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8/5/2003

Chapter 25. Tool Kit for Mergers, LBOs, Divestitures, and Holding Companies

In theory, merger analysis is quite simple. The acquiring firm performs an analysis to value the target company. The acquiring
firm then seeks to buy the firm at preferably below that estimated value. Meanwhile, the target company would only want to
accept the offer is the price exceeds its value if operated independently. In practice, however, the process of merger analysis is much
more involved and raises some difficult issues.

While many valuation techniques exist, we shall focus upon the two most common: the discounted cash flow and market multiple
analysis. Regardless of the method used, it is crucial to recognize that the target company typically will not continue to operate as a
separate entity, but rather it becomes part of the acquiring firm's portfolio of risky assets. This is significant because the
operational changes that may occur will affect the value of the business and must be considered. In addition, it is important to
remember that the goal of merger evaluation is to value the target company's equity, because the business is acquired from the
company's owners, not its creditors. For that reason, our focus will be the value of equity, not total value.

APV ANALYSIS

This process is very much like the process employed in Chapter 15 of the text to value stock. This method operates under the
assumption that the intrinsic value of a firm is determined by the future cash flows that the firm will 'generate, discounted to the
present. The value consists of two parts: the present value of the free cash flows and the present value of the tax savings due to the
deductibility of interest payments.

The first step in this approach is to create pro forma income statements for the target company as a subsidiary of the acquiring
firm. The purpose of these pro forma statements is to project expected cash flows, because the incremental free cash flows
generated by the merger are one of the key drivers of the valuation. The other driving factor of our valuation will be the discount
rate we use.

Generating Pro Forma Statements

Post merger cash flow forecasts are by far the most important factor in a merger analysis. In this scenario, the target company's
debt ratio is expected to remain at 50%, before and after of the merger. Both the target firm (Tutwiler Corporations) and the
acquiring firm (Caldwell) have a 40% marginal federal-plus-state tax rate. Financial 'analysts for Caldwell have created pro forma
income statements for the Tutwiler subsidiary for the years 2005 to 2009.

Long-term growth rate 6%


Tax rate 40%

Pro Forma Statements (figures in millions of dollars)

2005 2006 2007 2008 2009


. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
. Costs of goods sold 80.0 94.0 113.0 130.0 142.0
. Selling & admin. Expense 10.0 12.0 13.0 15.0 16.0
. Depreciation 8.0 8.0 9.0 9.0 10.0
. EBIT 7.0 12.0 16.0 20.0 23.0
. Taxes on EBIT 2.8 4.8 6.4 8.0 9.2
. NOPAT 4.2 7.2 9.6 12.0 13.80
. Plus Depreciation 8.0 8.0 9.0 9.0 10.0
. Operating Cash Flow 12.2 15.2 18.6 21.0 23.8
. Less gross retention for growth 9.0 12.0 13.0 15.0 17.0
. Free Cash Flow 3.2 3.2 5.6 6.0 6.8

. Interest 6.0 5.0 4.0 4.0 4.0


. Interest Tax Shield 2.4 2.0 1.6 1.6 1.6

TUTWILER'S UNLEVERED COST OF EQUITY

Before the merger, Tutwiler's beta is 1.20, and it has $27 million in debt and $62.5 million in equity. From Equation 17-
15, rL=rU + (rU -rD) (D/S). Solving for rU gives rU = wS rL + wd rd.
PROBLEM
Calculate Tutwiler's unlevered cost of equity and WACC
rRF 7.0%
Beta 1.2
MRP 5%
rd 9%
S $ 62.50
D $ 27.00
wd 30.168%

rL = rRF + Beta * MRP


rL = 7% + 1.2 * 5%
rL = 13.00%

WACC = wdrd(1-T) + wSrL


WACC = 1.63% + 9.08%
WACC = 10.710%

rU = wS rL + wd rd
rU = 0.698 0.13 + 0.302 0.09
rU = 0.1179

THE HORIZON, OR CONTINUING, VALUE OF THE SUBSIDIARY

In our projections, Tutwiler first experiences growth of about 20%, but that rate slowly dwindles down to the firm's long-term
growth rate of 6%. Now that we have found the cash flows to be generated by Tutwiler, we now seek to find the horizon, or
continuing, value of the firm to the time when growth becomes constant (in 2009). In the long run, Tutwiler will maintain the same
proportion of debt and equity as before the acquisition, so the WACC for the horizon should be equal to the WACC estimated
above.

PROBLEM
Calculate the 2009 horizon value of a firm with Tutwiler's 2009 free cash flow and Tutwiler's WACC and growth rate:

HV 2009 = FCF 2009 * (1 + g) (WACC - g)


HV 2009 = 6.8 * 1.060 0.1071 - 0.06
HV 2009 = $153.04

At this point we will reconstruct the proforma statements, only now they will reflect the horizon value as well.

