12/10/2012

Chapter 22. Mini Case for Mergers and Corporate Control

Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself”
materials and equipment rentals, is cash rich because of several consecutive good years. One of the
alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss,
has been asked to place a value on a potential target, Lyons’ Lighting, a chain which operates in
several adjacent states, and he has enlisted your help.

The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s
management (in millions of dollars). The interest expense listed here includes the interest (1) on LL’s
existing debt, which is $55 million at a rate of 9 percent, and (2) on new debt expected to be issued
over time to help finance expansion within the new “L division,” the code name given to the target
firm. If acquired, LL will face a 40 percent tax rate.

Security analysts estimate LL’s beta to be 1.3. The acquisition would not change Lyons’ capital
structure, which is 20 percent debt. Zona realizes that Lyons’ Lighting’s business plan also requires
certain levels of operating capital and that the annual investment could be significant. The required
levels of total net operating capital are listed below.

Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also
estimates that free cash flows after 2018 will grow at a constant rate of 6 percent. Following are
projections for sales and other items.

2013 2014 2015 2016 2017 2018

Net sales 60.00 90.00 112.50 127.50 139.70
Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
Interest expense 5.00 6.50 6.50 7.00 8.16
Total Net Operating Capital 150.00 150.00 157.50 163.50 168.00 173.00
Investment in net operating capital 0.00 7.50 6.00 4.50 5.00

risk free rate 7%

market risk premium 4%
pre-merger beta 1.3
pre-merger % debt 20%
pre-merger debt $ 55.00 million
pre-merger debt rd 9%
Tax rate 40%

Hager’s management is new to the merger game, so Zona has been asked to answer some basic
questions about mergers as well as to perform the merger analysis. To structure the task, Zona has
developed the following questions, which you must answer and then defend to Hager’s board.

a. Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax
considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost,
(5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable?
Which are not? Which fit the situation at hand? Explain.
 Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax
considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost,
(5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable?
Which are not? Which fit the situation at hand? Explain.

Economically justifiable reasons:

Synergy: Value of the whole exceeds sum of the parts. Could arise from:
Operating economies
Financial economies
Differential management efficiency
Taxes (use accumulated losses)
Break-up value: Assets would be more valuable if broken up and sold to other companies.

Questionable reasons for mergers:

Diversification
Purchase of assets at below replacement cost
Acquire other firms to increase size, thus making it more difficult to be acquired

b. Briefly describe the differences between a hostile merger and a friendly merger.

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.

c. What are the steps in valuing a merger?

When the capital structure is changing rapidly, as in many mergers, the WACC
changes from year-to-year and it is difficult to apply the corporate valuation model in
these cases. The APV model works better when the capital structure is changing.
The steps are:

1. Project FCFt ,TSt until the target is at its target capital structure for one year and and is
expected to grow thereafter at a constant growth rate.
2. Project the horizon growth rate.
3. Calculate the unlevered cost of equity, r su.
4. Calculate horizon value of tax shields using the constant growth formula and TS N.
5. Calculate the horizon value of the unlevered firm using the constant growth formula and
FCFN.
6. Calculate the unlevered firm value as the present value of the unlevered horizon value and
the FCFs at the unlevered cost of equity.
7. Calculate the value of the tax shields as the present value of the tax shield horizon value
and the individual tax shields.
8. Calculate Vops as the sum of the unlevered value and the tax shield value.

d. Use the data developed in the table to construct the L division’s free cash flows for 2014 through
2018. Why are we identifying interest expense separately since it is not normally included in
calculating free cash flows or in a capital budgeting cash flow analysis? Why is the investment in
net operating capital deducted in calculating the free cash flow?
 2013 2014 2015 2016 2017 2018
Net sales $ 60.0 $ 90.0 $ 112.5 $ 127.5 $ 139.7
Cost of goods sold (60%) 36.0 54.0 67.5 76.5 83.8
Selling/administrative expense 4.5 6.0 7.5 9.0 11.0
EBIT 19.5 30.0 37.5 42.0 44.9
Taxes on EBIT (40%) 7.8 12.0 15.0 16.8 18.0
NOPAT 11.7 18.0 22.5 25.2 26.9
Total net operating capital 150.0 150.0 157.5 163.5 168.0 173.0
Investment in operating capital 0.0 7.5 6.0 4.5 5.0
Free Cash Flow 11.70 10.50 16.50 20.70 21.94

Interest expense 5.00 6.50 6.50 7.00 8.16

Tax savings from interest $ 2.000 $ 2.600 $ 2.600 $ 2.800 $ 3.264

e. Conceptually, what is the appropriate discount rate to apply to the cash flows developed in Part
c? What is your actual estimate of this discount rate?

When debt levels are changing rapidly, as they do with many mergers, it is difficult to apply the
corporate value model or standard capital budgeting techniques to merger valuation because the
discount rate changes as the debt level changes. Instead, the APV method is easier to apply.

