MERGERS

Growth of Corporation occurs through;

1. Internal Expansion that is growth

2. Mergers

MERGERS:

 When two firms combine to form a single firm

 A merger usually involves combining two companies into a single larger company.

A merger usually involves combining two companies into a single larger company. The
combination of the two companies involves a transfer of ownership, either through
a stock swap or a cash payment between the two companies. In practice, both companies
surrender their stock and issue new stock as a new company. 

ACQUISITION:

An acquisition is when one company purchases most or all of another company's shares to
gain control of that company.

Purchasing more than 50% of a target firm's stock and other assets allows the acquirer to
make decisions about the newly acquired assets without the approval of the company’s
shareholders.

 (M&A) occur more regularly between small- to medium-size firms than between
large companies.

LEVERAGED BUYOUTSLBO):

A leveraged buyout (LBO) is the acquisition of another company using a significant

amount of borrowed money to meet the cost of acquisition.

DIVESTITURE:

A divestiture or divestment is the reduction of an asset or business through sale,

liquidation, exchange, closure, or any other means for financial or ethical reasons.

HOLDING COMPANY:

A holding company is a company that owns the outstanding stock of other companies. A
holding company usually does not produce goods or services itself. Its purpose is to own
shares of other companies to form a corporate group.

Primary motive of Merger:

1. Synergy: The primary motivation for most mergers is to increase the value of the
combined firms.
 If company A and B merged to form Company C and C’s value exceeds that of A and B
taken together, then synergy is said to exist and such a merger should be beneficial
to both A’s and B’s stockholders.

Item Company A Company B Combined (A+B)

No. of Shares 200,000 100,000 250,000

Earnings ($/year) 200,000 100,000 300,000

EPS($) 1.00 1.00 1.20

Share price ($) 10.00 5.00 10.00

P/E ratio 10.00 5.00 8.33

Market Value of equity $2M $ 0.5 M $ 2.5 M

After merger No of shares 200,000 50,000

EPS = Total earnings/No. of Shares = 300000/250000 = 1.2

P/E Ratio = Market Price/EPS = 10/1.2 = 8.33

Synergetic effect can arise from five sources:

 Operating economies; which result from economies of scale in management,

marketing, production or distribution?

 Financial economies, lower transaction cost and better coverage by security

analyst.

 Tax effect, combined firm pays less tax than to separate firms pay.

 Differential efficiency, which implies that management of one firm is more

efficient and the weaker firm’s assets are more productive.

 Improved market power due to reduced competition

2. Tax Consideration: A profitable firm in the highest tax bracket could acquire a firm
with large accumulated tax losses. Then these losses could then be turned into
immediate tax savings rather than carried forward.

3. Purchase of Assets Below Their Replacement Cost.

4. Diversification: Diversification helps stabilize a firm’s earnings and thus benefits its
owners.

5. Managers’ Personal Incentives.

 6. Breakup Value: Some takeover specialists estimate the company’s breakup value,
which is the value of individual part of the firm if they were sold off separately. If
this value is higher, then the firm is acquired at or even above its current market
value and, sells it off in pieces and earns a profit.

There are several types of mergers. For example,

1. Horizontal mergers may happen between two companies in the same industry, such
as banks or steel companies.

2. Vertical mergers occur between two companies in the same industry value chain,
such as a supplier or distributor or manufacturer.

3. Concentric Mergers between two companies in related, but not the same industry
are called concentric mergers. These mergers can use the same technologies or
skilled workforce to work in both industry segments, such as banking and leasing.

4. Conglomerate mergers occur between two diversified companies that may share

management to improve economies of scale for both companies.

Merger Analysis: There are two basic approaches used in merger valuation:

a. Discounted cash flow techniques.

b. Market multiple analyses: This approach assume that a target is directly comparable
to the average firm in the industry.

