You are on page 1of 22

Chapter 15 Acquisitions and Corporate Control

Overview and Learning Objectives In this chapter, we will analyze potential benefits and costs that result when two previously separate companies are combined. Any form of corporate combination is generally classified under the heading of mergers and acquisitions (or M&A) activity. This chapter provides a synthesis of many of the financial principles we have seen before, because in evaluating a potential corporate combination, we need to apply the valuation techniques and other concepts developed in earlier chapters. We will also examine the motives and tactics commonly found among the different parties to a corporate control contest. After reading this chapter, you should be able to: Identify the different types of economic gains from an acquisition, ranging from economies of scale or scope to cost saving from eliminating duplicate facilities Avoid confusing unlikely sources of acquisition benefit, such as diversification, for true benefits Distinguish the cost of acquisitions financed with cash from those financed with stock Project the appropriate future cash flows resulting from the acquisition of another company Find an appropriate valuation technique and cost of capital for evaluating an acquisition, both of which incorporate the risk and financing characteristics of the acquisition Analyze the motives of bidders and targets in a corporate control contest and the tactics they use

15.1 Mergers versus Acquisitions: Is There Any Distinction? The term mergers and acquisitions (or M&A) is applied to all types of combinations of two previously separate companies. In practice, the terms merger and acquisition tend to be used interchangeably, but technically, there is a distinction. An acquisition is a transaction in which one company (the acquiring company or acquirer) buys another company (the target) for cash, newly-issued

2 securities, or a combination of the two. The target companys shareholders relinquish their shares in exchange for the consideration paid by the acquirer, the targets assets are joined with those of the acquirer, and the target ceases to exist as a separate company. In a merger, by contrast, two companies agree to combine their assets, and the shares of both companies are extinguished in exchange for new shares in a combined company. In actual fact, most corporate combinations are acquisitions, so we will use the term acquisitions throughout this chapter. In practice, though, acquisition activity, merger activity and M&A activity tend to be used synonymously.

15.2 Acquisition NPV When one company acquires another, this represents an investment decision, similar to the decision to acquire a new plant or machine. As with any other investment decision, we can evaluate an acquisition by calculating its Net Present Value (NPV), using the same principles that we saw in Chapters 6, 8 and 11. Since NPV is essentially a cost-benefit measure, where all costs and benefits are measured in discounted cash flow terms, we can represent an acquisition NPV as:

NPV = BENEFIT COST

(15.1)

Equation (15.1) seems quite elementary, but its appearance is deceptively simple. One difference between an ordinary investment project and a company acquisition is that a company acquisition is typically a larger-scale decision. As such, the scope for error is also larger, so it is especially important that we conduct the analysis carefully, keeping in mind potential pitfalls. In the next two sections, we examine the measurement of acquisition benefit and acquisition cost more closely. 15.3 Measuring Acquisition Benefit Recall from Chapter 6 that the economic benefit of a project is measured as the present discounted value of the projects anticipated free cash flows. If we reason by analogy, it is tempting to assert that the economic benefit of an acquisition to the acquiring company is given by the present value of the free cash flows of the combined company. If A acquires T, and VAT is the enterprise value of the combined company, we might thus be tempted to measure the benefit of the acquisition as VAT. Recall, however, that a projects benefits should reflect only incremental free cash flows. The value of the combined companys free cash flows includes those cash flow components generated by As assets that would have occurred even in the absence of the acquisition. To get the value of incremental free cash flows from the acquisition, we need to subtract VA, the value of As stand-alone free cash flows, from VAT:

BENEFIT = V AT V A

(15.2)

3 To help guide us in estimating these benefits, we now turn to an analysis of their possible sources. 15.3.1 Possible Economic Sources of Gain from a Company Acquisition It is common to classify acquisitions as horizontal, vertical or conglomerate. A horizontal acquisition takes place between two similar companies in the same industry. Duke Energys currently proposed acquisition of Progress Energy, currently awaiting final regulatory approval, is an example of a horizontal acquisition, as both companies are North Carolina-based electric power producers. A vertical acquisition takes place between two companies that focus on different stages in the production or sale of a particular product or service. For example, both Coca-Cola and Pepsico recently bought separate companies that bottled their products. A conglomerate acquisition takes place between two companies that are in separate businesses. For example, movie producer and theme park operator Walt Disney acquired television broadcaster ABC in 1996. What are the economic motivations behind transactions of these different types? A horizontal acquisition might be motivated by potential elimination of duplicate facilities and achievement of possible economies of scale, both of which have been cited in the Duke-Progress transaction. A horizontal transaction may also be motivated by the possibility of achieving a dominant market position, accompanied by greater pricing power over customers or suppliers. Of course, a dominant market position also runs the risk of running afoul of antitrust authorities in one or more countries. A vertical acquisition might be motivated by companies desire to achieve greater control over and efficiency in their supply chain. For example, both Coca-Cola and Pepsico cited the need for greater control over bottling operations in order to achieve better coordination of their production and product distribution activities. Another potential example might include the combination of one company that is a low-cost producer of a product with another company that has a more efficient distribution network for that type of product. A conglomerate merger can have a variety of motivations. One may be that two businesses are not as unrelated as they initially seem. In the case of Disney ABC, both companies are in the entertainment business, and owning a broadcasting company gives Disney a ready outlet for some of the entertainment content that it produces. At the same time the combination gives ABC potentially greater market power over other content producers, since it can always turn to its own content as an alternative. This type of motivation is based on trying to generate of economies of scope. That is, there may be potential economic benefits from expanding the scope of a companys business, because two or more loosely related businesses complement one another in some way. Another possible motivation for a conglomerate acquisition is the elimination of inefficiencies, either in operations or financing. A private equity

