power (market share) does not pay. Paying with stock is generally costly; while paying with cash is neutral. M&A regulation is costly to investors. Tender offers create value for bidders. When managers have more at stake, more value is created. Initiation of an M&A program creates value for the buyer.
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Source: Does M&A Pay? A Survey of Evidence for the Decision-Maker, Bruner, Robert F., Journal of Applied Finance, Spring/Summer 2002, Volume 12, Number 1, pp. 7-27.

Table 17.12 Why Acquisitions Fail? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Ineffective integration poorly planned, poorly executed, too slow, too fast Culture clashes No business-economic logic to the deal Businesses unrelated bad fit Did not understand what they bought Internet, high tech Unduly hyped by investment bankers, consulting firms, and/or lawyers Underestimated regulatory delays or prohibitions Hubris of top executives ambition to run a bigger firm and increase salary Top executives want to cash out stock options Suppression of effective business systems of target firms, destroying the basis of their prior success Too much debt future interest payments a burden Too much short term debt repayment before synergies are realized Power struggles or incompatibility in new boardroom Mergers of equals delay requisite decisions Target resistance white knights, scorched earth, antitrust Multiple bidders cause overpayment Hostile takeovers prevent obtaining sufficient information, fail to uncover basic incompatibilities or create resentment and persistent ill will Basic industry problems such as overcapacity (autos, steel, telecoms) Overoptimistic expected synergies Pay too much

17 .5 5

Hershey Foods Sale 2002

17 .5 6

Established by Milton Hershey Almost 100 Years Ago


Founded an Orphanage Milton Hershey School 1909 Company Went Public in 1927 Trust Established to Oversee the Affairs of the School

Super Voting Stock Introduced in 1984


10 Votes Per Share Firmed the Trusts Majority Ownership 35% of the Shares; 77% of the Votes

Almost $1.2 Billion Shares Repurchased from Trust in the 1990s


17 .5 7

Before Hershey Became an Acquisition Target New Marketing Oriented CEO from Nabisco
Changing Approach to Going to Market Late 2001 Voluntary Work Force Reduction Program (i.e., Early Retirement Package) Plant and Product Rationalizations Leading to Cost Reductions

Continued Tradition of Excellence


Highly Ethical Firm Strong Operational and Financial Performance
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Established Solely for the Benefit of the Milton Hershey School Endowment Portfolio of $6 Billion
Hershey Foods is 50%-60% Decade Ago Hershey Foods was 80%-90% One of the Top Five School Endowments in the Country, Behind Harvard, Princeton, etc.

Owns 100% of Hershey Entertainment and Resort Corporation Significant (10,000 acres) of Landing Holdings Attorney Generals Office Suggests Diversification

17 .5 9

July 25, Trust Confirms It Is Exploring Possible Sale of Hershey Foods


July Share Price $60-63 Immediately Skyrocketed to $79

First Reports Estimate Value of $12 - $15 Billion


$88 to $100+ Per Share

Business Clarification Business Excludes:


KitKat Brand Reverts to Nestle ($0.9 B) Cadbury Brands Revert to Cadbury ($0.3 B) Additional Acquisition Expenses

Nestle Is Reported to Offer $11.5 B - $12.0 B


Nestle Stock Price Falls 10% in One Week

Trust Adds Stipulation of Keeping the Company Intact

17 .6 0

Acquisition Value Is Estimated Based on Projected Operating Cash Flows


Tested Against Historical Performance Enhanced With Projected Performance of New Programs

Value is Driven By:


Sales Growth Rates Margins Capital Requirements Fixed and Current Tax Rates Cost of Capital
17 .6 1