There are three discounted cash flow method:

i. Corporate valuation method

ii. The adjusted present value method and

iii. The equity residual method ( also called FCF to Equity FCFE method)

There are two types of firms:

Levered Firm: Cost of levered firm is determined as

KL = KRF + b (RP) RP=risk premium CAPM: It is the cost of equity.

Unlevered firm: Cost of unlevered firm is determined as

K U = W s K L + Wd K d

WACC = Wd Kd (1-T) + Ws KsL Kd = cost of debt

 Summary of Cash Flow Approaches

1. CORPORATE VALUATION MODEL

FCF = NOPAT − Net investment in operating capital

2. FREE CASH FLOW TO EQUITY MODEL

FCFE = FCF − Interest expense + Interest tax shield + Net change in debt

3. APV MODEL
FCF + Interest tax savings

ILLUSTRATION:
Consider Caldwell Corporation evaluates the potential acquisition of Tutwiler Controls.
Tutwiler’s current market value is $ 89.5 million, consisting of $ 27million debt and $ 62.5
million in equity. Tutwiler is a publically traded company, and its market determined pre-
merger beta was 1.2. Given a risk free rate of 7% and a 5% risk premium. After 2015, the
firm will grow at 6% per forever. Tax Rate 40%

Post -Merger Project ions for the Tutwiler Subsidiary (Mi l l ions of Dol lar s )
1/1/11 12/31/11 12/31/12 12/31/13 12/31/14
12/31/15
SELECTED ITEMS FROM PROJECTED
FINANCIAL STATEMENTS
1. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
2. Cost of goods sold 80.0 94.0 113.0 129.3 142.0
3. Selling and admin expenses 10.0 12.0 13.0 15.0 16.0
4. Depreciation 8.0 8.0 9.0 9.0 10.0
5. EBIT $ 7.0 $ 12.0 $ 16.0 $ 20.7 $ 23.0
6. Interest expense 3.0 3.2 3.5 3.7 3.9
7. Debtc 33.2 35.8 38.7 41.1 43.6 46.2
8. Total net operating capital 116.0 117.0 121.0 125.0 131.0 138

How much would Tutwiler be worth to Cardwell after the merger?

FCFE Method: It is the cash flow available for distribution to common stockholders. Because
FCFE is available for distribution to common stockholders, it should be discounted at cost of
equity.

K = Risk free rate + beta (Risk premium) =0,07 + 1.2 (0.05) = 0.13= 13%

EBIT(1-Tax) 4.2 7.2 9.6 12.42 13.8

Change in Net Operating Capital (1.0) (4.0) (4.0) (6.0) (7.0)
Free Cash Flow 3.2 3.2 5.6 6.42 6.8
Interest Expense (3.0) (3.2) (3.5) (3.7) (3.9)
Interest Tax Savings (40%) 1.2 1.28 1.4 1.48 1.56
Change in debt 6.2 2.6 2.9 2.4 2.5 2.6
FCFE 6.2 4 4.18 5.9 6.7 7.06

HV2015 = FCF2015(1+g)/(k-g) = 7.06(1.06)/0.07 = 106.9

VFCFE = 6.2 + 4/1.13 + 4.18/(1.13)2 + 5.9/(1.13)3+6.7/(1.13)4 +(7.06+106.9)/(1.13)5
VFCFE = $ 83.06 million.
As Tutwiler has no non-operating assets, its total equity value is $ 83.06 million.
This value is more than the current market value of $ 62.5 million. Therefore Tutwiler is
more valuable to Caldwell.