4 buyout firm, for example, may buy controlling ownership interests in companies in a wide range of unrelated industries. The buyout firms partners might argue that they possess superior management expertise that is applicable in a wide variety of industry settings. In addition, by taking its portfolio companies private, the buyout firm would argue that it eliminates additional costs of being a public company, such as reporting requirements and pressure to meet or exceed equity analysts shortterm earnings targets. This can in turn free management to cut costs, even when that means sacrificing profits in the short run. Finally, as discussed in Section 11.4 of Chapter 11, the private equity firm often finances its acquisition with substantial amounts of debt financing and concentrates equity ownership among a relatively small group of investors and managers. This puts pressure on owner-managers to hold costs to a minimum and not accumulate excess cash. Once the economic sources of acquisition gain have been identified, the analyst then faces the challenge of quantifying and discounting the expected cash flows using an appropriate valuation technique with its concomitant cost of capital measures. While this can be a difficult task, it is not different in principle from the valuation challenge faced by analysts for other types of corporate investment. 15.3.2 Unlikely Sources of Acquisition Benefit Having identified some legitimate potential sources of acquisition benefit, the analyst should also be wary of other, sometimes alleged but more dubious, sources. Prominent among these is risk reduction through diversification, sometimes promoted as a source of gain from conglomerate acquisitions. As we have seen, investors can diversify their own portfolios at least as easily, and at lower cost, as companies can. It is conceivable that there may be some risk management benefits from corporate diversification in the form of economizing on the use of tax shields or on the potential costs of bankruptcy and agency costs. However, other risk management tools are also available, as discussed in Chapter 13, and corporate diversification can exacerbate agency costs by giving managers the incentive to squander excess cash generated in one business by investing it in another of the companys businesses instead of paying it out to shareholders. In addition, conglomerate companies may be murkier to investors, because the operations of one business are harder to disentangle from those of another. As a result, it may be more difficult to accurately value a conglomerate and monitor management decisions. A second unlikely source of acquisition gain is an increase in debt capacity. This benefit is also sometimes alleged for conglomerate acquisitions. The argument is that the combined entity is safer than the separate pieces so that lenders are willing to provide more total debt financing than they would to the divisions as separate entities. However, this argument ignores the possibility that a company composed of one economically healthy division and an unhealthy one may dissipate cash flows from the healthy division to insulate bondholders from the unhealthy divisions losses.

5 As we have seen in Problem 8 in Chapter 11, combining two previously separate companies can afford a windfall to bondholders at shareholders expense. A third unlikely source of acquisition benefit is referred to as bootstrapping. When a high-PE ratio company acquires a low-PE ratio company through an exchange of stock, this automatically generates an increase in earnings per share. If investors were to then apply the acquirers PE ratio to the combined companys earnings per share, an increase in value would result. If this were to occur, the acquirer would be said to have pulled itself up by its own bootstraps, which of course is an impossible task. To illustrate, consider the example shown in Table 5.1. Company A, which has a forward PE ratio of 25, acquires Company T, which has a forward PE ratio of 5. Presumably, As higher PE ratio reflects market expectations that A has better growth prospects than T. Each company has 100 million shares outstanding and each expects total earnings in the upcoming year of $500 million, but because of its higher PE ratio, As stock price and total market capitalization are four times as large as Ts. Company A acquires Company T, offering one share of A for every four shares of T initially outstanding. Thus, A issues 25 million new shares in exchange for all of Ts shares, and the combined company has a total of 125 million shares outstanding. If the acquisition creates no synergies and investors in the market understand this fact, the combined company value should be just the sum of the two companies separate market capitalizations or $12.5 billion. With 125 million total shares outstanding, this implies a combined company share price of $100. Combined company earnings will be the sum of the two companies separate earnings, or $1 billion, so this implies combined earnings per share of $8.00.

