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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.
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.
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%
rU = wS rL + wd rd
rU = 0.698 0.13 + 0.302 0.09
rU = 0.1179
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:
At this point we will reconstruct the proforma statements, only now they will reflect the horizon value as well.
Table 25-2: Projected Postmerger Free Cash Flow Statement (figures in millions of dollars)
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.
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.
Since Caldwell only has to pay $62.5 million for the equity, it is a good deal for 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.
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.
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.
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.
Fixed assets 50 25 65 75 80 c
Goodwilld 0 0 0 0 10
Total assets $100 $50 $140 $150 $170
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.