Equity Valuation

1. TUTORIAL 9: TAKEOVERS
DISCUSSION QUESTIONS
Q1 Give an example of synergy benefit in a takeover situation. Will synergies provide value
for a merger?
Synergy, in general, may be defined as two or more agents working together to produce a
result not obtainable by any of the agents independently. Synergy is the potential additional
value from combining two firms. Sources of operational synergy may stem from, for
example a horizontal acquisition, where an increase in scale of operations that may result in
economies of scale allowing the firm to become more cost efficient. Alternatively, in vertical
takeover benefits may arise by securing supply from a major producer.
With financial synergies, the payoff can take the form of either higher cash flows or a lower
cost of capital. For example, the debt capacity may increase because when two firms
combine their earnings and cash flow become more stable. Another benefit may result from
reducing the tax burden when profits are combined with another firm’s net operating
losses.
If synergy is perceived to exist in a takeover, the value of the combined entity should be
greater than the sum of the bidding and target firms and it is possible that both
shareholders of target and bidder can be better off. The success of a merger or acquisition
depends on whether this synergy is achieved.
Q2 Will EPS increase, decrease or remain unchanged in a takeover financed by a share
exchange?
In a takeover financed by a share exchange, EPS after the takeover can increase, decrease or
remain unchanged depending on the relationship between earnings ratio and the ratio of
shares issued to shares already issued by bidder.
Condition for EPS to increase EPSCombined >EPSBidder
This condition can be represented by
EB+ET
n+m
>
EB
n
This can be re-organised as:
ET
EB
>
m
n

2. m: number of shares offered to issue to target shareholders
n: number of shares of bidder
For EPS to remain unchanged, the condition is:
ET
EB
=
m
n
For EPS to decrease,
ET
EB
<
m
n
This condition is applicable under zero sum game (no synergy) and non-zero sum game
(synergies exist). If synergies exist, after the takeover, earnings of target company will be
increased by the annual effect of synergy.
PROBLEMS
Q1 BHP Billiton Takeover of WMC 2005
a) Determine the value of the merged firm (assume Rf = 5% and Rm – Rf = 7%). Assume that
the Independent’s valuation of the target represents its intrinsic value.
VC = VB + VT + VSynergy – ConsT (Cash)
Value of Bidder
VB = = Share price * Outstanding Shares = 17.85 (3,113.82m) = $55,581.687m
Value of Target
Using Independent export valuation of target as Value ‘as is’ = number of shares x value per
share (mid-point of independent expert’s valuation)
= 1,222.93m x $7.50 = $9,171.975m Value ‘as is’
Value of gains/ synergy
 Once only saving of $120m
 Ongoing cost saving of $115 pa
Since these gains are linked with the target, the relevant cost of equity is that for WMC
re = 5% + 1.7 (7%) = 16.9%
Value of gains/ synergy = 120 + (115/ .169) = $800.473m
Total offer price = $9.6b
VC = $55,581.687m + 9,171.975m + $800.473m – 9,600m = $55,954.135m

3. b) Identify the target shareholders gain/ loss
Target shareholders gain/ loss (Premium) = 𝐶𝑜𝑛𝑠𝑇 − 𝑉𝑇 =$9,600m – 9,171.975m =
$428.025m
c) Identify the acquiring companies gain/ loss
𝐵𝑖𝑑𝑑𝑒𝑟𝑠 𝐺𝑎𝑖𝑛 = 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = $800.437m – 428.025m = $372.448m
Note that I have not factored the change of capital structure to the valuation. Recall, that
finance theory argues a separation of the investing and financing decisions. This means that
the capital investment decision is independent of the financing decision.
d) Re-calculate answers to parts a) –c), if BHP had offered shares instead
Assume share exchange (cash equivalent) in given in the form:
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑇
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝐵
=
7.85
17.85
= 0.44
This means BHP would issue 44 shares in BHP for every 100 shares held in WMC. Calculate
the number of shares issued by BHP
𝑚 =
7.85
17.85
(1,222.93) = 538 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑝𝑝𝑟𝑜𝑥
Using formula
Share price of merged firm
𝑃𝐶 =
𝑉𝐶
𝑛 + 𝑚
=
𝑉𝐵 + 𝑉𝑇 + 𝑉𝑆𝑦𝑛𝑒𝑟𝑔𝑦 − 𝐶𝑜𝑛𝑠𝑇 (𝐶𝑎𝑠ℎ)
𝑛 + 𝑚
𝑃𝐶 =
55,581.687 + 9,171.975 + 800.473 − 0
3,113.82 + 538
=
65,554.135
3,651.9092
= $17.95 𝑝𝑠
Consideration for target, ConsT = 17.95 (538) = $9,657.1m
Target shareholders gain/ loss: 9,657.1 – 9,171.975 = $485.128m
Acquirers gain/loss = 800.473 – 485.128 = $315.345m
e) Are BHP shareholders better off issuing cash or a share exchange?
Shareholders of the acquiring company are worse off since part of the premium is not
shared with the acquiring shareholders.
We can say that:
 If Vsyn > 0 then premium paid to target shareholders is greater for share exchange
than for a cash offer (since under a share exchange they receive part of the gain that
bidder shareholders would receive under a cash offer- this is because in a share
exchange they also become shareholders of the bidder).

