Chapter 21

Mergers and Acquisitions
Learning Objectives

After reading this chapter, students should be able to:

 Identity the different types of mergers and the various rationales for mergers.
 Conduct a simple analysis to evaluate the potential value of a target firm and discuss the
various considerations that influence the bid price.

 Explain whether the typical merger creates value for the participating shareholders.
 Discuss the value of other transactions such as leveraged buyouts (LBOs), corporate
alliances, and divestitures.

Chapter 21: Mergers and Acquisitions

Learning Objectives

37

which appears at the end of this chapter solution. merger regulation. merger rationales. and the way we cover it. please see the “Lecture Suggestions” in Chapter 5. classifications. Finally. LBOs. we discuss corporate alliances and private equity investments. where we describe how we conduct our classes. What we cover.Lecture Suggestions In this chapter we discuss mergers. and merger analysis. For other suggestions about the lecture. can be seen by scanning the slides and Integrated Case solution for Chapter 21. we talk about divestitures and the rationale behind them. and divestitures. DAYS ON CHAPTER: 2 OF 58 DAYS (50-minute periods) 38 Lecture Suggestions Chapter 21: Mergers and Acquisitions . In addition.

but most nonmanagement stockholders (1) would prefer $4. get whatever benefits of diversification there are by buying the stocks of the two firms without incurring unnecessary overhead. individually. (3) believed that by no means could Steinberg treat them worse than did the current management.22 per share. though.35 in December 2008 (even after a 3-for-one split in July. Still. In general. and that if Steinberg had taken control. we regarded the Disney affair as a flagrant abuse of outside stockholders by a management desperate to keep control. The recent state of corporate divestitures attests to the merits of this position. Personally. so perhaps management was right. Still.Answers to End-of-Chapter Questions 21-1 Horizontal and vertical mergers are most likely to result in governmental intervention. 21-3 An operating merger involves integrating the company’s operations in hopes of obtaining synergistic benefits.875. while a pure financial merger generally does not involve integrating the merged company’s operations. 21-4 Disney’s management could (and did) argue that its stock was worth more than $4. (2) were upset at having management give away $60 million of their value to Steinberg. we must note that Disney’s stock is selling for $22. Legislation might be desirable. Although many tender offers are made by surprise and over the opposition of the target firm’s management. and a new and perhaps better group now has control. investors could. Chapter 21: Mergers and Acquisitions Answers and Solutions 39 . do more good than harm in preserving the efficiency of our capital markets. This would increase the value of the merged company. and perhaps his actions forced a desirable management change. tender offers can and often are made on a “friendly” basis. Disney’s old management is largely gone. Conglomerate and congeneric mergers are attacked by the government less often. and if so. because the combined firm’s beta is a weighted average of the betas of the merged firms. it is safe to conclude that one should be wary of nonsynergistic mergers. in our judgment. 21-2 A tender offer might be used. In this case. thus lowering earnings. Disney’s stockholders paid a steep price ($60 million) to get the management change. 1998).22 to $2. management (the board of directors) of the target company endorses the tender offer and recommends that shareholders tender their shares. the remaining stockholders would be out in the cold and exploited by Steinberg. In other words. but they also are less likely to provide any synergistic benefits. and (2) relevant risk is not reduced. but the Disney situation does make it clear that a manager really can threaten to commit corporate suicide and use this tactic to fend off proposed takeovers. and (4) were more than a little suspicious that management’s primary motive was to keep their jobs and perks. but mergers of this type are also most likely to result in operating synergy. a balanced package of legislation would. 21-5 Academicians have long argued that conglomerate mergers that produce no synergy are not economically efficient because (1) overhead costs are incurred in managing the combined enterprise. Markets work reasonably well. Also. Perhaps so. Perhaps Steinberg was right about the value of the assets. The only logical rationale for nonsynergistic conglomerate mergers is that debt capacity may be increased by lowering the risk of bankruptcy. but there is a danger that legislation will help incompetent managers fight off legitimate and desirable efforts to put corporate assets into more effective hands. However.

21-7 Sometimes the acquiring group plans to run the acquired company for a number of years. which usually includes the current management of the acquired firm.21-6 It is called a “leveraged buyout (LBO)” where a small group of investors. boost its sales and profits. but the inherent risks are great due to the heavy use of financial leverage. However. It is legal. there is concern that leveraged buyouts dilute the claims of bondholders. and then take it public again as a stronger company. it has also been argued that acquisitions may increase shareholder wealth at the expense of bondholders—in particular. 40 Answers and Solutions Chapter 21: Mergers and Acquisitions . acquires a firm in a transaction financed largely by debt. The debt is serviced with funds generated by the acquired company’s operations and often by the sale of some of its assets. the acquiring group expects to make a substantial profit from the LBO. In either case. the LBO firm plans to sell off divisions to other firms that can gain synergies. In other instances.