A (PreAcquisition) EPS1 Stock Price P0 Forward PE ratio # Shares (mil) Total Earnings ($mil) Total Value ($mil) $5.00 $100.00 25 100 $500 $10,000

T (PreAcquisition) $5.00 $25.00 5 100 $500 $2,500

Post-Acquisition (Informed Market) $1,000/125 = $8.00 $12,500/125 = $100 100/8 = 12.5 125 $1,000 $12,500

Post-Acquisition (Uninformed Market) $1,000/125 = $8.00 25 x $8 = $200 25 125 $1,000 $25,000

Table 5.1 A Acquires T, Exchanging 1 Share in A for Every 4 Shares of T

7 With a $100 stock price, this further implies that the combined company PE ratio will be 12.5. If investors in the market were uninformed, on the other hand, they might look at the combined company earnings per share of $8.00, an increase of 60% over As stand-alone earnings per share, and see this increase as a validation of the high growth rate that was built in to As PE ratio. If investors then continue to apply a PE ratio of 25 to the combined companys earnings, this implies a stock price of $200 per share and a total market capitalization of $25 billion. Of course, the increase in earnings per share from $5 to $8 is simply an artifact of the acquisition. Investors should be able to see through this, so the kind of value creation legerdemain envisioned in the last column of Table 5.1 is unlikely to occur. 15.4 Measuring the Cost of an Acquisition As Equation (15.1) in Section 15.2 indicates, once we have estimated the benefit generated by an acquisition, we must net out the cost to determine the acquisitions overall NPV. We can measure cost as the value of the consideration paid by the acquiring company to the target companys shareholders, but here we must distinguish between acquisitions for cash and acquisitions for newly-issued shares in the acquiring company. 15.4.1 Acquisitions for Cash The cost of an acquisition is straightforward when the bidder offers cash to the target company shareholders in exchange for their shares. For example, if acquiring company A offers target company Ts shareholders cash in the amount CASH to acquire Ts shares, then the total cost of the acquisition to A is:

COST = CASH

(15.3)

For example, if A must offer $20 billion in cash to acquire T, Company As total cost for the acquisition is $20 billion. 15.4.2 Acquisitions for Stock When the bidder offers its own shares in exchange for the target shares, the cost of the acquisition is a bit more complicated. Suppose again that A acquires T and that the total market capitalization of the combined company will be VAT. If A has 100 million shares outstanding, while T has 50 million shares, and if A offers Ts shareholders one A share for each T share, then the combined company will have 150 million shares outstanding, of which Ts former shareholders will own 50 million shares, or one-third of the total shares outstanding. In this case, the total cost of the acquisition to A is (1/3)VAT. More generally, in an acquisition that involves an exchange of shares, Ts shareholders wind up with a fractional ownership share f in the combined company, and the total cost of the acquisition to A is:

COST = fV AT

(15.4)

8 A key distinction between acquisitions for cash and stock is that the acquisition cost is fixed when the consideration offered is cash. By contrast when the consideration offered is in the form of stock, the target company shareholders become partners in the fortunes of the combined company. If the combined company winds up being valued more highly than expected, then the acquisition becomes more costly to the bidder, after the fact. On the other hand, if the combined company is accorded a value that is lower than expected, the acquisition becomes less costly to the bidder, after the fact. 15.4.3 Acquisition NPV To calculate the NPV of an acquisition, we now go back to Equation (15.1) in Section 15.2 and subtract COST from BENEFIT. In an acquisition for cash, we can use Equations (15.2) and (15.3) to write the acquisitions NPV to A as:

NPV = V AT V A CASH
Equation (15.5) still holds if we both subtract and add Ts enterprise value, VT:

(15.5)

NPV = V AT V A VT CASH + VT = [ V AT (V A + VT ) ] ( CASH VT )


(15.6)

Whereas Equation (15.5) expresses acquisition NPV in terms of total benefit and total cost, we can think of the second line in Equation (15.6) as expressing NPV in terms of net benefit and cost. The first term in square brackets in Equation (15.6) is the amount by which the combined companys enterprise value exceeds the sum of the enterprise values of the two companies as stand-alone entities. This is called the acquisition synergy, or the incremental value created by the acquisition, over and above the sum of the two companies separate values. The second term, CASH VT, in the last line of Equation (15.6), can be thought of as the acquisition premium. If we let SYNERGY represent the term [VAT (VA + VT)], and PREMIUM represent the term CASH VT, we can write the acquisition NPV as:

NPV = SYNERGY PREMIUM

(15.7)

It is often easier to estimate the net acquisition benefit, or synergy, than it is to estimate the total acquisition benefit, as given by Equation (15.2). For example, if the merger benefit stems primarily from economizing on operating cost savings, we can focus our attention on valuing those savings, and we need not to try to estimate the total enterprise value of the combined company, VAT, a difficult task. Once we have quantified the acquisition synergy, the second step in the NPV calculation is then to determine how much of that synergy must be given to the target company shareholders to induce them to sell their shares.

