Corporate Alliances, Leveraged Buyouts, and Divestitures
CHAPTER 25 Mergers, LBOs, Divestitures, and Holding Companies
Mergers Announced in 2005
America West and US Airways
$1.5 billion - Announced May 19, 2005
Lenovo Goup and IBM PC Division
$1.25 billion – Announced April 20 th , 2005
Verizon and MCI
$7.6 billion – Announced March 29, 2005
Proctor and Gamble and Gillette
$57 billion – Announced March 28, 2005
IAC/Interactive and Ask Jeeves
$1.9 billion – Announced March 21, 2005
Met Life and Travelers Group
$11.5 billion – Announced January 31, 2005
Mergers Announced in 2004
K Mart and Sears Roebuck
$11 billion – Announced November 17, 2004
Wachovia and South Trust
$14.3 billion – Announced June 21, 2004
May Company and Marshall Field
Purchased from Target (an Acquisition)
$3.24 billion – Announced June 9, 2004
Wells Fargo and Strong Capital Management
$400 million (estimated) – Announced May 27, 2004
Marsh & McLennan – Kroll, Inc
$1.96 billion – Announced May 18, 2004
Mergers Announced in 2004 - Continued
Sun Trust and National Commerce Financial
$6.98 billion – Announced May 9, 2004
Cingular Wireless and AT & T Wireless
$47 billion – Announced February 17, 2004
J P Morgan Chase and Bank One
Mergers Announced in 2003
St. Paul Companies and Travelers Property Casualty
Announced November 17 th , 2003
Bank of America and Fleet Boston
Announced October 27, 2003
Manulife and John Hancock Financial Services
Announced November 4, 2003
Anthem and Wellpoint
Announced October 27, 2003
Mergers Announced in 2003 -Continued
R.J. Reynolds and British American Tobacco PLC
$3 billion for U.S. units of British American Tobacco
Announced October 27, 2003
Oracle and PeopleSoft
$5.1 billion hostile takeover – updated in 2004 to $9.2 billion
First Announced June 9, 2003
Manufactured Home and Chateau Communities
Berkshire Hathaway and Clayton Homes
Viacom and Comedy Central
Five Largest Completed Mergers (as of January 2002)
BUYER TARGET (Billion)
Vodafone AirTouch Mannesman $161
Pfizer Warner-Lambert 116
America Online Time Warner 106
Exxon Mobil 81
Glaxo Wellcome SmithKline Beecham 74
Foreign Acquisitions of U.S. Firms
Manulife and John Hancock Financial Services
Bridgestone and Firestone
Daimler Benz and Chrysler
HSBC Holdings and Household International
British Petroleum and Amoco, Sohio, and Atlantic Richfield
Ahold and Giant Food stores, Harris Teeter, and Price Chopper
Michelin and B.F. Goodrich
Grand Metropolitan and Pillsbury
Thomson and G.E. Small Appliances
Foreign Acquisitions and U.S. Firms - Continued
Credit Suisse and First Boston
Zurich Insurance and Scudder, Stevens
Bank of Tokyo-Mitsubishi and UnionBanCal
Toronto Dominion Bank and Waterhouse Securities
Hong Kong and Shanghai Bank and Marine Midland
Matushita and MCA
Broken Hill Proprietary and Utah International (from G. E.)
UBS and Paine Webber
Bertelsmann and Napster
Synergy: Value of the combined firm exceeds the sum of the values of the firms taken separately. Arises from:
Differential management efficiency
Tax Effects (possibly use accumulated losses) (More...)
Which of the reasons that have been proposed as justification for mergers are economically justifiable?
Increased Market Power: Due to reduced competition
World Wide Competition (Globalization)
Acquire Technological Skills
Break-up value: A company’s assets would be more valuable if sold to and then operated by some other company or spun off.
Stockholders can achieve diversification at lower cost than firms
Transfers wealth from stockholders to debt holders
No synergistic effects
Purchase of assets at below replacement cost (more)
What are some questionable reasons for mergers?
What are some questionable reasons for mergers? - continued
Retention of control
Acquire other firms to increase size, thus making it more difficult to be acquired
Managers’ personal incentives
Types of Mergers
First Union and Wachovia
DuPont and Conoco
Congeric - Related Enterprises
Duke Power and Pan Energy
Mobil Oil and Montgomery Ward
Management of one firm (acquirer) agrees to buy another firm (target).
This merger is supported by the management of both firms.
Differentiate between hostile and friendly mergers
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 the offer price is raised.
Merger Regulation - The Williams Act of 1968
Acquirers must disclose their current holdings within 10 days of amassing 5% of company’s stock
Acquirers must disclose source of funds to be used in the acquisition
Target firm’s SH must be allowed at least 20 days to tender their shares
If the acquiring firm increases the offer price, all SH who tendered must receive the higher price.
M & A “Terms”
Reason for Adjusted Present Value (APV) Merger Analysis
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.
The Adjusted Present Value (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 .