104  0. RPM = 6%. 21-4 a.168)3 1. b = 0.1) = 11.1.47 = 16.62 V =$14. RPM = rM – rRF = 14% – 8% = 6%. P0 = D1 rs  g $2. Chapter 21: Mergers and Acquisitions Answers and Solutions 41 .05 = $37.10 1/(1.63 CF5 = CF4(1.50 3 | 1. g = 5%.04.06) = $2.12 19.116  0. The appropriate discount rate reflects the riskiness of the cash flows to equity investors. it is SMI’s cost of equity.00 0.00 0.06) = $2.63 21.00(1.168)4 11.48. rRF = 5%.4%.48. is $14.82%  16. The value of SMI Corp.9) = 10.8% 2 | 1.11 1/(1. RPM = 6%. adjusted for leverage effects.00. Thus.93 million 16.07 = $43. Since Goldtron’s b = 1. g = 7%. P0 = ? rs = rRF + RPM(b) = 5% + 6%(1. P0 = D1 rs  g $2.168 1.Solutions to End-of-Chapter Problems 21-1 D1 = $2.168)2 1.10 1/(1.00 2.30  1/1. b.00.8%.9. then: rs = rRF + (rM – rRF)b = 8% + (14% – 8%)1. b = 1. rRF = 5%.93 million: 0 | 1 | 1.6%. the bid for each share should range between $37. P0 = ? rs = rRF + RPM(b) = 5% + 6%(0.04 and $43.75 4 5 | g = 6% | 2. = 21-3 On the basis of the answers in Problems 21-1 and 21-2. = 21-2 D1 = $2.12.

0) $142.0 (360.8(1.7) $194. PMax = V/N = $14. 21-6 a.7 2011 $555.7 2012 $600.63) into the cash flow register.7) $181.0) $115.000.2. is worth.4. The terminal value is $1.000 3 | 640.77. c. CF1-10 = $640. Since the NPV of the investment is positive.5 (33.75.Value at t4 of CF5 and all subsequent cash flows is: V4 = CF5 $2.5) $157.4) into the cash 42 Answers and Solutions Chapter 21: Mergers and Acquisitions .0) $210.50.0 (68. I/YR = 12.3 (38.0) $110. 61.0) $134.000 CF0 = -$4.4. 21-5 0 10% 1 | | -4.0) $ 94. I/YR = 16.4 2010 $518.218.14)3 (1. and solve for NPV = $360.8 The value of HKT to PCCW’s shareholders is the present value of the cash flows that accrue to the shareholders: V= $61.5 (45.8 + 1143. input 0.0) $128.0) $107. 0.93. 1.143.6) $ 71.63. Sue should make the purchase.0 (27.000 640.14) 2 (1. Since Goldtron is paying exactly what SMI Corp.3) $ 74.7.0 (336.000.14)1 (1.7.50 = 14%. the acquisition has a zero net present value and Goldtron’s share price should remain at its current price.2    = $877.000 and 640. 69. and r = 10%.000  12 | 640. Annual cash flows are calculated as follows: Sales Cost of goods sold (65%) Gross profit Selling/Admin.4: TV = $74.1) $ 61.000 (12) into the cash flow register.07 c.0 (292.0 (40.000 2 | 640.4 $69. rs  g 0.14  0. and 1218. expenses EBIT Interest EBT Taxes (35%) Net income 2009 $450.0 (390.3 (21.12 = = $19.30.000.2 (74. 1.5 (18.3 (60. NPV = ? NPV = $14.762. b.2 = $12.3 (53. input 0.8.143. Input -4. (1.000.07) = $1. and 21.0) $112.000.06 Alternatively.3 (37.168  0.14) 4 Alternatively.7 $1.00 + 19.44.7 $71. 71. Since the net cash flows are equity returns.6) $ 69.93/1.63 (2. the appropriate discount rate is that cost of equity which reflects the riskiness of the cash flow stream.3 (24. This cost is HKT’s cost of equity: rs = rRF + (RPM)b = 8% + (4%)1. 1.

flow register. I/YR = 14. Chapter 21: Mergers and Acquisitions Answers and Solutions 43 . and solve for NPV = $877.2.

the solution to Part c is not. 44 Comprehensive/Spreadsheet Problem Chapter 21: Mergers and Acquisitions .Comprehensive/Spreadsheet Problem Note to Instructors: The solutions for Parts a and b are provided at the back of the text. Instructors can access the Excel file on the textbook’s web site or the Instructor’s Resource CD. however. c. 21-7 See Parts a and b on the preceding page.