9 Acquisition NPV can be similarly rearranged for an acquisition for stock. Substituting Equations (15.2) and (15.4), we can write the acquisition NPV as:

NPV = (V AT V A ) fV AT

(15.8)

Then, subtracting and adding the target companys pre-acquisition value, VT, on the left-hand side of (15.8) gives:

NPV = (V AT V A ) VT fV AT + VT = [ V AT (V A + VT ) ] ( fV AT VT ) = SYNERGY PREMIUM


Note, however, that unlike a cash acquisition, we cannot avoid estimating VAT here, because when the acquisition is made with stock, we need to know the combined company value to determine how much has been paid to the target companys shareholders. Alternatively, we can simplify Equation (15.8) to write the NPV of an acquisition for stock as: (15.9)

NPV = (1 f )V AT V A
(15.10) That is, the NPV of the acquisition to the acquiring companys shareholders is equal to their share of the value of the combined company minus the pre-acquisition value of the acquiring company. 15.4.4 Competition and Acquisition Cost The NPV of an acquisition can be seen in either (15.6) or (15.9) as a balancing of the incremental value gain resulting from the merger against the fraction of that value gain that must be given to the target firm shareholders to induce them to sell. This in turn depends on how much competition there is among bidders to acquire the target. If the acquiring company is in a unique position to create value by making the acquisition, then we would expect the bid price to be such that most of the gain goes to the bidder. For example, suppose the bidder has a uniquely efficient distribution system or unique access to a low-cost production technology. By acquiring another company in the same industry, the bidder can apply its distribution system or its production technology to the targets product sales, thereby creating additional value. However, no other bidder will be in a position to create this value, so the

10 uniquely qualified acquirer should be able to negotiate a price quite close to VT to acquire target company T. On the other hand, if any acquirer could create value from the acquisition with equal ease, then we would expect competition among bidders to raise the bid price until most of the acquisition benefit goes to the target firms shareholders. Suppose, for example, that the target firm has too much excess cash on hand or too little debt to take optimal advantage of available tax shields. Any acquirer, even one from a different industry, would be in a position to acquire the target and pay out the excess cash to shareholders or issue additional debt. In this case, we would expect bidders to compete with one another to make the acquisition until most of the potential gain goes to the target company shareholders. 15.5 The Market for Corporate Control Acquisitions are an important element in what has been called the market for corporate control. Various sets of corporate assets are available to be managed at any given time, and teams of managers can potentially compete with one another to manage these assets. An important protection that shareholders in a public corporation have against managers not acting in their interest is the threat that another management team may try to take control of the corporation and replace the incumbent managers. Thus, the market for corporate control acts as a check on agency costs. When an alternative management team tries to wrest control of the corporations assets from the incumbents, a variety of tactics are frequently employed by both sides. 15.5.1 Acquisition Tactics Usually, the first approach when one company tries to acquire another is to try to negotiate an acceptable price with the targets incumbent executive team and board of directors. If negotiations are successful, the targets management and board will recommend the deal to their shareholders. Because the acquirer has won board support, this is called a friendly acquisition. The targets shareholders will then vote on whether or not to accept it. Corporate charters specify the fraction of outstanding shares that must be voted in favor of the transaction for approval. A twothirds majority is a common fraction necessary to approve being acquired, but some companies have supermajority provisions, calling for a larger fraction of shares needed for approval. If the incumbent management and board resist an acquisition attempt or refuse to even negotiate with the bidder, the bidding firm can respond by appealing directly to the shareholders. One tactic is to announce a bear hug, in which the bidder makes public the terms on which it is willing to acquire the target, hoping that the offer will appear sufficiently attractive both to stimulate shareholder pressure on the board in favor of the offer and also to preempt other potential bidders. The bidder can also launch a hostile takeover attempt by making a tender offer directly to the

11 target company shareholders. The offer will specify a price per share, the fraction of shares that the bidder is willing buy at that price, and usually a time period for which the offer will remain open. If the bidder acquires sufficient shares under the tender offer, the bidder will have enough votes to force a merger between the two companies. Short of an outright takeover, an outside party can also attempt to force changes in either managerial personnel or managerial strategy by launching a proxy fight. With this tactic, an investor acquires a number of shares and then proposes his or her own slate of directors to challenge the companys slate in the annual election. If the investors slate receives enough votes, a new set of directors is installed and can lobby for changes.

