Mergers and Corporate

Control

Dr. Lordina Amoah (PhD)

 Overview

• Mergers, acquisitions, takeovers, and buyouts are

all transactions in the markets for corporate
control.

• In each, the ownership of an entire firm changes

hands in a single transaction.

 Defining the Transactions…
• Mergers: In a merger, two firms combine to form a single firm. In
most cases, the shares of one firm are extinguished while the shares
of the other firm continue.

• In a consolidation, both firms cease to exist, and a new firm is

established with a new name, a new board, and/or new management.

• In the typical deal, the shareholders of the defunct firm receive shares
of the surviving firm and/or cash, while the surviving firm acquires the
assets (and liabilities) of the defunct firm.

• Thus, the term acquisition is used: the surviving firm is the acquiring
firm or bidder; and the defunct firm is the acquired firm or target.
 Defining the Transactions…
• A merger/acquisition is initiated when the
bidder’s board approves an offer of stock and/or
cash in exchange for the shares of the target.

• The deal is consummated when the target’s

board and shareholders vote to accept the offer.
Examples of Mergers
 …Defining the Transactions…
Takeovers: A takeover is the purchase of an entire firm by another
firm.

• In some cases, the takeover is consummated on friendly terms,

in which case the transaction can simply be called an acquisition.

• The type of takeover that is truly distinct from an acquisition is

a hostile takeover.

• In this case, the bidder’s intention is to acquire the target and

replace the target’s incumbent management, who vigorously
resist the attempt.
 …Defining the Transactions
• Buyouts: A buyout occurs when a group of individuals uses cash to
purchase the shares of a firm and takes ownership and control of the firm.

• Generally, the buyers arrange debt financing to facilitate the purchase.

Thus, the purchased firm generally has high leverage after the buyout. For
this reason, the transaction is often called a leveraged buyout, or LBO.

• The buyers in these transactions are often assisted by a buyout specialist,

or LBO association. If the group includes members of the target firm’s
management, the transaction is called a management buyout, or MBO.

• In any event, if the focal firm had been publicly traded, the buyers take the
firm private. For this reason, the transaction is often called a going private
transaction.
 Motives for the Transactions…
Classes of Mergers and their Motivation
• Horizontal: Two competitors in the same line of business combine.
• The typical motive is to create economies of scale or scope, or to enhance market power.
• Vertical: Two firms in different stages of the production process in a given industry combine.

The general justification is to stabilize:

(a) the supply of raw materials for a firm that is further down in the production process; or
(b) customer demand for the finished product of the firm that is further up in the production
process.

• Conglomerate: Two firms in unrelated industries combine. This type of merger is the most
difficult to justify;
• the diversification motive, discussed below, is most frequently cited.
• To many cases, the conglomerate merger is a prime example of managerial empire building.
 …Motives for the Transactions…
More on Motives for M&A
• Operating Synergy: obtains if the merger results in improvements in: (a)
management; (b) labor costs; (c) production or distribution; (d) resource acquisition
and allocation; or (e) market power.

• Financial synergy: obtains if the financial structure of the merged firm causes its
market equity value to be greater than the sum of the market equity values of the
separate firms (e.g., lower default risk allows higher leverage).

• Bankruptcy Avoidance for the Target: A distressed firm may agree to be acquired to
avert deadweight costs of bankruptcy.

• Evidence suggests that bankruptcy avoidance may be the primary rationale in a

substantial portion of acquisitions. Acquisitions of distressed firms generally are
attempts to restructure the troubled target.
 …Motives for the Transactions…

• Internal Capital Markets, Financial Slack, and Merger: The pecking order hypothesis
also provides a motive for merger.

• A cash-poor firm with substantial profitable investment opportunities faces the difficult
choice of either raising funds in the external markets or passing up profitable
investments. The firm can resolve this problem if it merges with a cash-rich, investment-
poor firm.

• The Hubris Hypothesis: The bidder’s management overvalues the target because they
overestimate their ability to create value once they wrest control of the target’s assets.

• Management Self-Interest: Risk Reduction and Entrenchment: The management of a

cash-rich, investment-poor firm has a self-serving incentive to overinvest in unprofitable
projects. Merging with a cash-poor, investment-rich firm may mitigate this problem.
 …Motives for the Transactions
Motives for Hostile Takeover
• The Failure of Target Management
• Bust-up (of an inefficient conglomerate)
• Industry Shocks
• Motives for Buyouts
• Increasing Management’s Incentives
• Averting a Takeover
• Tax Benefits
 …Mergers & Acquisitions…
• Defending Mergers as a Mechanism in the Market for Corporate Control.

• Failing-company argument: A failing firm in an industry can be efficiently absorbed

by a healthy firm in the same industry via
merger:
1. If mergers were completely legal, relatively few bankruptcies would occur in an
industry which was not itself contracting.