Long-term growth rate 6%


Tax rate 40%

Table 25-2: Projected Postmerger Free Cash Flow Statement (figures in millions of dollars)

2005 2006 2007 2008 2009


. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
. Costs of goods sold 80.0 94.0 113.0 130.0 142.0
. Selling & admin. Expense 10.0 12.0 13.0 15.0 16.0
. Depreciation 8.0 8.0 9.0 9.0 10.0
. EBIT 7.0 12.0 16.0 20.0 23.0
. Taxes on EBITb 2.8 4.8 6.4 8.0 9.2
. NOPAT 4.2 7.2 9.6 12.0 13.8
. Plus Depreciation 8.0 8.0 9.0 9.0 10.0
. Operating Cash Flow 12.2 15.2 18.6 21.0 23.8
. Less net retention for growthc 9.0 12.0 13.0 15.0 17.0
. Free Cash Flow 3.2 3.2 5.6 6.0 6.8

. Interesta 6.0 5.0 4.0 4.0 4.0


. Interest Tax Shield 2.4 2.0 1.6 1.6 1.6
. Plus terminal valued $153.0
. FCF and tax shield to Caldwelle $5.6 $5.2 $7.2 $7.6 $161.44
. Net incomef $ 0.60 4.2 7.2 9.6 11.4

Notes:
a
Interest payments are estimates based on Tutwiler's existing debt, plus additional debt issued in the acquisition.
b
Caldwell will file a consolidated tax return after the merger. Thus, the taxes shown here are the full corporate taxers
attributable to Tutwiler's operating profit.
c
Some of the cash flows generated by the Tutwiler subsidiary after the merger must be retained to finance asset
replacements and growth. The balance will be used to pay interest and principal on any remaining debt within
Tutwiler or transferred to Caldwell to pay dividends on its stock or for redeployment within the corporation.
d
Tutwiler's available cash flows are expected to grow at a constant 6 prcent rate after 2009. The value of all
post 2009 cash flows as of December 31, 2009, is estimated by use of the constant growth model to be (in
millions--calculations are above): $153.0
e
These are the free cash flows plus debt tax shield projected to be available to Caldwell by virtue of the acquisition.
The cash flows could be used for interest payments on debt, dividend payments to Caldwell's stockholders, to finance
asset expansion in Caldwell's other divisions and subsidiaries, and so on.
f
For a company without non-operating income, net income can be calculated as NOPAT - Interest + Interest tax shield.
You would probably be working with complete balance sheets when doing these calculations so net income would be
readily available.

The value of operations including the value of the tax shield can now be derived by finding the NPV of the net cash flow stream in
Row 15 above, discounted at Tutwiler's unlevered cost of equity.

V Ops 2004 = $111.66

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is $111.66 million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.

VEquity = V Ops 2004 - Debt2004


VEquity = $111.7 - $ 27.00
VEquity = $84.7

Since Caldwell only has to pay $62.5 million for the equity, it is a good deal for Caldwell.

VALUING THE TARGET WITH A CHANGE IN CAPITAL STRUCTURE


Tutwiler currently has equity worth $62.5 million and debt of $27 million, giving it a capital structure financed with about 30
percent debt: $27 / ($62.5 + $27.0) = 0.30 = 30 percent. If Caldwell decides to increase Tutwilers capital structure to about 50
percent after the acquisition, it will affect the analysis in three ways.

New Target % debt 50%


New interest rate on debt 9.50%
The Impact on Cash Flows to Caldwell

With more debt, the interest payments will be higher than those shown in Table 25-2. Although this does not affect free cash flow or
the unlevered cost of equity, it does affect the interest tax shield during the 5 years of explicit projections. Also, the long run WACC
will be different under a 50% debt level than it was under a 30% debt level. Note that the beauty of the APV method is that it is
easy to incorporate different assumptions about financing.

2005 2006 2007 2008 2009


. Net sales $105.0 $126.0 $151.0 $174.0 $191.0
. Costs of goods sold 80.0 94.0 113.0 130.0 142.0
. Selling & admin. Expense 10.0 12.0 13.0 15.0 16.0
. Depreciation 8.0 8.0 9.0 9.0 10.0
. EBIT 7.0 12.0 16.0 20.0 23.0
. Taxes on EBIT 2.8 4.8 6.4 8.0 9.2
. NOPAT 4.2 7.2 9.6 12.0 13.8
. Plus Depreciation 8.0 8.0 9.0 9.0 10.0
. Operating Cash Flow 12.2 15.2 18.6 21.0 23.8
. Less net retention for growth 9.0 12.0 13.0 15.0 17.0
. Free Cash Flow 3.2 3.2 5.6 6.0 6.8

. Interesta 6.0 6.0 7.0 8.0 8.5


. Interest Tax Shield 2.4 2.4 2.8 3.2 3.4
Note: a
Interest is calculated at the higher rate and on the higher level of debt

New Horizon Value Calculation


Free cash flows are the same in 2009 with the different debt level. But the WACC is different.
From Equation 17-15, rL=rU + (rU -rD) (D/S). If the target percentages are 40% debt, 60% equity:

% financed with debt = 50%


% financed with equity = 50%

New levered cost of equity, and WACC


rL = rU + ( rU - rD ) D/S
rL = 0.1179 + 0.1179 - 9.5% 1.00000
rL = 14.08%

WACC = wDrd(1-T) + wSrL


WACC = 2.85% + 7.04%
WACC = 9.89%
This WACC is lower than the WACC we obtained with 30% debt.

