CHAPTER 26

Mergers, LBOs, Divestitures,

and Holding Companies
26-2
Topics in Chapter
Types of mergers
Merger analysis
Role of investment bankers
LBOs, divestitures, and holding
companies
26-3
Economic Justifications for
Mergers
Synergy = Value of the whole exceeds
sum of the parts
Operating economies
Financial economies
Differential management efficiency
Taxes (use accumulated losses)
Break-up value = Assets more valuable
broken up and sold
26-4
Questionable
Reasons for Mergers
Diversification
Purchase of assets below replacement
cost
Acquire other firms to increase size,
thus making it more difficult to be
acquired
26-5
Merger Types
Horizontal
Vertical
Congeneric
Related but not same industry
Conglomerate
Unrelated enterprises

26-6
Five Largest Completed Mergers
(as of December, 2007)
TABLE 26-1
26-7
Friendly & Hostile Mergers
Friendly merger:
Supported by management of both firms
Hostile merger:
Target firms management resists the merger
Acquirer must go directly to the target firms
stockholders tender offer - try to get 51% to
tender their shares.
Often, mergers that start out hostile end up as
friendly, when offer price is raised

26-8
Merger Analysis
DCF Analysis
Corporate Valuation (Ch 11)
Adjusted Present Value Method (Ch 26.7)
Equity Residual Model (Ch 26.8)
= Free Cash Flow to Equity Method
Market Multiples Analysis
Provides a benchmark
26-9
The APV Model
Value of firm if it had no debt
+ Value of tax savings due to debt
= Value of operations

First term = unlevered value of the firm
Second term = value of the interest tax shield
26-10
The APV Model
TD V V
U L

(15-7)
(16-4)
(26-1)

1 t
t
sU
t
U OP
) R 1 (
FCF
V V

1 t
t
sU
t
TS
) r 1 (
TS
V
(15-1)
(26-2)
(26-3)
26-11
APV Model
V
U
= Unlevered value of firm
= PV of FCFs discounted at unlevered cost of
equity, r
sU

V
TS
= Value of interest tax shield
= PV of interest tax savings discounted at
unlevered cost of equity, r
sU


Interest tax savings = Interest * (tax rate) = TS
t
26-12
APV vs. Corporate Valuation
Best model when capital structure is changing
Merger often causes capital structure changes
over the first several years
Causes WACC to change from year to year
Hard to incorporate year-to-year WACC changes in
the corporate valuation model
Corporate Valuation (i.e., discount FCF at
WACC) = easier than APV when capital
structure is constant
26-13
Steps in APV Valuation
1. Calculate unlevered cost of equity, r
sU





2. Project FCF
t
,TS
t
until company is at its
target capital structure for one year and
is expected to grow at a constant rate
thereafter.
d d sL s sU
d sU sU sL
r w r w r
)
S
D
)( T 1 )( r r ( r r


(16-6)
(26-4)
(26-5)
26-14
Steps in APV Valuation
3. Project horizon growth rate, g
Calculate horizon value of unlevered firm
using constant growth formula and FCF
N



Calculate horizon value of tax shields using
constant growth formula and TS
N



g r
) g 1 ( FCF
g r
FCF
HV
sU sU
1 N
N , U

g r
) g 1 ( TS
g r
TS
HV
sU sU
1 N
N , TS

(26-7)
(26-8)
26-15
Steps in APV Valuation
4. Calculate Value of Operations
Calculate unlevered value of firm as PV of
unlevered horizon value and FCF
t



Calculate value of tax shields as PV of tax
shield horizon value and TS
t

N
1 t
N
sU
N , U
t
U , s
t
U
) r 1 (
HV
) r 1 (
FCF
V

N
1 t
N
sU
N , TS
t
U , s
t
TS
) r 1 (
HV
) r 1 (
TS
V
(26-9)
(26-10)
26-16
Steps in APV Valuation
4. Calculate Value of Operations
Calculate V
op
as sum of unlevered value and tax
shield value


5. Find total value of the firm
TS U OP
V V V
(26-11)
shares #
S
P
debt of Value
assets operating - non of Value

F
F op
op TS U
V S
V V
V V V
26-17
The FCFE Approach
FCFE = Free Cash Flow to Equity
Cash flow available for distribution to common
shareholders

debt issued newly payments principal
- expense interest tax - After

FCF FCFE
debt in change net shield tax interest
capital operating in investment Net