PROBLEM
The following information is required to work Problems 21-1 through 21-4.
Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1
million shares outstanding and a target capital structure consisting of 30% debt. Vandell’s
debt interest rate is 8%. Assume that the risk-free rate of interest is 5% and the market risk
premium is 6%. Both Vandell and Hastings face a 40% tax rate.
Data
Share = 1 Million
Debt = 30% @ 8%
RRF = 05%
RP = 6%
Tax Rate 40%

1. Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a
constant rate of 5% a year; its beta is 1.4. What is the value of Vandell’s operations?
If Vandell has $10.82 million in debt, what is the current value of Vandell’s stock?
Answer:
Data FCF = 2M G= 5% B= 1.4 Debt =10.82M
Ks= 5% + 1.4*6% = 13.4%
WACC = 0.3*0.08*0.6 + 0.7*0.134 = 10.82%
VOP = FCF(1+g)/WACC-g
VOP = 2(1+0.05)/(0.1082-0.05)
VOP = 36.082M
Value of Stock = Vop – Debt = 36.082M – 10.82M = 25.26M
Price of Stock = Value of Stock/ No. of Shares= 25.26/1M
P =25.26

2. Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000

per year for 3 years, after which the current target capital structure of 30% debt
will be maintained. Interest in the fourth year will be $1.472 million, after which
interest and the tax shield will grow at 5%. Synergies will cause the free cash flows
to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years 1 through 4,
respectively, after which the free cash flows will grow at a 5% rate. What is the
unlevered value of Vandell, and what is the value of its tax shields? What is the per
share value of Vandell to Hastings Corporation? Assume that Vandell now has
$10.82 million in debt.
 Answer:
Data FCF = 2.5M, 2.9M, 3.4M and 3.57M respectively
Debt = 30% G= 5% Debt= 10.82M
Interest 1-3 year = 1500000 and 1.472M in 4th year
Solution WACC = 0.3*0.08 + 0.7*0.134 =11.78%
Tax Shield = 1500000*0.4 = 600000
FCF + Tax Shield
2.5M + 600000 = 3.1M
2.9M + 600000 = 3.5M
3.4M + 600000 = 4M

Vop = 4(1+0.05)/ (0.1178-0.05) = 61.946M

PV= 3.1 / (1.1178)1 + 3.5/ (1.1178)2 + 4+61.946/ (1.1178)3 = 52.79
Value of Stock = 52.79 – 10.82 =41.52
Price = 41.52/1M = 41.52

3. On the basis of your answers to Problems 21-1 and 21-2, indicate the range of
possible prices that Hastings could bid for each share of Vandell common stock in an
acquisition.
Answer:
Possible range for the each Stock = 25.25 to 41.52

4. Assuming the same information as for Problem 21-2, suppose Hastings will increase
Vandell’s level of debt at the end of Year 3 to $30.6 million so that the target capital
structure is now 45% debt. Assume that with this higher level of debt the interest
rate would be 8.5%, and assume that interest payments in Year 4 are based on the
new debt level from the end of Year 3 and a new interest rate. Again, free cash flows
and tax shields are projected to grow at 5% after Year 4. What are the values of the
unlevered firm and the tax shield, and what is the maximum price that Hastings
would bid for Vandell now?
Answer:
Debt = 45% at 8.5%
5. Hastings estimates that if it acquires Vandell, interest payments will be $1,500,000
per year for 3 years, after which the current target capital structure of 30% debt
will be maintained. Interest in the fourth year will be $1.472 million, after which
interest and the tax shield will grow at 5%. Synergies will cause the free cash flows
to be $2.5 million, $2.9 million, $3.4 million, and $3.57 million in Years 1 through 4,
respectively, after which the free cash flows will grow at a 5% rate. What is the
unlevered value of Vandell, and what is the value of its tax shields? What is the per
share value of Vandell to Hastings Corporation? Assume that Vandell now has
$10.82 million in debt.
 Data:
Solution WACC= 0.45*0.085 + 0.55*0.134 =11.195%
Data FCF = 2.5M, 2.9M, 3.4M and 3.57M respectively
Debt = 30% G= 5%, Debt will increase at the end of 3rd year 30.6M
Tax Shield = 1500000*0.4 = 600000
FCF + Tax Shield
2.5M + 600000 = 3.1M
2.9M + 600000 = 3.5M
3.4M + 600000 = 4M
3.57M + 588800 = 4.1588M
Vop = 4.1588(1+0.05)/ (0.11195-0.05) = 67.796M
PV= 3.1/(1.11195)1 + 3.5/(1.11195)2 + 4+67.796/(1.11195)3 = 57.839
Value of Stock = 57.839 – 30.6 =27.229
Price = 47.839/1M = 47.839