Security analysts estimate Old Sheng’s beta to be 1. Wong realizes that Old Sheng’s Hardware also generates depreciation cash flows. The interest expense listed here includes the interest (1) on Old Sheng’s existing debt. (2) on new debt that B&Q’s would issue to help finance the acquisition. a small chain that operates in the Hebei Province of China. The table below indicates Wong’s estimates of Old Sheng’s earnings potential if it came under B&Q’s management (in millions of dollars).” the code name given to the target firm. B&Q’s treasurer and your boss. She also estimates that net cash flows after 2012 will grow at a constant rate of 6%. because B&Q is highly profitable. and (3) on new debt expected to be issued over time to help finance expansion within the new “S division. The retentions represent earnings that will be reinvested within the S division to help finance its growth. taxes on the consolidated firm would be 40%. and it pays corporate income tax at a 30% rate. and she has enlisted your help. a global home improvement and garden center retailer that specializes in do-it-yourself materials and garden equipment. B&Q’s management is new to the merger game. Wong estimates the risk-free rate to be 9% and the market risk premium to be 4%. so Wong has been Chapter 21: Mergers and Acquisitions Integrated Case 45 . If the acquisition were to take place. is cash-rich because of several consecutive good years. Old Sheng’s Hardware currently uses 40% debt financing. B&Q’s would increase Old Sheng’s debt ratio to 50%. has been asked to place a value on a potential target. Further.Integrated Case 21-8 B&Q plc Merger Analysis B&Q. which would increase its beta to 1.3. One of the alternative uses for the excess funds is a global acquisition. Old Sheng’s Hardware. Tracy Wong. but she believes that these funds would have to be reinvested within the division to replace worn-out equipment.2.

Synergy occurs when the value of the combined firm exceeds the sum of the values of the firms taken separately. and hence synergy is also called the “2 + 2 = 5” effect. (2) risk reduction. marketing.] The economically justifiable rationales for mergers are synergy and tax consequences. or better coverage by securities’ analysts that can lead to higher demand and. (3) control. 46 Integrated Case Chapter 21: Mergers and Acquisitions . which implies that new management can increase the value of a firm’s assets.asked to answer some basic questions about mergers as well as to perform the merger analysis. hence. In general. lower transactions costs. which could include higher debt capacity. To structure the task. (4) purchase of assets at below-replacement cost. Several reasons have been proposed to justify mergers. and (4) increased market power due to reduced competition. Answer: [Show S21-1 through S21-3 here. (If synergy exists. Synergy can arise from four sources: (1) operating economies of scale in management. which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain. as are mergers that increase managerial efficiency. and (5) synergy. which you must answer and then defend to B&Q’s board. higher prices. Operating and financial economies are socially desirable.) A synergistic merger creates value that must be apportioned between the stockholders of the merging companies. then the whole is greater than the sum of the parts. A. Among the more prominent are (1) tax considerations. or distribution. (2) financial economies. Wong has developed the following questions. production. (3) differential management efficiency.

Stabilization of earnings is certainly beneficial to a firm’s employees. and higher earnings instability does not necessarily translate into higher market risk. Why should Firm A and Firm B merge to stabilize earnings when stockholders can merely purchase both stocks and accomplish the same thing? Further. customers.but mergers that reduce competition are both undesirable and illegal. Without the merger. control. if a stock investor is concerned about earnings variability. However. but their value would be higher if used now rather than in the future. The motives that are generally less supportable on economic grounds are risk reduction. in the early 1980s. Managers often state that diversification helps to stabilize a firm’s earnings stream and thus reduces total risk. Thus. and managers. However. not from its cost. a firm that is highly profitable and consequently in the highest corporate-tax bracket could acquire a company with large accumulated tax losses. and globalization. and hence benefits shareholders. and immediately use those losses to shelter its current and future income. Another valid rationale behind mergers is tax considerations. we know that well-diversified shareholders are more concerned with a stock’s market risk than its stand-alone risk. suppliers. For example. purchase of assets at below replacement cost. For example. Sometimes a firm will be touted as a possible acquisition candidate because the replacement value of its assets is considerably higher than its market value. paying $1 million for a slide rule plant that would cost $2 million to Chapter 21: Mergers and Acquisitions Integrated Case 47 . oil companies could acquire reserves more cheaply by buying out other oil companies than by exploratory drilling. the value of an asset stems from its expected cash flows. he or she can diversify more easily than can the firm. the carry-forwards might eventually be used.

