BA 7000-093

Chapter 11

Chapter 11 Mergers and Acquisitions

Key Learning Outcomes
Understanding the potential items to value in M&A and to be able to assess potential implications of acquirers method of payment

A. Basics
Valuation of merger target is from the perspective of acquiring companys shareholders Net present value of acquisition is the value of the target to acquirer minus the effective cost B. Value of target to acquirer Value of the target to the acquirer is made up of: 1. Stand alone value of the target plus - Value of improvements at target made by acquirer management plus - Value of pure synergies between target and acquirer C. Valuations must make a capital structure assumption
The valuations (stand alone, improvements, and synergies) must make a capital structure assumption 1. WACC model or APV model Be careful! 2. The capital structure assumption should not be reflective of the financing used to buy the target per se, but should reflect the degree to which owning the target incrementally affects your debt capacity

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For example, suppose you bought the target with debt If you are using WACC to value target, the weights should reflect the debt capacity of the target, not 100% debt If you are using RE or AEG, the tax shields should only reflect the contribution of the target firm towards affording those tax shields

C. What is the effective cost?

1. Acquirer pays cash ($100M) Cash price is the effective cost of the acquisition 2. Acquirer must raise the cash ($100M) - Assume Acquirer must borrow the money from government with a subsidized rate Loan is $100M, but PV of loan payments is $95M Purchase price is $100M, but acquirer makes $5M NPV on loan. Effective cost of acquisition is $95M
3. Assume Acquirer sells shares of combined firm ($100M)

- Purchase price is $100M, but suppose shares are actually worth $60M. NPV on share sale is $40M. Effective cost of acquisition is $60M.

D. Mergers and Acquisitions often involve share issues

Residual earnings valuation cannot be done by forecasting pershare amounts if shares outstanding are likely to change Always carry out residual earnings valuations on a dollar basis, then divide by current shares outstanding Abnormal Earnings Growth (AEG) valuation can be carried out by forecasting per-share earnings and dividends However, must then work on a levered basis (requiring changes in the cost of equity capital) Best to work with operations on a dollar basis
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Valuation with an Anticipated Acquisition: Dealing with Value Implicit in Exchange Ratio
Valuation of an Anticipated Acquisition: PPE Inc. PPE Inc. is expected to acquire another firm at the end of Year 2 by issuing 50 million shares to that firms shareholders. The analyst follows the following steps: 1. Forecast the value the new merged firm at the end of Year 2 from the forecasted balance sheet of the new merged firm at that date and the present value of subsequent residual earnings that the balance sheet is anticipated to generate. 2. Calculate the anticipated value per share at the acquisition date (at the end of Year 2) by dividing the merged firms value by the total shares outstanding for the new firm. 3. Calculate the present value of this per-share value at Year 0. 4. Add the present value of expected dividends from the pre-merged firm up to the merger date. Suppose pro forma analysis calculates a value for the merged firm at the end of Year 2 of $180 million. With 150 million shares outstanding (100 million held by the original PPE shareholders and 50 million by the shareholders of the acquired firm), the per-share value is $1.20. The value of one of PPEs 100 million shares outstanding at Year 0 is calculated as follows: Present value (at Year 0) of per-share Year 2 value:
1.20 1.1134 2

$0.97

Present value of Year 1 and Year 2 dividends per share Assume DPS in Year 1 of $038 and in Year 2 of $0.041

0.038 0.041 + 1.1134 1.11342

Per-share value of PPE Inc.

0.07 $1.04

Question 1.

As PPE was valued at $0.96 before the anticipated acquisition, this calculation indicates that the acquisition adds value to the current shareholders. During the a early there a noticeable increase in mergers and acquisitions Assume cost 1990s of equity of was 11.34% before the acquisition. between firms in different countries (termed cross-border acquisitions). What factors -3-

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could explain this increase? What special issues can arise in executing a crossborder acquisition and in ultimately meeting your objectives for a successful combination? Several factors could help explain the increase in merger and acquisition activity between firms in different countries. These factors may include:

Relaxation of foreign ownership law s. As countries have allowed greater foreign

ownership of companies in certain industries (e.g., broadcasting, telephone, steel, automobile), foreign companies have undertaken mergers that were previously prevented due to governmental restrictions.

Expansion of regional free trade areas. Once a regional trading block is implemented, it can
become more difficult for foreign firms to export its products to countries within the block. As a result, a foreign firm may purchase a company within the block to guarantee access to the block. For example, many American firms rushed to purchase European firms before January 1, 1996 to assure continued access to markets of European Union members as integration of the EU markets entered its next phase. Similarly, increased free trade can create new opportunities for firms within the block to expand their markets. Acquisitions can provide a way of taking advantage of these opportunities. For example, the integration of markets in Europe may provide opportunities for, say, German and U.K. banks to use cross-border acquisitions to develop into a European bank.

Globalization of certain industries. Once a company has reached the maximum production in
its home market, it may seek greater economies of scale and scope by purchasing competitors in foreign markets. By expanding its production to the greatest extent possible, the firm hopes to achieve the most efficient cost structure. This globalization forces the remaining companies to consolidate to achieve the same level of scale and scope economies.