These estimated cash flows are unlevered flows plus the tax shelter from interest payments.
Because the free cash flows are unlevered equity flows, they should be discounted at the unlevered
cost of equity. Similarly, the tax savings (also called tax shields) should be discounted at the
unlevered cost of equity. Note that the cash flows reflect the target’s business risk, not the acquiring
company’s. However, if the merger will affect the target’s leverage and tax rate, then it will affect its
financial risk. The horizon value should be calculated once the capital structure is stable at its post-
merger target level of debt.

rs(Target) = rRF + (rM - rRF) bTarget

rsL(Target) = 7% + 4% X 1.3
rsL(Target) = 12.2%

rsU(Target) = wd rd + wS rL
rsU(Target) = 20% 9% 80.0% 12.2%
rsU(Target) = 11.560%

f. What is the estimated horizon, or continuing, value of the acquisition; that is, what is the
estimated value of the L division's unlevered cash flows and tax shields beyond 2018? What is
Lyons' value to Hager’s shareholders? Suppose another firm were evaluating Lyons' as an
acquisition candidate. Would they obtain the same value? Explain.

Beta = 1.3
Unlevered (2018 Free Cash Flow)(1+g) Tax Rate 40%
Horizon Value = rsU - g rsU = 11.56%
g = 6%
Unlevered Horizon Value = $ 418.3 million
 2014 2015 2016 2017 2018
Free Cash Flow $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 21.94
Unlevered Horizon Value $ 418.3
Total $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 440.2

Unlevered Value = PV at rsU = $ 298.9 million

Tax Shield (2018 Tax Shield)(1+g)

Horizon Value = rsU - g

TS. Horizon Value = $ 62.2 million

Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 3.264

Tax shield horizon value $ 62.23
Total $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 65.49

Tax Shield Value = PV at rsU = $ 45.462 million

Vops = Tax shield value + Unlevered value = $ 344.4 million

- Debt $ 55.00
= Equity $ 289.4 million

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.
Note: Change the shaded cells above ( beta or tax rate ) to see the change in value

g. Assume that Lyons' has 20 million shares outstanding. These shares are traded relatively
infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should
Hager’s make an offer for Lyons'? If so, how much should it offer per share?

Estimated Value of Target = $ 289.4

Target's Current Value = $ 220.0 20 million shares x $11/share
Merger Premium = $ 69.4

Presumably, the target’s value is increased by $69.4 million due to merger synergies, although realizing
such synergies has been problematic in many mergers.

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.

h. How would the analysis be different if Hager's intended to recapitalize Lyons' with 40 percent debt
costing 10% at the end of 4 years? This amounts to $221.6 million of debt at the year prior to the
horizon.

The free cash flows and the unlevered cost of equity would be unchanged. If we assume that the
interest payments in the first 4 years are unchanged, and the intention is to use $221.6 million in debt
from year 5 on, then the horizon value of the tax shield would increase.
new level of debt at end of 2017 $221.60 million
new % debt 40%
new rd 10%

Unlevered value (From before. This doesn't change) $ 298.9 million

New tax shield in 2018 = Debt in 2018 x new interest rate x T

Interest in 2018 $ 22.16
Tax shield in 2018 $ 8.864 million

Tax Shield (2018 Tax Shield)(1+g)

Horizon Value = rsU - g

Tax shield horizon value = $ 169.0 million

2014 2015 2016 2017 2018
Interest tax shield $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 8.864
Tax shield horizon value $ 169.0
Total tax shield cash flows $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 177.9

Tax Shield Value = PV at rsU = $ 110.5 million

Vops = Tax shield value + Unlevered value = $ 409.4 million

- Debt 55.0
= Equity $ 354.4 million

Old equity value under the 20% debt capital structure $ 289.4
New equity value under the 40% debt capital structure $ 354.4
Increase in value due to increased tax shields 65.02

Lyons' Lighting is worth $ 65.02 million more to Hager's at 40% debt

than at 20% debt. The difference is the added benefit of a larger tax shield.
This amounts to $ 3.25 per share difference in maximum purchase price.

There has been considerable research undertaken to determine whether mergers really create
i. value, and, if so, how this value is shared between the parties involved. What are the results of
this research?

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.

j. What method is used to account for mergers?

Pooling of interests has been eliminated. Only purchase accounting may be used.
Purchase:
The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the
net asset value.
 The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the
net asset value.
Goodwill is often created, which appears as an asset on the balance sheet.
Common equity
Goodwill is account isorincreased
not amortized expensedtoover
balance
time.assets andit claims.
Instead, is subject to an "impairment" test. If
goodwill drops in market value, then a charge for this reduction must be taken. Otherwise, no
expense for goodwill is recorded. Note: goodwill is still amortized for Federal income tax
purposes.

k. What merger-related activities are undertaken by investment bankers?

