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1. “Best practice in M&A requires that we augment the deterministic focus on structure with a
Structural factors drive success in M&A. These are distinct—they are the resources and
constraints one operates within—and can easily be rattled off: economic opportunity,
strategy, organization, brand, etc. We can have a deterministic mindset about these factors
and say, “If X structure is present, Y is the outcome.” However, M&A success is also driven
by conduct, which lends itself less easily to such clear boundaries and definition, and is
therefore more probabilistic. Best practice in M&A must therefore take in both a
2. The chapter described six elements of structure that influence M&A transactions. What are
Organization The ability of merging firms to mesh well will depend in part on
“Brand” The reputation and influence of buyer and target are key
Law Laws and regulations constrain the actions of buyer and target
firms. But there are also opportunities to shape them. The M&A
that simply verifies facts and due diligence that identifies patterns, synthesizes facts into
While the search for partners is usually based on careful, structured research, sometimes,
partners are discovered serendipitously. In such instances, social skills – networking skills –
Other areas of M&A in which conduct might have an influence are negotiation and bidding,
dealing with laws and regulations, deal design, post-merger integration, leadership and
Process is important because it lends discipline to thinking and by doing so, helps ensure
that deals are pursued based on well-founded reasons. Process also helps build good M&A
practice – one that synthesizes lessons from past deals into a continually evolving body of
o Financial stability
o Organizational strength
o Enhanced “brand”
o Improved process
8. Why is a deal a system? It being a system, what are the implications in terms of
Each deal reflects choices in several dimensions, such as price, form of payment, social
issues, etc. The choices interact with one another and cannot, therefore, be considered in
isolation. Hence, each deal is a system. This systemic nature suggests that tinkering with
one aspect of the deal will have an effect on some other aspect. As such, it behooves deal
designers to think through each action carefully in order to avoid unanticipated side effects.
9. Should one use the same blueprint for all M&A deals? Explain.
No. One should design deals according to the specific needs of the situation. For instance,
cross-border deals may warrant a different design from domestic deals. Or, some specific
circumstances (the target CEO nearing retirement, the need for equal standing between
buyer and target, etc.) may warrant different designs. Even for a specific deal, there cannot
10. An “enhanced brand” in M&A should be one of the goals that deal makers aspire to. Why is
this important?
A firm and its deal maker’s “brand” can affect success in future M&A deals, which in turn
can affect the very survival of the firm. Therefore, a deal should improve not only the
True or False
1. The field of business ethics is important because it provides detailed solutions to the
2. Ethical business practices build trust, but they do not yield economic gains.
3. Following and paying attention to the law are necessary, but not sufficient requisites for
acting ethically.
4. The U.S. legal framework generally requires directors and managers to operate a
6. Utilitarianism is an ethical theory that believes actions should provide the greatest good
follows this ethical theory would consider what a virtuous person would do in a given
situatio n.
8. The tradition of ancient Greek philosophy, which defines “right” and “wrong” by virtues,
9. Incorporating business ethics in the workplace builds stronger teams and leaders.
10. A company’s only defense against unethical business behavior is to institute a code of
1. False. The field of business ethics is indeed important, but it does not provide the answers
to ethical dilemmas. What it does offer are some tools and frameworks with which an
2. False. Trust and loyalty that a company can gain from its customers, consumers, and
counterparties can lead to successful branding of products and services. Companies with
strong brands (and brand images) can command price premiums in the marketplace.
3. True. The law only provides the lowest common denominator: a baseline measured by what
is not legal. However, it does not prescribe norms or standards of behavior. Even if
everyone abided by the law, there would still be ample opportunities for business managers
to behave unethically. The law tells you what you cannot do, but it does not provide
guidance for what you should do to act ethically. While the law may set clear-cut
boundaries around “illegal” managerial actions, it does not set any boundaries between
what constitutes ethical versus non-ethical behavior. The important takeaway here is that
the legal and ethical realms, however connected, are distinct and separate. Following the
5. False. Freeman offers a different view than Friedman’s notions of managerial capitalism.
Freeman argues that managers bear a fiduciary responsibility to all of its stakeholders:
6. False. Utilitarianism holds that moral actions achieve the greatest good for the greatest
number.
8. True. Virtue ethics considers a person’s pride as an appropriate barometer for deciding if
an action is ethical. An ethical act would make a person proud to see his/her reflection in
the mirror. An unethical act would hurt a person’s pride if it were broadcast on the news
9. True. Adopting ethical standards for behavior contributes to the strength of teams and
10. False. Instituting a corporate code of ethics is a good defense against unethical business
behavior in the workplace. Adopting a code of ethics, however, can easily be reduced to a
defense, which should complement and not substitute a corporation’s code of ethics, is to
create a culture of mindfulness. Companies can achieve this by discussing ethics in the
workplace within teams and within the enterprise. In addition, they can foster a culture of
mindfulness by offering seminars and training sessions in business ethics and ethical
decision-making.
1. Describe and explain the role of ethics in Mergers and Acquisitions by providing some
Ethics is important in the M&A field because it promotes best practices and positive
corporate cultures that in turn lead to sustainable business. Ethical behavior builds
teams and leadership, which underpin process excellence. Because ethics sets a higher
standard than laws and regulations, it provides incentives for managers to do more than
just comply with a baseline of norms; in essence, it motivates a positive spirit for business
practitioners to go above and beyond the call of duty. Ethical behavior rewards
business leaders by building strong individual reputation and good consciences. Ethical
counterparties, which can lead to more effective and economically attractive mergers and
acquisitions.
People make excuses for why ethical standards and practice do not apply to their
business teams and enterprises. They claim that they are not trained to discuss ethical
matters, it is not a part of their job descriptions, they are in the business of making
money, being ethical is pointless and futile because many companies and business people
behave unethically.
3. Does Milton Friedman’s Stockholder school of thought promote (or not promote) ethical
Perhaps one could argue that the main tenet of Milton Friedman’s Stockholder Theory,
“To maximize returns to stockholders,” has prompted some corporate managers to make
unethical decisions. In fact, Milton Friedman has been criticized for his famous article,
“The Social Responsibility of Business is to Increase its Profits,” which first appeared in
the New York Times Magazine in September 1979. In the text, however, Professor
a. The company must obey the rules set by society (i.e., government).
Whether or not one agrees with Friedman’s Stockholder school of thought, one should
realize that it does not condone the aforementioned unethical business practices.
4. James, the Chief Learning Officer of Best Investments, has just been charged with the
James could begin by crafting or revising the company’s Code of Ethics: this is often best
approach builds buy-in and yields a richer perspective. This effort should capture the
most appropriate norms and relevant standards of conduct that he believes employees
should uphold. In addition, James could look at the ethics codes of prominent companies
Ethics, James could set up group training on the subject matter, with the support of CEO
and senior executives of the firm. Through training, employees could learn how to apply
the code of ethics to specific work-related scenarios and develop mindfulness for what
must be aware that codes of ethics should be taught through informal examples and
buyer for the buyer’s accumulated shares in the target. Some consider it unethical
because:
right/privilege of selling their shares at the premium price paid to hostile buyer.
c. It could transfer the wealth of other public shareholders to a more powerful raider
True or False
1. Despite the unique characteristics of M&A deals and their respective targets and buyers,
2. Since the 1970s, event studies have dominated the field of M&A research; this technique
was considered a genuine innovation, theoretically well grounded, cheap to execute, and
able to evade the problem of holding constant other factors that plague ex post studies of
mergers’ effects.
4. Statistical significance is essentially the same thing as economic materiality, and each can
5. Average returns to target and buyer company shareholders are stable over time.
Answers to True or False Questions
1. T
2. T
3. T
4. F: While statistical significance and economic materiality both collectively shed light on
whether M&A transactions create or destroy value, they are neither the same thing nor
an indicator of M&A value on a stand-alone basis. One needs both the proof of
statistical significance (that a result is not due to chance) and economic materiality (that
the wealth effect is large enough that shareholders or society should be concerned
about).
5. F: Returns from M&A vary over time, perhaps with changes in the economic cycle,
To conserve value is to earn the required rate of return from an investment, or the rate at
which the net present value for the investment is zero. Economically speaking, investors
2. Why shouldn’t the gains from M&A activity be evaluated using benchmarks other than
the economic one? Shouldn’t strategic benefits such as human capital, economies of
There could be many grounds on which to evaluate M&A activity—economics is but one
affords a general measure of welfare. Also, economic measures of M&A results are the
most rigorous: one can observe market prices and financial accounting results.
3. Suppose you are an investor in Company A, which has just completed an acquisition.
The returns resulting from the event are 1.2% in the first week. Theoretically, how does
this compare to those of Company B, another stock in your portfolio that experienced a
75% annualized gain in the last year? What assumption underlies this comparison?
The annualized returns for Company A, based on the weekly return after the acquisition
is:
(1.012)^ 52 – 1 = 86%.
This stock offers a higher yield than Company B’s stock. This comparison assumes that
b. Expected synergies.
f. M&A programs
g. Value-style acquiring
h. Restructuring
b. M&A regulation.
6. Why are hostile takeovers more profitable to buyers than friendly offers?
The positive returns from hostile deals may reflect bargain prices and/or the economic
suitors may have discovered special value-created synergies with target firms.
7. The main challenge of evaluating the profitability of M&A to combined entities (the
buyer and target firms combined) stems from the size differential between the buyer and
Research studies conducted to address the size differential between buyer and target
firms examine weighted average returns, weighted by the relative sizes of the two firms,
statistical study of M&A deals. The sample size is large and random; the data results are
clear. One student says that 60% of the M&A transactions failed, while the other says
that 60% of the M&A deals succeeded. Could they both be right? How might you
Arguably, the students could both be right, depending on the assumptions they make
about deal success and failure, and how they define these two terms. The first student
may define success as the creation of value, whereas the second student may define
success as value creation and value conserved. Twenty-percent of deals conserved value,
which the first student includes in the “failure” group; whereas the second student
This example should underscore the importance of scrutinizing the blanket statements
9. A popular notion is that the acquisition premiums that buyers pay represent expected
future value. How would you explain why buyers, on average, receive zero to slightly
negative returns?
Buyers pay premiums because they believe that acquiring target companies will
eventually yield returns in excess of those premiums, and thus create value for their
great uncertainty surrounding mergers and acquisitions, a buyer may make projections
True or False
1. Despite the correlation between certain economic conditions and M&A activity, scholars
have cited the occurrences of M&A waves as one of the ten most important unresolved
2. The second wave of M&A activity (1925-1929) was characterized by horizontal mergers
and produced the following firms: General Electric, Eastman Kodak, and U.S. Steel.
3. M&A waves are pro-cyclical to the stock market; they occur in line with increases in
stock prices.
4. Possible explanations for waves of M&A activity include bargaining power effects in
only because of their important function in creative destruction but also because their
independence and tendency to appear singly makes them easy to miss in the crowd.
6. Holding the view that market manias always drive M&A activity is consistent with the
1. T
2. F: The second wave of M&A activity was characterized by vertical mergers. However,
3. T
4. T
their role in creative destruction, it is not because “their tendency to appear singly makes
them easy to miss in the crowd.” On the contrary, Schumpeter explains why
wrote that “The appearance of one or a few entrepreneurs facilitates the appearance of
6. F: A belief that market manias always drive M&A activity is consistent with an
a. I only
b. I & II only
2. In which of the following periods did M&A activity involve more hostile takeovers and
a. 1965-1970
b. 1992-2000
c. 1981-1987
II. M&A activity was high in the banking and high technology sectors.
III. Defense spending increased and led to high M&A activity in the defense sector.
a. I only
b. I & II only
d. I, II & III
a. III only
b. I & II only
a. I & II only
d. I, II & III
1. b
2. c
3. b
4. d
5. a
Short Answer
1. What are some common characteristics among the different merger waves between 1895
and 2000?
In each wave, the economy was expanding and capital markets were strong, with low or
falling rates of interest and rising stock prices. Technological innovation and the
power effects at different points of a supply chain, and the domino effect of
Schumpeter identifies “turbulence” as the driver of M&A activity; it is the force that
allows creative destruction to occur. In Schumpeter’s view, M&A deals are responses to
turbulence, which destructs and then renews the landscape of an industry or the
organization of a firm.
4. After 1989, Western firms were able to make toehold acquisitions in Central and Eastern
Europe. What was the turbulence that created this opportunity? How does Schumpeter’s
In 1989, the cold war came to an end. The turbulence that allowed for M&A activity was
the fall of the Iron Curtain, a major geopolitical change that transformed the landscape
the fall of the Iron Curtain, crumbling of the Berlin Wall, disintegration of the Soviet
Union, and collapse of Communist party dictatorship in Central and Eastern Europe had
5. Describe an “inside out” approach and “outside in” approach for identifying turbulence
An “inside out” approach starts with looking at hard data: financials, market share, cost
information to derive conclusions about the performance results of firms and markets,
and to come up with stories, or general patterns and themes. An “inside out” approach
An “outside in” approach starts with qualitative information: newspaper, magazine and
journal articles, securities analysts’ reports, CEO speeches, op-ed columns, etc.
Aggregate ideas provide cues for where to drill down for specific details.
Chapter 5 Questions and Answers
1. The volume of cross-border M&A transactions has risen to record levels in recent years.
What, in your view, are some of the factors that have contributed to this trend?
include:
allow companies to run global operations efficiently and in real-time. That companies
can operate efficiently even on a global basis has certainly created incentives for
greater access to capital are among the benefits of financial market integration that have
raised to that of the level of global titans. To compete effectively, many companies have
• More related – cross-border acquisitions tend not to diversify far beyond the buyer’s
core industry. Expanding into a new country is risky enough; diversifying into a different
• Payments for cross-border acquisitions are mainly in cash as many cross-border buyers
• Cross-border targets are mainly manufacturing firms with low intangible assets,
providing evidence that acquirers look to developing nations as a source of cheap labor.
3. What motivations might drive companies to look for acquisition targets overseas?
common growth strategy. Teaming up with local players usually is a more cost effective
these industries (e.g. financial services) have needed to seek overseas alliances in order
to compete effectively.
• Profitability. Access to cheap labor and raw material may drive companies to seek
overseas alliances.
• Leverage. Companies may use overseas acquisitions as a means by which to extend the
• Tax issues. Lower tax rates may entice companies to expand overseas.
4. For purposes of reducing risk through diversification, does it make more sense to invest in a
For risk-diversification, it makes more sense to invest in a market that is less integrated
because such a market will have a lower correlation with movements of the global market.
integration, and improves capital flows – making it easier for foreign companies to do
business locally. Free trade creates a level playing field between domestic and foreign
companies.
Macroeconomic factors such as GDP growth, per capita GDP, inflation, interest rates, and
currency are good starting points. Microeconomic factors such as costs of production,
demand characteristics, industry structure, and competition are important as well. The
degree and nature of government intervention must be considered too: what are the
strategies behind the government’s fiscal, monetary, currency and trade policies? How
Institutional factors, particularly the applicability of the rule of law, are also important.
Cultural and political factors are certain to have some impact on business, and must be
considered as well.
7. What factors, according to Porter’s Diamond Model, must an analyst consider when
nurturing institutions that create and then continually upgrade specialized factors of
production. A country analyst would therefore be well served to assess how specialized a
nation’s factors are, and whether they meet the needs of the target.
conditions at home, argues Porter. An analyst might therefore look into how
discriminating local consumers are – can they drive companies to strive for higher
standards?
