CHAPTER 9

Mergers, Divestitures and

Business failures
 Mergers
 Analyzing and negotiating merger
 LBOs and divestitures
 Business failures
 Reorganization and liquidation in
bankruptcy
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What is a merger?
 A merger occurs when two firms combine to
form a single company.
 The primary motives for mergers are:
 Synergy
 Tax considerations
 Purchase of assets below their replacement costs
 Diversification
 Gaining control over a large enterprise
 Breakup value
21-2
Types of merger
 A horizontal merger occurs when two
firms in the same line of business
combine.
 A vertical merger combines a firm with
one of its customers or suppliers.
 A congeneric merger involves firms in
related industries but where no
customer–supplier relationship exists.
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Why do mergers occur?
 Synergy: Value of the whole exceeds sum
of the parts. Could arise from:
 Operating economies
 Financial economies
 Differential management efficiency
 Increased market power
 Taxes (use accumulated losses)
 Break-up value: Assets would be more
valuable if sold to some other company.
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What is the difference between a
“friendly” and a “hostile” takeover?
 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.

21-5
Reasons why alliances can make
more sense than 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

21-6
Merger analysis:
Post-merger cash flow statements
2018 2019 2020 2021
Net sales $60.0 $90.0 $112.5 $127.5
- Cost of goods sold 36.0 54.0 67.5 76.5
- Selling/admin. exp. 4.5 6.0 7.5 9.0
- Interest expense 3.0 4.5 4.5 6.0
EBT 16.5 25.5 33.0 36.0
- Taxes 6.6 10.2 13.2 14.4
Net Income 9.9 15.3 19.8 21.6
Retentions 0.0 7.5 6.0 4.5
Cash flow 9.9 7.8 13.8 17.1

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What is the appropriate discount rate
to apply to the target’s cash flows?
 Estimated cash flows are residuals which
belong to acquirer’s shareholders.
 They are riskier than the typical capital
budgeting cash flows. Because fixed
interest charges are deducted, this increases
the volatility of the residual cash flows.
 Because the cash flows are risky equity
flows, they should be discounted using the
cost of equity rather than the WACC.

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Discounting the target’s cash flows
 The cash flows reflect the target’s
business risk, not the acquiring
company’s.
 However, the merger will affect the
target’s leverage and tax rate, hence
its financial risk.

21-9
Calculating terminal value
 Find the appropriate discount rate
kS(Target) = kRF + (kM – kRF)βTarget
= 9% + (4%)(1.3) = 14.2%
 Determine terminal value
 TV2021 = CF2021(1 + g) / (kS – g)
= $17.1 (1.06) / (0.142 – 0.06)
=$221.0 million

21-10
 Net cash flow stream
2018 2019 2020 2021
Annual cash flow $9.9 $7.8 $13.8 $ 17.1
Terminal value 221.0
Net cash flow $9.9 $7.8 $13.8 $238.1

 Value of target firm

 Enter CFs in calculator CFLO register, and enter
I/YR = 14.2%. Solve for NPV = $163.9 million

21-11
Would another acquiring
company obtain the same value?
 No. The input estimates would be
different, and different synergies would
lead to different cash flow forecasts.
 Also, a different financing mix or tax rate
would change the discount rate.

21-12
The target firm has 10 million shares
outstanding at a price of $9.00 per share.
What should the offering price be?

The acquirer estimates the maximum price

they would be willing to pay by dividing the
target’s value by its number of shares:

Max price = Target’s value / # of shares

= $163.9 million / 10 million
= $16.39

Offering range is between $9 and $16.39 per

share.
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Making the offer
 The offer could range from $9 to
$16.39 per share.
 At $9 all the merger benefits would
go to the acquirer’s shareholders.
 At $16.39, all value added would go
to the target’s shareholders.
 Acquiring and target firms must
decide how much wealth they are
willing to forego.
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 Shareholder wealth in a merger
Shareholders’ Bargaining
Wealth Range

Acquirer Target

$9.00 $16.39
Price Paid
for Target
0 5 10 15 20
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Shareholder wealth
 Nothing magic about crossover price from
the graph.
 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 $9.

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Shareholder wealth
 Acquirer might want to make high
“preemptive” bid to ward off other
bidders, or low bid and then plan to go up.
It all depends upon their strategy.
 Do target’s managers have 51% of stock
and want to remain in control?
 What kind of personal deal will target’s
managers get?

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Do mergers really create value?
 The evidence strongly suggests:
 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, because of competitive
bids.

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RA 10667 and commercial law
 Basically, the Philippine Competition
Act (PCA) is the primary competition
policy of the Philippines for promoting
and protecting competitive market
especially on mergers and
acquisitions.

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What are LBOs?
 A leveraged buyout (LBO) is a
transaction in which a firm’s publicly
owned stock is acquired in a mostly
debt-financed tender offer, resulting in
a privately owned, highly leveraged
firm.
 Often, the firm’s own management
initiates the LBO.

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What are divestitures?
 A divestiture is the sale of some of a
company’s operating assets.
 A divestiture may involve
 selling an operating unit to another firm,
 spinning off a unit as a separate company,
 carving out a unit by selling a minority
interest, or
 the outright liquidation of a unit’s assets
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Reasons for a divestiture
 to settle antitrust suits,
 to improve the transparency of the
resulting companies so that investors
can more easily evaluate them,
 to enable management to concentrate
on a particular type of activity, and
 to raise the capital needed to strengthen
the corporation’s core business

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Business failures
 A company’s intrinsic value is the
present value of its expected future
free cash flows.
 The fundamental issue that must be
addressed when a company encounters
financial distress is whether it is “worth
more dead than alive”; that is, would
the business be more valuable if it
continued in operation or if it were
liquidated and sold off in pieces? 21-23
Business failures
 There are many factors that can cause
this value to decline. These factors
include:
 general economic conditions,
 industry trends,
 company-specific problems (shifting consumer tastes,
obsolescent technology, and changing demographics in existing
retail locations), and
 financial factors (such as too much debt and unexpected
increases in interest rates) 21-24
Reorganization and Liquidation in
bankruptcy
 In the case of a fundamentally sound
company whose financial difficulties
appear to be temporary, creditors will
frequently work directly with the
company, helping it to recover and
reestablish itself on a sound financial
basis.
 Such voluntary reorganization plans are
called workouts.
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Reorganization and Liquidation in
bankruptcy
 Reorganization plans usually require
some type of restructuring of the firm’s
debts.
 This may involve an extension, which
postpones the date of required payment
of past-due obligations, and/or a
composition, by which the creditors
voluntarily reduce their claims on the
debtor or the interest rate on their
claims. 21-26
 RA 10142 and Commercial Law
 Basically, the Financial Rehabilitation and
Insolvency Act shortly known as FRIA, is
a law which governs the rehabilitation or
liquidation of debtors, may it be a sole
proprietorship, partnership, corporation or
an individual debtor.
 It guarantees a timely, fair, transparent,
effective and efficient rehabilitation or
liquidation of debtors.
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THANK YOU
References:
Eugene Brigham and Joel F. Houston
(2019). Fundamental of Financial
Management, 15th Edition
Tim Koller, Marc Goedhart and David

Wessels (2020). Valuation “Measuring

and Managing the Value of Companies”,
7th Edition
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