1. CHAPTER 26
Mergers, LBOs, Divestitures,
and Holding Companies
1

2. Topics in Chapter
 Types of mergers
 Merger analysis
 Role of investment bankers
 LBOs, divestitures, and holding
companies
2

3. What are some valid economic
justifications for mergers?
 Synergy: Value of the whole exceeds
sum of the parts. Could arise from:
 Operating economies
 Financial economies
 Differential management efficiency
 Taxes (use accumulated losses)
3

4. Valid Reasons (Continued)
 Break-up value: Assets would be more
valuable if broken up and sold to other
companies.
4

5. What are some questionable
reasons for mergers?
 Diversification
 Purchase of assets at below
replacement cost
 Acquire other firms to increase size,
thus making it more difficult to be
acquired
5

6. Five Largest Completed Mergers
(as of December, 2007)
BUYER TARGET VALUE (Billion)
Vodafone
AirTouch Mannesman $161
Pfizer Warner-Lambert 116
America Online Time Warner 106
ABN-AMRO
RFS Holdings Holding 99
Exxon Mobil 81
6

7. Differentiate between hostile
and friendly mergers
 Friendly merger:
 The merger is supported by the
managements of both firms.
7

8.  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.
8

9. Reasons why alliances can make
more sense than acquisitions
 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
9

10. Reason to Use APV in Merger
Valuation
 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.
10

11. 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.
11

12. 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 discounted at unlevered cost of
equity.
Interest tax savings = Interest(tax rate) = TSt.
12

13. Note to APV
 APV is the best model to use when the
capital structure is changing.
 The Corporate Valuation model (i.e.,
discount FCF at WACC) is easier to use
than APV when the capital structure is
constant.
13

14. Steps in APV Valuation
 Project FCFt ,TSt until company is at its target
capital structure for one year and is expected
to grow at a constant rate thereafter.
 Project horizon growth rate.
 Calculate the unlevered cost of equity, rsU.
 Calculate horizon value of tax shields using
constant growth formula and TSN.
 Calculate horizon value of unlevered firm
using constant growth formula and FCFN.
14

15. Steps in APV Valuation
(Continued)
 Calculate unlevered value of firm as PV
of unlevered horizon value and FCFt
 Calculate value of tax shields as PV of
tax shield horizon value and TSt
 Calculate Vops as sum of unlevered value
and tax shield value.
15

16. Estimating the Value of Equity
Value of operations
+ Value of any non-operating assets
= Total value of the firm
- Value of debt (pre-merger)
= Value of equity
16

17. APV Valuation Analysis (In Millions)
Based on Post-Acquisition Cash Flows
2009 2010 2011
Net sales $ 60.00 $ 90.00
Cost of goods sold (60%) 36.00 54.00
Selling/administrative expense 4.50 6.00
EBIT 19.50 30.00
Taxes on EBIT (40%) 7.80 12.00
NOPAT 11.70 18.00
Total net operating capital 150.0 150.00 157.50
Investment in net operating capital 0.00 7.50
Free Cash Flow 11.70 10.50
17

18. Cash flows… continued
2012 2013 2014
Net sales $ 112.50 $ 127.50 $ 139.70
Cost of goods sold (60%) 67.50 76.50 83.80
Selling/administrative expense 7.50 9.00 11.00
EBIT 37.50 42.00 44.90
Taxes on EBIT (40%) 15.00 16.80 17.96
NOPAT 22.50 25.20 26.94
Total net operating capital 163.50 168.00 173.00
Investment in net operating capital 6.00 4.50 5.00
Free Cash Flow 16.50 20.70 21.94
18

19. Interest Tax Savings after
Merger
2009 2010 2011
Interest expense 5.00 6.50
Tax savings from interest $ 2.00 $ 2.60
2012 2013 2014
Interest expense 6.50 7.00 8.16
Tax savings from interest $ 2.60 $ 2.80 $ 3.26
Note: Tax savings = interest expense (Tax rate). The tax
rate is 40%
19

20. What is investment in net
operating capital?
 Recall that firms must reinvest in order
to replace worn out assets and grow.
 Investment in net operating capital =
change in total net operating capital.
 This is equivalent to gross investment in
operating capital minus depreciation
20

21. Non-Operating Assets
 Short-term investments and marketable
securities are non-operating assets.
The Target has none of these.
21

22. 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.
 These cash flows can be redeployed
within the acquiring firm.
22

23. Discount rate…
 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, rsU
 The interest tax shields are also
discounted at the unlevered cost of
equity, rsU
23

24. Note: Comparison of APV with
Corporate Valuation Model
 APV discounts FCF at rsU and also the tax
shields at rsU; the value of the tax savings is
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 the capital
structure is constant. But if the capital
structure is changing, then APV should be
used.
24

25. Discount Rate for Horizon
Value
 The last year of projections must be at the
target capital structure with constant growth
thereafter.
 Discount the FCFs using the constant growth
formula to find the unlevered horizon value.
 Discount the tax shields using the constant
growth formula to find the horizon value of
the tax shields.
25

26. Discount Rate Calculations
Target’s data: rRF = 7%; RPM = 4%, beta =
1.3, wd =20%, rd = 9%.
rsL = rRF + (RPM)bTarget
= 7% + (4%)1.3 = 12.2%
rsU = wdrd + wsrsL
= 0.20(9%) + 0.80(12.2%)= 11.56%
26