• Related or supporting industries. Porter maintains that the presence of strong upstream
and downstream industries can create industry clusters that in turn enhance a nation’s
competitive advantage. The analyst could examine whether such clusters exist and to
8. What do researchers suggest is the reason behind cross-border acquisition targets being
broadening the scale and use of intangible assets such as patents and brand name.
Chapter 6 Questions and Answers
Strategy in M&A flows from the company’s business strategy. Whether and how to grow
inorganically, or whether and how to restructure are the typical strategic decisions in that
2. Briefly describe the BCG Growth-Share Matrix, and cite its advantages and disadvantages.
This tool seeks to identify the relative positions of firms along three dimensions: size,
growth, and relative share of the market. Four positions are identified:
Cash cow – a business with high market share and low growth and hence low ongoing
Star – a firm with high market share and high growth: it generates plenty of cash for its
ongoing expansion
Problem child – a business with a high growth rate and low market share
The advantage of this matrix is that it is easy to use and is attractive visually. However, it
relies on historical rather than forecast data and says nothing about the capabilities
necessary for success in various businesses. In addition, this matrix seems to imply that
3. According to Porter what are the five factors that drive economic attractiveness of an
Barriers to entry: Barriers to entry are forces or constructs that make it difficult for new
competitors to enter into an industry and then shield current industry players from higher
levels of competition. Some examples of entry barriers include regulatory restrictions, brand
Customer Power: Because powerful customers can dictate prices, product quality, and
demand in an industry, their power directly affects the power of firms in industries that serve
those customers. Thus, the relative power between customers and the firms (and industries)
that serve them are inversely correlated: the greater the power of customers, the weaker the
Supplier Power: Similar to customer power, the relative power of suppliers to firms in an
industry will dictate the strength of the firms and the industry in which they reside.
Threat of substitutes: Because product (goods and services) substitutes limit the pricing
power of firms in any given industry, firms and industries are better off when there are few to
and interdependent, the actions taken by any/all firms in an industry will affect the relative
power of other firms in that industry. Porter noted that rivalry conduct may be sharper in
industries where firms are similar in size, barriers to exit are high, fixed costs are high,
4. What are the strategic map and the strategic canvas? What are they used for?
Both the strategic map and canvas profile the strategies of competitors. A strategic map
positions the players in an industry on the basis of size and two other dimensions that are
strategically meaningful. The map is helpful in identifying gaps in the competitive field. On
the other hand, a strategic canvas illustrates the similarity or difference among competitors’
strategies.
5. Briefly describe the attractiveness-strength matrix and its use. What is its chief drawback?
industry, and the attractiveness of the position within the industry. Industry attractiveness
would be assessed through an analysis of growth and prospective returns based on the
structure of the industry, and the drivers of change. The firm’s position would be assessed
and core competencies. The firms and their industries are then scored by a weighted
average of ratings on various dimensions. The chief drawback of this tool is that the ratings
for business and industry attractiveness may be arbitrary and not linked to financial returns.
A firm’s competitive position can only be properly assessed if the analysis can be defined
down to a level where the firm’s competitors and position within an industry can be clearly
drawn. As such, business definition is key: are there well-defined strategic sectors? Who
The three classic successful strategies are low-cost leadership, differentiation, and focus or
specialization. The low-cost leadership strategy seeks to create a sustainable cost advantage
advantage through distinguishing the firm or its products sufficiently to command a higher
price and/or a strong customer franchise. The focused strategy sustains a competitive
Diversification might create value if it promotes knowledge transfer, reduces costs, creates
critical mass, and exploits better transparency and monitoring through internal capital
markets. It may be successful where high relatedness in terms of industry focus between the
target and buyer, where the internal markets for talent and capital are truly disciplined, and
managers are properly rewarded, where the local capital market is less effective, where
product markets are experiencing an episode of deregulation or other turbulence, and when
10. What are the alternatives to M&A for achieving inorganic growth? How do these avenues
Contractual relationships, strategic alliances, joint ventures, and minority investments are
other paths to achieving inorganic growth. Contractual relationships are simply business
arrangements between two parties to perform certain services, or link certain business
investment. A joint venture agreement creates a separate entity in which the two parties
invest, whereas in a minority investment, a firm invests directly into the counter-party firm.
11. What are some of the benefits that joint ventures and strategic alliances might bring?
Joint ventures and alliances can help reduce risk exposures – firms have been found to
engage in alliances or JVs where the risk of the venture is greater than its core businesses.
JVs and alliances can also increase focus for the buyer, as well as reduce agency costs. JVs
and alliances help commit the partners not to divert resources in inefficient ways.
13. What does a business manager need to consider for choosing a path for inorganic growth?
coordination gains, 2) Need for ownership and control and 3) Manage risk exposure. The
business?
Motives include: the adverse effects of industry turbulence -- the need to exit from
unattractive businesses, the need to sharpen strategic focus, correct “mistakes” and harvest
“learning”, to correct the market valuation of assets, to improve the internal capital market,
reduce tax expense, strengthen managerial incentives and align them with the interests of
shareholders, respond to capital market discipline, and gain financing when external funds
are limited.
o Carve-out
o Spin-off
o Split-off or exchange
o Tracking stock
o Financial recapitalization
16. What is a carve-out? A spin-off? A split-off? What is tracking stock?
A carve-out organizes the business unit as a separate entity and sells to the public an interest
A spin-off, like a carve-out, creates a separate entity for the business and results in public
trading of its shares with majority ownership retained by the parent. But in the case of a
spin-off, the shares are given to the parent’s shareholders, in the form of a dividend. No
money is exchanged.
In a split-off, shares of the subsidiary business are swapped by shareholders of the parent for
shares in the subsidiary. This results in a freestanding firm, no longer a subsidiary of the
With tracking stock, a special equity claim on the subsidiary business is created, the dividend
restructuring?
optimize the mix of debt or equity, or to adjust the equity interests in the business. Leveraged
restructuring and ESOP restructuring are some ways to recapitalize. In a leveraged
dividend. In an ESOP restructuring, the firm purchases its own shares for sale to an
o is proactive
o has screening criteria that are consistent with the strategy of the buyer
2. In the acquisition search phase, what might be some screening criteria used to evaluate
potential targets?
o Profitability
o Risk exposure
o Asset type
o Management quality
o Prospective control
o Organizational fit
o Prospective control
o Organizational fit
The sweet spot of acquisition searches is in the realm of private information, where one can
4. What is the “efficient markets hypothesis” and what are its implications for the acquisition
search process?
The efficient markets theory posits that public information is impounded into security prices
rapidly and without bias. What the market knows clearly is fully priced. Therefore, if the
Networks are important because they generate information, and can make the search process
efficient and effective. Membership in networks can be attained and enhanced by being part
guides.”
o the higher the speed (the efficacy with which information is distributed)
7. What is the role of ‘navigators’ in the acquisition search field? Who are these navigators?
What were the two categories of navigators discussed in the chapter, and what functions do
they serve?
Navigators are intermediaries of information, and can affect its dissemination. Examples of
capitalists, etc. Two categories of navigators are gatekeepers and river guides. Gatekeepers
give access to information and deals. River guides are industry or regional experts that
highlight emerging trends that might affect the availability of investment opportunities.
Yes, there is a role for opportunism in acquisition searches. Although careful planning of
acquisition is always advisable, one must also allow for a certain degree of opportunism,
Jemison have written, “Most acquisitions involve an iteration between a strategy that is
9. How can a searcher increase the probability of a ‘positive payoff’ from the acquisition search
process?
o Choosing promising arenas – those where there is uncertainty about who knows what
information
10. What lessons about the acquisition search process did the example of Kestrel Ventures
illustrate?
The managers of Kestrel Ventures went about their acquisition search very carefully, taking
• Having a clear objective – the Kestrel managers were clear that their goal was to offer
• Use of screening criteria – Screening criteria for the target companies were well
thought-out and articulated, and were based on careful analysis not only of the potential
• Use of networks and river guides – The Kestrel managers relied on a network of contacts
that could help identify investment opportunities, and kept in regular contact with these
people. Kestrel’s managers also made it a point to cultivate relationships with industry
undertook its own “grassroots” efforts – visiting target companies, talking to suppliers,
it may be quite the opposite: weaker ties may matter more than strong ties, and the breadth
(quantity) of contacts may be more meaningful than the quality. Please explain.
In social networks, the breadth (quantity of contacts) may matter more than the quality of
contacts because there is great strength in “weak ties.” According to Malcolm Gladwell, “Weak
ties tend to be more important than strong ties.” The reason for this is that your closest
connections occupy the same world that you do and share the same resources of information.
Weak ties, however, can offer more because they are more likely to know something, and have
access to information, that you don’t. In a sense, the information you share with your closest
circles is “public knowledge” within those circles, whereas weak ties (those outside your close
circles of family and friends) will tend to offer information that is not public knowledge (more
private) to you and your close contacts. Granovetter also argues that what matters in getting
ahead is not the quality of your relationship, but how many people you know with whom you
12. What does Metcalfe’s Law say and what implications does it have in the Acquisition Search
process?
The value of a network is proportional to the number of working nodes (points of connection) in
it. This emphasizes the importance of establishing and expanding the breadth of contacts (social
network) in the search process and in business practices in general. As research has shown,
social networks become more and more powerful when there are more points of connection.
Chapter 8 Questions and Answers
1. A compliance mentality will prepare for M&A success better than an investor mentality.
accounting and legal issues, rather than to try to cover many areas.
4. Professionals can be held liable for the failure to know of potential risks.
5. Due diligence should begin when the buyer approaches the target.
Solutions:
1. False. Compliance is concerned narrowly with risk. The investor mentality is concerned
with risk and return, and is a better foundation for M&A success.
2. False. Broad due diligence will reveal more about risk and opportunity than will narrow due
diligence.
3. False. Obtaining facts is only a first step. Facts should then be translated to information
and knowledge.
4. True. Under U.S. securities laws, investment bankers and other intermediaries may be held
liable for damages resulting from the failure to disclose risks that a “duly diligent”
5. False. Due diligence ought to begin well before the buyer approaches the target.
6. True.
A narrower scope of due diligence might be justified in highly competitive situations or where
Due diligence ought to begin well before the buyer approaches the target. It should begin as
soon as the possibility of a transaction arises. Public sources of information and knowledgeable
observers outside the target company (such as consultants, securities analysts, and retired
executives) can be a foundation for due diligence before the first contact.
not fully revealed to the outsider. As with an option, the due diligence research will be more
valuable the greater the uncertainty about the target, the longer the period of exposure, the
greater the value of the underlying asset (the target), and the lower the exercise price (the
Part III.
For each of the following issues, write out some due diligence questions you would want to ask:
Legal issues
Accounting issues
Tax issues
Information
technology
issues
Environmental
issues
Market presence
property issues
Intellectual and
intangible assets
Finance
Cross-border
issues
Human resources
Cultural issues
Ethics
Possible Solutions:
Accounting issues What are the target’s accounting procedures? Are they
and buyer?
and sales issues How strong is its brand, franchise, or goodwill among
Real and personal What is the condition of the properties being acquired?
property issues Are there potential exposures to claimants?
Intellectual and Have all intangible assets been identified? How well are they
claims?
financial policies?
Human resources How deep is the talent and leadership pool at the target firm?
liabilities?
Cultural issues What are the target’s beliefs, mission, values, norms, and
ethics?
ethics issues?
Are the ethics of the target firm compatible with the buyer’s?
Chapter 9 Questions and Answers
focus on cash flow, get paid for risks, account for the time value of money and for
2. Is intrinsic value something that can be measured precisely? Why or why not? Ho w
imperfectly. One can only estimate intrinsic value; therefore, one should work with a
range of values rather than a point estimate. One can arrive at a reasonable range of
values by triangulation.
3. What is the theory of value additivity? How does knowing this theory enable one to
create value?
The theory of value additivity states that enterprise value should be equal to the sum of
An arbitrage opportunity exists when the equation doesn’t hold true, and value can be
created by taking adv antage of that inequality, either by buying the asset that is
4. Describe and define the nine estimators of value discussed in this chapter. List an
advantage and disadvantage for each and explain why they are advantages/disadvantages.
Describe situations in which certain valuation approaches are more useful than others.
Use
assets as yet
piecemeal appraiser
divided by • Liquidation
shares value of
may be
difficult to
estimate
shares in whole or by
outstanding parts
information companies
whose debt
and equity
securities are
illiquid or not
publicly
traded
Price/Earnings, • Vulnerable to
Enterprise manipulation
Value/EBITDA
of comparable
companies to the
target company
Transaction Target is valued • Market-based • Finding • Generally
is usually premiums
and depend on
many factors
investor”
principles
present value of be
with a highly
levered
structure.
• Incorporates
“think-like-an-
investor”
principles
• Incorporates established or
“think-like-an- proven, and
the market
• The discount
rate is hard to
determine for
highly risky
prospects
tech, valuation
needed, some
of which are
complicated
and time-
consuming.
5. Think through each of the eight “big-picture” rules on valuation discussed in this chapter.
Intrinsic value is unobservable; we can One might put too much faith in “the
An opportunity to create value exists where If you don’t look for differences, you might
price and intrinsic value differ. not profit from a “golden” opportunity.
“Have a view” about the estimators. One might misuse estimates as conditions
vary.
find key value drivers, and the inherent surrounding the estimates. Worse, one
Think critically; triangulate carefully. One might give too much weight to
uncertainty.
Focus on process, not product. One might tend to force the analysis into
“answers.”
If you get confused, see rule #1. One might get distracted by competing
modes of thinking.
6. Discuss the differences between the enterprise value and equity value approaches of
DCF.
The enterprise value approach values both debt and equity; free cash flows (i.e., before
interest payments) are discounted at WACC. The equity value approach values only the
company’s equity. Cash flows are net of interest payments, and are discounted at the
cost of equity.
7. What are the different ways of estimating the cost of equity? Describe the methods and
Under the CAPM, one adds a risk premium to the risk-free rate to account for the
riskiness of equities, and to compensate investors for taking on such risk. The risk
premium can, and is usually, represented by the market’s historic returns over risk-free
rates, and is adjusted for the systematic risk of each company, using beta. There is no
premium for unsystematic or specific risk because such risk can be diversified away.
The Dividend Growth Model derives the cost of equity from the relationship between a
firm’s current stock price, and its future dividends. This model posits that a firm’s
current stock price represents the present value of all future dividends. As such, the
discount rate that equates the present value of all future dividends with the stock price is
the cost of equity. The formula for cost of equity using the Dividend Growth Model
implies that in equilibrium, with a firm’s dividends growing at a constant rate, the cost of
equity will equal the dividend yield plus the constant growth rate in dividends.
The low-side boundary is often the target’s current market price. Sometimes, however,
the low-side boundary may go below the target’s market price, particularly if such
market price is subject to unreasonable future expectations. The high-side bid is bound
by the value of the target to the buyer. Such value should account for synergies and
• when a company’s debt-equity structure changes significantly from year to year; and
• when the target being valued is not publicly traded and betas of peer public
companies reflect different debt-equity structures than that of the company under
consideration.
10. List and define the two approaches discussed in this chapter for estimating terminal value
Terminal value growth rates can be estimated using the Sustainable Growth Model
Under the Sustainable Growth Model, the terminal growth rate is a function of how large
a return the company makes on its equity, and how much of that return is reinvested in
sustainable growth rate is a function of a real growth rate and inflation. Hence the
formula
nominal rate of growth (inflation and real growth in the economy) rather than an internal
11. Suppose you are establishing the terminal value growth rate for a large industrial goods
manufacturer. In recent years, the company’s return on equity has averaged 10%, and it
has paid out roughly 10% of its annual profit in dividends. Economists project both the
a. Calculate the terminal value growth rate using the Sustainable Growth Model and the
Fisher Equation.
b. Which of your two results do you think is more appropriate to use? Why?