NI FCFE
(26-12)
26-18
FCFE Approach
Value of Equity =
Assuming constant growth:

1 t
t
sL
t
FCFE
) r 1 (
FCFE
V
g r
) g 1 ( FCFE
g r
FCFE
HV
sL sL
1 N
N , FCFE

N
1 t
N
sL
N , FCFE
t
sL
t
FCFE
) r 1 (
HV
) r 1 (
FCFE
V
(26-13)
(26-14)
(26-15)
assets operating - Non
FCFE
V S
(26-16)
26-19
TABLE 26-2
26-20
Valuation Examples
Caldwell Incs acquisition of Tutwiler
Tutwiler
Market value of equity = $62.5 m
Debt = $27 m
Total market value = $89.5 m
% Debt = 30.17%
Cost of debt, r
d
= 9%
10 million shares outstanding
26-21
Tutwiler Acquisition
Tutwilers pre-merger beta = 1.20
Risk-free rate = 7%
Market risk premium = 5%
CAPM r
sL
= 13%

% 707 . 10 WACC
%) 13 ( 6983 . 0 %) 9 )( 60 . 0 ( 3017 . 0 WACC
r w r ) T 1 ( w WACC
sL s d d

26-22
Tutwiler Acquisition
Both firms = 40% tax rate
Post-horizon g= 6%
Caldwell will issue debt to maintain
constant capital structure:
$6.2 m debt increase at merger

26-23
Projecting Post-Merger CFs
01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel A: Selected Items
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 & 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 Debt 33.2 35.8 38.7 41.1 43.6 46.2
8 Total Net Operating Capital 116.0 117.0 121.0 125.0 131.0 138.0
26-24
Post-Merger CF Projections
01/01/10 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14
Panel B Corporate Valuation CFs
9 NOPAT=EBIT(1-T) (T=40%) $4.2 $7.2 $9.6 $12.4 $13.8
10 Less net invest. In op cap 1.0 4.0 4.0 6.0 7.0
11 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Panel C: APV Model Cash Flows
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
13 Interst tax savings = INT(T) 1.2 1.28 1.4 1.48 1.56
Panel D: FCFE Model Cash Flows
14 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
15 Less A-T Interest=INT(1-T) 1.8 1.9 2.1 2.2 2.4
16 Plus debt 6.2 2.6 2.9 2.5 2.5 2.6
17 FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $7.1
26-25
Tutwiler Corporate Valuation
m 1 . 83 $ 27 $ 1 . 110 $
1 . 110 $ V
m 1 . 153 $
06 . 0 1070 / 0
) 06 . 1 ( 800 . 6 $
HV
g WACC
) g 1 ( FCF
g WACC
FCF
HV
Operation
2014 , OP
2014 2015
2014 , OP

Equity of Value
(26-7)
26-26
Tutwiler: Corporate Valuation
Panel B Corporate Valuation CFs
9 NOPAT=EBIT(1-T) (T=40%) $4.2 $7.2 $9.6 $12.4 $13.8
10 Less net invest. In op cap 1.0 4.0 4.0 6.0 7.0
11 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon value $153.1
FCF $3.2 $3.2 $5.6 $6.4 $159.9
Present Value of FCF $110.1
Minus Value of current debt $27.0
Value of Equity $83.1
26-27
Tutwiler APV Approach
% 793 . 11 r
%) 9 ( 3017 . 0 %) 13 ( 6983 . 0 r
r w r w r
sU
sU
d d sL s sU

5) - (26
Estimate Tutwilers Unlevered Cost of Equity:
26-28
Tutwiler APV Approach
Panel C: APV Model Cash Flows
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon Value of FCF $124.4
Total FCF $3.2 $3.2 $5.6 $6.4 $131.2
Value (Unlevered) $88.7
13 Interest tax savings = INT(T) 1.2 1.28 1.4 1.48 1.56
Horizon Value of tax savings $28.7
Total Tax Shield $1.2 $1.3 $1.4 $1.5 $30.3
Value(Tax Shield) $21.4
Total Value of Firm $110.1
Minus Value of current debt $27.0 r(sU) 11.793%
Value of Equity $83.1 g = 6%
26-29
Tutwiler FCFE Model
m 9 . 106 $
06 . 0 13 . 0
) 06 . 1 ( 06 . 7 $
HV
g r
) g 1 ( FCFE
g r
FCFE
HV
N , FCFE
sL sL
2015
2014 , FCFE