2. The function so wastefully performed by bankruptcies and liquidations would be

better performed by mergers.

3. Also, merger is justified if the assets of a poorly managed company are transferred
to a company with superior
management.
 …Mergers & Acquisitions
• Merger Waves and Industry Dynamics

• M&A activity seems to wax and wane gradually over time, much like a sine
wave, and the phrase merger waves has been coined to describe this process.

• Acquisitions as a Measure of Industry Vitality: M&A activity may be an

important indicator of an industry’s vitality.

• For example, a bidder may recognize synergy with a target, or may wish to
convert the assets of a poorly performing firm to more efficient uses.

• Accordingly, the relative frequency of acquisitions in an industry may be a

good measure of the industry’s vitality.
 Differentiate between hostile and friendly
mergers
• Friendly merger: The merger is supported by the
managements of both firms.

• Hostile merger: Target firm’s management resists the

merger.

• Acquirer must go directly to the target firm’s stockholders, try

to get 51% to tender their shares.

• Often, mergers that start out hostile end up as friendly, when

offer price is raised.
Question- Is there an overall economic gain
to the merger?
 There is an economic gain only if the two firms are
worth more together than apart.

PV(AB) > PV(A) + PV(B)

– Do the terms of the merger make the company

and its shareholders better off?
 Estimating Merger Gains and Costs

Gain  PV(AB) - [PV(A) + PV(B)]  PV(AB)

• If this gain is positive, there is an economic justification

for merger.

• If payment is made in cash, the cost of acquiring B is

estimated as
Cost = cash paid – PV(B)
Estimating Merger Gains and Costs
• The Net Present Value to A of a merger with B is
measured as
– NPV = gain – cost
= ∆PV (AB) – (cash – PV(B)

• Decision rule: Go ahead with merger if NPV is

positive.
 Example
 Firm A has a value of ¢200million, and B has a value of ¢50
million. Merging the two would allow cost savings with a
present value of ¢25 million. Suppose B is bought for cash
¢65million. PV  GH¢200 Gain  PV  GH¢25
A AB

PVB  GH¢50 Hence, PV ( AB)  ¢275 million

Cost  Cash paid  PVB  65  50  GH¢15million

NPV  25  15  GH¢10million
 Stockholders of firm B receive the ¢15million
 Thus of the ¢25 merger gain, 15 goes to B and
10 goes to Firm A.
 Right and Wrong Ways to Estimate the
Benefits of Mergers
• Estimated net gain = DCF valuation of target (including
merger benefits) - cash required for acquisition

• What if forecasts are overly optimistic or pessimistic?

• Other analysts consider the stand-alone market value

PV(B) and changes in the cash flow that would result
from the merger.
 Reason to Use Compressed Adjusted Present
Value (APV) in Merger Valuation

Often in a merger the capital structure changes

rapidly over the first several years.

• This causes the WACC to change from year to

year.
• It is hard to incorporate year-to-year changes in
WACC in the corporate valuation model.
 The APV Model
Value of firm if it had no debt
+ Value of tax savings due to debt
= Value of operations

• First term is called the unlevered value of the

firm.
• The second term is called the value of the interest
tax shield.
 APV Model
• Unlevered value of firm = PV of FCFs discounted at
unlevered cost of equity, rsU.

• Value of interest tax shield = PV of interest tax savings

discounted at unlevered cost of equity.

Interest tax savings = Interest(tax rate) = TSt

 Note to APV
• APV is the best model to use when the capital
structure is changing.

• The Corporate FCF Valuation model (i.e., discount FCF

at WACC) is easier to use than APV when the capital
structure is constant.
 Steps in APV Valuation
• Project FCFt, TSt until company is at its target capital structure for
one year and is expected to grow at a constant rate thereafter.

• Project horizon growth rate.

• Calculate the unlevered cost of equity, rsU.

• Calculate horizon value of tax shields using constant growth formula

and TSN

• Calculate horizon value of unlevered firm using constant growth

formula and FCFN
 Steps in APV Valuation (Continued)
• Calculate unlevered value of firm as PV of
horizon value and FCFt

• Calculate value of tax shields as PV of tax shield

horizon value and TSt

• Calculate Vop as sum of unlevered value and tax

shield value.
 Estimating the Value of Equity

Value of operations
+ Value of any non-operating assets
= Total value of the firm
- Value of debt (pre-merger)
= Value of equity
APV Valuation Analysis (In Millions) Based
on Post Acquisition Cash Flows
Cash flows… continued
Interest Tax Savings after Merger
 What is investment in net operating
capital?
• Recall that firms must reinvest in order to replace worn out
assets and grow.
• Investment in net operating capital = change in total net
operating capital.
• This is equivalent to gross investment in operating capital
minus depreciation.
 Non-Operating Assets
• Short-term investments and marketable securities
are non-operating assets.