Using the Sustainable Growth Model, the terminal value growth rate comes out to 9%:
= 10% * (1 – 10%)
= 9%
Using the Fisher Equation, the terminal value growth rate comes out to 6.1%:
= 6.1%
In this particular case, the result obtained from the Sustainable Growth Model implies
that the company can grow at a much faster pace than the economy. If carried to infinity,
the suggestion is that the firm will eventually own the world economy! The better choice,
12. Why does the terminal value, rather than near-term forecasts of cash flows, often account
for a majority of the value of a firm? Why is the terminal value growth rate the “tail that
The terminal value has a significant impact because it capitalizes the growth of a firm to
perpetuity, whereas cash flows before the terminus are short and finite. The terminal
value growth rate has a major impact on terminal value because of its compounding
effect to perpetuity.
Chapter 10 Questions and Answers
a. An option is the right not the obligation to do something. For this reason, it is always less
c. An American option may be exercised at any moment before expiration. Therefore, it has
a higher value than a European option with exactly the same terms.
d. Options are very risky instruments. Therefore, the addition of an option to your portfolio
Solution:
a. Although an option is the right not the obligation to do something, it is riskier than
b. Even when an option is out-of-money, it still has time value, which gives the underlying
c. An American option may be exercised at any moment before expiration. Therefore, it has
valuable. Therefore, an American option has a higher value than a European option with
hedge open positions or reduce the overall risk of the portfolio by using corresponding
2. Suppose that a stock trades at $50 today, and that you can buy call options that expire in one
a. Calculate your potential payoff one month later for these three options by assuming the
stock will trade at $30, $35, $45, $50, $55, $60, $65, and $70 at expiration.
b. Draw the payoffs on one graph and intuitively decide which option is more valuable.
Solution:
a.
b.
Option payoff vs. Future stock price
$35.0
$30.0
Call option payoff
$25.0
Call option (Ex: $40)
$20.0
Call option (Ex: $50)
$15.0
Call option (Ex: $60)
$10.0
$5.0
$-
$30.0
$35.0
$40.0
$45.0
$50.0
$55.0
$60.0
$65.0
$70.0
Future stock price
The option with a lower exercise price has a higher value because there is more chance for
3. Briefly explain why does a call option price rise as stock price increases, exercise price
decreases, time to maturity increases, volatility increases, and risk-free rate increases.
Solution:
Stock price and exercise price can affect option prices directly by changing the underlying
value of the asset and the intrinsic value of the options. Both increase of stock price and
decrease of exercise price will increase the intrinsic value of the call options. Time to
maturity will increase the time value of the options. Volatility will also increase the time
value of options because it offers potential upside returns and no downside risk to investors.
Risk-free rate influences the values of the options indirectly by affecting the present value of
the exercise price and the expected value of the stock in the future. The increase of the risk-
free rate will lead to the decrease of present value of exercise price, which increases the
4. Briefly explain why it is never optimal for an investor to exercise an American call option for
Solution:
Option value is composed of intrinsic value and time value. By exercising the option early,
one sacrifices the time value. Therefore, it is always better to sell an American option in the
market than to exercise it. For out-of-the-money options, this argument is even truer because
5. By using various combinations of simple call and put options, one can implement different
trading strategies. Draw the payoff diagram for a portfolio that includes:
All the options expire at the same time and the stock trades at $20 today. Explain what
someone who holds this portfolio might be thinking about this stock; and conversely what
a.
Stock price Option A payoff Option B payoff Option C payoff Total payoff
$ - $ - $ - $ - $ -
$ 2.50 $ - $ - $ - $ -
$ 5.00 $ - $ - $ - $ -
$ 7.50 $ - $ - $ - $ -
$ 10.00 $ - $ - $ - $ -
$ 12.50 $ - $ - $ - $ -
$ 15.00 $ - $ - $ - $ -
$ 17.50 $ (2.50) $ - $ - $ (2.50)
$ 20.00 $ (5.00) $ - $ - $ (5.00)
$ 22.50 $ (7.50) $ 5.00 $ - $ (2.50)
$ 25.00 $ (10.00) $ 10.00 $ - $ -
$ 27.50 $ (12.50) $ 15.00 $ (2.50) $ -
$ 30.00 $ (15.00) $ 20.00 $ (5.00) $ -
$ 32.50 $ (17.50) $ 25.00 $ (7.50) $ -
$ 35.00 $ (20.00) $ 30.00 $ (10.00) $ -
$ 37.50 $ (22.50) $ 35.00 $ (12.50) $ -
$ 40.00 $ (25.00) $ 40.00 $ (15.00) $ -
b.
Payoff diagram
$50
$40
$30
Option C payoff
$10
Total payoff
$- Option A payoff
$10
$13
$15
$18
$20
$23
$25
$28
$30
$33
$35
$38
$40
$3
$5
$8
$-
$(10)
$(20)
$(30)
Stock price
From the graph, we can see that someone holding this portfolio is betting the volatility of
stock will increase, increasing the probability of a big move from $20 in either direction.
Therefore, he or she can capture the option premium difference between a long call and a
short call. Conversely, the seller of this portfolio might be thinking that the stock will not fall
below $15 or rise above $25. This portfolio is called a short butterfly. Therefore, the seller is
6. On May 21, 2003, the S&P 100 (OEX) closed at 463.58, the Dow Jones Industrials (DJX) at
84.91, and the NASDAQ 100 (NDX) at 1112.85. The following option prices were quoted
the underlying assumptions of put-call parity and why put-call parity might not always hold
Solution:
From the table, we can see put-call parity does not always hold in the real world. There are
several reasons: a. the quoted prices are transaction price for the last trade, therefore in the
volatile market the difference of timing will cause large deviation of put-call parity; b. the
transaction costs or slippage will also lead to deviation from put -call parity; c. different
option pricing models will lead to different price of call options, which consequently cause
the violation of put -call parity and d. many option prices are American options, for which
7. Refer to problem 6. Select any index and calculate the intrinsic value and time value for the
options on that index. Compare the time values among the options on that index that expire
Expiration 20-Jun 18-Jul 12-Sep To calculate the intrinsic value or time value:
OEX 465 Call ($) $ 13.50 $ 14.90 $ 25.00
Intrinsic value $ - $ - $ - Step 1. Find parameters.
Time value $ 13.50 $ 14.90 $ 25.00 For example: Vc OEX 465 Call June 20 = $13.50
OEX 465 Put ($) $ 9.50 $ 14.50 $ 20.50 Exercise price: 465
Intrinsic value $ 1.42 $ 1.42 $ 1.42 Stock price: 463.58
Time value $ 8.08 $ 13.08 $ 19.08
Step 2. Calculate intrinsic value of the option.
Expiration 20-Jun 18-Jul 12-Sep For call options: Intrinsic value = Max (S-EX, 0)
DJX 84 Call ($) $ 2.40 $ 3.10 $ 4.10 For put options: Intrinsic value = Max(Ex-S, 0)
Intrinsic value $ 0.91 $ 0.91 $ 0.91
Time value $ 1.49 $ 2.19 $ 3.19 For OEX 465 Call June 20: Max (463.58-465, 0) =0
DJX 84 Put ($) $ 1.55 $ 2.45 $ 3.70
Intrinsic value $ - $ - $ - Step 3. Calculte time value of the options:
Time value $ 1.55 $ 2.45 $ 3.70
Time value = Option value - Intrinsic value
Expiration 20-Jun 18-Jul 12-Sep
NDX 1125 Call ($) $ 31.00 $ 47.00 For OEX 465 Call June 20: $13.50 - $0.00 = $13.50
Intrinsic value $ - $ - $ -
Time value $ 31.00 $ 47.00
NDX 1125 Put ($) $ 39.00 $ 59.00 $ 82.50
Intrinsic value $ 12.15 $ 12.15 $ 12.15
Time value $ 26.85 $ 46.85 $ 70.35
From the tables, it is clear that the time values of the options increase with the increase of
8. Why can the equity of a firm be viewed as an option on its assets? How would you calculate
Solution:
An equity holder has the right to ride on the increase in asset value of a firm, but not the
obligation to repay the firm’s debt. Therefore, equity is analogous to an option on the assets
of the firm, with the exercise price equal to the par value of the debt, and expiration equal to
the maturity of the debt. By using corresponding volatility, one can value the equity of the
9. Briefly explain how the option analogy can be used to value loan guarantees and debts.
Solution:
Option-pricing theory provides the first rigorous approach to valuing loan guarantees. The
value of the put or default risk discount will be equal to the value of a loan guarantee
necessary to convert the debt from risky to default-risk free. The value of the contingent
liability the guarantor assumes will equal the value of a put option on the firm's assets.
Similar to loan guarantees, default risk discount of debts is also the value of a put option on
the firm’s asset. By adding the put option value to risk-free debt, one will have the value of
risky debts.
10. Suppose stock ABC trades at $40 today, and there is an equal chance of it going up to $60 or
down to $20 next year. The one-year risk- free rate is 10%.
a. Calculate the value of at-the- money call and put options. Does put-call parity hold in this
b. What probability of ABC going up to $60 next year will make the put-call parity hold?
Solution:
a. Step 1. Draw the tree and input probability and payoff of the options at the expiration.
Time Now One year later Probablity Call option payoff Put option payoff
Ex. Price: $40 Ex. Price: $40
$ 60.00 50% $ 20.00 $ -
Step 2. Calculate the expected value of option values and discount it back to now.
b. To calculate the implied probability, you need to setup the put-call parity formula. Use Goal
Step 2. Go to Tab tool, select goal seek. Set C-P equal to S-Ex*Exp(-rt) and changing cell as
probability.
Step 3. Enter OK and copy the solution from the changing cell.
New probability for ABC going up is 60%, as seen in the excel sheet attached.
Time (year) 1
Stock price $ 40.00
Exercise price $ 40.00
Call value $ 11.00
Put value $ 7.19
C-P $ 3.81
S-Ex*exp(-rt) $ 3.81
Risk-free rate 10.00%
Another way to think about this question is to calculate the expected return of the stock and
derive what rate makes today's stock rise to that expected value.
11. For $20, you can buy a six- month call option on stock XYZ at exercise price $90. Stock
XYZ trades at $100 today. It has a 30% annual volatility. The annualized six- month risk- free
rate is 8%. Is the option overvalued or undervalued? How might you take advantage of this
Solution:
Stock price $ 100.00 Black-Scholes
Volatility 30% European: No Dividend
Risk-free rate 8%
Dividend yield 0% Call value $ 16.41
Time (year) 0.5 Call delta (hedge ratio) 0.785616193
Call elasticity 4.787585662
Therefore, the quoted price for the call option with an exercise price at $90 is higher than the
price calculated from the Black-Scholes formula. If we believe the B-S equation, we would
say the option is overvalued. One can sell this option at the market naked or cover by buying
the stock and wait for the price to go back to its fundamental value.
12. Mr. Thompson was a portfolio manager at a mid-sized asset management firm. Due to
current market turbulence, he wanted to diversify the risk in his portfolio by adding three
stocks. He picked three industries: financial, chemical, and computer services, and assigned
his associate to come up with some choices. After the associate handed him the folder with
the information about three stocks she picked, Mr. Tho mpson misplaced the folder and only
recovered three pages containing today’s stock option quotes. Could you use these data to
help Mr. Thompson identify which stock is in which industry from the implied volatilities in
these options? Please compute these implied volatilities using Option Valuation.xls and make
Stock A B C
$ $ $
$ $ $
date June, 20 20 20
Dividend $ $
Call option $ $ $
Put option $ $ $
Solution:
To calculate the implied volatility, you need to Goal seek to find appropriate volatility that
will make the option price calculated from Black-Scholes equation equals to the quoted
price. First, input all parameters from stock price, exercise price, time to expiration,
volatility, risk-free rate, and dividend yield in the template. Then set the option price equal to
the quoted price, solve the implied volatility using Goal Seek in excel.
As seen in the above calculation, company A has the lowest volatility and company C has the
highest volatility. Based on knowledge of these three industries, one should find that the
chemical industry is a stable and mature industry, and therefore has low volatility.
Conversely, the computer services industry is a very volatile industry with high risk.
Therefore, one should be able to point out that Company A is in the chemical industry (3M),
B is in the financial industry (Citigroup) and C is in the computer services industry (AOL).
Chapter 11 Questions and Answers
The defining feature of a synergistic transaction is that it creates value for shareholders by
harvesting benefits from merger that they would be unable to gain on their own.
2. Why must one “think like an investor” when evaluating synergies? What could go wrong
To “think like an investor” is to focus on value creation. Some merger “benefits” might be
called synergies when in fact they do nothing to create value. Thinking like an investor helps
to separate true synergies from false ones and helps to ensure that the buyer won’t overpay.
To think like an investor includes focusing on future expectations, on cash flow, on risks and
returns, on accounting for time value of money and opportunity cost, on considering any
3. In what instances will a buyer’s share price rise, fall, or remain the same in connection with
an acquisition announcement?
4. Explain in your own words the following equation, and provide definitions and examples of “in-place
VSynergies = VSynergies
In Place
+ VSynergies
Re al Option
The equation states that synergies can be valued as the sum of in-place synergies and real
option synergies. In-place synergies are those that can be reasonably predicted and
expected to happen. Real option synergies are those that pay off upon the occurrence of a
triggering event – usually a decision by management to exercise the right, not obligation, to
actualize a real option synergy. Such decisions are usually made in response to stimuli such
revenue enhancements, cost reduction synergies, asset reduction synergies, tax reduction
synergies, and WACC reduction synergies. Examples of real option synergies include
growth options, exit options, options to defer, options to alter operating scale and options to
switch.
5. Is there an option embedded in each of these cases? If so, what type of option is it?
Case 1
SuperSodas, an international soft drink manufacturing company of Latin American origin,
recently acquired a 40% interest in a Southeast Asian bottler. SuperSodas’ stake was limited
because laws in the Southeast Asian country prohibited companies that were more than 40%
foreign-owned from acquiring real estate. Among the synergies projected by SuperSodas was
$87 million in revenue enhancements if the Southeast Asian bottler were to build another plant in
the country’s southern region, which was currently underserved. Purchasing land and building a
Answer: SuperSodas has a growth option (long call) in this case. The revenue enhancements
will only materialize if SuperSodas and its Southeast Asian affiliate exercise their option by
Case 2
A large oil company has agreed to merge with a steel company. Their operations intersect nowhere. But
the CEO believes that the debt capacity of Newco will be larger than the sum of the debt capacity of the
two firms standing alone. The CEO has no plans to actually use this new debt capacity in the near term.
The creation of new debt capacity arises from the coinsurance effect described in the chapter.
But since there are no definite plans to use the new debt capacity, it cannot be valued as
illustrated in the chapter. However, the added financial flexibility of the unused debt capacity is
Case 3
Kinetic Utility, a company in the business of electricity generation, has agreed to acquire Alpine
Utility. Kinetic’s generation plants are all gas- fired, while Alpine’s plants are all oil- fired. They
serve the same market. Part of the rationale for acquiring Alpine was to achieve cost savings
through greater flexibility in responding to changes in the relative prices of the two fuels.
The merger creates a real option synergy through a switching option (long call) on fuel.
6. What are the two forms of WACC synergies described in the chapter? Define each form and
explain how each might create economic value. On what conditions are these truly
synergies?