15.5.2 Defensive Tactics Of course, incumbent management and board members are often opposed to an attempt to acquire their company. If the acquisition attempt succeeds, many of them stand to lose their jobs. Shareholders understand this incentive, and many companies have installed golden parachute provisions, which afford the CEO and sometimes other top officers a handsome payout in the event of a change in control of the company. The rationale for these provisions is to give the CEO an incentive to keep shareholders interests in mind when negotiating with an acquirer, knowing that he or she will be well compensated if a takeover occurs. However, some company boards choose to resist anyway. Possible tactics include seeking a white knight, or an alternative buyer who may allow most incumbent management and board members to keep their jobs. The target can also adopt scorched earth tactics, by changing the company in ways that will make it less attractive to the bidder. Possible scorched earth tactics include issuing a substantial amount of debt or selling off a crown jewel, a division of the company that may be especially attractive to the bidder. Alternatively, the target might try to adopt some of the policies that the bidder is advocating, such as increasing dividend payouts or selling one or more of the companys divisions. One of the most common antitakeover tactics currently in use is a poison pill (often called a shareholder rights plan by the target company). In the event of an attempted takeover, these plans give existing shareholders the right to buy additional stock in the company at a discount price, thus diluting any ownership share that a bidder may have acquired and making it considerably more expensive to consummate a successful takeover. Regardless of such defensive tactics, the market for corporate control remains active, and it is an important mechanism for assuring some degree of alignment between managerial decisions and shareholders interests. A board of directors that resists any and all offers to buy the company with excessive zeal faces the threat of shareholder legal action.

12 15.6 Analyzing an Acquisition Bid: A Synthesis of Corporate Finance One reason for covering acquisition analysis as the last topic in this book is that it affords a synthesis of nearly all of the important topics in corporate finance. To see this, consider the hypothetical problem for an acquiring company A of developing an acquisition bid for target company T. This problem is discussed in general terms in this section, and the chapter-end problems afford a number of specific, numerical examples. The steps in developing such a bid are outlined in Figure 15.1. Valuation of companies and other assets has been the fundamental issue in this book, and this issue lies at the heart of developing an acquisition bid. We first need to ask what Company T is worth to Company A, and this means coming up with a valuation for T, including all acquisition synergies that might be available. That value represents the maximum possible bid that it would be worthwhile to make for T, and if A did bid that much, the acquisition would just be a zero-NPV transaction. However, we may not have to bid that much. We also need to ask what T is worth in the market now, how much it

13

How much should we bid?

What is T worth now? A?

Competition for T?

What is T worth to

Comparables valuation

DCF valuation

Valuation metrics: PE, Mkt/Bk, EBITDA

Ts FCF Now

How is T financed?

Ts Post-Acquisition FCF Capital Structure OK?

Excess cash?

Incorporate In valuation WACC method costs APV method information

Tax situation Distress costs Agency Investor

New capital structure?

14

Adjust rWACC or use APV method

Figure 15.1 Developing an Acquisition Bid for Target Company T

might be worth to other potential acquirers and how much competition we might face in trying to acquire T. If there is a gap between what T is worth in the market now and how much it is worth to us, this might result from a capital market inefficiency, as discussed in Chapter 9. In that case, we would expect a good deal of competition from other investors, since they can try to profit from the inefficiency simply by trading in Ts securities, rather than by mounting a full acquisition bid. On the other hand, a valuation gap between what T is worth in the market now and what it is worth to us may be caused by potential acquisition synergies. As we saw in section 15.4.4 of this chapter, if our company has a unique ability to generate synergies from buying T, we may be able to capture most of the value of those synergies for ourselves. Proceeding next through the valuation exercise, we have at our disposal two broad valuation methods: comparables valuation and discounted cash flow (DCF valuation). Comparables valuation proceeds by applying one or more valuation metrics to our target company T. These valuation metrics include such ratios as the EBITDA multiple, market-to-book ratio and PE ratio, which we saw in Chapter 5. The method calls for applying valuation metrics from comparable companies or transactions to our target company T and coming up with the valuation implied for T if T were valued similarly to our comparison companies. For example, if T has EBITDA equal to $500 million, and if the comparable company EBITDA multiple is 5, this implies an enterprise valuation for T of $2.5 billion. Alternatively, DCF valuation techniques call for estimating a set of future cash flows and then choosing a specific DCF valuation method and cost of capital measure to match those cash flows. Cash flow estimation was discussed in detail in Chapter 6, and in the exercise at hand, we need to understand both the cash flows for target