Search for new markets. Once domestic markets for a specific product have matured, a
domestic firm will often try to continue its expansion in foreign markets. Often, the easiest way to enter a foreign market is to purchase a company already operating in that market. It guarantees immediate market share and instant name recognition with local consumers. International mergers will create special issues that will ultimately affect the success of the merger. These special issues may include valuing a foreign company that operates and prepares its financial reports under different accounting rules. Differences in accounting rules may include: Treatment of intangibles, such as R&D expenses, brand names, goodwill, patents, etc. Treatment of inflation.; Foreign exchange exposure.; Hedging acquisition price. Hedging future cash flows from the foreign firm.; Regulatory considerations. Foreign government investment approvals.; Foreign government antitrust approvals. Ability to expatriate earnings from the foreign country. Differences in laws, regulations, and rules governing personnel and human resources areas. Differences in the operations of foreign markets and companies, including differences in management practices, worker norms and expectations, roles of government in the economy, and corruption in the business and political environments of the economy. Management and coordination of domestic and foreign operations.

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BA 7000-093 Question 5.

Chapter 11 You have been hired by GS Investment Bank to work in the merger department. The analysis required for all potential acquisitions includes an examination of the target for any off-balance-sheet assets or liabilities that have to be factored into the valuation. Prepare a checklist for your examination.

Off-Balance Sheet Liabilities Executory contracts; Contingent obligations; Operating leases; Liabilities under environmental regulations Off-Balance Sheet AssetsDepending on the specific circumstance, these assets may already be included on the balance sheet. These assets are either valued (e.g., intangible assets) or revalued (e.g., land held for sale) once they have been purchased by another company. Research and development expenditures Patents, trademarks, and other intellectual property Brand names; Goodwill; Land held for sale Question 8. A leading oil exploration company decides to acquire an Internet company at a 50 percent premium. The acquirer argues that this move creates value for its own stockholders because it can use its excess cash flows from the oil business to help finance growth in the new Internet segment. Evaluate the economic merits of this claim.

The oil company is arguing that a merger could create value by providing low-cost financing to a financially-constrained electronics firm. This argument is based on the idea that capital market imperfections have prevented the electronics company from investing in all of its growth opportunities. These imperfections may have developed as a result of information asymmetries between management and outside investors. If the electronics firm has to rely on outside investors to finance its growth, capital market constraints could prevent it from undertaking worthwhile projects because public capital markets would probably be a costly source of funds for the firm. However, by purchasing the electronics company, the oil company can help it overcome the capital market imperfections and enable the electronics firm to invest in all of its growth opportunities. The merits of the oil companys argument for buying the electronics company depend on two conditions. First, financial constraints must be preventing the electronics firm from undertaking some profitable projects. If the electronics firm is not financially-constrained or does not have a set of unfunded but profitable projects, then having access to the additional capital of the oil company will not create value. The only projects the firm would have left would be unprofitable ones. Second, the financial constraints must be due to capital market imperfections. It is plausible that the electronics firm could face capital market imperfections due to information asymmetries. Information problems are likely to be severe for newly-formed, high-growth companies, a description typical of many electronics firms. If information problems make it difficult for outside investors to value the electronics firm because of its short track record or because its financial statements provide little insight about the value of its growth opportunities, then outside investors could be an expensive source of funds.

Digital Equipment Company Valuations:

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Stand Alone Valuation: Digital - Status Quo Digital had earning before interest and taxes of $391.38 million in 1997, which translated into a
A pre-tax operating margin of 3% on its revenues of $13,046 million An after-tax return on capital of 8.51%

Based upon its beta of 1.15, an after-tax cost of borrowing of 5% and a debt ratio of approximately 10%, the cost of capital for Digital in 1997 was Cost of Equity = 6% + 1.15 (5.5%) = 12.33% Cost of Capital = 12.33% (.9) + 5% (.1) = 11.59% Digital had capital expenditures of $475 million, depreciation of $ 461 million and working capital was 15% of revenues. Operating income, net cap ex and revenues are expected to grow 6% a year for the next 5 years, and 5% thereafter.

Year FCFF 1 $133.26 2 $141.25 3 $149.73 4 $158.71 5 $168.24 Terminal Year $156.25 Firm Value = $2,110.41

Terminal Value

$2,717.35

PV $119.42 $113.43 $107.75 $102.35 $1,667.47

The capital expenditures are assumed to be 110% of revenues in stable growth; working capital remains 15%; Debt ratio remains at 10%, but after-tax cost of debt drops to 4%. Beta declines to 1.