The two forms of WACC synergies described in the chapter are 1) optimization in the use of debt
tax shields, and 2) coinsurance effects. The first has the potential to create economic value by
exploiting debt tax shields. This is only truly a synergy if investors cannot by themselves
optimize the use of leverage. The second has the potential to create economic value by enlarging
the debt capacity of the two firms beyond the sum of their debt capacities on a stand-alone
basis—this arises from the risk diversification effect of combining two cash flow streams with
low or less-than-perfect correlations. This is only truly a synergy if investors cannot diversify
7. For valuing each of the synergies described below, explain whether you would use a discount
rate equal to WACC, greater than WACC, or less than WACC. Explain the reasoning behind
your decision.
a. The French Government wants to promote the merger of two companies and
b. PepsiCo management believed that by acquiring Quaker Oats, they would be able to
c. In the proposed merger between Hewlett Packard and Compaq in 2002, the CFO of
HP announced that $2.5 billion in cost synergies were expected from the Compaq
acquisition. Most of the cost synergies would come from layoffs and organizational
restructurings. 2
d. Among the main arguments for the AOL- Time Warner merger was the potential
content (Time Warner). By combining these offerings, it was expected that both
Answers:
a. If the cash flow is truly government-guaranteed, then the French Government bond
yield should be used to value the annuity stream—this amounts to using the risk-free
rate.
1
Andrew Conway and Christopher O’ Donnell, “PepsiCo Acquires Quaker: Strengthening the Core,” Morgan
Stanley Dean Witter, December 5, 2000.
b. The combination of revenue enhancements and cost savings into a single synergy
discount rate as it blends the spectrum of risks of the entity into one rate.
c. Since cost-synergies coming from layoffs and organizational restructuring are more
certain than other kinds of synergies, with a level of risk about as variable as EBIT, a
d. Revenue enhancement synergies are riskier than other types, and probably greater
than the average risk of the firm. A discount rate greater than WACC is probably
appropriate in this case. To the extent that they are considered even riskier, a higher
8. Brown Paper Mills is planning to acquire Woodland Pulp and Paper. Michael Brown is
trying to determine an offer price and has asked you to estimate the value of synergies.
Brown expects that with greater market power, revenues will increase in nominal terms by
$50 million in the first year, by another 8% in years 2 and 3, by 5% in year 4, and zero in
year 5. Increased revenues will require an increase in working capital equivalent to 2% of the
first year’s sales. Thereafter, additional working capital needs will increase at the rate of
0.5% of revenues per year. Cost savings of $25 million are expected in the first year, $30
million in the second year, and $40 million thereafter. The cost savings after year 3 will have
2
Pui-Wing Tam, “Hewlett-Packard Tries to Gain Votes for Compaq Deal,” The Wall Street Journal, February 28,
to be adjusted to reflect inflation. An initial investment of $90 million is required to realize
the cost savings. Expected inflation is 2%, and expected operating margins are 10%. Brown
wants you to discount the synergies at 10%. The tax rate is 35%.
Answer:
The problem may be analyzed using the spreadsheet file, “Valuing Synergies.xls,” found on
2002.
Chapter 12 Questions and Answers
1. Cite some country factors that analysts must consider when evaluating cross-border acquisitions.
Analysts must consider factors such as inflation, exchange rates, tax rates, the timing of cash
social/cultural issues.
2. How does a worldwide tax credit system differ from a territorial tax system? Which tax system does
Under a worldwide tax credit system, the buyer’s country recognizes taxes paid in a foreign country
as a credit against tax liability at home. Under a territorial tax system, the buyer’s country exempts
3. At the end of August 1998, the exchange rate between the US dollar and the Chilean peso stood at
US$ 1: CLP 473.5. The one-year Treasury rate in Chile stood at 15.84 percent, while the yield on the
one-year U.S. Treasury was 4.71 percent. Based on these numbers, what would be the peso-dollar
Solution:
(The actual rate one year later was US$ 1 : CLP 517.2, representing a 1.3 percent difference from
4. You are reviewing a DCF valuation for an overseas acquisition target. You feel that the valuation is
too optimistic given the high political risks of operating in the country. In what ways might you
To reflect your view of the political risk, the DCF calculations may be adjusted by 1) “haircutting”
5. Assume you have acquired manufacturing equipment for $800 million, and that it has a useful life of
10 years. Inflation is 2.5 percent, the real discount rate is 4.00 percent, and the tax rate is 40 percent.
a. What would be the present value of the depreciation tax shields from Year 1 to Year 5? Use the
b. Now assume that you can inflate depreciation expense at a rate of 2.5 percent annually. Using the
same discount rate, what is the present value of depreciation tax shields from Year 1 to Year 5?
c. Go back to (a). This time, use the real discount rate to calculate the present value of the tax
shields. What do you observe? How would you interpret the results?
Solution
Note: The nominal discount rates in (a) and (b) were calculated using the Fisher equation: (1.025 *
1.04) -1 = 6.6%.
Notice that the NPVs in (b) and (c) are the same, consistent with the illustration in the
chapter. The NPV in scenario (a) is lower because the cost basis of the depreciating assets
is not allowed to increase with inflation, thus resulting in a lower depreciation tax shield.
This is one of the ways in which inflation transfers wealth from the private sector to the
public sector.
6. Below is a free cash flow estimate and valuation for a Taiwanese company. Values are given in
Taiwan dollars (NT$), and the NPV is translated into U.S. dollars at the current exchange rate of US$
1 : NT$ 34.96.
b. Please estimate the discounted cash flow value of the investment under the two forecasts (U.S.
dollars and Taiwan dollars). Did you come up with the same present value? What rate did you use to
discount the US dollar flows? What assumptions are necessary to obtain equivalency between
Approach A (converting local flows into dollars and discounting at a dollar rate), and B (forecasting
Solution:
Year 0 1 2 3 4 5 6
(US$, in millions) 2003 2004 2005 2006 2007 2008
First, forecast forward exchange rates using the given inflation rates. Then, use the forecasted
forward rates to convert the Taiwanese cash flows into US dollar cash flows. To come up with the
same values between Approaches A and B, the dollar flows must be discounted at the nominal
discount rate in US dollars, which is equal to 7.52%, calculated as ((1+5%)*(1+2.4%)-1). The key
underlying assumptions are that inflation is the only differing variable between the US and
Taiwanese discount rates, and that the real discount rate in Taiwan dollars is the same as that in US
dollars. Inflation is already reflected in the exchange rate and in the US dollar cash f lows; therefore
it is necessary only to discount the US dollar cash flows using the real rate of return. These
7. What factors might contribute to the segmentation of an economy? Would identical assets in separate
• Lack of country funds or cross-listed securities that provide benchmarks for arbitrage.
In the presence of segmentation, identical assets in different geographical areas would not
8. You are trying to determine the cost of equity for a foreign target whose cash flows you have
Solution:
Based on the data provided, one could use the adjusted CAPM for calculating Ke:
[ ]
K equity = Π countryrisk + Rrisk free + (β country * β firm ) * (Rmarket − Rrisk free )
Rf 5.50%
Country credit spread 2.25%
Beta of target versus foreign country stock index 0.96
Beta of foreign country stock index versus US index 1.30
Market risk premium, US 6.00%
Ke 15.2%
9. Assume you are CEO of a US company evaluating three companies listed on the Hong Kong Stock
Exchange. China Mobile (Hong Kong) Ltd. provides cellular phone services in China. Hang Seng
Bank Ltd. provides banking and other financial services. Hutchison Whampoa Ltd. is a holding
company that operates in areas such as ports and related operations, telecommunications, property
and hotels, retail and manufacturing, infrastructure, finance and investments, etc. Their betas relative
to the global equity portfolio over the past 12 months were 1.31, 0.74, and 1.21 respectively. You
estimate, based on the last 10 years of data, that the equity market risk premium on the global
portfolio is approximately 6%. Currently, the long term US Treasury bond yields 1.4 percent. What
is your estimate of each company’s cost of equity based on the above data?
Solution:
d. Hutchison Whampoa
Rf 1.4%
Rm-R f (world) 9.9%
beta (world) 1.21
Ke 13.4%
10. Country A has a local market volatility of 36% and a country beta relative to the United States of 1.0.
Country B has a local market volatility of 20%, and also a beta of 1.0 versus the US market. The US
market has a volatility of 18%. Of the two countries, which is more segmented? Explain?
Solution:
Based on the data given, one can calculate the correlation between each country and the US. As the
calculations below show, Country A has the lower correlation. Because the US is the dominant
market in the global market, a low correlation with the US market suggests a low correlation with the
global market, and therefore greater segmentation. This example shows that although two countries
can have the same beta, they might have different natures of risk – with risk stemming from either
Country A Country B US
Volatility 36% 20% 18%
Beta 1.00 1.00
Correlation 0.50 0.90
11. List the different ways of calculating Ke discussed in the chapter and provide a brief explanation for
each.
Solution:
R +β
CAPM: Useful for cross- Home
k e
= f
* ( RHome − R f )
i
border valuation where the
integrated.
R +β
International CAPM w
= * ( Rm − R f )
w
k e f i
(“ICAPM”): Similar to CAPM
integration.
+ π + (β *β
CAPM adjusted for Mdom US
= ) * (R m − R f )
US US US
k e R f i Mdom
segmentation and political
problems commonly
encountered in developing
factors.
Credit model: relies on non- Ki ,t +1 = γ 0 + γ 1 * ln( Country Credit Risk Rating it ) + ε it+1
equity measures of risk.
Economical data
Please review the following case and then answer the questions that follow.
In 1984, Jay Forte, a deal maker well known for managing successful company turnarounds,
manufacturer, Guru Technologies Company (“GTC”) from its parent company, Allegro
Electronics Inc. Brown worked in the corporate finance division of Kuchler & Bevill (“K&B,”
or the “Bank”), at which Forte was a well-known customer. With the bank’s lending and
investment criteria in mind, Brown needed to consider making both a bridge loan and an equity
investment.
Forte was seeking to borrow $2.5 million from K&B, to be used towards the $3.5 million cash
purchase of GTC. He proposed that he and the Bank would make an equity investment of $1
million.
Brown created a financial structure that she anticipated following the buyout. She developed the
forecast of residual cash and the structure of the transaction flow based on specific assumptions
(found in Exhibits 1 and 2 below). She assumed that the credit agreement as finally negotiated
would prohibit the payment of dividends to common stockholders until the debt was
substantially reduced. She would repay the debt as fast as the required cash balance (2 % of
sales) would allow. Therefore, practically speaking, the only cash flow to be received by
common stockholders would receive would come from the terminal value. Brown also made the
assumption that the equity would begin at a value of $1 million (the total equity investment value
The management group originating the buyout would benefit from including K&B Bank as an
equity investor since the debt provided by the Bank would be priced approximately 250 basis
points less than had the deal been financed strictly with debt from another lender. Forte
indicated that any equity investment negotiated with the Bank would reduce the original
investors’ contribution by a similar amount, so new equity invested by Forte and the bank would
To successfully turn-around the company, Forte proposed a business plan for a sharp reduction
in overhead, a new incentive system for managers to meet their budget, and a restructured
marketing effort. His financial analysis projected that in a worst-case scenario, company sales
_______________________________________________________________________
Please refer to the following exhibits and notes before answering the questions below:
Exhibit 1
GURU TECHNOLOGIES INC.
Dollar Figures in thousands ($000)
Pro Forma Assumptions
Tax rate 48%
Shares outstanding 100,000
Other net working capital/sales 23%
Cash/sales 2.0% Bank requirment
NOTES:
Note 1:Interest expense is computed as the interest rate (base rate plus one percent where the
base rate is as given in Exhibit 1) times the average debt balance for the year.
Note 2:Assumes debt is repaid as fast as required cash balance will allow. (Requirement equals 2
percent of sales.)
Note 3:Because this residual cash flow nets out the repurchase of Global Electronics Inc.’s
shares, it is specifically the residual cash flow to Jay Forte and K&B Bank.
Note 5:Other net working capital is computed by multiplying the ratio of (Other Net Working
Questions:
1. What do you estimate to be the equity value of Guru Technologies (GTC)? Please refer to
Exhibit 13.4 as a guide for your calculation of the terminal value and the appropriate annual
Cumulative
Discount Factor 0.80 0.65 0.53 0.43 0.36
Note 1: Assumes no more debt is repaid. The terminal value for 1989 was calulated as the residual cash flow in 1990 capitalized
at Ke - g. The residual cash flow in 1990 was assumed equal to the net income in 1989 times (1+g) (or $999,000 * 1.07).
To calculate GTC’s terminal value, you first need to calculate the residual cash flows. The
terminal value for 1989 is derived from the residual cash flow in 1990 capitalized at Ke - g.
Assume the residual cash flow in 1990 is equal to the net income in 1989 multiplied by (1+g) (or
$999,000 x 1.07).
Using the circularity method illustrated in Exhibit 4 of the chapter, you can start with a fixed
approximate equity value (hard-code in cell) and then derive the debt-to-equity ratio. Then,
using the D/E ratio you calculated and the unlevered beta of 1.45 (given in Exhibit 1), you can
determine the levered beta (BL) for the equity as well as the cost of equity.
After determining the cost of equity, you can now re-calculate the terminal value by inputting the
equation:
Then you can start the circularity iterations to calculate the approximate solution for the equity
value of the firm. With this calculation, you can back-solve to determine the various years’
discount rates and annual equity values. Finally, you can arrive at the Net Present Value of the
2. From the bank’s point of view, what is the Net Present Value of the $2.5 million loan? Hint:
Please lay out the amortization and payment structure to calculate the NPV.
What percentage of the equity should the bank request as part of its commitment to lend in order
Required Return
Base Rate 13.50% 13.50% 13.50% 13.50% 13.50%
Base + 3.5% 17.00% 17.00% 17.00% 17.00% 17.00%
Discount Factor 0.85 0.73 0.62 0.53 0.46
To determine the NPV of the bank loan, you need to lay out the debt amortization and payment
schedule for the five-year projection. The debt payment schedule is derived from the cash flows,
and the interest expense is calculated on an annual basis by using the following formula:
The proposed interest rate on the loan (equal to the base rate plus 1.0 percent) is clearly below
the going rate on credits of similar risk (i.e., base plus 3.5 percent). You need to use this going
rate (the required rate of return for comparable investments) as your discount rate to then
In order to break-even on the loan shortfall, the bank should acquire an appropriate percentage
of the equity:
($228,009) = X * ($1,000,000 – $2,550,480)
X = 14.71%
3. Please perform a sensitivity analysis on the terminal growth rate. How sensitive is your
valuation to the growth rate? With this information, please analyze this deal structure from the
The equity forecast may be varied in numerous ways to test the sensitivity of this result.
For instance, with a data table, varying the perpetual growth rate embedded in the terminal
perpetual-growth-rate assumption. The reasons are that most of the value is created by growth
in the 1985-89 period and that the cost of equity in 1989 is still very high, 21.88%. Thus, small
It is important to contemplate and understand this problem from the two parties’ point of view.
From each party’s positions, there must be some balance between equity and debt. Jay Forte
gives up some equity in order to get a better interest rate from the bank. In turn, the bank
benefits from taking some equity so it can satisfy its required rate of return.