15 company T as it now stands and the incremental cash flows that might result if we acquire T. Discount rate estimation was discussed in Chapters 7 and 8. Note also that the two broad valuation methods are not mutually exclusive. It is common practice, for example, to project year-by-year cash flows for a limited time, such as 5 or 10 years, and then use comparables valuation to estimate a terminal value at the end of the cash flow forecast period. If we have settled on a DCF valuation as at least one approach to coming up with an appropriate acquisition bid, we need to choose between the Weighted Average Cost of Capital (WACC) and Adjusted Present Value (APV) methods. As we saw in Chapter 11, an important consideration in this choice is whether we envision a capital structure for the acquired company that maintains a constant or changing proportion of debt financing. The WACC is easier to apply with a constant debt proportion, while the APV method is well-suited to handle debt proportions that change over time, as long as we can predict year-by-year levels of debt. The question of capital structure in turn raises the issue of whether we believe the target companys current capital structure is ideal or whether we plan to make changes. If we plan changes, then any cost of capital measures that we estimate using data for Company T as it currently stands may need to be adjusted to reflect the planned capital structure. These adjustments were discussed in detail in Chapter 11. One common capital structure adjustment may occur if the target company is thought to have excess cash. The excess cash should be reflected in the development of our acquisition bid, since we can use that cash to help buy out the target companys shareholders or to pay down some of the targets debt, effectively reducing our out-of-pocket cost for the acquisition. On the other hand, if it is our acquiring company that has excess cash, the wisdom of using that cash to help pay for an acquisition should be weighed against the effects of paying it out to shareholders, as discussed in Chapter 10. Moving beyond the mechanics of the target company valuation, an acquisition may also raise other issues discussed in this book. For example, acquisitions often entail option features, as discussed in Chapter 12. These may be operating options, such as the option to expand our market presence regionally or internationally, or the option to distribute existing products through a new distribution network. Option features may also be present in the securities used to finance an acquisition, as when pay-in-kind bonds are issued as part of a leveraged buyout. Acquisitions may take place across national borders, so we may need to employ some of the tools of multinational financial management, discussed in Chapter 14, when analyzing and integrating an international acquisition. Acquisitions can bring new risks, so they raise questions of whether and how to try to manage these risks, as discussed in Chapter 13. And finally, since acquisitions involve the control over corporate assets, they force

16 us to think about the best way to structure this control so as to efficiently manage agency costs and ensure that the assets are managed in the best interests of shareholders.

Summary One way to help ensure that corporate assets are managed to provide maximum value to shareholders is to encourage competition for the right to control those assets. The market for corporate acquisitions is the arena in which this competition often takes place. Acquiring another corporation is a capital budgeting decision, similar in many respects, but often larger in scale, to the corporate investment decisions that we have analyzed in earlier chapters. The net present value rule still governs acquisition decisions, and an acquiring company values such a decision by balancing benefits against costs in present value terms. When measuring acquisition benefits, it is often useful to focus attention on the incremental benefits created from the acquisition. This can be easier and less subject to error than trying to determine the correct value of the acquired company as an entire entity. When measuring acquisition cost, it is important to distinguish between acquisitions for cash and acquisitions for stock. When stock is exchanged in an acquisition, it is impossible to avoid estimating the entire value of the combined entity, since the acquired companys shareholders will be shareholders in the combined company as well. Acquisitions often raise questions about the best way to organize corporate governance. The market for corporate control is an important element in corporate governance and in holding agency costs in check, since it provides a mechanism through which control over corporate assets can be transferred to the management team that can use those assets most efficiently and for the benefit of shareholders. Acquisition analysis provides a synthesis of every important topic in finance. We need to have all of our valuation tools at the ready to measure the NPV of an acquisition, and the choice of valuation method and cost of capital measure goes hand in hand with the analysis of how the acquisition should be financed and how our own cash and the cash of the acquired company should be deployed or distributed. Acquisitions may entail option elements, in both operations and financing, they may cut across international boundaries, and may raise new issues in risk management and in designing the best control mechanisms by which a corporation is governed.

17

Problems 1. GoGetter Corp. and FatCat Corp. are in the same industry. They have identical business risk and capital structure. However, GoGetter is more profitable as the most recent years results show: GoGett er Sales ($million) Cost of Goods Sold (COGS) Selling, General & Admin Expense (SG&A) Earnings Before Taxes Taxes (35%) Net Income Common Shares Outstanding (million) Earnings Per Share (EPS) Year-End Stock Price 1000 700 200 100 35 65 20 $3.25 $32.50 Fat Cat 2000 1500 450 50 17.5 32.5 10 $3.25 $32.50

GoGetters success is largely attributable to a group of B.C. MBA graduates on the management team. These hard-driving executives have relentlessly cut costs, giving GoGetter the lowest ratio of total operating costs to sales in the industry. GoGetter feels that if it acquired FatCat (which is managed by Harvard MBAs), it could realize similar cost economies in FatCats operations. Thus, GoGetter is preparing a hostile tender offer for FatCats shares. a) If GoGetter could successfully reduce FatCats costs (COGS plus SG&A) so that they bear the same relationship to sales as GoGetters own costs, what is the total potential increase in the value of FatCats operations that GoGetter could hope to achieve (note that the cost reduction should not affect FatCats price-earnings ratio)? b) If GoGetter were to make a cash tender offer for all of FatCats shares at a price of $50 per share, what would be GoGetters NPV (assuming the offer is fully accepted)? c) As an alternative, GoGetter is considering a share-for-share exchange. That is, it would offer one newly-issued GoGetter share for each currently outstanding share of FatCat. If this offer were fully accepted, what would its NPV be to GoGetter?