27. Unlevered Horizon Value
(Constant growth of 6%)
(FCF2014)(1+g)
Unlevered Horizon Value =
rsU - g
= $21.94(1.06)
0.1156 – 0.06
= $418.3 million.
27

28. Unlevered Value
2010 2011 2012 2013 2014
Free Cash Flow $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 21.94
Unlevered Horizon Value $ 418.3
Total $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 440.2
$11.7 $10.5 + $16.5
VUL = + + $20.7 + $440.2
(1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5
= $298.9 million.
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29. Unlevered Value
The unlevered value is the value of the
firm’s operations if it had no debt. In
this case Lyons’ operations would be
worth $298.9 million if it were financed
with 100% equity.
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30. Tax Shield Horizon Value
(TS2014)(1+g)
Tax Shield Horizon Value =
rsU - g
= $3.26(1.06)
0.1156 – 0.06
= $62.2 million.
30

31. Tax Shield Value
2010 2011 2012 2013 2014
Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 3.264
Tax shield horizon value $ 62.2
Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 65.5
$ 2.0 $ 2.6 + $ 2.6
VTS = + + $ 2.8 + $ 65.5
(1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5
= $45.5 million.
31

32. What Is the value of the Target Firm’s
operations to the Acquiring Firm? (In Millions)
Value of operations
= unlevered value + value of tax shield
= 298.9 + 45.5 = $344.4 million
32

33. What is the value of the Target’s
equity?
 The Target has $55 million in debt.
 Vops + non-operating assets – debt =
equity
 344.4 million + 0 – 55 million = $289.4
million = equity value of target to the
acquirer.
33

34. 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.
 Further, a different beta estimate,
financing mix, or tax rate would change
the discount rate.
34

35. The Bid Price
 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?
35

36.  Estimate of target’s value = $289.4 million
 Target’s current value = $220.0 million
 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.
36

37.  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.
37

38. Change in Shareholders’
Wealth
Acquirer Target
$11.00 $14.47
Price Paid
for Target
0 5 10 15 20
Bargaining Range
38
= Synergy

39. 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.
39

40.  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?
40

41. What if the Acquirer intended to increase the
debt level in the Target to 40% with an interest
rate of 10%?
 Assume debt at the end of 2013 will be
$221.6 million.
 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). Interest in 2014 will change.
 Interest2014 = 0.10(221.6) = $22.16 million
 Tax Shield2014 = 22.16(0.40) = $8.864 million
41

42. New Tax Shield Horizon Value
Calculation
(TS2014)(1+g)
Tax Shield Horizon Value =
rsU - g
= $8.864(1.06)
0.1156 – 0.06
= $169.0 million.
42

43. New Tax Shield Value
2010 2011 2012 2013 2014
Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 8.864
Tax shield horizon value $ 169.0
Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 177.9
$ 2.0 $ 2.6 + $ 2.6
VTS = + + $ 2.8 + $177.9
(1.1156)1 (1.1156)2 (1.1156)3 (1.1156)4 (1.1156)5
= $110.5 million.
43

44. Increase in Tax Shield
 The old tax shield value was $45.5
million when the company was financed
with 20% debt.
 When the company is financed with
40% debt, the tax shield value
increases to $110.5 million. The
increase is due to the larger interest
deductions.
44

45. New Vops and Vequity
Value of operations
= unlevered value + value of tax shield
= 298.9 + 110.5 = $409.4 million
Value of equity
= Value of operations + non-operating
assets – debt
45

46. New Equity Value
 $409.4 million - 55 million = $354.4
million
 This is $65 million, or $3.25 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.
46

47. Do mergers really create
value?
 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.
47

48. What method is used to
account for mergers?
 Pooling of interests is GONE. Only
purchase accounting may be used now.
48

49. Purchase Accounting
 Purchase:
 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.
49

50. Goodwill Amortization
 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.
 Goodwill is still amortized for Federal
Tax purposes.
50

51. What are some merger-related
activities of investment bankers?
 Identifying targets
 Arranging mergers
 Developing defensive tactics
 Establishing a fair value
 Financing mergers
 Arbitrage operations
51

52. What is a leveraged buyout
(LB0)?
 In an LBO, a small group of investors,
normally including management, buys
all of the publicly held stock, and hence
takes the firm private.
 Purchase often financed with debt.
 After operating privately for a number
of years, investors take the firm public
to “cash out.”
52

53. What are the advantages and
disadvantages of going private?
 Advantages:
 Administrative cost savings
 Increased managerial incentives
 Increased managerial flexibility
 Increased shareholder participation
 Disadvantages:
 Limited access to equity capital
 No way to capture return on investment
53

54. What are the major types of
divestitures?
 Sale of an entire subsidiary to another
firm.
 Spinning off a corporate subsidiary by
giving the stock to existing
shareholders.
 Carving out a corporate subsidiary by
selling a minority interest.
 Outright liquidation of assets.
54

55. What motivates firms to divest
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.
55

56. What are holding companies?
 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.
56

57. Advantages and Disadvantages of
Holding Companies
 Advantages:
 Control with fractional ownership.
 Isolation of risks.
 Disadvantages:
 Partial multiple taxation.
 Ease of enforced dissolution.
57