Digital: Change in Control

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Digital will raise its debt ratio to 20%. The beta will increase, but the cost of capital will decrease.
New Cost New Cost Beta = 1.25 (Unlevered Beta = 1.07; Debt/Equity Ratio = 25%) of Equity = 6% + 1.25 (5.5%) = 12.88% After-tax Cost of Debt = 5.25% of Capital = 12.88% (0.8) + 5.25% (0.2) = 11.35%

Digital will raise its return on capital to 11.35%, which is its cost of capital. (Pre-tax Operating margin will go up to 4%) The reinvestment rate remains unchanged, but the increase in the return on capital will increase the expected growth rate in the next 5 years to 10%. After year 5, the beta will drop to 1, and the after-tax cost of debt will decline to 4%.

Digital Valuation: Change in Control

Year FCFF Terminal Value 1 $156.29 2 $171.91 3 $189.11 4 $208.02 5 $228.82 $6,584.62 Terminal Year $329.23 PV $140.36 $138.65 $136.97 $135.31 $3,980.29

Value of the Firm: with Control Change = $ 4,531 million Value of the Firm: Status Quo = $ 2,110 million Value of Control = $2,421 million
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Synergy Effects in Valuation Inputs

If synergy is
Economies of Scale

Valuation Inputs that will be affected are

Operating Margin of combined firm will be greater than the revenue-weighted operating margin of individual firms.
More projects:Higher Reinvestment Rate (Retention) Better projects: Higher Return on Capital (ROE)

Growth Synergy

Longer Growth Period

Again, these inputs will be estimated for the combined firm.

Valuing Synergy: Compaq and Digital

In 1997, Compaq acquired Digital for $ 30 per share + 0.945 Compaq
shares for every Digital share. ($ 53-60 per share) The acquisition was motivated by the belief that the combined firm would be able to find investment opportunities and compete better than the firms individually could.

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Background Data ($ in Millions)

Current EBIT Current Revenues Capital Expenditures - Depreciation Expected growth rate -next 5 years Expected growth rate after year 5 Debt /(Debt + Equity) After-tax cost of debt Beta for equity - next 5 years Beta for equity - after year 5 Working Capital/Revenues Tax rate is 36% for both companies

Compaq $ 2,987 $25,484 $ 184 10% 5% 10% 5% 1.25 1.00 15%

Digital: Opt Mgd $ 522 $13,046 $ 14 (offset) 10% 5% 20% 5.25% 1.25 1.0 15%

Valuing Compaq
Year 1 2 3 4 5 Terminal Year FCFF $1,518.19 $1,670.01 $1,837.01 $2,020.71 $2,222.78 $2,832.74 Terminal Value PV $1,354.47 $1,329.24 $1,304.49 $1,280.19 $33,278.53 $38,546.91

$56,654.81

Value of Compaq = $ 38,547 million

After year 5, capital expenditures will be 110% of depreciation.

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Combined Firm Valuation

1. The Combined firm will have some economies of scale, allowing it to increase its current after-tax operating margin slightly. The dollar savings will be approximately $ 100 million.
Current Operating Margin = (2987+522)/(25484+13046) = 9.11% New Operating Margin = (2987+522+100)/(25484+13046) = 9.36%

2. The combined firm will also have a slightly higher growth rate of 10.50% over the next 5 years, because of operating synergies. 3. The beta of the combined firm is computed in two steps:
Digitals Unlevered Beta = 1.07; Compaqs Unlevered Beta=1.17 Digitals Firm Value = 4.5; Compaqs Firm Value = 38.6 Unlevered Beta = 1.07 * (4.5/43.1) + 1.17 (38.6/43.1) = 1.16 Combined Firms Debt/Equity Ratio = 13.64% New Levered Beta = 1.16 (1+(1-0.36)(.1364)) = 1.26 Cost of Capital = 12.93% (.88) + 5% (.12) = 11.98%

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Combined Firm Valuation

Year 1 2 3 4 5 Terminal Year FCFF $1,726.65 $1,907.95 $2,108.28 $2,329.65 $2,574.26 $3,345.38 Terminal Value PV $1,541.95 $1,521.59 $1,501.50 $1,481.68 $39,463.87

$66,907.52

Value of Combined Firm = $ 45,511

The Value of Synergy

Value of Combined Firm with Synergy Value of Compaq + Value of Digital = 38,547 + 4532 Total Value of Synergy = $45,511 million = $ 44,079 million = $ 1,432 million

Digital: Valuation Blocks

Value of Firm - Status Quo = $ 2,110 million + Value of Control = $ 2,521 million Value of Firm - Change of Control = $ 4,531 million + Value of Synergy = $ 1,432 million Total Value of Digital with Synergy = $ 5,963 million
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Evaluating Compaqs Offer

Value of Digital with Synergy - Value of Cash paid in deal = $ 30 * 146.789 mil shares - Digitals Outstanding Debt (assumed by Compaq) Remaining Value / number of Shares outstanding = Remaining Value per Share Compaqs price per share at time of Exchange Offer = $5,963 mil = $4,403 mil $1,006 mil $ 554 mil / 146.789 $ 3.77 $ 27

Appropriate Exchange Ratio = 3.77/27 = 0.14 Compaq shares/Digital share Actual Exchange Ratio = 0.945 Compaq shares/Digital Share

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