(26-14)
26-30
Panel D: FCFE Model Cash Flows
14 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
15 Less A-T Interest=INT(1-T) 1.8 1.9 2.1 2.2 2.4
16 Plus debt 6.2 2.6 2.9 2.5 2.5 2.6
17 FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $7.1
Horizon value of FCFE 106.9
Total FCFE $6.2 $4.0 $4.1 $6.0 $6.7 $114.0
Value of FCFE $83.1
r(sL) 13.0%
g = 6%
Tutwiler FCFE Model
26-31
Tutwiler Value Recap
Tutwiler is worth more as part of
Caldwell than stand-alone
Current Value of Equity $62.5
Corporate Valuation $83.1
APV Approach $83.1
FCFE Model $83.1
TUTWILER Equity
26-32
The Bid Price
Caldwells Bid for Tutwiler
Caldwell will assume Tutwilers debt
Added short-term debt for acquisition
Analysis shows Tutwiler worth $83.1m
to Caldwell
If Caldwell pays more Caldwell value
diluted
How much should Caldwell offer?
26-33
Caldwells Bid for Tutwiler
Targets Estimated value = $83.1 million
Targets current value = $62.5 million
Merger premium = $20.6 million
Synergistic Benefits = $20.6 million

Realizing synergies has been problematic
in many mergers
26-34
Caldwells Bid
Offer range = $62.5m to $83.1m
$62.5m merger benefits would
go to the acquiring firms
shareholders
$83.1m all value added would go
to the target firms shareholders
26-35
Bid Strategy Issues
High preemptive bid to ward off other
bidders
Low bid and then plan to go up
Do targets managers have 51% of
stock and want to remain in control?
What kind of personal deal will targets
managers get?
26-36
Do mergers really create value?
According to empirical evidence,
acquisitions do create value as a result of
economies of scale, other synergies, and/or
better management.
Target firm shareholders reap most of the
benefits
Final price close to full value
Target management can always say no
Competing bidders often push up prices
26-37
Acquisition with Permanent
Change in Capital Structure
Tutwiler currently:
$62.5m value of equity
$27m debt = 30.17% debt
Caldwells plan
Increase debt to 50%
Maintain level from 2012 on
New rate on debt = 9.5%
Tax shield, WACC and bid price will change

26-38
Change in Tax Shield
This last debt level is consistent with the assumed
long-term capital structure
The last interest payment is consistent with the long-term capital
structure
9. Debt 52.63 63.16 73.68 78.95 87.33
10. Interest
a
5.000 6.000 7.000 7.500 8.296
11. Interest tax savings 2.000 2.400 2.800 3.000 3.319
26-39
Effect on the Bid Price
New Horizon Value Calculation
First, calculate Tutwiler's horizon value if it were unlevered.
HV
U
= FCF
2014
* (1 + g) (r
U
- g)
HV
U
= 6.8 * 1.060 0.1179 - 0.06
HV
U
= $124.42
Second, calculate the horizon value of Tutwiler's tax shields under new financing plan:
HV
TS
= TS
2014
* (1 + g) (r
U
- g)
HV
TS
= 3.319 * 1.060 0.1179 - 0.06
HV
TS
= $60.72
Horizon value of Tax Shields is larger due to increased debt level.
26-40
Revised Value of Tutwiler
12 Free Cash Flow $3.2 $3.2 $5.6 $6.4 $6.8
Horizon Value of FCF $124.4
Total FCF $3.2 $3.2 $5.6 $6.4 $131.2
Value (Unlevered) $88.7
13 Interest tax savings = INT(T) 2.0 2.4 2.8 3.0 3.3
Horizon Value of tax savings $60.7
Total Tax Shield $2.0 $2.4 $2.8 $3.0 $64.0
Value(Tax Shield) $44.3
Total Value of Firm $133.0
Minus Value of current debt $27.0 r(sU) 11.793%
Revised Value of Equity $106.0 g = 6%
Panel C: APV Model Cash Flows with Increased Debt
26-41
Recap: Value of Tutwiler Equity
Total Per Sh
Current Value of Equity $62.5 $6.25
Original Merger Value $83.1 $8.31
APV Approach Revised $106.0 $10.60
TUTWILER Equity
26-42
Merger Payment
Cash
Shares in acquiring firm
Debt of the acquiring firm
Combination
26-43
Bid Structure Effects
Capital structure of post-merger firm
Tax treatment of shareholders
Ability of target shareholders to
benefit from post merger gains
Federal & state regulations applied to
acquiring firm
26-44
Tax Consequences
Shareholders
Taxable Offer
Payment = primarily cash or bonds
IRS views as a sale
Target shareholders taxed on gain
Original purchase price vs. Offer price
Taxed in year of merger
26-45
Non-taxable Offer
Payment = primarily stock
IRS views as an exchange
Target shareholder pay no taxes at
time of merger
Taxed at time of stock sale
Preferred by shareholders
Tax Consequences
Shareholders
26-46
Tax Consequences
Firms
Non-taxable offer
Simple merger of balance sheets
Continue depreciating targets assets as
previously
Taxable offer depends on offer type
Offer for targets assets
Offer for targets stock

