25 - 1 .  Types of mergers  Merger analysis  Role of investment bankers  LBOs, divestitures, and holding companies CHAPTER 25 Mergers, LBOs, Divestitures, and Holding Companies 25 - 2 .  Synergy: Value of the whole exceeds sum of the parts. Could arise from:  Operating economies  Financial economies  Differential management efficiency  Taxes (use accumulated losses) What are some valid economic justifications for mergers? (More ) 25 - 3 .  Break-up value: Assets would be more valuable if broken up and sold to other companies. 25 - 4 .  Diversification  Purchase of assets at below replacement cost  Acquire other firms to increase size, thus making it more difficult to be acquired What are some questionable reasons for mergers? 25 - 5 . Five Largest Completed Mergers (as of January 2003) VALUE BUYER TARGET (Billion) Vodafone AirTouch Mannesman $161 Pfizer Warner-Lambert 116 America Online Time Warner 106 Exxon Mobil 81 Glaxo Wellcome SmithKline Beecham 74 25 - 6 .  Friendly merger:  The merger is supported by the managements of both firms. Differentiate between hostile and friendly mergers (More ) 25 - 7 .  Hostile merger:  Target firm’s management resists the merger.  Acquirer must go directly to the target firm’s stockholders, try to get 51% to tender their shares.  Often, mergers that start out hostile end up as friendly, when offer price is raised. 25 - 8 .  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 Reasons why alliances can make more sense than acquisitions 25 - 9 . Reason for APV  Often in a merger the capital structure changes rapidly over the first several years.  This causes the WACC to change from year to year.  It is hard to incorporate year-to-year changes in WACC in the corporate valuation model. 25 - 10 . The 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 ) [...]... differential synergies  Further, a different beta estimate, financing mix, or tax rate would change the discount rate 25 - 26 Assume the target company has 20 million shares outstanding The stock last traded at $11 per share, which reflects the target’s value on a stand-alone basis How much should the acquiring firm offer? 25 - 27 Estimate of target’s value = $289.4 million Target’s current value = $220.0million... rsLwill change, so horizon WACC will change, so horizon value will change 25 - 33 New WACC Calculation New rsL = rsU + (rsU – rd)(D/S) = 11.56% + (11.56% - 10%)(0.4/0.6) = 12.60% New WACC = wdrd(1-T) + wsrsL = 0.4(10%)(1-0.4) + 0.6(12.6%) = 9.96% 25 - 34 New Horizon Value Calculation Horizon value = (FCF2008 )(1 + g) WACC − g $20.7(1.06) = 0.1084 − 0.06 = $554.1 million 25 - 35 New Vops and Vequity... structure is constant—such as at the horizon 25 - 13 Steps in APV Valuation 1 Project FCFt ,TSt , horizon growth rate, and horizon capital structure 2 Calculate the unlevered cost of equity, rsU 3 Calculate WACC at horizon 4 Calculate horizon value using constant growth corporate valuation model 5 Calculate Vops as PV of FCFt, TSt and horizon value, all discounted at rsU 25 - 14 APV Valuation Analysis... bidders, or low bid and then plan to go up 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? 25 - 32 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... order to replace worn out assets and grow  Net retentions = gross retentions – depreciation 25 - 17 Conceptually, what is the appropriate discount rate to apply to the target’s cash flows?  After acquisition, the free cash flows belong to the remaining debtholders in the target and the various investors in the acquiring firm: their debtholders, stockholders, and others such as preferred stockholders... synergies, although realizing such synergies has been problematic in many mergers (More ) 25 - 28  The offer could range from $11 to $289.4/20 = $14.47 per share  At $11, all merger benefits would go to the acquiring firm’s shareholders  At $14.47, all value added would go to the target firm’s shareholders  The graph on the next slide summarizes the situation 25 - 29 Change in Shareholders’ Wealth... (1.1156)4 = $344.4 million 2006 25 - 24 What is the value of the Target’s equity?  The Target has $55 million in debt  Vops – debt = equity  344.4 million – 55 million = $289.4 million = equity value of target to the acquirer 25 - 25 Would another potential acquirer obtain the same value?  No The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies... 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 BUT it is difficult to apply the Corp Val Model when WACC is changing from year-to-year 25 - 20 Discount rate for Horizon Value  At the horizon the capital structure is constant, so the corporate valuation model can be used, so discount FCFs at WACC 25 - 21 Discount... expenses 9.0 EBIT 42.0 Taxes on EBIT (40%) 16.8 NOPAT 25. 2 2005 2006 2007 2008 $60.0 $90.0 $112.5 36.0 54.0 4.5 6.0 67.5 7.5 19.5 30.0 37.5 7.8 12.0 15.0 11.7 18.0 22.5 25 - 15 Interest Tax Savings after Merger 2005 Interest expense Interest tax savings 2006 5.0 2.0 2007 6.5 2.6 Interest tax savings are calculated as interest(T) T = 40% 2008 6.5 2.6 7.0 2.8 25 - 16 What are the net retentions?  Recall that.. .25 - 11 APV Model Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity, rsU Value of interest tax shield = PV of interest tax savings at unlevered cost of equity Interest tax savings = Interest(tax rate) = TSt 25 - 12 Note to APV  APV is the best model to use when the capital structure is changing  The Corporate Valuation model is . 25 - 1 .  Types of mergers  Merger analysis  Role of investment bankers  LBOs, divestitures, and holding companies CHAPTER 25 Mergers, LBOs, Divestitures, and Holding Companies 25 -. economic justifications for mergers? (More ) 25 - 3 .  Break-up value: Assets would be more valuable if broken up and sold to other companies. 25 - 4 .  Diversification  Purchase of assets at below replacement. Wellcome SmithKline Beecham 74 25 - 6 .  Friendly merger:  The merger is supported by the managements of both firms. Differentiate between hostile and friendly mergers (More ) 25 - 7 .  Hostile