• The Target has none of these.

 What is the appropriate discount rate to
apply to the target’s cash flows?
• After acquisition, the free cash flows belong to the remaining
debtholders in the target and the various investors in the
acquiring firm: their debtholders, stockholders, and others
such as preferred stockholders.

• These cash flows can be redeployed within the acquiring firm.

• Free cash flow is the cash flow that would occur if the firm
had no debt, so it should be discounted at the unlevered cost
of equity, rsU
• The interest tax shields are also discounted at the unlevered
cost of equity, rsU
 Note: Comparison of APV with FCF Corporate
Valuation Model
• APV discounts FCF at rsU and the tax shields at rsU;
• the value of the tax savings is incorporated explicitly.

• FCF Corp. Val. Model discounts FCF at WACC, which has a

(1-T) factor to account for the value of the tax shield.

• Both models give same answer if the capital structure is

constant.
• But if the capital structure is changing, then APV should
be used.
 Discount Rate for Horizon Value
• The last year of projections must be at the target
capital structure with constant growth thereafter.

• Discount the FCFs using the constant growth

formula to find the unlevered horizon value.

• Discount the tax shields using the constant growth

formula to find the horizon value of the tax shields.
Discount Rate Calculations
Horizon Value (Constant growth of 6%)

(FCF2021)(1+g)
Horizon Value =
rsU - g

= $21.94(1.06)
0.1156 – 0.06

= $418.3 million.
Unlevered Value
 Unlevered Value
• The unlevered value is the value of the firm’s
operations if it had no debt.
•
• In this case firm operations would be worth $298.9
million if it were financed with 100% equity.
Tax Shield Horizon Value

(TS2021)(1+g)
Tax Shield Horizon Value =
rsU - g

= $3.26(1.06)
0.1156 – 0.06

= $62.2 million.
Tax Shield Value
•What Is the value of the Target Firm’s operations to
the Acquiring Firm? (In Millions)

Value of operations
= unlevered value + value of tax shield
= 298.9 + 45.5 = $344.4 million
 What is the value of the Target’s
equity?
• If the Target has $55 million in debt.
Vop + non-operating assets – debt = equity
344.4 million + 0 – 55 million = $289.4 million =
equity value of target to the acquirer.
 Would another potential acquirer obtain
the same value?
• No. The cash flow estimates would be different,
both due to forecasting inaccuracies and to
differential synergies.

• Further, a different beta estimate, financing mix, or

tax rate would change the discount rate.
 The Bid Price
• Assume the target company has 20 million shares
outstanding.

• The stock last traded at $11 per share, which

reflects the target’s value on a stand-alone basis.

• How much should the acquiring firm offer?

The Bid Price
 The Bid Price
• The offer could range from $11 to $289.4/20 =
$14.47 per share.
• At $11, all merger benefits would go to
the acquiring firm’s shareholders.
• At $14.47, all value added would go to
the target firm’s shareholders.
• The graph on the next slide summarizes
the situation.
Change in Shareholders’ Wealth
 Points About Graph

• Nothing magic about crossover price.

• Actual price would be determined by bargaining.
• Higher if target is in better bargaining position, lower if
acquirer is.
• If target is good fit for many acquirers, other firms
will come in, price will be bid up. If not, could be
close to $11.
 Points About Graph
• Acquirer might want to make high “preemptive” bid to
ward off other bidders, or low bid and then plan to
go up.
• Strategy is important.
• Do target’s managers have 51% of stock and want
to remain in control?

• What kind of personal deal will target’s managers

get?
•What if the Acquirer intended to increase the debt level in the
Target to 40% with an interest rate of 10%?

• Assume debt at the end of 2020 will be $221.6 million.

• Free cash flows wouldn’t change
• Assume interest payments in short term won’t change (if they
did, it is easy to incorporate that difference). Interest in
2021 will change.
• Interest2021 = 0.10(221.6) = $22.16 million
• Tax Shield2021 = 22.16(0.40) = $8.864 million
New Tax Shield Horizon Value
Calculation
New Tax Shield Value
 Increase in Tax Shield
• The old tax shield value was $45.5 million when
the company was financed with 20% debt.

• When the company is financed with 40% debt, the

tax shield value increases to $110.5 million. The
increase is due to the larger interest deductions.
 New Vop and Vequity
•Value of operations
= unlevered value + value of tax shield
= 298.9 + 110.5 = $409.4 million Value of equity
= Value of operations + non-operating assets – debt
 New Equity Value
• $409.4 million - $55 million = $354.4 million.

• This is $65 million, or $3.25 per share more than if the

horizon capital structure is 20% debt.

• The added value is the value of the additional tax

shield from the increased debt.
 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.

• Shareholders of target firms reap most of the benefits,

that is, the final price is close to full value.

• Target management can always say no.

• Competing bidders often push up prices.