26-47
Taxable Offer for Targets assets
Acquirer pays gain on offer asset value
Acquirer records targets assets at
appraised value
Depreciation based on new valuation
Goodwill = offer new valuation
Amortized over 15 years/straight line
Tax Consequences
Firms
26-48
Taxable Offer for Targets Stock
2 Choices of tax treatment
1. Record acquired assets at book value
and continue depreciating on current
schedule
2. Record acquired assets at appraised
value and generate goodwill
Tax Consequences
Firms
26-49
Figure
26-1
26-50
Purchase Accounting
Purchase:
Assets of acquired firm are written up or
down to reflect purchase price relative to
net asset value
Goodwill often created
An asset on the balance sheet
Common equity account increased to
balance assets and claims
26-51
Table 26-4
26-52
Income Statement Effects
Table 26-5
26-53
Goodwill Amortization
Goodwill amortization:
No longer amortized over time for
shareholder reporting
Still amortized for Federal Tax purposes
Goodwill subject to annual impairment
test
If fair market value has declined, then
goodwill is reduced
26-54
The Role of Investment Bankers
Arranging mergers
Identifying targets
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
26-55
Defensive Tactics
Super Majority
1/3 of Directors elected each year
75% approval for merger versus simple majority
Convince target price is too low
Raising anti-trust issues
Open market repurchase of stock to push price up
Finding a White Knight
Finding a White Squire
Taking a Poison Pill
ESOP plans
26-56
Poison Pills
Any technique used to discourage
hostile takeovers
Borrowing on terms that require
immediate repayment if acquired
Selling desirable assets at low prices
Granting lucrative golden parachutes
Allowing current shareholders to buy
shares at reduced prices

26-57
Risk Arbitrage
Arbitrageurs or arbs
Speculation in likely takeover
targets
Insider trading scandals
Ivan Boesky
26-58
Who Wins?
Takeovers increase the wealth of
target firm shareholders
Benefit to acquiring firm debatable
Event Studies Target stock price
30% for hostile tender offers
20% for friendly mergers

26-59
Alliances versus Acquisitions
Access to new markets and technologies
Multiple parties share risks and expenses
Rivals can often work together
harmoniously
Antitrust laws can shelter cooperative
R&D activities
26-60
Leveraged Buyout (LB0)
Small group of investors buys all
publicly held stock
Takes the firm private
Group usually includes management
Purchase often financed with large
amounts of high-yield debt
Investors take firm public to cash out
26-61
Advantages and Disadvantages of
Going Private
Advantages:
Administrative cost savings
Increased managerial incentives
Increased managerial flexibility
Increased shareholder participation
Disadvantages:
Limited access to equity capital
No way to capture return on investment
26-62
Types of Divestitures
Sale of entire subsidiary to another firm
Spin-off
Spinning off a corporate subsidiary by
giving the stock to existing shareholders
Carve-out
Selling a minority interest in a subsidiary
Outright liquidation of assets
26-63
Motivation for Divestitures
Subsidiary worth more to buyer than
when operated by current owner
Settle antitrust issues
Subsidiarys value increased operated
independently
Change strategic direction
Shed money losers
Get needed cash when distressed
26-64
Holding Companies
Corporation formed for sole purpose of
owning the stocks of other companies
Typically, subsidiary companies:
Issue their own debt
Equity held by the holding company
Holding company sells stock to individual
investors
26-65
Advantages and Disadvantages of
Holding Companies
Advantages:
Control with fractional ownership
Isolation of risks
Disadvantages:
Partial multiple taxation
Ease of enforced dissolution