HV 2009 = FCF 2009 * (1 + g) (WACC - g)


HV 2009 = 6.8 * 1.060 0.0989 - 0.06
HV 2009 = $185.30

Cash Flows 2005 2006 2007 2008 2009


. Free Cash Flow 3.20 3.20 5.60 6.00 6.80
. Interest Tax Shield 2.40 2.40 2.80 3.20 3.40
. Plus Horizon Value $185.30
. FCF and tax shield to Caldwell 5.60 5.60 8.40 9.20 195.50

The value of operations including the value of the tax shield can now be derived by finding the NPV of the net cash flow stream in
Row 13 above, discounted at Tutwiler's unlevered cost of equity.

V Ops 2004 = $133.4

Therefore, according to our analysis, the value of Tutwiler's operations to Caldwell is $133.4 million
The value of Tutwiler's equity, which is what Caldwell will purchase, is the value of operations less the debt.

VEquity = V Ops 2004 - Debt2004


VEquity = $133.4 - $ 27.00
VEquity = $106.4

So with 30% debt, the value of Tutwiler's equity to Caldwell is $84.66


So with 50% debt, the value of Tutwiler's equity to Caldwell is $106.369

Setting the Bid Price

Table 25-3 Analysis of the Tutwiler Acquisition with a Change in Capital Structure
(Millions of Dollars)
Tutwiler as a
Tutwiler as a Separate Company Subsidiary with No Tutwiler as a Subsidiary
Prior to the Acquisition Change in Debt with a 50% Debt Ratio
Value of equity: $62.5 $84.7 $106.4
Value of debt: $27.0 $27.0 $27.0
Total value: $89.5 $111.7 $133.4
Maximum amount Caldwell
should pay for Tutwiler's
equity:a $84.7 $106.4
Maximum price per share
Caldwell should pay for
Tutwiler's equity:b $8.47 $10.64

Notes: a
Calculated as the total value as a subsidiary minus the amount of debt as a separate company.
b
Calculated as the maximum amount divided by the 10 million shares of Tutwiler stock.
ACCOUNTING FOR MERGERS

Firm A will acquire Firm B. Current laws only allow for purchase accounting.

Table 25-3: Accounting for Mergers: A Acquires B

Purchase Accounting Postmerger: Firm A


Firm A Firm B $20 Paida $30 Paida $50 Paida Is price paid equal to NAV?
(1) (2) (3) (4) (5)
Current assets $50 $25 $75 $75 $80 c

Fixed assets 50 25 65 75 80 c

Goodwilld 0 0 0 0 10
Total assets $100 $50 $140 $150 $170

Debt $40 $20 $60 $60 $60


Common equity 60 30 80 80 110 f

Total claims $100 $50 $140 $140 $170


Notes:
a
The price paid is the net asset value, that is, total assets minus debt.
b
In column (3) we assume that Firm B's current and fixed assets are writen down from $25 to $15 before constructing
the consolidated balance sheet.
c
In column (4) we assume that Firm B's current and fixed assets are both increased to $30.
d
Goodwill refers to the excess paid for a firm above the apprised value of the physical assets purchased. Goodwill
represents payment both for intangibles such as patents and for "organization" value such as that associated with
having an effective sales force.
e

In column (3), Firm B's common equity is reduced by $10 prior to consolidation to feflect the fixed asset write-off.
f
In column (5), Firm B's equity is increased to $50 to reflect the above-book purchase price.

Table 25-4 Income Statement Effects of Purchase Accounting

Firm A Firm B Purchase


(1) (2) (3)
Sales $100.0 $50.0 $150.0
Operating costs 72.0 36.0 109.0 a

Operating income $28.0 $14.0 $41.0


Interest (10%) 4.0 2.0 6.0
Taxable income $24.0 $12.0 $35.0
Taxes (40%) 9.6 4.8 14.0
Earnings after taxes $14.4 $7.2 $21.0
Goodwill write-off 0.0 0.0 0.0 b

Net income $14.4 $7.2 $21.0


EPSc $2.40 $2.40 $2.33
Notes:
a
Operating costs are $1 higher than they otherwise would be to reflect the higher reported costs (depreciation and cost
of goods sold) caused by the physical asset markup at the time of purchase.
b
Prior to 2001 goodwill was written off over its expected life. Now goodwill is subject to an annual "impairment" test.
If its fair market value has decreased during the year then goodwill is reduced, otherwise it is not.
c
Firm A had six shares and Firm B had three shares before the merger. A gives one new share for each of B's, so A has
nine shares outstanding after the merger.

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