Chapter 14 Questions and Answers
1. Real options are pervasive everywhere even in daily life. Please identify which of the
a. Automobile insurance,
Solution:
a. Insurance is a put option. You “put” your wrecked car to the insurance company
b. A defined benefit retirement plan is not an option because you know how much
c. Cash or credit cards in your wallet are options to you because cash and unused
debt capacity offer you financial flexibility. Generally, the cash balance and
unused debt capacity of corporations carry some real option value for
operational flexibility under future business uncertainty. The cost of the training
e. Taking swimming lessons is buying an option because it will give you a skill that
Solution:
Opportunities and options tend to differ on five dimensions: exclusivity, cost to acquire, finite
3. Suppose you go to an automobile dealer to buy a car. After you pick the right model, the
salesperson recommends four alternatives to you. They are metallic painting, adjustable
passenger side seat, automatic transmission, and adjustable steering wheel. Among these
Solution:
Among the four choices, the adjustable passenger side seat and adjustable steering wheel give
you because they offer you the flexibility to change and switch after the purchase. The other two
as power sources. Assume one such car sells for $2,000 more than a normal gasoline-
powered car. Based on your estimation, a normal gas-powered car will consume present
value of $10,000 of over its lifetime if gas prices stay at the current level. If you only use
electricity for the hybrid car, it will cost you $15,000 now. But if a new source of energy
is developed soon, the cost of electricity for the lifetime of the car may drop to $10,000 in
present value term and gas price may double in the future. The probability of status quo is
predicted at 60%. Does the hybrid car represent an option to you? How much of its
Solution:
Probability
PV of cost ($10,000) 60%
EMV of cost $ (10,000) Gas is cheaper, you use gas.
Buy Hybrid car
The EMV of the cost is calculated by averaging costs based on their probabilities. The total
expected cost for hybrid car is $10,000 and is $14,000 for normal car. It implies a $4,000
saving by buying hybrid car. Compared to $2,000 premium, it makes the choice to buy hybrid
5. You can purchase the right to drill in a natural gas field for $6 million. If you have a dry well,
the present value of future payoffs is zero. If you find natural gas, the PV of future payoffs
will be $10 million. After consulting with a geologist, you estimate that there is roughly a
70% chance of finding gas. He also told you that you can spend a certain amount of money to
drill a test well in the field so that you can be sure whether you will find gas or not. Please
draw a decision tree that determines the value of the test. What kind of option is the test?
Solution:
PV $ - 30%
Decision
PV $4,000,000 70%
EMV $ 1,000,000
No test
PV ($6,000,000) 30%
Value of the test $ 3,000,000
The value of the test: $4 million - $1 million = $3 million
The test is an “R&D” option that allows the buyer to obtain accurate information to determine
whether to exercise the right to buy drilling right or not. Therefore, even without changing the
possibilities of events, while the test indicates a dry well, the buyer will not buy the right to drill.
Therefore, the net payoff for that branch is $0 not -$6,000,000 in the case of no test. The option
creates value by giving the buyer the right to withdraw from the purchase of drilling right.
R&D will cost $5 million right now. The software development can be finished in one year.
Forecasted profit from the sales of software follows a lognormal distribution with a mean of
$10 million and a standard deviation of 50%. Marketing and advertising expenses for the
sales are estimated at $5 million. The one-year risk-free rate is 7%. In your opinion, is the
investment in R&D an option? If so, what kind, and what is its value? (Calculate the option
Solution:
The investment in R&D is essentially the purchase of a call option on an uncertain future
discovery. For simplicity, you could consider this to be a European call option, of the sort that
the Black-Scholes Option Pricing Model is ideally suited for valuing. Using “Option
Valuation.xls,” insert the assumptions and estimate the option value. As these results show, the
price of the option ($5 million) is less than its estimated value ($5.43 million). The CEO should
7. Suppose you are negotiating an agreement with a start-up company that allows you to buy 50
percent of its equity 3 years from now at $10 million. The market value of the equity today is $8
million. The annual historical volatility of this company’s equity is 25%. The three-year
government bond yield is 6%. Assuming risk neutrality, please estimate the value of this option
using the binomial method: a) draw the lattice; b) fold it back to determine the present value.
Solution:
Step 1 Grow the tree Now Year 1 Year 2 Year 3
In the above table, the boldface numbers indicate when you will exercise the option. In these cases, the payoff is greater than
the exercise price, $10,000,000
$ 6,936,000
-
- $ 272,203
- -
- -
-
-
Step 5 Calculate the present value of expected future payoffs.
$ 6,936,000
$ 3,755,808
$ 2,031,881 $ 272,203
$ 1,098,290 $ 142,928
$ 75,048 -
-
-
B --- $3,755,808 = ($6,936,000 * Pu + $272,203 * Pd)/(1+Rf)
Take the example of $3,755,808, one would take the expected value of the Pu*$6,936,000+Pd*$272,203, or
(.5666*$6,936,000)+(0.4434*$272,203) to yield $3,981,156—discounting this by one year at the risk-free rate, 0.06 yields $3,755,808.
This process is repeated for the other cells, folding back to the present, to find a value of $1,098,290 for the agreement.
By folding back the tree to now, the value of the option is obtained in the term of present value. Therefore, although the
current value of the firm is $8 million. This agreement still has a positive value of $1,098,290.
8. A big pharmaceutical company XYZ is considering a joint venture deal with biotech
company ABC. Company ABC has a promising drug candidate in the pipeline, which just
passed the Phase II Clinical trials. ABC needs cash to push the clinical trials forward and
apply for FDA approval. Therefore, it approached company XYZ to offer XYZ the right to
share the future profits from this drug in exchange for a cash payment now. (Assume no time
a. Company ABC asks for $5 million cash payment now in exchange for fifty percent of the
future profits from the drugs. There is an 80% chance for this drug to pass the Phase III
clinical trial and get FDA approval. If FDA approves its use, the forecasted sales will
most likely be $200 million with a minimum of $100 million and a maximum of $300
million. The profit margin on the sales is estimated at 20%. To obtain fifty percent of the
profit, Company XYZ also needs to share fifty percent of the marketing expense of $20
b. After reexamining the possibility of passing FDA approval, company XYZ found that
there is a 90% chance for this drug to have a positive result from the Phase III Clinical
trial and there is a 90% chance for it to obtain FDA approval. Company XYZ proposes to
ABC that it can pay $2 million if the drug passes the Phase III test and pay a certain
amount now. Suppose the sales forecast, profit margin and other terms stay the same.
How much should company ABC ask for the initial payment?
Solution:
a. First, we draw a tree to illustrate how XYZ should process this decision: XYZ needs to
estimate the expected value of ABC based on probabilities of FDA approval, and projected sales
figures and profit margins. Then, we build a Monte Carlo simulation model incorporating the
uncertainties as defined in the problem. Running 5,000 simulations, we get a mean expected net
Expected payoff: 0
Step 3. Go to cells with uncertaint distributions and specify the distribution. In this problem, this is done for you:
the chance of approval is a customerized discrete distribution with 80% probability to be 1 and 20%
probability to be 0; the payoff is a triangle distribution with high at $300, low at $100 and the best guess at
$200.
Step 4. Run crystal ball 5000 times, get the results in the following.
Summary:
Display Range is from ($5) to $14 Million
Entire Range is from ($5) to $15 Million
After 5,000 Trials, the Std. Error of the Mean is $0
Statistics: Value
Trials 5000
Mean $3
Median $4
Mode ($5)
Standard Deviation $5
Variance $29
Skewness -0.10
Kurtosis 1.95
Coeff. of Variability 1.83
Range Minimum ($5)
Range Maximum $15
Range Width $20
Mean Std. Error $0.08
.151 755.2
.101 503.5
.050 251.7
.000 0
b.
Step 1. Draw the tree
Payoff
10% chance of Distribution of Sales:
getting FDA approval Triangle with a maximum 20% of Sales -
at $300 million, a Marketing expense
minimum at $100 million ($20 million)
90% chance of and the most possible
passing Phase III value at $200 million
Cost of the right: $2
Step 2. Build an Excel spreadsheet model (See the model on CDROM accompanying the book: CHPT9B.xls.
Step 3. Go to cells with uncertaint distributions and specify the distribution. In this problem, this is done for
you: the chance of passing Phase III trial is a customerized discrete distribution with 90% probability to
be 1 and 10% probability to be 0; the chance of FDA approval is a customerized discrete distribution
with 90% probability to be 1 and 10% probability to be 0 and the payoff is a triangle distribution with
high at $300, low at $100 and the best guess at $200.
Step 4. Run crystal ball 5000 times, get the results in the following.
Summary:
Display Range is from -2.00 to 17.10 million
Entire Range is from -2.00 to 17.70 million
After 5,000 Trials, the Std. Error of the Mean is 0.07
Statistics: Value
Trials 5000
Mean 6.45
Median 7.02
Mode 0.00
Standard Deviation 5.16
Variance 26.62
Skewness -0.06
Kurtosis 1.99
Coeff. of Variability 0.80
Range Minimum -2.00
Range Maximum 17.70
Range Width 19.70
Mean Std. Error 0.07
.074 369
.049 246
.025 123
.000 0
From the Monte Carlo simulation, it is noted that a mean of $6.45 million is obtained. Therefore,
it is the maximum amount company ABC can charge for. The risk profile of this project indicates
it is fairly risky. There are two major spikes at -$2 million and $0. So, company ABC may want
to lower the ask price to compensate the risk. What is also worth to mention is that the total
amount company ABC can charge for this deal increases from $8 million to $8.45 million due to
Solution:
There are no simple approaches to value real options because of the following:
• The exercise price and data may be contingent rather than fixed
• The value of the underlying asset may not be very uncertain, and the uncertainty may be
hard to estimate.
• The option may actually consist of a cluster of options, or a series of options, or options
on options.
Chapter 15 Questions and Answers
Solution:
Liquidity refers to the ability to find a ready price and counterparty for a transaction to
purchase or sell an asset. It is valuable because it offers both the buyer and the seller an
valuation, ABC is worth $10 million. The total synergy, if the merger is completed, is
estimated to be $4 million. Suppose that in this case, the discount for liquidity for public
companies similar to ABC is around 45%. Please estimate the maximum payment for this
company.
Solution:
Maximum Payment for T arg et = VS tan d Alone + VSynergies + π Liquidity and Control
Solution:
Examples include: Letter stock; entrepreneurs’ restricted shares; private placements before
public transactions; and private equity investments. In M&A activities involving any the
above, liquidity will play a pivotal role in determining the deal value or structure.
4. Briefly explain why “control” is valuable to business managers. How does one value
control?
Solution:
“Control” is the power and right to direct the strategy and activities of the firm, to allocate
resources, and to distribute the economic wealth of the firm. Because having control grants
owners the right to determine the future strategy of the firm, control is analogous to having
a switching option. As described in the Real Options chapter (Chapter 14), you can use
different methods to value this option. However, it is important to estimate key drivers such
as volatility and duration of the option if one is using the binomial model or the decision
tree methods. If one is using the Black-Scholes model, one needs to accurately estimate the
Emily. Other owners of the firm are oceanic voters. Mr. Jones is the first major shareholder
and Mrs. Emily is the second major shareholder. Assuming the following three scenarios,
please use the Excel model “Power.xls” to calculate the Shapley Value for all the parties.
If power determines the value of votes, whose votes will be worth the most in each
situation?
Scenario 1: Jones has 30% of votes; Emily has 20% of votes and the other 50% of votes are
Scenario 2: Jones has 40% of votes; Emily has 10% of votes and the other 50% of votes are
Scenario 3: Jones has 40% of votes; Emily has 20% of votes and the other 40% of votes are
Solution:
Looking at the results across-the-board from the point of view of the first major
shareholder, we observe that Mr. Jones’s power index rises to 0.64 when he acquires an
additional 10 percent stake from another major shareholder versus 0.56 when the stake is
from oceanic shareholders. Although he acquires the same number of shares in either case,
the balance of power between him and the second major shareholder becomes much more
tilted in his favor when the additional shares are taken from the second major shareholder.
Likewise, from the point of view of the second major shareholder, Mrs. Emily’s power index
is much greater if she acquires an additional 10 percent share from the first major
shareholder as compared to when he acquires the same stake from the oceanic
shareholders.
The most interesting observation, however, is found when looking at what happens to the
power index of the oceanic shareholders. Comparing (1) and (2) we see that their stakes
remains constant but the power index rises significantly when the balance of power between
the first and second major shareholders is more evenly distributed. Even more interesting,
when comparing (2) and (3), we see that the power index of the oceanic shareholders is
greater in (3), even though their stake has actually decreased! This is because selling 10
percent of their stake to the second major shareholder allows them to effectively
redistribute the power balance – the first major shareholder now becomes less powerful
relative to the second major shareholder, making the balance of power more even and
6. Suppose you are the principal at a private equity firm and are considering an opportunity to
purchase the majority of shares in a publicly traded machinery tool company. You think the
company is mismanaged and you would like to expand its product lines and to sell them
abroad. The purchase of 60% of shares will give you control over implementing your
expansion project. The base value for this company is estimated at $100 million. The
expansion project will cost about $10 million and has an 80% chance of succeeding. If the
project succeeds, you believe it will generate a busine ss worth $20 million in present value
terms. If it fails, the present value will be zero. Can control in this case be seen as an
option? If so, what kind of option is it and what is the value of this option? How much of a
Solution:
Buying the company will give you the right to switch from an old strategy to a new one. In
this sense, the investment in the company represents a real option, specifically a switching
option. The decision tree below illustrates the optionality created by the purchase of the
company. The different branches of the tree illustrate the payoffs under different
circumstances. Using the estimated payoffs and probabilities, the expected value of the
payoff can be calculated – this is the value of the option. The premium that one would be
willing to pay can be calculated by comparing the value of the option to the base case
Probability
PV of Benefit $20,000,000 80%
Net EMV of $6,000,000
Expand project
Decision
Net EMV of $0
Not expand project
7. Suppose you are the CEO of a firm, and a public company want s to purchase your
company. There are several major shareholders that cumulatively/together hold 60% of
your firm’s share. The other 40% are oceanic voters. The base value for your firm--the
DCF value excluding any value for illiquidity or control--is $100 million. Assume that the
public company is willing to pay a 30% premium for control. Assume your opponent uses
the base price as his bid price and that there are a total of one hundred shares. How much
will the individual share price be for block shareho lders and for oceanic shareholders?
Solution:
Base case value of the equity (1) $ 100.00
Adjustment for illquidity (2) 0%
Value of equity adjusted for possible illiquidity (3) $ 100.00
(1) The base value of the company is the value of the firm with marketable shares but no control
blocs or the value of the firm calculated from the DCF model.
(2) Illiquidity is assumed to affect all shares equally. Here, there is no illiquidity adjustment.
(3) Value after illiquidity adjustment = Base value * (1-%Discount for illiquidity)
(4) Percentage ownership of controlling bloc.
(5) Value of the control bloc = Value of equity adjusted for possible illiquidity * (1+Control premium)
* Size of the controlling bloc
(6) The value of the minority bloc equals the difference between the value of equity adjusted for
possible illiquidity and the value of the control bloc.
(7) The law of conservation of value requires that the value of minority and control blocs sum up to
the value of equity adjusted for possible illiquidity.
(8) Controlling bloc price per share equals the value of the controlling bloc divided by the number
of shares for the controlling bloc.
(9) Minority bloc price per share equals the value of the minority bloc divided by the number of
shares for the minority bloc.
The price per share for the controlling block is $1.3 million. And the price per share for the
minority block is $0.55 million. The difference between the two is caused by the total
8. You are an M&A advisor, facing an interesting deal. One of your clients is preparing to
purchase an oil- refining company, which does not have any long-term debt on its balance
sheet. The company is worth $100 million today on a stand-alone basis. The deal proposed
by both parties is structured so that the buyer will purchase 60% of the seller’s shares today
and is restricted from selling its holdings in the next five years. After your client gains
make the company more profitable. If the program succeeds, you believe it will generate total
savings of $20 million in one year. If it fails, the PV will be zero. The cost of the program is
around $5 million and the chance of success is estimated at 70%. The historical volatility for
the assets of this firm is about 20%. What kinds of options are embedded in this deal?