2. Wolfco management is currently considering a merger with Lambco. Both companies are in the same industry, and both companies shares sell at a ratio of price to free cash flow of 10. If the two companies merged, there is no reason to

18 believe that this valuation multiple would change. Wolfco has 20 million shares outstanding, selling at a price of $22.50 per share. Lambco has 10 million shares outstanding. Neither company has any debt. Lambco has revenues of $400 million per year and cash operating costs of $200 million per year. Annual depreciation expense is $100 million and annual capital expenditures are $110 million per year. Lambco also invests $20 million each year in additional net working capital. The corporate tax rate is 35%. If Wolfco and Lambco were to merge, Wolfco believes that it could apply its superior inventory control and accounts receivable management techniques to Lambco and thereby cut Lambcos annual investment in net working capital in half. The two companies management teams are now trying to negotiate the terms of a merger. a) What is the value of Lambco to Wolfco? b) Wolfco management proposes to pay $40 cash for each Lambco share. What is the Net Present Value (NPV) of this offer to Wolfco? c) Lambco management counters with a proposal under which Wolfco would offer two Wolfco shares for each currently outstanding Lambco share. What is the NPV of this offer to Wolfco? d) What are the primary factors that determine whether the final agreement will be closer to the terms of the cash offer in part (b) or the share exchange in part (c)?

3. Slug, Inc. has a management team that has grown fat and lazy. Slug is expected to have revenues of $1 billion, cash operating costs of $600 million, depreciation deductions of $100 million, net additions to working capital of $25 million and capital expenditures of $100 million annually for the foreseeable future. The corporate tax rate is 35%, and Slug has no debt. Slugs cost of capital is 10%. Slug also has $270 million in excess cash on its balance sheet. a) Given current policies, what do you think should be Slugs total market value? Suppose Slug currently has a total market capitalization of $1.9 billion. Why do you think the current market capitalization is less than the value you have just calculated for Slug? b) Sprinter, Inc. is in the same industry as Slug and is interested in acquiring Slug. Sprinter believes that, if it acquired Slug, it would pay out Slugs excess cash to shareholders, and issue $800 million in new, perpetual debt against Slugs assets. Sprinter also has a proprietary inventory control and accounts receivable management system, unmatched by any other firm in the industry. By applying this system to Slug, Sprinter believes that it could eliminate Slugs need for any additions to net working capital in the foreseeable future. What is the value of Slug to Sprinter?

19 c) Other firms in Slug and Sprinters industry are also potentially interested in submitting a bid for Slug. What do you think is the minimum bid that Sprinter could afford to submit and still win the bidding for Slug?

4. Vodaphony, a British telecommunications firm, is in a bidding contest to purchase a U.S. wireless telecommunications company. Vodaphony is considering a bid of $40 billion. If it succeeds, Vodaphony expects to realize $15 billion in annual revenue from the U.S. firm over the next four years. Over the same period, Vodaphony expects to incur $10 billion per year in cash operating expenses and $3 billion per year in depreciation expense. Vodaphony also expects that it will need to spend $3 billion per year in capital expenditures in each of the next four years to maintain the U.S. firms wireless network. At the end of four years, Vodaphony expects to be able to sell the U.S. wireless company for $50 billion. Any gain on the sale over the original purchase price will be taxable. Vodaphony expects to sell a combination of new shares in the U.K. and new bonds in the U.S. to finance this purchase. Vodaphony wishes to maintain a debt-equity ratio in market value terms of 1.0. Management estimates that Vodaphonys cost of equity on -denominated shares is 14%. The underwriters estimate that new $-denominated bonds could be issued at a yield to maturity of 6%. The current spot exchange rate is 0.5 /$, while the forward rate for an exchange to take place one year from now is (1/1.95) /$. Between the U.S. and the U.K., Vodaphony estimates that it will face an effective tax rate of 40% on all taxable income generated from its ownership of the U.S. wireless company. a) Vodaphony wishes to use the foreign currency approach to estimating the viability of this bid. That is, it plans to discount dollar-denominated cash flows at a dollardenominated discount rate and then translate the resulting NPV into pounds at the spot exchange rate. What cost of equity should Vodaphony use in calculating a weighted average cost of capital for this purchase? What weighted average cost of capital should Vodaphony use to discount the cash flows associated with the purchase? b) What yearly cash flows should Vodaphony use to calculate a net present value for this purchase? Be sure to identify cash flow components in addition to the net cash flow total. c) What is the net present value in pounds to Vodaphony of making this purchase? Should Vodaphony proceed with its bid?

