FM213 Principles of Finance

Part 2
Lecture 9

Kim Fe Cramer

LSE Finance
Assistant Professor
What Did We Do?

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

1
What Did We Do?

• Venture capital

• Fund structure

• Capital flows

• Monitoring

• IPOs

• Procedure

• Underpricing

• Seasoned offerings

2
This Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

3
The Biggest Bank Fail Since the 2008 Financial Crisis

• In March 2023 Silicon Valley Bank (SVB), providing banking

services to nearly half of U.S. start-ups and 2,500 VCs, became
the largest bank to fail since the 2008 financial crisis

• The following week, stocks of several banks plunged

(e.g., Signature Bank, Credit Suiss)

4
Why Did Silicon Valley Bank Fail?

• SVB kept few deposits in cash and used the rest to buy
long-term assets like Treasury (=government) bonds

• Fed raised interest rates to combat inflation

(higher rates = less borrowing = less money spent = lower prices)

• SVB’s existing treasury bonds much less attractive as newer

bonds got more interest

• As start-up funding decreased, clients withdrew more money from

their accounts - to fulfil the requests, the bank had to sell some
assets at a steep discount

• SVB tried to finance theses losses through new shares ($1.8b),

worrying investors that they were in trouble

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Why Did Silicon Valley Bank Fail?

• The tech industry panicked and rushed to pull out their money
("bank run")

• Federal Deposit Insurance Corporation ("FDIC") took over SVB

after they couldn’t find another buyer

• Costs of the aftermath of these bank failures financed by fees paid

by banks into the FDIC

• In 2008, hundreds of billions of dollars were provided to rescue

the banking industry, largely shouldered by taxpayers

• In 2018, Trump had signed a bill that reduced how often regional
banks had to submit to stress tests

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M&A to the Rescue

• Spurred by the collapse of Silicon Valley Bank, Credit Suisse’s

stock price decreased sharply and people became worried about
its weaknesses

• Credit Suisse (founded 1856) has long been bad news - decades of
scandals, management upheals, and failed attempts to reform
damaged its reputation and attracted lawsuits. E.g., lost $147b
worth of customer deposits in the last three months of 2022

• In March 2023 UBS acquired Credit Suisse in a $3.24b all

stock deal brokered by the government to prevent Credit Suisse
from failing

• Credit Suisse shareholders received 1 UBS share for every 22.48

Credit Suisse shares they held

• UBS also got $9.72b from the government (= taxpayer money)

should certain assets fail, plus a $108b credit line
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Course Evaluation

• Please fill out the course evaluation

• It is crucial for my career path at LSE

• And helps me make course corrections if you didn’t like something

• Any private feedback via email is also appreciated

• Thank you!

Please fill out teacher questions twice, once for your class teacher and
once for me as a lecturer (Kim Fe Cramer)

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Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

9
Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

10
Motivation

• Mergers and acquisitions ("M&A") are typically the largest

investment decisions a financial manager can make

• These decisions are very consequential; successful M&As can

transform a company, unsuccessful ones can destroy it

• In 2020, U.S. companies were involved in over 17,000 deals

totalling more than $2 trillion

• During periods of intense M&A, managers spend a large amount

of time of either searching for firms to acquire or worrying about
being acquired ("eat or be eaten")

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Motivation

Some important recent M&As

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Definitions

Mergers

• Several companies consolidated into single new firm

• Mostly friendly merge on an equal basis

• Don’t take place frequently

• Stocks of both companies are surrendered and new stocks issued

• E.g. Continental Airlines and United Airlines

We will mostly focus on more frequent acquisitions

13
Definitions

Acquisitions

Takeover

• Larger firm buys shares of smaller target firm

• Can be friendly or hostile

• E.g. US Airways and American Airlines

Buyout

• A (public) firm (or a division) is bought and then taken private

• Can be friendly or hostile

• E.g. M. Dell bought company he founded to have better control

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Types of M&A

Horizontal Vertical Conglomerate

Firms are in the same Firms are in the same Firms are in
industry and the industry but at different different industries
same production stages production stages

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M&A Waves

United States
1. 1893-1904: Horizontal M&A to create monopolies

2. 1915-1929: Horizontal M&A resulting in oligopolies

3. 1960s-1970s: Conglomerate M&A to create internal capital markets

4. 1980s: Hostile gigantic M&A to create diversified businesses

5. 1990s: Less hostile big M&A fuelled by globalization

6. 2000s: More buyouts due to growth in private equity

Europe
1. 1984-1989: transatlantic acquisitions by U.S.