Assuming the risk-free rate is at 8% annually, how much are the options worth in value?
Solution:
There are two options in this deal: a long switching (call) option from the control and a short
put option from illiquidity. The total value of the firm equals the total of the base value for
EMV
No control Payoff $ -
The put value could be estimated using the Black-Scholes Option Pricing model:
Volatility: 20%
Time: 5 years
Total value of the firm = base value of the firm + value of switch option - value of put option
=$100,000,000+$7,962,963-$36,626,622 = $71,336,341.25
Purchase accounting is a method of recording the acquisition of a firm. The central feature
of this approach is that the target is recorded on the buyer’s books at the purchase price.
2. Define “goodwill” in the context of purchase accounting. Can goodwill be amortized? How
Goodwill is the difference between the purchase price and the fair market value of the
target’s identifiable assets. Under the new rules, goodwill cannot be amortized, but must be
3. What criteria determine whether an asset should be classified as intangible, rather than as
The contractual-legal criterion and the separability criterion. By the first criterion, an
acquired asset is considered intangible and distinct from goodwill if it arises from
contractual or other legal rights. By the second criterion, an acquired asset is considered
intangible and distinct from goodwill if it is capable of being separated from the acquired
5. Describe the Consolidation Method of accounting for acquisitions. For what percentage of
share ownership acquired is this method suggested, and why? How are balance sheet and
income statement items of the target reflected? How are balance sheet and income statement
The Consolidation Method is suggested for acquisitions involving 50% or more of target
stock, which typically gives the acquirer control over the assets. This situation is captured
by the consolidation method’s subsuming the target’s accounts into the buyer’s accounts.
Profits (losses) attributable to minority investors are subtracted from (added to) the income
statement.
6. Describe the Equity Method of accounting for acquisitions. When is this method used? How
are the target’s balance sheet and income statement items reflected?
The Equity Method is used when a firm acquires a significant interest in – but not majority
between 20 to 50 percent. Balance sheet and income statement items of the target are not
Target Company,” is created when the buyer makes the initial investment, upon which this
account will record the investment at the buyer’s purchase price. This account will be
increased or decreased by the buyer’s proportionate share in the target’s profits and losses.
The buyer is also obligated to report profits and losses of the target on its (the buyer’s)
income statement. These profits and losses then make their way to the balance sheet through
7. How is a receipt of dividends from the target recorded under the Equity Method?
Dividends received by the buyer are reflected as a reduction in the account “Investment in
8. Describe the Cost Method of accounting for acquisitions. When is this method used? What
are the three methods of recording acquisitions that fall under the Cost Method? Explain
each.
The Cost Method is used when the buyer does not acquire significant control of the target.
Such acquisitions typically involve the purchase of less than a 20 percent stake in the target.
9. How do the Consolidation Method and the Equity Method of accounting differ in their
many of the buyer’s cash flow items can be affected by the target’s performance. Under the
equity method, only the actual cash flows between the target and buyer will be reflected in
1. In purchase accounting, the buyer records assets acquired at their historical cost rather than at
2. Purchase accounting requires that the purchase price be allocated among the various asset
4. In purchase accounting, the buyer’s past financial results can be retroactively restated.
5. The Consolidation Method is used when material voting power but not majority control is
acquired.
6. Under the Consolidation Method, balance sheet items attributable to minority investors are
8. Under the Equity Method, the buyer recognizes its investment in a target through a balance
9. Under the Equity Method, the target’s profits and losses are not reflected on the buyer’s
income statement.
10. The Equity Method recognizes dividends received from the target as an addition to the
11. The Cost Method is typically used whe n the buyer acquires less than a 20% share in the
target.
Answers:
2. True.
control.
6. True.
7. True.
8. True.
9. False. The target’s profits and losses are reflected in the buyer’s income statement,
10. False. Dividends are recognized as a reduction to the “Investment in Target Company”
account.
11. True.
Chapter 17 Questions and Answers
1. In the chapter, four cases are discussed to illustrate the concept of momentum acquisition
The cases on “Automatic” Sprinkler, Ling-Temco-Vought, U.S. Office Products, and Tyco
• “Feedback effect” from the stock market: high share valuation that creates an attractive
acquisition currency.
• Earnings management.
• Change of management.
2. Among different momentum strategies, EPS momentum and revenue momentum are the
The EPS momentum holds that stock prices are driven by changes in EPS and that therefore
steady and aggressive growth in EPS will result in high stock prices (and high P/E
multiples). EPS can be managed by designing deals in ways that avoid EPS dilution. In some
industries, the momentum focus is on revenues instead of earnings per share due to the fact
that a significant portion of the market values of firms in these industries derives from their
growth options; therefore some analysts advocate using revenue multiples as a basis for
3. In the chapter, Scott Sterling Johnson, a momentum investor, said, “I want to be in the sweet
First of all, the momentum investor believes that a “hot hand” or a winning streak is
sustainable over some period of time. One tries to be the first to identify the trend and the
first to withdraw when the trend stops. If one is able to do this, the strategy will provide high
returns; however, timing-based strategies have not proved an ability to beat benchmarks
consistently. It is doubtful whether any momentum investor can consistently foresee the
future, and in particular, whether they can answer the question “When will the momentum
stop?”
4. Momentum advocates believe that firms with momentum enjoy higher earnings (or revenue)
practitioners. First, momentum investment strategies may indeed pay, though the effect may
not be consistent or sizable enough to overcome taxes and transaction costs. Second, the
finding is not uniform across national markets. Third, the profitability of momentum
investment strategies is almost entirely explained by industry momentum rather than firm
momentum.
5. Why is momentum acquiring unsustainable indefinitely? How might analysts incorporate this
Momentum acquiring is not sustainable indefinitely for at least three reasons: 1) the annual
acquisition volume cannot get bigger forever; 2) the world is finite and 3) unexpected events
can happen at any time in the future to halt growth. To reflect the unsustainability of
momentum acquiring, analysts should adjust their long-term growth prospects for firms that
6. Assume that buyer and target agree to a stock-for-stock acquisition. The buyer has 2 million
shares outstanding and $2 million in earnings. Its current P/E ratio is 20. The target has 1
million shares outstanding and $500,000 in earnings. The target’s current P/E ratio is 16.
Suppose the buyer is willing to offer a 20 percent premium for the target and a purchase
related transaction charge of $50,000 is expected. Calculate the earnings per share for Newco
after the merger and the percentage change in the buyer’s EPS.
Solution:
As seen in the above table, the earnings per share for Newco after the merger is $0.99. This
implies dilution of 1.2% from the buyer’s EPS before the merger.
7. Refer to problem 6. By changing the bid price for the target, the buyer can avoid dilution.
Please calculate the percentage dilution or accretion for purchase premiums of 0%, 10%,
20%, 30% and 40%, and for target earnings of $250,000, $500,000, $750,000, $1,000,000 to
$1,250,000, assuming the target still has same P/E ratio. Explain the results.
Solution:
From the above table, it is clear that an increase in the target’s earnings will reduce dilution
and enhance accretion. At the same time, when the premium required for the purchase
8. Assume you as the CEO of a publicly listed company are considering a purchase in a related
advanced, which implies a high growth potential. But it also demands a higher premium than
company B, which has lower growth opportunities. Both companies have 2 million shares
outstanding and projected earnings for this year for both companies are the same at $2
million. Company A’s stock trades at $20 and company B’s stock trades at $15. After a
careful study of their businesses, you estimate that earnings of company A will grow at a rate
of 12% and those of company B will grow at 3%. You estimate your own firm’s earnings
will grow at 8%. Assume that the earnings of Newco after the merger will be just the simple
arithmetic addition of the forecasted earnings of your firm and the target. There are 3 million
shares outstanding for your firm; projected earnings for this year are $3 million. Your firm’s
stock trades at $25. If company A asks for a 60% premium over its market price and
company B only asks for a 20% premium, which company would you acquire? Please use
Solution:
Earning forecasts:
Now Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Buyer before $3,000 $3,240 $3,499 $3,779 $4,081 $4,408 $4,761 $5,141 $5,553 $5,997 $6,477
EPS for Buyer alone $1.00 $1.08 $1.17 $1.26 $1.36 $1.47 $1.59 $1.71 $1.85 $2.00 $2.16
Target A before $2,500 $2,875 $3,306 $3,802 $4,373 $5,028 $5,783 $6,650 $7,648 $8,795 $10,114
EPS for Buyer after
$5,500 $6,115 $6,805 $7,581 $8,454 $9,436 $10,543 $11,792 $13,200 $14,792 $16,591
acquiring target A
EPS after merger $0.81 $0.90 $1.00 $1.12 $1.25 $1.39 $1.56 $1.74 $1.95 $2.18 $2.45
Growth rate for Newco 11.18% 11.29% 11.40% 11.51% 11.62% 11.73% 11.84% 11.95% 12.06% 12.16%
Target B before $3,000 $3,090 $3,183 $3,278 $3,377 $3,478 $3,582 $3,690 $3,800 $3,914 $4,032
EPS for Buyer after
$6,000 $6,330 $6,682 $7,057 $7,458 $7,886 $8,343 $8,831 $9,353 $9,911 $10,509
acquiring target B
EPS after merger $1.16 $1.23 $1.29 $1.37 $1.45 $1.53 $1.62 $1.71 $1.81 $1.92 $2.04
Growth rate for Newco 5.50% 5.56% 5.62% 5.68% 5.74% 5.79% 5.85% 5.91% 5.97% 6.03%
EPS growth with a dilutive target and an accretive
target
$2.60
$2.40
$2.20
Earnings per share ($)
$2.00
Buyer
$1.80 alone
Buyer with
$1.60 target A
$1.00
$0.80
$0.60
0 1 2 3 4 5 6 7 8 9 10
Years from closing of the acquisition
From the above table and figure, it can be seen that a deal with company A is immediately
dilutive (-10.1%) and a deal with company B is immediately accretive (12.6%). But the deal
with company A offers faster growth in earnings after the merger. Looking at near-term
dilution ignores possible long-term benefits. Ultimately, however, a choice between the two
Value creation is the best criterion for acquisition strategies because it focuses on the
longer-term future, accounts for the time value of money, focuses on economic reality,
focuses on risk and return, and accounts for opportunity costs. Further, the use of NPV
acquisition strategies have the ultimate virtue of weeding out bad deals more effectively than
Each deal reflects choices in several dimensions, such as price, form of payment, social
issues, etc. The choices interact with one another. For instance, the more value a buyer
gives to the target company management, the less the buyer will likely give to the target’s
One must assess them simultaneously, as a bundle of terms. Hence, deal design is a system.
o Create value
o Manage incentives
Commonly negotiated deal terms include price, form of payment, form of reorganization and
tax implications, deadlines, timing, control and governance, commitments and warranties,
4. What are some issues to be considered when deciding on a form of payment? What are the
general forms of payment? And what are some circumstances under which each might be
used?
o Tax implications
Types of payments include fixed payments, semi-fixed payments, contingent payments, and
side payments:
o Fixed payments employ cash and senior debt securities, and can be used when there
securities. Semi-fixed payments might be used when the buyer does not have the cash
or debt capacity to finance the acquisition. They may also be used to allow target
o Contingent payments are used to hedge against uncertainties about the value of the
firm or about the future. For instance, earn-outs and convertible bonds might be
used when buyer and target disagree on the value of the firm. Caps, floors, and
collars might be used to protect target and buyer against fluctuations in the buyer’s
share price.
o Side payments are payments to parties other than the owners of the target firm,
parties that may have some influence in the success of the post-merger firm. These
might include managers, unions, bank lenders, and governments. Examples of side
etc.
The use of fixed payments could be interpreted as a lack of confidence by target shareholders
in the buyer’s future management of the enterprise, thus prompting them to demand fixed
payments.
6. How might deal terms be designed to deter either party from backing out of an M&A deal?
Deals can include terms that impose penalties on the party that backs out of an M&A deal.
For instance, the buyer and target can agree on a walk-away fee to be paid by whichever
party backs out. The parties might also agree on lock-up options, which automatically allow
one party the right to buy shares in the counterparty at a given price if the latter enters into
An earn-out is an arrangement where a portion of the purchase price for a company would
especially useful in situations where the buyer and target cannot come to agreement on the
A cash payment, for instance, would result in an immediately taxable deal, which in turn
could cause the target to demand a higher price from the buyer. Research suggests that
where selling shareholders are exposed to a higher tax payment in the near term, the
9. How can a deal be tailored to hedge against security price risk in a share- for-share exchange?
A collar can be incorporated into the deal terms in order to hedge against security price risk. A
collar places both a cap and a floor on the effective purchase price. In the buyer’s case, a cap
might adjust the exchange ratio downward when the buyer’s stock rises above a certain price.
In the seller’s case, a floor could adjust the exchange ratio upward when the buyer’s stock falls
10. What impact might the Form of Payment have on the Timing of a deal?
The Form of Payment would impact the Closing Date of a deal. For instance, cash deals
typically are quicker to finance and to pay. On the other hand, stock deals might draw out
the closing date for a deal, as stock issuance often entails registration and may require a
shareholder vote.
No, it is unlikely that there will be one “best” single feasible deal. Rather, there is likely to
be an area within which feasible deals may be achieved. Deal design involves tradeoffs
among the various objectives of the buyer and seller. Both parties must decide on which
tradeoffs are acceptable and which are non-negotiable. Often, there are several acceptable
solutions arrived at through a process of optimization where the desirability of one set of
terms is compared against another set of terms. As such, there is no single best feasible deal.
Chapter 19 Questions and Answers
1. What three possible kinds of tax benefits are M&A transactions usually associated with?
o A reduction in tax expense through the exploitation of net operating loss tax carry
o A reduction in tax expense through the “step-up,” or increase, in the basis or value of
2. Which main issues must a deal designer consider when deciding on the form of acquisitive
reorganization? Explain.
o Tax impact: will the form of reorganization create a tax liability that is immediate or
deferred?
o Target’s liabilities: how can the reorganization be structured to shield the buyer from
o Surviving entity: should the buyer or the target be the surviving entity? How will this
o Form of payment: what form of payment will result in the most tax -efficient structure?
o Limitations on other actions: which form of reorganization allows the buyer most
flexibility?
3. From a tax standpoint, which alternative is more desirable to the seller, the sale of a
A sale of stock is preferable to selling assets. This is because a sale of assets incurs tax
liabilities at two levels (one, a capital gain at the corporate level, and the other at the
shareholder level when securities are sold or liquidated). A sale of stock incurs tax only at
the shareholder level. Also, the liabilities of the target carry over to the buyer with a sale of
the entity.
4. Explain how a buyer might realize a tax benefit from purchasing an asset for cash.
If the asset purchased is depreciable or amortizable, and if the purchase premium can be
allocated to the asset, the buyer benefits from the step-up in basis. This increases
5. In a purchase of assets for cash, how might a conflict of interest due to tax consequences
A possible allocation conflict might ensue between buyer and seller in tax jurisdictions where
capital gains tax rates are lower than income tax rates. The buyer will want to allocate the
fair market value of the purchase in ways to shield taxes on ordinary income (e.g., toward
inventory), while the seller will want to allocate the fair market value to capital items such as
plant and equipment to create capital gains rather than ordinary income.
