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Bootstrapping Effect Example

Assume two companies are planning a merger the following figures are given:

Stock Price
EPS
P/E
Outstanding

A
100
4
25
100,000

T
50
2.5
20
50,000

shares
Total earnings
MV

400,000
10,000,000

125,000
2,500,000

Steps:

In order to know the number of shares that need to be issued: 2,500,000/100 =


25,000

Total shares of both company = 100,000 + 25,000 = 125,000

Total earnings = 400,000 + 125,000 = 525,000

New EPS of post-merger = 525,000/125,000 = $4.2

If the market is efficient, the post-merger P/E should adjust to the weighted average of
EARNINGS contributions of both companies. This means:

New P/E = 400,000/525,000 * 25 + 125,000/525,000 * 20 = 23.8

Price = 23.8 * 4.2 = $100

If investors apply the pre-merger P/E of 25x, then price would increase to 4.2 * 25 = 105

What are the methods to be used in Merger Analysis?

Target Company Valuation


First: DFC
The discounted cash flow analysis is one way to value a merger by discounting the
companys expected future free cash flows in order to derive the value of the company.
FCF estimation has been covered in a detailed topic in the equity investments section.
In summary, however, FCF can be estimated as:

When
evaluating the target from a non-control perspective, we should use the targets WACC.
Finding the terminal value can be found in one of two ways:
(1) Constant growth rate; that is:

(2) Applying a multiple at which the analyst expects the average company to sell
at the end of the first stage.

Second: Comparable Company Analysis


The analyst first defines a set of other companies that are similar to the target under
review. The next step is to calculate various relative value measures based on the
current market prices. After finding the mean/median of the multiples and apply it to the
target company, we would be able to find the stock price. Up to this point, we have
determined the stock price. In order to calculate an acquisition value, the analyst must
also estimate a takeover premium which is the amount by which the takeover price for

each share must exceed the current stock price in order to entice shareholders to
relinquish control of the company to an acquirer.

Where PRM is the takeover premium (as percentage of stock price), DP is the deal price
and SP is the stock price.
The following example shows a very simplified illustration of the method. Assuming that
the ABC Company is trying to analyze the fair value of XYZ in order to determine the
acquisition price, using comparable company analysis, ABC has determined two
comparable companies and the following valuation variables:
Valuation
Variable
Current

Company 1
Stock 20

Price
EPS
BVPS
We can find the following multiples

Company 2
15

2
8

1.67
5

Multiple
Company 1 Company 2
Mean
P/E
20/2 = 10
15/1.67 = 9
9.5
P/BV
20/8 = 2.5
15/5 = 3
2.75
If XYZ has EPS of 2.5 and BVPS of 7 then applying the mean multiples:
Variable

Target

Mean

Estimated Stock Price

Company
Multiple
EPS
2.5
9.5
2.5 * 9.5 =23.75
BVPS
7
2.75
7 * 2.75 = 19.25
The mean stock price is then 21.5; Now, we need to add the takeover premium. We
estimate it from 3 transactions (recent takeovers) in companies in the same industry

Target

Stock

Company
Target 1

Takeover
20

Price

Before Takeover
Price
25

Takeover Premium
(%)
25%

Target 2
Target 3

15
30

20
36
MEAN

33.33%
20%
26.11%

Therefore, the estimated takeover price for the target is 21.5 * 1.2611 = 27.11
Third: Comparable Transaction Analysis]
Similar to comparable company analysis except that the analyst uses details from recent
takeover transactions for comparable companies to make direct estimates of the target
companys takeover value. For this approach, we compare multiples actually paid for
similar companies in other M&A deals. Therefore, there is no need to estimate the
premium.

he following example shows a very simplified illustration of the method. Assuming that
the ABC Company is trying to analyze the fair value of XYZ in order to determine the
acquisition price, using comparable company analysis, ABC has determined two
comparable acquired companies and the following valuation variables:
Valuation

Acquired Company Acquired Company 2

Variable
Acquisition Price
EPS
BVPS

1
20
2
8

15
1.67
5

We can find the following multiples


Multiple

Acquired

Acquired Company Mean

Company 1
2
P/E
20/2 = 10
15/1.67 = 9
9.5
P/BV
20/8 = 2.5
15/5 = 3
2.75
If XYZ has EPS of 2.5 and BVPS of 7 then applying the mean multiples:
Variable

Target Company

Mean Multiple

Estimated

Stock

Price
EPS
2.5
9.5
2.5 * 9.5 =23.75
BVPS
7
2.75
7 * 2.75 = 19.25
If the analyst determines equal weighting for each multiple (50% for each) then the
mean stock price is then 21.5. If the analyst thinks that earnings are more important
determinant of value, he could assign a weight of 60% to it and 40% to book value and
the estimate stock price will be 0.6 * 23.75 + 0.4 * 19.25 = 21.95
Bid Evaluation
Assessing the targets value is important but it is insufficient for an assessment of the
deal.

When evaluating a bid, the pre-merger value of the target company is the minimum
value that target shareholders should expect. The maximum that acquirers should pay
on the other hand is pre-merger value of target company plus expected synergies or
else there will be reduction in value.