Identifying targets
Arranging mergers
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
Hopefully: not paying kickbacks to CEOs for business, and not providing fraudulent
analyst reports to pump up stock prices.

l. What are the major types of divestitures? What motivates firms to divest assets?

Sale of an entire subsidiary to another firm.

Spinning off a corporate subsidiary by giving the stock to existing shareholders.
Carving out a corporate subsidiary by selling a minority interest.
Outright liquidation of assets.

A firm divests assets:

Because the subsidiary worth more to buyer than when operated by current owner.
To settle antitrust issues.
Because subsidiary’s value increased if it operates independently.
To change strategic direction.
To shed money losers.
To get needed cash when distressed.

m. What are holding companies? What are their advantages and disadvantages?

A holding company is a corporation formed for the sole purpose of owning the stocks of other
companies. In a typical holding company, the subsidiary companies issue their own debt, but their
equity is held by the holding company, which, in turn, sells stock to individual investors.

Advantages:
Control with fractional ownership.
Isolation of risks.
Disadvantages:
Partial multiple taxation.
Ease of enforced dissolution.
This worksheet shows how the debt and interest were projected at the end of the horizon.
See the Web Extension to this chapter for a complete explanation of how to project
consistent interest expenses.

2018
Free Cash Flow 21.94
growth rate at horizon 6.0%

Step 1: Calculate the WACC at the horizon:

rsL(Target) = 12.2%
wd = 20.0%
rd = 9.0%
T= 40.0%
rsU(Target) = wd rd + wS rL
rsU(Target) = 20% 9% + 80.0% 12.2%
rsU(Target) = 11.56%

WACC(Target) = wd(rd)(1 - T) + ws(rs)

WACC(Target) = 1.08% + 9.76%
WACC(Target) = 10.84%

Step 2: Calculate the horizon value using the Corporate Valuation Model. This is ok since the capital
structure is constant once the horizon is reached.

Horizon Free Cash Flow)(1+g)

Horizon Value =
WACC - g
Horizon Value = $ 480.50

Step 3: Calculate the value of operations as of the year before the horizon. We need this because we need
to set the debt level in the next to last year of projections so we can set the interest expense in the last year
of projections.

Horizon Value + Horizon Free Cash Flow

Vops 2017 =
1+ WACC
= $ 453.31

Note: we can discount the FCF and Horizon Value at the WACC for this year because we've assumed the
capital structure is constant in the last year of projections.

Step 4: Calculate the amount of debt that is consistent with this value of operations and the assumed debt
percent.
 Debt 2017 = Vops 2017 x wd
Debt 2017 = 453.31 x 20.0%
Debt 2017 = $ 90.66

Step 5: Calculate the interest expense in the last year that corresponds to the debt calculated in the
previous step.

Interest 2018 = Debt 2017 x rd

Interest 2018 = 90.66 x 9.0%
Interest 2018 = $ 8.16
This is the amount of interest expense we projected for the last year of projections.

Calculations with a change in capital structure

This is exactly the same as above, but we use the new capital structure and new cost of debt to calculate a
new WACC, which is used in Steps 2 and 3 above. The new cost of debt is used in Step 4.

Step 1: Calculate the new WACC at the horizon:

Calculate a new levered cost of equity:

New wd = 40%
New rd = 10%
New rsL = rU + ( rU - rD ) D/S
New rsL = 11.56% + 11.56% - 10% 0.6666666667
New rsL = 12.60%

Calculate a new WACC:

New WACC(Target) = wd(rd)(1 - T) + ws(rs)
New WACC(Target) = 2.40% + 7.56%
New WACC(Target) = 9.96%

Calculate a new Horizon Value of Operations

Step 2: Calculate the horizon value using the Corporate Valuation Model. This is ok since the capital
structure is constant once the horizon is reached.

Horizon Free Cash Flow)(1+g)

Horizon Value =
New WACC - g
Horizon Value = $ 587.28
Step 3: Calculate the value of operations as of the year before the horizon. We need this because we need
to set the debt level in the next to last year of projections so we can set the interest expense in the last year
of projections.

Horizon Value + free cash flow2011

Vops 2017 =
1+ New WACC
Vops 2017 = $ 554.04
Note: we can discount the FCF and Horizon Value at the WACC for this year because we've assumed the
capital structure is constant in the last year of projections.

Step 4: Calculate the amount of debt that is consistent with this value of operations and the assumed debt
percent.

Debt 2017 = Vops 2017 x wd

Debt 2017 = 554.04 x 40.0%
Debt 2017 = $ 221.62

Step 5: Calculate the interest expense in the last year that corresponds to the debt calculated in the
previous step.

Interest 2018 = Debt 2017 x rd

Interest 2018 = 221.62 x 10.0%
Interest 2018 = $ 22.16
This is the amount of interest expense we projected for the last year of projections.