Table 1

Hershey Foods Hypothetical Valuation


($ millions) 2002 Net sales Cost of sales Selling, general, & administrative Operating income Income tax expense Net operating profit after tax $ $ 4,275.0 2,479.5 1,175.6 619.9 244.9 375.0 $ $ 2003 4,574.3 $ 2,641.6 1,257.9 674.7 266.5 408.2 $ 2004 4,871.6 $ 2,801.2 1,315.3 755.1 298.3 456.8 $ 2005 5,163.9 $ 2,956.3 1,394.2 813.3 321.3 492.1 $ 2006 5,473.7 $ 3,120.0 1,477.9 875.8 345.9 529.9 $ 2007 5,802.1 $ 3,307.2 1,537.6 957.4 378.2 579.2 $ 2008 6,092.2 $ 3,472.6 1,614.4 1,005.2 397.1 608.2 $ 2009 6,396.8 $ 3,646.2 1,695.2 1,055.5 416.9 638.6 $ 2010 6,716.7 $ 3,828.5 1,779.9 1,108.3 437.8 670.5 $ 2011 7,052.5 4,019.9 1,868.9 1,163.7 459.6 704.0

Net operating profit after tax Depreciation and amortization Change in (NCNIBD*) working capital Change in long-term operating assets and liabilities Capital expenditures Operating cash flow without residual Residual value Total operating cash flow Cost of Capital Present value of 5 years of CF Present value of residual Enterprise value Add: cash Less: debt Equity value Number of shares outstanding (mm) Value per share

375.0 144.0 (53.4) 32.1 (145.0)

408.2 $ 152.2 (57.2) 34.3 (155.2)

456.8 $ 161.1 (60.9) 36.5 (165.2) 428.3 $

492.1 $ 170.4 (64.5) 38.7 (175.1) 461.5 $

529.9 $ 180.3 (68.4) 41.1 (185.7) 497.2 $

579.2 $ 190.9 (72.5) 43.5 (196.8) 544.2 $

608.2 $ 201.9 (76.2) 45.7 (206.6) 573.0 $

638.6 $ 213.6 (80.0) 48.0 (217.0) 603.2 $

670.5 $ 225.8 (84.0) 50.4 (227.8) 634.9 $

704.0 238.7 (88.2) 52.9 (239.2) 668.2 15,591.7

352.6

382.4 $

352.6 9.5% $3,065.3 6,291.5 9,356.8 134.1 (884.9)

382.4

428.3

461.5

497.2

544.2

573.0

603.2

634.9

$ 16,260.0 5.0%

Perpetual Growth: Residual value =

$ 15,591.7

(FCF yr10)(1 + g) / (COC - g) = $668.2 (1 + .05) / (.095 - .05)

$ $

8,606.0 136.3 63.14

Major Value Drivers - Assumptions


Net sales growth Cost of sales (58.5% - 2001) Selling, general, & administrative (27.9% - 2001) Tax rate (39.7% - 2001) Change in (NCNIBD*) working capital (% of sales) Change in LT oper assets and liabilities (% of sales) Capital expenditures * NCNIBD: Non-cash non-interest bearing debt

2002

2003 7.00%

2004 6.50% 57.50% 27.00% 39.50% -1.25% 0.75% 165.2 $

2005 6.00% 57.25% 27.00% 39.50% -1.25% 0.75% 175.1 $

2006 6.00% 57.00% 27.00% 39.50% -1.25% 0.75% 185.7 $

2007 6.00% 57.00% 26.50% 39.50% -1.25% 0.75% 196.8 $

2008 5.00% 57.00% 26.50% 39.50% -1.25% 0.75% 206.6 $

2009 5.00% 57.00% 26.50% 39.50% -1.25% 0.75% 217.0 $

2010 5.00% 57.00% 26.50% 39.50% -1.25% 0.75% 227.8 $

2011 5.00% 57.00% 26.50% 39.50% -1.25% 0.75% 239.2

58.00% 27.50% 39.50% -1.25% 0.75% 145.0 $

57.75% 27.50% 39.50% -1.25% 0.75% 155.2 $

17 .6 2

Nestle and Cadbury Joint Bid


$10.5 Billion or $78 Per Share All Cash

Wrigley
$12.5 Billion or $89 Per Share Cash and Equity

Underlying Operating Assumptions

17 .6 3

Table 3

Hershey Foods Hypothetical Sensitivity Acquisition Valuation


Excludes the Value of KitKat and Cadbury ($ billions)

0.0% 1.0% 2.0% Additional Margin Improvement 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%