2. 1993-2001: surge in intra-European transactions, many cross-boarder

due to the Euro and deregulation/privatization

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Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

17
Reasons for M&A

Valid reasons
• Economies of scale (= efficiency by volume)
• Economies of scope (= efficiency by variety)
• Change in corporate control
• Taxes
• Restructuring
• Market power

Dubious reasons
• Diversification
• Reduced borrowing costs
• Increased management prestige or compensation
• Higher earnings per share

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Reasons for M&A: Valid

Economies of scale/scope ("synergies/strategic benefit")

• Higher cash flows, e.g. through higher revenue or lower costs

• Scale = small firm gets access to distribution and advertisement

• Scope = big firm gets access to innovative technology of start-ups

Change in corporate control

• Replace bad managers

• Prevent entrenched management or captured board

• Prevent empire building (=expand rather than profit shareholder)

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Reasons for M&A: Valid

Taxes

• Interest tax shields from debt of other firm

• Reorganize into other corporate form

• Other tax tricks

Restructuring

• Restructuring often necessary through regulation/deregulation

(e.g. banking, airlines)

• Other reasons: obsolete product

• Merger often cost effective way to restructure

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Reasons for M&A: Valid

Market power

• If you can’t undercut competitors, you can buy them

• Lower competition allows monopoly prices

• Good for companies but bad for society

(e.g., Alphabet, parent of Google)

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Reasons for M&A: Dubious

Diversification

• Combining several industries is diversification on firm level

• But investors simply can hold a diversified portfolio of firms

Reduced borrowing costs

• Combined firms can often get lower interest rates

• But only because they guarantee for each other (which is a cost)

Increased management prestige or compensation

• Managers simply want to show off

• Or derive higher benefits

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Reasons for M&A: Dubious

Higher earnings per share (=EPS)

• Some M&As offer no evident economic gains but get higher EPS

• Example: Assume A and B have identical earnings (100m) and

identical number of shares (1m). However, firm A has a stock
price of 4 and B of 2, since B has poor growth perspectives.
Thus, firm A only needs 0.5m shares to buy B’s 1m shares.
Earnings double but the nr of shares increases only by 50%. So
EPS is now 200m/1.5m=133m.

Firm A Firm B After M&A

Earnings 100m 100m 200m
Shares 1m 1m 1.5m
Stock price 4 2 4
Market value 4m 2m 6m
EPS 100 100 133

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Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

24
Takeover Types: Cash vs Stock

1. Cash deals
• Target shareholders receive cash compensation

• E.g. every share of target receives $10

2. Stock deals
• Target shareholders receive acquires’ shares (post-takeover firm)

• E.g. every share of target receives 0.3 shares of acquirer

3. Combination of cash and stock

Does it matter? No in Modigliani-Miller world, yes in reality.

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Takeover Types: Friendly vs Hostile

Friendly

• Board of directors of two firms agree to combine firms

• Seek shareholders approval for combination (generally >50%)

Hostile

• Raider can make offer to board of directors

• ... or directly to shareholders ("tender offer")

• Often a hostile takeover attempt will result in being sold to a

friendly third party

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Defence Against Hostile Takeovers

1. Bribe raider to go away ("greenmail")

2. File antitrust law suit to block acquisition

3. Anti-takeover amendments ("shark repellents")

• Poison pill (more shares to all shareholders but acquirer)

• Staggered terms for board of directors (hard to quickly replace)

• Super majority provisions (require more than 50% of votes)

4. Employee stock ownership plan (=put vote in hands of employees)

5. Look for friendly alternatives

Stock price ↓1.3% at anti-takeover amendment announcement

27
Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

28
Takeovers: Gains and Costs Under Cash Deal

• Suppose you are the financial manager of acquirer A and want to

analyse the possible target firm T. There is an economic gain
only if the two firms are worth more together than apart
Gain = PVAT − (PVA + PVT ) = △PVAT

• To buy T, A almost certainly need to pay T’s shareholders more

than it is currently worth ("acquisition premium")

Cost = Cash paid − PVT

• A should go ahead with the takeover if the NPV is positive

N P V = △PVAT − (Cash paid − PVT ) > 0

29
Takeovers: Gains and Costs Under Stock Deal

• Suppose you are the financial manager of acquirer A and want to

analyse the possible target firm T. There is an economic gain
only if the two firms are worth more together than apart
Gain = PVAT − (PVA + PVT ) = △PVAT

• To buy T under stock deals, A needs to sell N shares at the price

P of the post-takeover firm AT

Cost = N ∗ PAT − PVT

• Optimistic managers prefer to finance takeovers with cash (they

think that price of AT will be high, increasing costs)

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Example

• Assume that the market value of the acquirer is $2,000m and the
market value of the target is $1,100m

• The acquirer thinks that the combined companies can cut

operating costs by $40m p.a. in perpetuity

• Assume discount rate is 11%

• The acquirer thinks a successful cash bid will cost $1,400m

• Alternatively, the acquirer could offer target’s shareholders 33%

in post-takeover firm

• What are gains, costs, and NPVs of the two alternatives?