Illustration for Bid Evaluation Method:


Pre-merger stock price
Outstanding
share

Acquirer
15
(in 75

millions)
Pre-merger market value (in 1125
millions)
The expected synergy = 90 million
Option 1: Cash offer of $12 per share

Target
10
30
300

PT = 12 * 30 = 360

Premium = PT VT = 360 300 = 60 million

Acquirers again = 90 60 = 30 million

Post-merger value = 1125 + 300 + 90 360 = 1155 million

Acquirers again = 1155 1125 = 30 million

Post-merger price = 1155/75 = 15.4

Option 2: Stock offer of 0.8 shares of As stock per share of Ts stock

Number of stocks = 0.8 * 30 = 24

Post-merger value = 1125 + 300 + 90 0 = 1515 million

Post-merger price = 1515/(75+24) = 15.3

Price paid = 15.3 * 24 = 367

Premium = PT VT = 367 300 = 67 million

Acquirers again = 90 67 = 23 million

Option 3: Mixed offer of $6 plus 0.4 shares of As stock per share of Ts stock

Number of stocks = 0.4 * 30 = 12

Post-merger value = 1125 + 300 + 90 6(30) = 1335 million

Post-merger price = 1335/(75+12) = 15.35

Price paid = 15.35 * 12 + 180 = 364

Premium = PT VT = 364 300 = 64 million

Acquirers again = 90 64 = 26 million

Q:
The target firm has 10 million shares outstanding at a price of $9.00 per
share. What should the offering price be?

The acquirer estimates the maximum price they would be willing to pay by dividing the
targets value by its number of shares:
Max price

= Targets value / # of shares


= $163.9 million / 10 million
= $16.39

Offering range is between $9 and $16.39 per share.


The offer could range from $9 to $16.39 per share.
At $9 all the merger benefits would go to the acquirers shareholders.
At $16.39, all value added would go to the targets shareholders.
Acquiring and target firms must decide how much wealth they are willing to
forego.
Q:

Merger analysis: Post-merger cash flow statements

2003 2004 2005 2006


Net sales $60.0 $90.0 $112.5
$127.5
- Cost of goods sold 36.0 54.0
67.5
76.5
- Selling/admin. exp.
4.5 6.0
7.5
9.0
- Interest expense
3.0 4.5
4.5
6.0
EBT 16.5 25.5 33.0
36.0
REQUIRED:
- Taxes
6.6discount
10.2
14.4
What is the appropriate
rate to apply to13.2
the targets cash flows?
Determine terminal value
Net
Income
9.9 15.3 19.8
21.6
Retentions
0.0 7.5
6.0

4.5
Cash flow
9.9 7.8 13.8
17.1
Find the appropriate

discount rate

kS(Target) = kRF + (kM


kRF)Target
= 9% + (4%)(1.3) =
14.2%

Determine terminal
value

What are the Motives for Mergers?

TV2006 = CF2006(1 + g) /
(kS g)

There are many motivations behind mergers such as:

1.

Synergy: it refers to the concept that the whole of the combined company will be worth more
than the sum of its parts. Cost synergies typically achieved through economies of scale and
revenue synergies are created through cross-selling of products, expanded market share, and

= $17.1 (1.06) /
(0.142 0.06)
=$221.0 million

increasing prices because of lowering competition


2.

Growth: Companies can grow either by making investments internally (i.e. organic growth)
or by buying the necessary resources externally (i.e. external growth faster to be done and
less risky because of familiarity with business)

3.

Increasing market power: when a company increases its market power through horizontal
mergers, it may have greater ability to influence market prices. Taken to an extreme, horizontal
integration results in a monopoly

4.

Acquiring unique capabilities and resources: Many companies undertake a merger or an


acquisition either to pursue competitive advantages or to shore up lacking resources

5.

Diversification: If diversified, the variability of the conglomerate cash flows is reduced (at
least to the extent that cash flows are uncorrelated). Although this may seem like a rational
motive, it has been challenged: (1) in a well-functioning markets, shareholders can diversify
their own portfolios and (2) the desire to diversify makes companies lose sight of their major
competitive strengths

6.

Bootstrapping earnings: when a companys earnings increases as a consequence of


merger transaction itself (rather than because of resulting economic benefits), it is referred to
as bootstrap effect. For this to happen, the acquirers P/E must be higher than the targets
P/E I will refer to an example in a while

7.

Managers personal incentives: Managerialism theories posit that because executive


compensation is highly correlated with company size, corporate executives are motivated to
engage in mergers to maximize the size of their company rather than shareholder value. Also,
being the senior executive of a larger company conveys more power and prestige

8.

Tax considerations: It is possible for a profitable acquirer to benefit from merging with a
target that has accumulated a large amount of tax losses

9.

Unlocking hidden value: when a potential target is underperforming, an acquirer may


believe it can acquire the company cheaply and then unlock hidden values. It can actually
acquire it for less than breakup value (i.e. the value that can be achieved if company assets
are sold separately)

10.

Cross-border motivations: cross-border mergers can provide an efficient way of achieving


other international business goals: exploiting market imperfections, overcoming adverse
government policy, technology transfer, product differentiation, and following clients.