but management’s support generally assures that the votes will be favorable. In recent years. such defensive mergers are usually debt-financed. increased globalization has led to increased economies of scale. Answer: [Show S21-4 here. defensive mergers appear to be designed more for the benefit of managers than for stockholders. which makes it harder for a potential acquirer to use debt financing to finance the acquisition. To merge just to become international is not an economically justified reason for a merger. To keep their companies independent. managers sometimes engineer defensive mergers which make their firms more difficult to “digest. B. Then they issue statements to their stockholders recommending that they agree to the merger. the shareholders of the target firm normally must vote on the merger. Briefly describe the differences between a hostile merger and a friendly merger. In general.build from scratch is not a good deal if no one uses slide rules. however. synergism often results—which is an economically justifiable reason for mergers.] In a friendly merger. and also to protect their jobs. the management of one firm (the acquirer) agrees to buy another firm (the target). the action is initiated by the acquiring firm. 48 Integrated Case Chapter 21: Mergers and Acquisitions . Synergy appears to be the reason for this merger. The managements of both firms get together and work out terms that they believe to be beneficial to both sets of shareholders. In most cases. Thus. but in some situations the target may initiate the merger. Of course.” Also. many hostile takeovers have occurred. An increased desire to become globalized has resulted in many mergers.

or some combination of the three. assuming that the acquisition is made (in millions of dollars).0 $16. whereby the target firm’s shareholders are asked to “tender” their shares to the acquiring firm in exchange for cash.5 Interest expense 3.5 7. then the acquiring firm’s advances are said to be hostile rather than friendly.5 [Show S21-5 through S21-7 here.5 $112.5 $25.0 6.5 2011 2012 $112. then the merger will be completed over management’s objection.0 4.5 76.0 4.5 4.0 Necessary retained earnings 0. This takes the form of a tender offer.0 4.0 $127.0 54.5 67.] The easiest approach here is to create cash flow statements for the S division.5 7.0 6.0 $ 36.0 6. bonds.5 6.0 Cost of goods sold (60%) 36.5 $90.5 3.0 Integrated Case 49 .5 $ 33. In this case. C. whereas it is not normally deducted in a capital budgeting cash flow analysis? Why are earnings retentions deducted in the cash flow statement? 2009 Net sales $60. the acquirer. Why is interest expense deducted in merger cash flow statements.0 36.If a target firm’s management resists the merger.5 9.0 Selling/administrative expense 4.5 7.5 $127. Use the data developed in the table to construct the S division’s cash flow statements for 2009 through 2012. stock.0 Answer: 2010 $90. must make a direct appeal to the target firm’s shareholders.5 67.5 9. if it chooses to.0 4.0 54. Net sales Cost of goods sold (60%) Selling/administrative expense Interest expense Earnings before taxes Chapter 21: Mergers and Acquisitions 2009 2010 2011 2012 $60.5 76.0 6. If 51% or more of the target firm’s shareholders tender their shares.0 4.

2 $ 19. In regards to retentions.5 $ 7. but some of the cash flows generated by an acquisition are generally retained with the new division to help finance its growth.4 $ 21. the debt involved all costs the same. Thus. Hence. The easiest solution is to explicitly include interest expense in the cash flow statement.9 10. all of the cash flows from an individual project are available for use throughout the firm.9 0. all debt involved is new debt that is issued to fund the asset additions.8 13.2 $15. in a merger the acquiring firm usually both assumes the existing debt of the target and issues new debt to help finance the takeover. Conceptually.0 $ 13.0 $ 9.6 $ 9. Smitty’s management could pay these out as dividends or reinvest them in other divisions of the firm. what is the appropriate discount rate to apply to the cash flows developed in Part C? What is your actual estimate of this discount rate? 50 Integrated Case Chapter 21: Mergers and Acquisitions . In straight capital budgeting. they must be deducted in the cash flow statement. With interest expense and retentions included in the cash flow statements.Taxes (40%) Net income Retentions Cash flow 6. as they see fit.6 4. However.8 6.3 7. the cash flows are residuals that are available to the acquiring firm’s equity holders. and this cost is accounted for by discounting the cash flows at the firm’s WACC. and hence cannot be accounted for as a single cost in the WACC.1 Note that these statements are identical to standard capital budgeting cash flow statements except that both interest expense and retentions are included in merger analysis. D. Since such retentions are not available to the parent company for use elsewhere.5 $ 17. the debt involved has different costs. rd.8 14.