5. Bullseye Corp. expects to have annual sales of $5 billion for the foreseeable future. Bullseyes EBIT margin (EBIT/Sales) is 20% and it expects annual capital expenditures to be approximately equal to depreciation each year. Bullseye feels that its current level of working capital is sufficient to support annual sales, and it does not anticipate

20 needing to commit any additional working capital to its business in the future. Bullseye faces a corporate tax rate of 40%. Bullseye currently has a ratio of debt to total enterprise value of 10%, and the company estimates that its cost of debt is 5% and its weighted average cost of capital is 12%. Bullseye has 100 million shares of common stock outstanding. a) Based on the information above, what should be Bullseyes total enterprise value? At what price per share should Bullseyes shares be selling? b) Arrow Corp. is seeking to acquire Bullseye. It hopes to buy all of Bullseyes outstanding shares and also to assume Bullseyes currently outstanding debt. However, Arrow feels that Bullseye is underleveraged. Once the acquisition is complete, Arrow believes that Bullseyes assets and cash flows could support 50% of their value in debt with an increase in rD of only 1%, so that the new rD is 6% (when Arrow assumes Bullseyes existing debt, it agrees to increase the coupon rate on the old debt so that Bullseyes original bondholders do not lose any value from the increase in leverage). If this is the only value-enhancing change that Arrow plans to make, what is the maximum price per share that Arrow can afford to bid for Bullseye shares? c) If Bullseye is successfully acquired, either by Arrow or by another company, do you think the price the acquirer bids for Bullseyes shares will be closer the to the share price you calculated in (a) or the share price you calculated in (b)? What would be the NPV of the acquisition to Bullseye shareholders at your most likely acquisition price?

6. Boss Threads, Inc. is a maker of high-end apparel. Bosss business has been battered by the recession, and the company is laboring under a heavy debt load. Bosss bonds have been downgraded to junk status and now have a beta of 1.25. Even though the bonds have lost value in recent months, the companys equity value has fallen even faster, and the market value of outstanding bonds now accounts for 75% of Bosss total market value (debt plus equity). At this debt ratio, Bosss equity has a beta of 2.5. The risk-free rate of return is 4%, and the expected risk premium on the overall market is 8%. Boss faces a 40% tax rate. a) What is Bosss current weighted average cost of capital? b) Boss currently has annual sales of $900 million. Cash operating expense is $600 million per year, and depreciation expense is $100 million per year. All of these levels are expected to remain unchanged for the foreseeable future. Yearly capital expenditures and additions to net working capital have been eliminated indefinitely in an effort to conserve cash. What is your estimate of the total market value of Bosss assets?

21 c) Cobra Clothes has managed to weather the recession as a result of brilliant business strategies (not surprisingly, all of Cobras top executives are graduates of the B.C. MBA program). Cobra now sees opportunity in Bosss plight. Specifically, Cobra feels that Bosss excessive debt burden is keeping it from making key investments that could result in substantially increased sales. Cobra management is considering buying up all of Bosss debt and equity securities at somewhere near their current market prices. Cobra would then replace Bosss previous bonds with a more manageable 50% of total enterprise value in new bonds, carrying an 8% coupon rate. Cobra would increase capital expenditures in its Boss division to $100 million per year and additions to net working capital to $50 million per year. Cobra feels that this would result in annual Boss sales of $1400 million per year. At the same time, Cobra estimates that annual cash operating expense and depreciation expense would increase to only $690 and $110 per year, respectively. If Bosss annual free cash flow remains at this new higher level indefinitely, how much value do you think Cobra can create relative to Bosss previous value in (b) above? d) In attempting to implement its plan, what problems do you think Cobra might encounter in trying to buy up Bosss currently outstanding bonds at something close to their current market value? Do you think Cobra or the Boss bondholders would have the better bargaining position here? Briefly explain.

7. A trust fund, which is the majority shareholder in Unhealthful Foods Corporation (UFC), a candy manufacturer, is looking to sell its entire block of stock in UFC in order to diversify its portfolio. It is currently soliciting bids for its block of stock. UFC has 50 million total shares of stock outstanding and no debt. The stock has a beta of 0.5. The long-term government bond rate is currently 4%, and the historical average market risk premium over and above the long-term risk-free rate is 10%. The corporate tax rate is 40%. UFC expects to generate $100 million in free cash flow (FCF) next year. The industry is mature, so FCF after next year is expected to grow indefinitely only at the expected annual inflation rate of 2.2%. Wahoo!, an internet company, has a beta of 2.0. Wahoo!s managers feel that their company is quite volatile, and they are considering making a bid for the UFC block in order to reduce Wahoo!s overall risk. a) Do you think that acquiring UFC purely for risk-management purposes will create value for Wahoo!s shareholders? Briefly explain. b) Wahoo! is preparing a cash bid for the UFC block. It will have to issue a combination of debt and equity securities to finance the entire bid. Wahoo! believes that UFC is currently underleveraged and that it could afford to issue 50% of the total amount of its bid in new, long-term debt, which it estimates would carry a 5% yield. If it issues this amount of debt to finance the acquisition, what is the value of the weighted average cost of capital that Wahoo! should use in analyzing its UFC bid?

22 c) Suppose, in addition, that Wahoo! believes its internet marketing prowess could enable it to add $15 million to UFCs revenues next year (the additional revenue would then grow at the 2.2% annual inflation rate in subsequent years), with no increase in operating costs, if the acquisition were completed. What is the maximum price per UFC share that Wahoo! can afford to bid for the trust funds block?

You might also like