Unlevered value of firm = PV of FCFs discounted at unlevered cost of equity, r sU .
Value of interest tax shield = PV of interest tax savings at unlevered cost of equity. Interest tax savings =
Interest(tax rate) = TS t .
Note to APV
APV is the best model to use when the capital structure is changing.
The Corporate Valuation model is easier than APV to use when the capital structure is constant—such as at the horizon.
Steps in APV Valuation
Project FCF t , TS t , horizon growth rate, and horizon capital structure.
Calculate the unlevered cost of equity, r sU .
Calculate WACC at horizon.
Calculate horizon value using constant growth corporate valuation model.
Calculate V ops as PV of FCF t , TS t and horizon value, all discounted at r sU .
Net sales $60.0 $90.0 $112.5 $127.5
Cost of goods sold (60%) 36.0 54.0 67.5 76.5
Selling/admin. expenses 4.5 6.0 7.5 9.0
EBIT 19.5 30.0 37.5 42.0
Taxes on EBIT (40%) 7.8 12.0 15.0 16.8
NOPAT 11.7 18.0 22.5 25.2
Net Retentions 0.0 7.5 6.0 4.5
Free Cash Flow 11.7 10.5 16.5 20.7
APV Valuation Analysis (In Millions) 2004 2005 2006 2007 Free Cash Flows after Merger Occurs From Mini Case in Chapter 25
Interest Tax Savings after Merger
Interest expense 5.0 6.5 6.5 7.0
Interest tax savings 2.0 2.6 2.6 2.8
Interest tax savings are calculated as
interest(T). T = 40%
2004 2005 2006 2007
What are the net retentions?
Recall that firms must reinvest in order to replace worn out assets and grow.
Net retentions = gross retentions – depreciation.
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.
These cash flows can be redeployed within the acquiring firm.
Conceptually, what is the appropriate discount rate to apply to the target’s cash flows? (More...)
Free cash flow is the cash flow that would occur if the firm had no debt, so it should be discounted at the unlevered cost of equity.
The interest tax shields are also discounted at the unlevered cost of equity.
Note: Comparison of APV with Corporate Valuation Model
APV discounts FCF at r sU and adds in present value of the tax shields—the value of the tax savings are incorporated explicitly.
Corp. Val. Model discounts 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.
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.
Discount Rate Calculations r sL = r RF + (r M - r RF )b Target = 7% + (4%)1.3 = 12.2% r sU = w d r d + w s r sL = 0.20(9%) + 0.80(12.2%) = 11.56% WACC = w d (1-T)r d + w s r sL =0.20(0.60)9% + 0.80(12.2%) = 10.84%
Horizon value =
= $453.3 million.
Horizon, or Continuing, Value
What Is the value of the Target Firm’s operations to the Acquiring Firm? (In Millions) 2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7 Horizon value 453.3 Interest tax shield 2.0 2.6 2.6 2.8 Total $13.7 $13.1 $19.1 $476.8 V Ops = + + + = $344.4 million . $13.7 (1.1156) 1 $13.1 (1.1156) 2 $19.1 (1.1156) 3 $476.8 (1.1156) 4
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.
No. The cash flow estimates would be different, both due to forecasting inaccuracies and to differential synergies.
Further, a different beta estimate, financing mix, or tax rate would change the discount rate.
Additionally, a different estimating procedure could result in a different discount rate .
Would another potential acquirer obtain the same value?
Estimate of target’s value = $289.4 million
Target’s current value = $220.0million
Merger premium = $ 69.4 million
Presumably, the target’s value is increased by $69.4 million due to merger synergies, although realizing such synergies has been problematic in many mergers. (More...)
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?
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.
0 5 10 15 20 Change in Shareholders’ Wealth Acquirer Target Bargaining Range = Synergy Price Paid for Target $11.00 $14.47
Points About Graph
Nothing magic about crossover price.
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 $11. Most of the time the target’s stockholders receive the vast majority of the benefits.
Acquirer might want to make high “preemptive” bid to ward off other 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?
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 did, it is easy to incorporate that difference)
Long term r sL will change, so horizon WACC will change, so horizon value will change.
New WACC Calculation New r sL = r sU + (r sU – r d )(D/S) = 11.56% + (11.56% - 10%)(0.4/0.6) = 12.60% New WACC = w d r d (1-T) + w s r sL = 0.4(10%)(1-0.4) + 0.6(12.6%) = 9.96% All data are from the mini case.
New Horizon Value Calculation
Horizon value =
= $554.1 million.
New V ops and V equity 2004 2005 2006 2007 Free Cash Flow $11.7 $10.5 $16.5 $ 20.7 Horizon value 554.1 Interest tax shield 2.0 2.6 2.6 2.8 Total $13.7 $13.1 $19.1 $577.6 V Ops = + + + = $409.5 million . $13.7 (1.1156) 1 $13.1 (1.1156) 2 $19.1 (1.1156) 3 $577.6 (1.1156) 4
New Equity Value
$409.5 million - 55 million = $354.5 million
This is $65.1 million, or $3.26 per share more than if the horizon capital structure is 20% debt.