6. VolWorld Communications Inc., a large telecommunications company, is evaluating

the possible acquisition of Bulldog Cable Company (BCC), a regional cable company.
VolWorld’s analysts project the following post-merger data for BCC (in thousands of
dollars, with a year end of December 31)
Data 2010 2011 2012 2013 2014 2015
Net sales $450 $518 $ 555 $ 600 $ 643
Selling and admin expense 45 53 60 68 73
Interest 40 45 47 52 54
Total net operating capital $800 850 930 1,005 1,075 1,150
Tax rate after merger: 35%
Cost of goods sold as a percent of sales: 65%
BCC’s pre-merger beta: 1.40
Risk-free rate: 6%
Market risk premium: 4%
Terminal growth rate of free cash flows: 7%
If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in
the income statements are assumed to occur at the end of the year. BCC currently
has a capital structure of 40% debt, which costs 10%, but over the next 4 years. Vol-
World would increase that to 50%, and the target capital structure would be
reached by the start of 2015. BCC, if independent, would pay taxes at 20%, but its
income would be taxed at 35% if it were consolidated. BCC’s current market-
determined beta is 1.4. The cost of goods sold is expected to be 65% of sales.
a. What is the unlevered cost of equity for BCC?
b. What are the free cash flows and interest tax shields for the first 5 years?
c. What is BCC’s horizon value of interest tax shields and unlevered horizon value?
d. What is the value of BCC’s equity to VolWorld’s shareholders if BCC has $300,000
in debt outstanding now?
Answer
Ks = 6% + 1.4* (4%) = 11.6%
A. WACC (Unleveraged) = 0.4*0.1 + 0.6*0.116 = 0.1096 = 10.96%

After Merger Debt ratio is 50%

KsL = Ksu + (Ksu - Ks)*(Debt ration/Equity Ratio)
KsL = 10.96% + (10.96% - 10%)*(50%/50%) = 11.92%
WACC = 0.5*0.1*0.65 + 0.5*0.1192 = 9.21%

Data 2010 2011 2012 2013 2014 2015

Net sales $450 $518 $ 555 $ 600 $ 643
Cost of Goods Sold 292.5 336.7 360.75 390 417.95
Selling and admin expense 45 53 60 68 73
EBIT 112.5 188.3 134.25 150 152.05
Tax 35% (39.375) (65.91) (46.99) (52.5) (53.22)
EBIT (1-T) 73.13 83.40 87.26 92.30 98.83
Change in Net operating Capital (50) (80) (75) (70) (75)
FCF 23.13 3.40 12.26 22.30 23.83
Interest Saving 14 15.75 16.45 18.2 18.9

HVU,2015 = FCF2015*(1 + g) / (rU – g)

= 23.83*(1 + 0.07) / (0.1096 – 0.07) = $643,891
HVTS,2015 = TS2015*(1 + g) / (rU – g)
= 18.90*(1 + 0.07) / (0.1096 – 0.07) = $510,682

VUnlevered = FCF11 + FCF12 + FCF13 + FCF14 + (FCF15 + HVU)

= 20.85 + 2.76 + 8.97 + 14.71 + 14.17 + 382.81 = $444,270
VTS = TS11 + TS12 + TS13 + TS14 + TS15 + HTS
= 12.62 + 12.79 + 12.04 + 12.01 + 11.24 + 303.61= $363,310

VOperation = VUnlevered + VTS

= 444,270 + 363,310= $807,580
Since there is no non-operating asset, BCC total value is the same as Value of
operation.
Vequity = Vtotal – Vdebt
= 807,580 – 300,000= $507,580