In a triangular cash merger, the buyer forms a subsidiary (Subco) and capitalizes it with
enough cash to purchase the target’s stock. The target then merges with Subco.
7. What is a reverse triangular cash merger? How does the IRS view this transaction?
A reverse triangular cash merger is one where the buyer forms a subsidiary (Subco) to
acquire a target’s stock. Subco then merges into the target. The target company survives, as
do its tax attributes and liabilities. The IRS views this transaction as a cash purchase of
target shares.
8. What is a forward triangular cash merger? How does the IRS view this transaction?
A forward triangular cash merger is one where the buyer forms a subsidiary (Subco) to
acquire a target’s shares. The target then merges into Subco, which becomes the surviving
entity. The target company’s liabilities are transferred to Subco and its tax attributes cease
9. What advantage does a cash merger have over a cash purchase of stock?
In a cash merger no minority shareholders remain in the target; all target shareholders have
been paid cash and the target ceases to be an independent entity. As long as the buyer can
attract a voting majority of the target’s shareholders, the merger can be effected and the
In a statutory merger, one company absorbs the other. The target company ceases to exist.
The buyer assumes the liabilities of the target. All shares in the target company become
In a statutory consolidation, two or more corporations combine into one new corporation.
In both cases, at least part of the consideration is made up of the buyer’s stock. While the
two transactions are legally different, common language of finance refers to both as
“mergers.”
11. What condition does the IRS require for statutory mergers and consolidations to be tax- free?
Statutory mergers and consolidations can be considered tax-free if there is sufficient
“continuity of interest” by the selling shareholders, which requires that at least 50 percent of
12. What happens in a forward triangular merger under an “A” type reorganization? What is
In this transaction, the target company is merged into a subsidiary of the buyer (Subco). To
qualify as a tax-free transaction, the subsidiary must acquire substantially all of the target’s
assets (e.g., at least 70 percent of the fair market value of gross assets and 90 percent of the
13. What happens in a reverse triangular merger under an “A” type reorganization? What
requirements must be met for this kind of transaction to qualify as tax- free?
In a reverse triangular merger, the buyer’s subsidiary (Subco) is merged into the target, with
the target as the surviving subsidiary of the buyer. In order to qualify as a tax-free
transaction, at least 80 percent of the consideration must be paid in the buyer’s parent
corporation voting stock. Also, the buyer must control “substantially all” of the target’s
assets.
14. What happens in a voting stock- for-stock acquisition (“B” type reorganization)? How can
wholly (or partially)-owned subsidiary of the buyer. To qualify as a tax-free transaction, the
buyer must exchange only voting common or preferred stock, and afterwards, control at least
15. What happens in a voting stock- for-assets acquisition (“C” type reorganization)? How can
In a voting stock -for-assets acquisition, the buyer offers shares of its voting stock for
substantially all of the assets of the target company. The target company must liquidate after
the transaction, and distribute the shares in the buyer to the target shareholders in liquidation.
Tax-free status requires that at least 70 percent of the fair market value of the gross assets,
and 90 percent of the FMV of net assets of t he target company be transferred to the buyer.
16. A CEO wants to acquire a target but faces dissident shareholders in his own company. In
addition, he must seek shareholder authorization if he pays for the target with stock. Which
among the reorganization structures saves the CEO from a confrontation with dissidents?
A cash purchase of stock saves the CEO from a confrontation because it does not require
1. For each of the following, identify whether stock or cash tends to be the prevalent form of
b. hostile takeover
c. jumbo deal
d. ownership is concentrated
Solution:
a. During buoyant periods in the stock market cycle, stock tends to be the prevalent form of
payment, probably due to opportunism – companies tend to use stock as payment when
b. In hostile takeovers, cash is the preferred medium because it can preempt competitors.
Cash payments remove any contingency about the value of the bid. In addition, cash
does not involve complications that come with a stock deal, such as shareholder approval
requirements. Finally, cash payments are more effective at winning arbitrageurs over:
c. Stock payments tend to be used in jumbo deals – this may be due simply to the inability to
“write a check”; paying for jumbo deals in cash may overly strain financial reserves.
d. Cash deals tend to be used when ownership of the target and/or buyer is concentrated.
By not paying with stock, the buyer possibly avoids bringing in a new significant
shareholder that might destabilize the internal politics of the equity ownership group.
2. A study on shareholder returns found that over the five years following the deal, share-for-
share transactions yielded average excess returns of +14.5%, while cash deals yielded
The opportunistic use of stock during times of overvaluation might explain this phenomenon
– inflated stock prices may result in overpayment or higher payments, leading to a lower
3. Why do the following seem to affect the choice of form of payment: minimization of costs,
a. Minimization of costs. Forms of payment can have very different effects on costs;
managers will want to reduce the overall cost of capital and other costs such as taxes,
b. Agency costs. Some managers may choose to barricade themselves from the rigors of
the marketplace by using cash to pay for acquisitions. Using debt or equity exposes
than do outsiders, and may thus take advantage of stock as a medium of payment in times
of overvaluation.
4. Research indicates that for buyer shareholders, payment in cash is associated with close to
zero returns, while payment in stock is associated with significantly negative returns. What
This phenomenon might be explained by a tendency to overpay when stock is used, because
of its nature as “soft” currency, as opposed to cash. The use of hard currency may enforce
stricter discipline in the price paid. In addition, these findings suggest that the use of stock
5. What are the tax implications of a cash deal for the target? What about a stock deal?
In a cash deal, target shareholders must immediately pay taxes on their capital gain. In a
stock deal, the target shareholders’ taxes are deferred until the shares of Newco are sold.
6. Do abnormal returns to target shareholders tend to be larger in stock or in cash deals? Why?
Abnormal returns to targets tend to be larger in cash deals perhaps because target
shareholders expect the buyer to compensate them for their tax exposure—in cash deals,
target shareholders have an obligation to pay taxes immediately on their capital gain. Also,
in cash deals the buyer may be able to offer a higher price because of the larger tax shield
7. How is it that some forms of payment might consume financial slack, and others might create
it?
Paying with cash uses financial slack (cash and/or unused debt capacity) unless the cash
payment is financed with a sale of equity; paying with equity increases Newco’s debt
capacity.
8. Are there any signaling implications when the target insists on a cash payment?
Yes. If a target insists on a cash payment, it may signal pessimism about the prospects of the
9. Explain how issuing equity to fund an acquisition might send negative signals to the markets.
There is some evidence of a ‘pecking order’ when managers choose among funding
alternatives – issuing equity is usually less preferred to using internal funds or raising debt.
This leads to the hypothesis that managers will issue new equity only when the firm is
overvalued. The abundance of stock -for-stock deals when the stock market is buoyant
supports this hypothesis. Issuing stock, therefore, might be a signal to the markets that the
firm is overvalued.
10. Do stock prices of bidders react positively or negatively upon the announcement of a cash
Stock prices of bidders tend to react neutrally or positively at the announcement of cash
deals, and negatively at the announcement of stock deals. This is because bidders who are
optimistic about the value of merger synergies will tend to offer cash; therefore, a stock offer
may be perceived to be a signal of pessimism, or at least, of less optimism, hence the negative
11. Explain the difference in price, form of payment, and financing between a pre-emptive and a
contingent strategy. How does the choice of strategy affect the form of payment and
financing chosen?
an offer that target shareholders “cannot refuse.” If a buyer chooses to follow this strategy,
the form of payment often has to be cash, and the funding source internal, leaving no doubt
about the value of securities or about financing. On the other hand, a contingent strategy is
used when the probability of competing offers is low. If a buyer chooses this strategy, the
form of payment is often only partially or not even at all in cash, and the financing chosen
may be external.
12. The chapter discussed seven dimensions of M&A transaction financing: mix, maturity, yield
basis, currency, exotic terms, control features, and distribution. Explain how each plays into
o Mix. The decision maker will want to choose a form of financing that preserves a firm’s
financial flexibility, minimizes its cost of capital, and is compatible with its asset base.
o Maturity structure. Decision makers can choose a maturity structure for liabilities that
will expose the firm to reinvestment risk, refinancing risk, or not expose the firm to either.
o Basis for the yields. A decision maker’s outlook for interest rates will affect whether a
o Currency. A firm’s exposure to foreign exchange rate fluctuations and the possibility of
exploiting unusual financing opportunities in global capital markets will influence the
o Exotic terms. A firm may choose to issue exotic securities if these can lower the cost of
capital and/or reduce risk. Exotic securities may also be used in cases where there is
control.
o Distribution. The form of financing chosen will affect the way a firm markets its
securities, and the way it delivers value to investors. Decision makers will want to
13. What is a risk- neutral maturity structure? Reinvestment risk? Refinancing risk?
A risk-neutral maturity structure is one that equates the life of a firm’s assets with the life of
its liabilities. A structure in which the maturity of liabilities is greater than the maturity of
the firm’s assets creates reinvestment risk, the risk that management will not be able to
deploy the cash released by the firm’s assets to achieve returns sufficient to service the
liabilities. In the opposite case, where the maturity of assets is greater than the maturity of
liabilities, the firm is exposed to refinancing risk, the risk that the firm will not be able to roll
The six C’s are cash flow, collateral, capital, conditions, course, and character.
flexibility, risk, income, control, timing, and other—dimensions used by the framework to
The exchange ratio is the number of shares of the buyer’s stock to be exchanged for each
2. Which party does not want to go above a certain ‘maximum’ exchange ratio? Which party
The buyer does not want to go beyond a maximum, and the seller does not want to go beyond
3. Why does the value of Newco matter in exchange ratio determination? Put another way, why
does the exchange ratio not depend only on the current ratio of the buyer’s va lue to the
target’s value?
The value of Newco matters because it is the shares of Newco, not the buyer’s shares, that
will determine the value created or destroyed for the shareholders of both companies.
value of Newco may differ so much that there is no exchange ratio that satisfies both the
5. What three factors tend to determine how the middle ground is carved up in cases where
there is a large zone of potential agreement between buyer and seller? Explain.
• Bargaining power. The party with greater bargaining power—either in the form of
• Focal points such as control premiums in comparable transactions. Sellers may bargain
• Relative contributions of the two firms. The middle ground may be carved up according
to each party’s relative contribution, which may be measured in terms of relative share
Use the spreadsheet file “Deal Boundaries.xls” in answering the questions below.
and target’s share prices are currently trading at $35 and $20, respectively. The buyer is
projected to earn $200 million, and the target, $150 million. Synergies of $10 million are
expected from the deal. Each party has 80 million shares outstanding. Both buyer and target
expect Newco to trade at a price-earnings ratio of 11 times. What is the range of feasible
Solution:
There is no acceptable exchange ratio – the target’s minimum requirement is higher than the
maximum the buyer is willing to pay: the negotiators are in Zone III.
7. Refer to the problem above. How high must Newco’s price-earnings ratio be for a deal to be
possible? What does your answer tell you in general about price-earnings expectations of
By running a data table, we see that Newco’s price-earnings ratio must be around 13 times
or more for a deal to be possible. In general, parties that enter into M&A transactions
expect the P/E ratio of t he combined firm to improve—it makes no sense to enter into a
transaction if the resulting P/E ratio will be lower than before the merger.
8. Referring to the same problem, suppose that buyer and target both estimate Newco’s DCF
value to be $5 billion. What would be the range of feasible exchange ratios for the deal?
Solution:
Using the DCF model of exchange ratio determination, the feasible exchange ratios are
DCF12 $ 5,000
Maximum Minimum
Acceptable Acceptable
ER1 ER2
DCF 0.7857 0.4706
9. Now run a sensitivity analysis using projected DCF values from $3 billion to $7 billion.
What are the resulting maximum and minimum exchange ratios? Graph your solution and
Solution:
DCF Model Assumptions
P1
P2
$ 35.00
$ 20.00
Win-Loss Boundaries: DCF Analysis
S1 $ 80
S2 $ 80 1.6
1.4
DCF12 $ 5,000
Exchange Ratio
1.2
1.0
Maximum Minimum II. Target Wins,
Acceptable Acceptable 0.8
Buyer Loses
ER1 ER2 0.6
DCF 0.7857 0.4706 III. Both I. Both Win
0.4
$ 3,000 0.0714 1.1429 Lose
$ 3,500 0.2500 0.8421 0.2
$ 4,000 0.4286 0.6667 0.0 IV. Buyer Wins
$ 4,500 0.6071 0.5517 Target Loses
$3,000
$3,500
$4,000
$4,500
$5,000
$5,500
$6,000
$6,500
$7,000
$ 5,000 0.7857 0.4706
$ 5,500 0.9643 0.4103
$ 6,000 1.1429 0.3636 DCF Value of "Newco"
$ 6,500 1.3214 0.3265 Buyer's Maximum ER
$ 7,000 1.5000 0.2963 Target's Minimum ER
The DCF value of Newco has to be at least $4.4 billion for a deal to be feasible.
10. Now suppose the parties agree to a cash-for-stock transaction instead. Assuming again that
the expected P/E ratio for Newco is 11 times, is there a feasible deal? Why or why not?
Solution:
11. Run a sensitivity analysis using a range of P/E ratios from 11 to 17 times—what should the
expected minimum P/E ratio be in order for a deal to be feasible? Graph your solution and
Solution:
20
Results Based on the P/E of Newco III. Both
Maximum Minimum Lose
Acceptable Acceptable IV. Buyer Wins
Target Loses
$ per shr $ per shr
PE12
11 14.50 20.00
0
12 19.00 20.00
11 12 13 14 15 16 17
13 23.50 20.00 P/E Ratio of "Newco"
14 28.00 20.00
15 32.50 20.00 Buyer's Maximum ER
16 37.00 20.00 Target's Minimum ER
17 41.50 20.00
This is the same deal, so as in # 2 above, the P/E should be around 13 times in order for a
deal to be feasible.
12. Assume again that the expected DCF value for Newco is $5 billion. What would be the
The range of feasible cash payments is from $20 to $27.50 per share:
DCF12 $ 5,000
Maximum Minimum
Acceptable Acceptable
ER1 ER2
DCF 27.50 $ 20.00
13. Now run a sensitivity analysis using projected DCF values from $3 billion to $7 billion.
DCF12 $ 5,000
$30
Exchange Ratio
II. Target Wins,
Buyer Loses I. Both Win
Maximum Minimum
Acceptable Acceptable $20
ER1 ER2 III. Both
DCF 27.50 $ 20.00 Lose IV. Buyer Wins
$10 Target Loses
$ 3,000 $ 2.50 $ 20.00
$ 3,500 $ 8.75 $ 20.00
$ 4,000 $ 15.00 $ 20.00 $-
$3,000
$3,500
$4,000
$4,500
$5,000
$5,500
$6,000
$6,500
$7,000
$ 4,500 $ 21.25 $ 20.00
$ 5,000 $ 27.50 $ 20.00
$ 5,500 $ 33.75 $ 20.00
$ 6,000 $ 40.00 $ 20.00 P/E Ratio of "Newco"
$ 6,500 $ 46.25 $ 20.00 Buyer's Maximum ER
$ 7,000 $ 52.50 $ 20.00
Target's Minimum ER
As in problem 4 above, regardless of the form of payment, the DCF value of Newco has to be at
1. If earnouts are useful, why are they not pervasive in big public deals?
Solution:
Earnouts are less useful where there is higher certainty about a target’s performance and
where the merging firms are from similar industries. Also, where the firms are large, the
earnout may be very complex to structure. The level of uncertainty for private companies
and high technology industries is much higher than that for public companies and firms in
2. Earnouts are options, but there are also some differences between earnouts and options.
Please describe the differences and explain their implications for value of earnouts.