3 = 14. the cash flows are residuals. not B&Q’s business risk.Answer: [Show S21-8 and S21-9 here. which is the appropriate discount rate to apply to the merger cash flows.2%: rs(H division) = rRF + (rM – rRF)bH division = 9% + (4%)1. that is. the S division’s required rate of return on equity. Answer: [Show S21-10 through S21-12 here. because the merger affects Hill’s leverage and tax rate. What is the estimated terminal value of the acquisition. the market risk of the S division is not the same as the market risk of Old Sheng’s operating independently.2%. and these cash flows have Old Sheng’s business risk. what is the estimated value of the S division’s cash flows beyond 2012? What is Old Sheng’s value to B&Q? Suppose another firm were evaluating Old Sheng as an acquisition candidate. E. and they belong to the acquiring firm’s shareholders.] The 2012 cash flow is $17. the Gordon model can be used to value the cash flows beyond 2012: Chapter 21: Mergers and Acquisitions Integrated Case 51 . B&Q’s investment bankers have estimated the H division’s beta will be 1. Since interest expense has already been considered. With a constant growth rate. Further. However. Thus.1 million.3 after the merger and the additional leverage has been employed. Would they obtain the same value? Explain. the cash flows are riskier than the typical capital budgeting cash flows. and it is expected to grow at a 6% constant growth rate in 2013 and beyond.] As discussed above. is 14. and they must be discounted using the cost of equity rather than the WACC. To obtain the required rate of return on equity. the discount rate must reflect the riskiness of the flows. note that rRF = 9% and RPM = 4%.

how much should it offer per share? Answer: [Show S21-13 through S21-18 here.1 Now. they would probably obtain an estimate different from $163. and hence estimate a different discount rate.9 million.06) 0. discounted at 14.Terminal value = = (2012Cashflow)(1 g) rs  g $17.] With a current price of $9 per share and 10 million shares outstanding.1(1.2%. Old Sheng’s current market value is $9(10) = $90 million.06 = $221. it appears that the merger would be beneficial 52 Integrated Case Chapter 21: Mergers and Acquisitions . and hence the cash flow estimates would differ. was at a price of $9 per share.0 million. Also. These shares are traded relatively infrequently. Since Old Sheng’s expected value to B&Q is $163. the value of Old Sheng to B&Q is the present value of this stream.9 million. the net cash flow stream looks like this (in millions of dollars): Annual cash flow Terminal value Net cash flow 2009 2010 2011 2012 $9. another potential acquirer might use different financing. If another firm were valuing Old Sheng.1 221. but the last trade.8 $9. Adding the terminal value. or have a different tax rate.0 $238.8 $13.142  0.8 $13. F. Assume that Old Sheng’s has 10 million shares outstanding. Most important. or $163.9 $7.8 $ 17. made several weeks ago.9 $7. the synergies involved would likely be different. Should B&Q make an offer for Old Sheng’s? If so.9 million.

Further. At $9. the $9 price may not represent a fair minimum price. Note that this discussion assumes that Old Sheng’s $9 price is a “fair. A low initial offer. all of the benefit of the merger goes to B&Q’s shareholders. As to the actual offering price.to both sets of stockholders. The difference. (2) aiding target companies in Chapter 21: Mergers and Acquisitions Integrated Case 53 . Old Sheng’s management should make an evaluation (or hire someone to make the evaluation) of a fair price and use this information in its negotiations with B&Q. yet acceptable to Old Sheng’s shareholders. Conversely. and they could end up outbidding B&Q.] The investment banking community is involved with mergers in a number of ways. all of the value created goes to Old Sheng’s shareholders. while at $16.39 per share.39 per share. would probably be rejected and the effort wasted. What merger-related activities are undertaken by investment bankers? Answer: [Show S21-19 here.9 – $90. The offering range is from $9 per share to $163. say $9.9/10 = $16. a high price.0 = $73. is the added value to be apportioned between the stockholders of both firms. the offer may influence other potential suitors to consider Old Sheng.39.” equilibrium value in the absence of a merger.50 per share. and B&Q’s managers should retain as much of the synergistic value as possible for their own shareholders. passes almost all of the gain to Odl Sheng’s stockholders. say $16. Since the stock trades infrequently. B&Q should make the offer as low as possible. then wealth would be transferred from B&Q’s stockholders to Old Sheng’s stockholders.9 million. If B&Q offers more than $16. Several of these activities are: (1) helping to arrange mergers. G. $163.

54 Integrated Case Chapter 21: Mergers and Acquisitions . (3) helping to value target companies. and (5) risk arbitrage—speculating in the stocks of companies that are likely takeover targets. (4) helping to finance mergers.developing and implementing defensive tactics.