4.  If Vsyn = 0 then premium paid to target shareholders is greater for a cash offer than
for a share exchange (since under a share exchange they receive part of the loss that
bidder shareholders receive under a cash offer).
f) Identify the exchange offer that is fair to both shareholders of target and acquiring firm.
An exchange offer in the proportion of the fair value in shares of both the target and
acquiring company.
𝐹𝑎𝑖𝑟 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 =
𝐹𝑎𝑖𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑎𝑟𝑔𝑒𝑡 𝑠ℎ𝑎𝑟𝑒𝑠
𝐹𝑎𝑖𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑏𝑖𝑑𝑑𝑒𝑟 𝑠ℎ𝑎𝑟𝑒𝑠
=
$7.50
$17.85
=
42 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝐵𝐻𝑃 𝑓𝑜𝑟 𝑒𝑣𝑒𝑟𝑦 100 𝑠ℎ𝑎𝑟𝑒𝑠 ℎ𝑒𝑙𝑑 𝑖𝑛 𝑊𝑀𝐶’s
This means that shareholders of Target are getting a better deal (44 shares) than a ‘fair
exchange’.
Exchange offer: lấy share price (WMC) following BHP’s offer
Fair exchange: lấy share price prior to BHP’s offer
g) Determine the P/E ratio that should be used to value the merger under the exchange
offer (part (g)) that is consistent with your answer for part (d).
From (d)
𝑉𝐶 = 55,581.687 (𝐵𝐻𝑃) + 9,171.975 (𝑊𝑀𝐶)+ 800.473 (𝑆𝑦𝑛𝑒𝑟𝑔𝑦) = $65,554𝑚
𝑃𝐶 =
65,554
3,651.9092
= $17.95𝑝𝑠
From (g)
𝐸𝑃𝑆𝐶 =
4,939.8 (𝐵𝐻𝑃) + 1,326.9 (𝑊𝑀𝐶)+ 115 (𝑆𝑎𝑣𝑖𝑛𝑔𝑠)
3,113.82 (𝐵𝐻𝑃) + 538 (𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠)
= $1.75
Therefore $1.75 𝑥 𝑃
𝐸
⁄ = $17.95
𝑃
𝐸
⁄ =
17.95
1.75
= 𝟏𝟎.𝟑
Consistent with lecture, the P/E ratio for the combined entity can be verified using a
weighted average P/E’s of the bidder and target in proportion of profit contribution as
follows:
𝑃/𝐸𝐶 = 𝑃/𝐸𝐵 (
𝐸𝐵
𝐸𝐵 + 𝐸𝑇 + 𝐸𝑆𝑌𝑁
) + 𝑃/𝐸𝑇 (
𝐸𝑇 + 𝐸𝑆𝑌𝑁
𝐸𝐵 + 𝐸𝑇 + 𝐸𝑆𝑌𝑁
)
𝑃/𝐸𝐵 =
17.85
1.59 (𝑖.𝑒.
4939.8
3113.82
)
= 11.23

5. 𝑃/𝐸𝑇 =
7.50
(1,326.9
1,222.93
⁄ )
= 6.91
Therefore
𝑃/𝐸𝐶 = 11.23(
4939.8
4939.8 + 1326.9 + 115
) + 6.91 (
1326.9 + 115
4939.8 + 1326.9 + 115
) = 10.3