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Example

Gains
• Cash: 40m/0.11=364m
• Stock: 40m/0.11=364m

Costs
• Cash: 1,400m-1,100m=300m
• Stock: 0.33*(2,000m+1,100m+364m)-1,100m=43m

NPV
• Cash: 364m-300m=64m
• Stock: 364m-43m=321m

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Valuation By NPV: Pros and Cons

Pro
• Construct transparent spreadsheet of FCF
• FCF come from specific assumptions and forecasts
• Can see impact of changes in strategies
• Valuation tied to underlying fundamentals

Con
• Calculation only as good as your assumptions and forecasts
• You might forget something
• Need to forecast managerial behaviour (unless you are in control)
• Need to estimate discount rate that may be incorrect

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Valuation By Multiples

Assess firm’s value based on publicly traded comparables

1. Cash-flow-based value multiples

Market value of firm divided by earnings, EBITDA, or FCF

2. Cash-flow-based price multiples

Price of firm divided by earnings (P/E ratio), EBITDA, or FCF

3. Asset-based multiples
Market value of firm divided by book value of assets, or
market value of equity divided by book value of equity

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Valuation By Multiples

• Step 1: if you want to value firm A, find firm B in same business

• Step 2: calculate a multiple (e.g. P/E) for firm B (or take the
average among multiple comparison firms) to come up with an
estimate of the multiple for firm A

• Step 3: solve for the price of firm A

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Example

• Assume Google’s market capitalization (= market value of

equity) is 300b and it has 400m shares. The earnings per share
was 75 last year

• Further assume Facebook is similar to Google and had

earnings per share of 9.5 last year

• Price Facebook shares by the P/E ratio

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Example

Google

• Share price = 300b/400m = 750

• P/E = 750/75 = 10

Facebook

• P/E = 10 (from Google)

• P/9.5 = 10 ⇐⇒ P = 95

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Valuation By Multiples: Pros and Cons

Pro
• Free-ride on market’s info
• Incorporate a lot of info from other valuations in simple way
• Embodies market consensus about growth and discount rate
• Discipline in valuation by ensuring it is in line with others

Con
• Implicitly assumes all companies equal in growth rates, etc.
• Hard to incorporate firm-specific info
• Accounting differences across firms
• Book value differences across firms based on age
• If everyone uses comparisons, who does fundamental analysis?

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Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

39
Who Benefits? Target Shareholders!

Abnormal performance of takeover target stocks (U.S., 1975-2019)

• This is the premium investors expect acquirer needs to pay

• Acquirer firms do a little better than zero (stock price ↑0.5%)

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Why Do Only Target Shareholders Benefit?

Explanations

1. Buyer is often much larger such that even substantial gains don’t
show up in share price

2. Excessive competition among buyers

3. Free-rider problem (see example)

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Free-Rider Problem: Example

• You are a shareholder of Nothing Hill Bookshop, whose stock is

trading for 45. You expect management is not running the shop
well and it could be worth 60

• Ownership is dispersed and convincing all shareholders to vote a

new board is unlikely

• SoullessBooks is known for buying and turning around

under-performing bookshops by replacing and properly
incentivizing management

• They make a bid of X per share, but they need 51% of shares

Question: What must X be for you to sell?

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Free-Rider Problem: Example

• If you think SoullessBooks succeeds with the bid, you would not
sell below 60 because that is what your share will be worth
afterwards

• If all think similarly, SoullessBooks only succeeds if it bits 60

• At 60 however, SoullessBooks makes no profits

• SoullessBooks will receive a firm worth 60 and pay 60 plus

transaction costs

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Free-Rider Problem: Logic

• Only buyer can unlock extra value in target firm

• But current shareholders want to free-ride on buyer’s efforts

• This means either buyers overpay or nothing happens

• This explains why target prices jump on takeover announcement

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What Did We Do?

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

45
Lecture Overview (Chapter 32)

M&A
• Definitions and facts

• Reasons for M&A

• Takeovers

- Types
- Gains and costs (NPV and multiples)
- Why does the target price jump on announcement?

46
Next Lecture

1. What projects should you invest in?

• Lecture 1: Capital budgeting and the NPV rule
• Lecture 2: Real options

2. How should you distribute the money you made?

• Lecture 3: Payout Policy

3. How should you raise more money for investments?

• Lecture 4: Does debt policy matter?
• Lecture 5+6: How much debt should a firm borrow?
• Lecture 7: The many different types of debt
• Lecture 8: Initial public offerings

4. Should you agree to a merger?

• Lecture 9: Mergers, corporate governance, and control

5. How can you manage risk?

• Lecture 10: Risk management and hedging

47
End

Questions?
• Ask during lectures

• Ask during classes

• Class teacher office hours see Moodle (approach first)

• Kim’s office hours Friday after lecture (5-6pm, MAR 7.35)

• Moodle forum

• Email only for sensitive/personal questions

48