CHAPTER 21 Mergers and DivestituresWhy do mergers occur?What are some questionable reasons for mergers?What is the difference between a “friendly” and a “hostile” takeover?Reasons why alliances can make more sense than acquisitionsMerger analysis: Post-merger cash flow statementsWhat is the appropriate discount rate to apply to the target’s cash flows?Discounting the target’s cash flowsCalculating terminal valueNet cash flow streamWould another acquiring company obtain the same value?The target firm has 10 million shares outstanding at a price of $9.00 per share. What should the offering price be?Making the offerShareholder wealth in a mergerShareholder wealthSlide 16Do mergers really create value?Functions of Investment Bankers in Mergers21-1CHAPTER 21Mergers and DivestituresTypes of mergersMerger analysisRole of investment bankersCorporate alliancesLBOs, divestitures, and holding companies21-2Why do mergers occur?Synergy: Value of the whole exceeds sum of the parts. Could arise from:Operating economiesFinancial economiesDifferential management efficiencyIncreased market powerTaxes (use accumulated losses)Break-up value: Assets would be more valuable if sold to some other company.21-3What are some questionable reasons for mergers?DiversificationPurchase of assets at below replacement costGet bigger using debt-financed mergers to help fight off takeovers21-4What is the difference between a “friendly” and a “hostile” takeover?Friendly merger: The merger is supported by the managements of both firms.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.21-5Reasons why alliances can make more sense than acquisitionsAccess to new markets and technologiesMultiple parties share risks and expenses Rivals can often work together harmoniouslyAntitrust laws can shelter cooperative R&D activities21-6Merger analysis:Post-merger cash flow statements2003 2004 2005 2006Net 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 6.0EBT 16.5 25.5 33.0 36.0- Taxes 6.6 10.2 13.2 14.4Net Income 9.9 15.3 19.8 21.6Retentions 0.0 7.5 6.0 4.5Cash flow 9.9 7.8 13.8 17.121-7What is the appropriate discount rate to apply to the target’s cash flows?Estimated cash flows are residuals which belong to acquirer’s shareholders.They are riskier than the typical capital budgeting cash flows. Because fixed interest charges are deducted, this increases the volatility of the residual cash flows.Because the cash flows are risky equity flows, they should be discounted using the cost of equity rather than the WACC.21-8Discounting the target’s cash flowsThe cash flows reflect the target’s business risk, not the acquiring company’s.However, the merger will affect the target’s leverage and tax rate, hence its financial risk.21-9Calculating terminal valueFind the appropriate discount ratekS(Target) = kRF + (kM – kRF)βTarget = 9% + (4%)(1.3) = 14.2%Determine terminal valueTV2006= CF2006(1 + g) / (kS – g)= $17.1 (1.06) / (0.142 – 0.06)=$221.0 million21-10Net cash flow stream2003 2004 2005 2006Annual cash flow $9.9 $7.8 $13.8 $ 17.1Terminal value 221.0Net cash flow $9.9 $7.8 $13.8 $238.1Value of target firmEnter CFs in calculator CFLO register, and enter I/YR = 14.2%. Solve for NPV = $163.9 million21-11Would another acquiring company obtain the same value?No. The input estimates would be different, and different synergies would lead to different cash flow forecasts.Also, a different financing mix or tax rate would change the discount rate.21-12The 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 target’s value by its number of shares:Max price = Target’s value / # of shares= $163.9 million / 10 million= $16.39Offering range is between $9 and $16.39 per share.21-13Making the offerThe offer could range from $9 to $16.39 per share.At $9 all the merger benefits would go to the acquirer’s shareholders.At $16.39, all value added would go to the target’s shareholders.Acquiring and target firms must decide how much wealth they are willing to forego.21-14Shareholder wealth in a mergerShareholders’WealthAcquirer TargetBargaining RangePrice Paid for Target$9.00 $16.390 5 10 15 2021-15Shareholder wealthNothing magic about crossover price from the graph.Actual price would be determined by bargaining. Higher if target is in better bargaining position, lower if acquirer is.If target is good fit for many acquirers, other firms will come in, price will be bid up. If not, could be close to $9.21-16Shareholder wealthAcquirer might want to make high “preemptive” bid to ward off other bidders, or low bid and then plan to go up. It all depends upon their strategy.Do target’s managers have 51% of stock and want to remain in control?What kind of personal deal will target’s managers get?21-17Do mergers really create value?The evidence strongly suggests: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, because of competitive bids.21-18Functions of Investment Bankers in MergersArranging mergersAssisting in defensive tacticsEstablishing a fair valueFinancing mergersRisk
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