0.0% $ 7.41 8.02 8.63 9.23 9.84 10.45 11.06 11.66 12.27 12.88 13.49

1.0% $ 7.78 8.42 9.05 9.68 10.32 10.95 11.58 12.22 12.85 13.48 14.12

2.0% $ 8.17 8.83 9.49 10.15 10.81 11.47 12.13 12.79 13.45 14.11 14.77

3.0% $ 8.57 9.26 9.95 10.63 11.32 12.01 12.70 13.38 14.07 14.76 15.45

4.0% $ 8.98 9.70 10.42 11.13 11.85 12.57 13.28 14.00 14.72 15.43 16.15

Additional Annual Sales Growth for 10 Years 5.0% 6.0% 7.0% 8.0% $ 9.41 $ 9.86 $ 10.32 $ 10.80 10.16 10.64 11.13 11.64 10.91 11.41 11.94 12.48 11.65 12.40 13.14 13.89 14.64 15.38 16.13 16.88 12.19 12.97 13.74 14.52 15.30 16.07 16.85 17.63 12.75 13.55 14.36 15.17 15.98 16.79 17.60 18.41 13.32 14.16 15.00 15.85 16.69 17.53 18.37 19.21

9.0% 11.29 12.16 13.04 13.92 14.79 15.67 16.54 17.42 18.30 19.17 20.05

10.0% 11.80 12.71 13.62 14.53 15.44 16.35 17.27 18.18 19.09 20.00 20.91

11.0% 12.33 13.27 14.22 15.17 16.12 17.06 18.01 18.96 19.91 20.85 21.80

12.0% 12.87 13.86 14.84 15.83 16.81 17.80 18.78 19.77 20.75 21.74 22.72

Hershey Foods Valuation: Incremental Cost Cutting and Growth Requirements


12.0%

Additional Growth (10 Years)

10.0%

8.0%

$12.5 Billion
6.0%

$10.5 Billion
4.0%

2.0%

0.0% 0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

Additional Cost Cutting

17 .6 4

Nestle
Significant Cost Cutting $214 Million

Wrigley
Grow The Business Combination of Cost Cutting and Growth

17 .6 5

Nestl's Cost Cutting Negatively Impacts the Community and Other Stakeholders Wrigley
Reject Offer Hershey Is 62% Larger Different Business International Market Issues Wrigley Is Unfamiliar with Managing In A DebtLaden Environment Trust Moves Its Undiversified Position to Wrigley Instead of Hershey Reject Offer

17 .6 6

Managerial Lessons Organizational Lessons Finance Lessons


Valuation Plans Must Begin With Sound Strategic Vision and Plans Valuation Based on Growth and Margins
In Addition to Tax Rates and Other Cash Requirements (Working & Fixed) Cost of Capital

Valuation Plans Must Continue to Be Fully Integrated With Sound Strategic Vision and Plans Valuation Performance Must be Targeted, Monitored, and Adjusted as Necessary

17 .6 7

Shareholder Value is Created By:


Growing the Business Faster Than Plan Eliminating Unnecessary Costs Enhancing Efficiency of Working Capital Implementing Sound Capital Investments Reducing Tax Rates and Cost of Capital

17 .6 8

Growth opportunities for firms can be enhanced by multiple internal and external strategies.
Multiple Growth Strategies include M&AS, joint ventures, alliances, partnerships, investments, licensing, and exclusive agreements

It is predictable that a relatively high percentage of acquisitions do not earn their cost of capital Changing industry characteristics require substantial adjustments
Adjustments required by such destabilizing forces are massive and difficult

Large companies impacted by external change factors often require large acquisitions to offset substantial declines in their core business
But combining two large firms involve difficult problems of cultural and organizational integration
17 .6 9

Traditional measures of average long run returns assume independence of events which is not valid Merger activities reflect increasingly competitive pressures
Firms seek to adjust to their changing environments by programs to augment their capabilities and resources Economic forces will continue to result in these forms of external investments Evidence of winners curse, hubris, and misevaluations will be observed in turbulent and changing economic and financial environments

M&As of all types conducted over long time periods effectively related to long range plans based on strong core capabilities can help achieve superior returns to shareholders
17 .7 0