The added value is the value of the additional tax shield from the increased debt.
Pooling of interests is GONE. Only purchase accounting may be used now.
What method is used to account for for mergers? (More...)
The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net asset value.
Goodwill is often created, which appears as an asset on the balance sheet.
Common equity account is increased to balance assets and claims.
Goodwill is NO LONGER amortized over time for shareholder reporting.
Goodwill is subject to an annual “impairment test.” If its fair market value has declined, then goodwill is reduced. Otherwise it is not.
AOL Time Warner wrote down $54 billion of goodwill in 2002 because of “impairment test.”
Goodwill is still amortized for Federal Tax purposes. Can amortize goodwill over 15 years using straight-line method.
Should also consider factors other than cash flows, such as Corporate Culture, marketing philosophies, and personnel policies.
Merger talks often collapse because of “social issues” and “chemistry.”
Who will run the combined company?
What will be the name of the combined firm?
Where will the headquarters be located?
Analysis for a “True Consolidation” - Merger of Equals
Develop pro forma financial statements for the consolidated corporation. Determine the projected consolidated free cash flows available to stockholders.
Estimate the new company’s unlevered cost of equity, and use that rate to discount the free cash flows and interest tax shields of the consolidated company.
Decide how to allocate the new company’s stock between the two sets of old stockholders.
Help arrange mergers
No “parked stock”
Develop defensive tactics
Value target companies
Help finance mergers
Invest in stocks of potential merger candidates
Trend is away from using investment bankers, especially for smaller deals
What merger-related activities are undertaken by investment bankers?
According to empirical evidence, 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, that is, the final price is close to full value.
Target management can always say no.
Competing bidders often push up prices.
Do mergers really create value?
Studies show stock price of target firms increase by 30% in hostile tender offers, while in friendly tender offers, the increase is 20%.
61% of buyers destroyed their own shareholder’s wealth
In April 2002, AOL Time Warner took a $54 billion charge
17 out of the 21 “winners” in the merger spring of 1998 were a “bust” for investors who owned the shares
Reasons for Merger Failure
Overpay by a sizeable premium
Overestimate likely cost savings and synergies
Delay over integrating operations after merger
Emphasis on cost-cutting, damaging the business and losing key personnel
Other Failure Results
Paid $11.3 billion for CIT in June 2001 and completed an IPO for $4.6 billion in July 2002 (loss of 6.7 billion)
First Union Corp
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
Leveraged Buyout (LBO)
A small group of equity investors, usually including current management, acquires a firm in a transaction financed largely by borrowing. They “go private.” Typically buy publicly held stock. Can be a subsidiary of a public company.
Purchase often financed mostly with debt.
After operating privately for a number of years, investors might take the firm public to “cash out.”
Very prevalent during the 1980s
Leverage Buyout (LBO) Continued
Between January 2002 and November 6, 2002, LBOs were up 50% vs. the same period the previous year to $20 billion. In the third quarter of 2002, LBOs accounted for almost 10% of all mergers & acquisitions, their largest share since 1989.
Nov. 19, 2002 – Northrop Grumman Corp. sold TRW Automotive Business to Blackstone for $4.73 Billion
April, 2003 – Investor Group purchased Aladdin Resort & Casino for $500 million
Nov. 17, 2003 – DuPont sold its Invista textiles unit to Koch Industries for $4.4 billion
Administrative cost savings
Increased managerial incentives
Increased managerial flexibility
Increased shareholder participation
Limited access to equity capital
No way to capture return on investment
How to exit an LBO
Sell to another company
What are are the advantages and disadvantages of going private?
Types of Divestitures
Sale of an entire subsidiary to another firm
Target and Marshall Field
Spinning off a corporate subsidiary by giving stock to existing shareholders
AT&T and Lucent Technologies
A minority interest in a corporate subsidiary is sold to new shareholders, so the parent gains new equity financing yet retains control
Philip Morris and Kraft
Outright liquidation of assets
Subsidiary worth more to buyer than when operated by current owner.
To settle antitrust issues.
Subsidiary’s value increased if it operates independently.
To change strategic direction.
To shed money losers.
To get needed cash when distressed.
What motivates firms to divest assets?
Divestitures vs. Acquisitions
Not the “opposite side of a coin” of an acquisition
Like selling a house, one purchaser at a time
Have to decide what it is worth to someone else
Typically an admission of failure
Hurts the Balance Sheet and benefits the Income Statement
Risks and Returns are different
A holding company is a corporation formed for the sole purpose of owning the stocks of other companies.
In a typical holding company, the subsidiary companies issue their own debt, but their equity is held by the holding company, which, in turn, sells stock to individual investors.
What are holding companies?
Holding Companies - Advantages and Disadvantages
Control with fractional ownership
Isolation of risks (but often the parent is still responsible)