Solution:
Similar to call options, earnouts are financial derivatives with an underlying asset. But
financial options are standardized exchange-traded contracts. And the underlying assets for
financial options are stocks, fixed-income instruments and other publicly traded securities,
whereas for earnouts, the underlying assets are actual operational performances measured
by revenues, earnings, cash flow etc. Compared to publicly traded securities, these assets are
much more difficult to value, and their uncertainties much more difficult to assess. These
difficulties create many implications for value of earnouts because earnouts are normally
valued from option valuation methods such as the binomial model or Monte Carlo simulation
3. You are the CEO of a local beverage firm that is negotiating a deal with a large national food
company. The deal is structured as follows: the acquirer will pay $20 million in cash now.
However, if the revenues of your firm reach $200 million after three years, the acquirer will
pay another $20 million. In addition, the management team will be awarded a 10% bonus on
any extra revenues exceeding $200 million. Checking your firm’s financial statement over
the past several years, you estimate that its revenues have a volatility of 18%. You expect
$180 million in revenues this year. Assuming a 6% of risk- free rate, what is the probability
that your firm’s shareholders will get a $20 million payment three years later? How much is
the bonus plan to the management team worth? Try using the binomial option-pricing model
Solution:
Your firm’s shareholders will have a 67.78 percent chance of getting a $20 million payment
three years later. And the bonus plan is worth $4.33 million to the management team.
Step 1 Grow the tree Now Year 1 Year 2 Year 3
In the above table, the shaded numbers indicate when the earnouts will be paid. In these cases, the sales
is greater than the trigger, $200 million
Step 4 Estimate the probabilities and payments associated with these end-states.
$14.32
$9.80
$6.57 $3.94
$4.33 $2.31
$1.35 -
-
-
(B) --- $9.80 = ($14.32 * Pu + $3.94 * Pd)/(1+Rf)
For instance, to arrive at (B), $9.80 million, one would take the expected value of (Pu*$14.32+Pd*$3.94), or
(.6209*$14.32)+(0.3791*$3.94) to yield $10.39. Discounting this by one year at the risk-free rate, 0.06 yields $9.80.
This process is repeated for the other cells. Folding the expected values back to the present, we arrive at a value of
$4.33 million for this bonus plan.
By adding all probabilities of events when sales exceed $200 million, the probability of shareholders'
getting $20 million payment three years later is 67.78 percent. By folding back the tree to now, the value of
the bonus plan is obtained in the term of present value.
4. Refer to problem 3. After consulting with an outside marketing firm your estimation of the
volatility of revenues for the next three years increases from 18% to 30%.
a. How much is the bonus plan to management team worth now?
b. Moreover, if the three year time period is reduced to two years, are you better off
in terms of the chances of getting the bonus as well as the value of the bonus
plan?
Solution:
As with problem number 3, build a binomial lattice laying out the outcomes. Then calculate
the payoffs for each outcome. Fold back the expected value of the payoffs to arrive at the
value of the option. The answers are given below, and the complete solutions can be found
a. After increasing the volatility of the firm’s revenue to 30%, your firm’s shareholders will
have a 53.61% chance of getting $20 million payment three year later. And, the bonus plan is
b. If the three year time period is reduced to two years, the probability of getting $20 million
payment increases to 77.35 percent and the value of the bonus plan decreases to $4.02
million.
5. Refer to problem 3 again. After careful consideration, the buyer changes the bonus plan.
The management team will still get 10% of any revenues exceeding $200 million but
there will be a $5 million cap on the amount of the bonus. This means that the
management team will only get $5 million even if the revenues exceed $250 million.
Keeping other parameters the same, how much is the bonus plan worth now?
Solution:
As with problem number 3, build a binomial lattice laying out the outcomes. Then calculate
the payoffs for each outcome. Fold back the expected value of the payoffs to arrive at the
value of the option. The answer is given below, and the complete solution can be found in
If there is a $5 million cap on the amount of the bonus, the value of bonus plan will drop to
$2.46 million, which implies a 43.2 percent decrease compared to the result of problem 3.
6. Refer to problem 5.
1. Using volatility of 12%, 15%, 18%, 21%, 24% and 27% for the revenues,
2. Then, changing the agreement from three years to two years, recalculate the value
of the bonus plan for the above range of volatilities. Plot the values and time
Solution:
As with problem number 3, build a binomial lattice laying out the outcomes. Then calculate
the payoffs for each outcome. Fold back the expected value of the payoffs to arrive at the
value of the option. The answers are given below, and the complete solutions can be found
a. By changing the volatility cell, one can obtain a series of the data for the values of bonus
plan and probability of payment as shown above. It is noted that with the increase of
volatility, the value of bonus plan decreases at first, and then increases. After it reaches 21%,
the value of the bonus plan decreases again. This is matched with the nature of the
optionality of the bonus plan with a cap—a collar assembled by a long call at a low strike
b. By comparing the results of a three-year period and those of a two-year period, it is clear
that the longer the time period, the more valuable the bonus plan is. Furthermore, due to the
unique nature of the collar, in which the dependence of its value on volatility of the
underlying asset is not linear, the value of the bonus plan for the two-year time period
Your estimation of the value of your firm is $12 million. To bridge the gap between you and
the buyer, both of you agree on an earnout plan with the following terms: you will get $5
million now; the earnout, which is based on the EBITDA of your firm, will last for three
years. An earnout trigger will start at $2 million and increase by that amount each year.
Currently, the sales of your firm are $55 million. Based on your knowledge, sales growth is
most likely to be 12% with a minimum at 6% and a maximum at 15%. Your best guess for
the EBITDA to sales ratio is 10% with a minimum of 5% and a maximum of 15%. The three-
year risk-free rate is at 6%. Given the above information, is this deal economically attractive
to you?
Solution:
After building the three-year forecast as follows, the uncertainties about sales and EBITDA
ratio are input in the model as a triangular distribution. Running CrystalBall 5,000 times,
the result is shown below. From the seller’s point of view, the enterprise valuation of the
proposed earnout has a mean of $12.79 million, which is higher than your asking price.
Statistics: Value
Trials 5000
Mean $12.79
Median $12.77
Mode ---
Standard Deviation $2.06
Variance $4.25
Skewness 0.07
Kurtosis 2.77
Coeff. of Variability 0.16
Range Minimum $6.59
Range Maximum $19.74
Range Width $13.15
Mean Std. Error $0.03
.017 84.75
.011 56.5
.006 28.25
.000 0
distribution with a mean of 10% and a standard deviation of 5%. He expects the EBITDA to
sales ratio to likewise follow a normal distribution with a mean of 8% and a standard
Solution:
After building the three-year forecast as follows, the uncertainties about sales and EBITDA
ratio are input in the model as triangular distribution. Running Crystal Ball 5,000 times, the
result is shown below. From the seller’s point of view, the enterprise valuation of the
proposed earnout has a mean of $9.86 million, which is lower than his bid price. Therefore,
Buyer Valuation
Base Year Sales $ 55
Earnout Period, in Years 3 Year 1 Year 2 Year 3
Statistics: Value
Trials 5000
Mean $9.86
Median $9.66
Mode $5.00
Standard Deviation $2.44
Variance $5.98
Skewness 0.55
Kurtosis 3.41
Coeff. of Variability 0.25
Range Minimum $5.00
Range Maximum $22.64
Range Width $17.64
Mean Std. Error $0.03
.016 79.5
.011 53
.005 26.5
.000 0
online media niche. During negotiations with a start-up internet service company
JUMPONLINE, the two sides had a heated debate on the assumptions about future revenue
growth and profit margins, which led to different valuation of the firm based on DCF model.
FREESPEECH thinks the start-up company is worth $30 million while the investment banker
for company JUMPONLINE thinks that it is worth at least $50 million based on the rapid
growth of internet related businesses over the past several years. To resolve the
b. After the acquisition, FREESPEECH will pay JUMPONLINE’s shareholders cash equal
is $10 million now will increase at a compound annual rate of 50 percent for the next five
years;
percent of JUMPONLINE’s gross profits, minus a deductible amount of $1 million now but
which would increase at a compound rate of 50 percent annually for the next five years.
Currently, the sales of JUMPONLINE are $10 million. Sales growth is most likely to be at
40% with a minimum of 30% and a maximum of 55%. The profit margin will improve
gradually over the next five years. Currently the profit margin is 10%, but FREESPEECH’s
estimation of profit margin of the next five years follows a normal distribution with means of
12%, 15%, 20%, 25%, and 30% respectively and with standard deviations of 20 percent of
these numbers respectively. Assuming a risk- free rate of 8%, what is the value of
JUMPONLINE from FREESPEECH’s perspective? Please use the excel sheet given to you
Solution:
After building the five-year forecast model as follows, the uncertainties about sales and profit
margin are input in the model as triangular distribution and normal distribution. Running
crystal ball 5,000 times, the result is shown below. From FREESPEECH’s perspective,
enterprise valuation of proposed earnout has a mean of $28,337 million, which is lower than
Earnout Target for sales Increase per year 50% $ 10,000 $ 15,000 $ 22,500 $ 33,750 $ 50,625
Annual Earnout Value $ 804 $ 1,099 $ 1,362 $ 1,371 $ 1,052
Earnout Target for Profit Increase per year 50% $ 1,000 $ 1,500 $ 2,250 $ 3,375 $ 5,063
Annual Earnout Value $ 208 $ 835 $ 2,279 $ 1,300 $ 7,830
Total annual earnout values $ 1,012 $ 1,933 $ 3,641 $ 2,672 $ 8,882
Statistics: Value
Trials 5000
Mean $28,337
Median $28,279
Mode ---
Standard Deviation $2,748
Variance $7,548,967
Skewness 0.26
Kurtosis 2.96
Coeff. of Variability 0.10
Range Minimum $18,700
Range Maximum $38,971
Range Width $20,271
Mean Std. Error $38.86
.019 93
.012 62
.006 31
.000 0
Based on your knowledge, sales growth is most likely to be 45% with the minimum at 60%
and the maximum at 70%. The profit margin will improve gradually in the next five years.
Currently the profit margin is 10%. Your estimations for profit margins during the next five
years follow normal distributions with means of 15%, 20%, 25%, 30%, and 35% respectively
and with standard deviations of 15 percent of means. Please use the excel sheet given to you
and run the crystal ball model. Compare the result with problem 9 and explain.
Solution:
After building the five-year forecast model as follows, the uncertainties about sales and profit
margin are input in the model as triangular distribution and normal distribution. Running
crystal ball 5,000 times, the result is shown below. In your point of view, enterprise valuation
of proposed earnout has a mean of $52,548 million, which is lower than his bid price. By
comparing to problem 9, it is clear that the earnout plan works for both parties. Therefore,
this earnout plan successfully bridges the $20 million valuation gap between buyer and
seller.
Seller Valuation
Base Year Sales $ 10,000
Earnout Period, in Years 5 Year 1 Year 2 Year 3 Year 4 Year 5
Earnout Target for sales Increase per year 50% $ 10,000 $ 15,000 $ 22,500 $ 33,750 $ 50,625
Annual Earnout Value $ 1,157 $ 2,024 $ 3,842 $ 6,619 $ 10,987
Earnout Target for profits Increase per year 50% $ 1,000 $ 1,500 $ 2,250 $ 3,375 $ 5,063
Annual Earnout Value $ 628 $ 2,134 $ 4,242 $ 8,548 $ 19,636
Total annual earnout values $ 1,785 $ 4,158 $ 8,084 $ 15,168 $ 30,623
Statistics: Value
Trials 5000
Mean $52,548
Median $52,505
Mode ---
Standard Deviation $4,148
Variance $17,209,296
Skewness 0.09
Kurtosis 2.85
Coeff. of Variability 0.08
Range Minimum $39,084
Range Maximum $67,205
Range Width $28,122
Mean Std. Error $58.67
.017 84
.011 56
.006 28
.000 0
M&A deals are negotiated transactions; there is no competitive bidding with which to set an
equilibrium price for risk management features in a deal. Therefore, one needs to estimate
independently whether the whole package of the deal (cash or stock payment plus the cost of
simulation are the most common ways to price risk management features.
The true value of a bid is the sum of the consideration paid and the value of ancillaries such
3. M&A is a risky activity. What costs are associated with deal failure? What value is at risk
The costs associated with deal failure before consummation include: research expenses,
legal, accounting, and financial advisory fees, management time, damage to reputation, and
the cost of the lost opportunity. The opportunity cost can be massive where there are solid
synergies or strategic options that might have been created. When a deal fails, a
participant’s reputation is at risk, too. The value at risk also grows over the time period of
4. What are the four classic profiles of payments in M&A? What are the differences between a
The four classic profiles of payments in M&A are a fixed exchange ratio deal, fixed value
deal, floating collar and fixed collar. With a floating collar, payment can vary a between a
maximum and minimum, downside losses are limited (which pleases target shareholders) and
upside gains are capped (which pleases buyer shareholders). The resulting payoff diagram
from a floating collar resembles the well-known “bull spread” used by options traders. With
a fixed collar, the payment is fixed as long as the buyer’s share price remains within a
reasonable range, but beyond that range, the gains and losses will be shared. The following
5. Suppose the fixed exchange ratio in a deal is 1.2:1, and that at the time of agreement, the
buyer’s share price is $25.00. The buyer and seller agree to a floating collar, which has a low
trigger of $15.00 and a high trigger of $35.00. Thus, the exchange ratio is 1.2 to 1, unless the
buyer’s stock price falls below $15.00, in which case the exchange ratio will be equal to
$18.00 divided by the buyer’s share price, or unless the buyer’s share price is greater than
$35.00, in which case the exchange ratio will equal $42.00 divided by the buyer’s share
price. Please calculate and graph the number of shares issued for one share of the seller’s
stock, assuming the following share prices for the buyer: $0.01, $5.00, $10.00, $15.00,
$20.00, $25.00, $30.00, $35.00, $40.00, $45.00, and $50.00. Also, calculate and graph the
value of the bid with the collar at these prices. (Please use the spreadsheet, “Collars
Analysis.xls.”)
Insert the parameters into the model “Collars Analysis.xls.” You should obtain the following
results:
Number of Buyer
Shares Issued Per
Buyer's Stock Value of Bid Target Share
Price With Collar With Stock Collar
"Fixed" Exchange Ratio 1.20 $ 0.01 $ 18.00 1,800.00
Collar upper strike $ 35.00 $ 5.00 $ 18.00 3.60
$ 10.00 $ 18.00 1.80
Exch. Ratio above upper strike Upper strike/Buyer's Stock Price $ 15.00 $ 18.00 1.20
Collar lower strike $ 15.00 $ 20.00 $ 24.00 1.20
$ 25.00 $ 30.00 1.20
Exch Ratio below lower strike Lower strike/Buyer's Stock Price $ 30.00 $ 36.00 1.20
$ 35.00 $ 42.00 1.20
$ 40.00 $ 42.00 1.05
$ 45.00 $ 42.00 0.93
$ 50.00 $ 42.00 0.84
$50 4.00
3.50
$40 3.00
From the standpoint of the target investor, the collar for this fixed exchange rate deal 2.50
Share
Share
$30
2.00
$20 1.50
essentially consists of a long put option (with a strike price of $15.00) and a short call option 1.00
$10 0.50
0.00
$-
(with a$0strike price
$10
of $35.00).
$20 $30 $40
When
$50
combined with the
$5 stock
$10 $15position the
$20 $25 $30 $35payoff
$40 $45 presented
$50
share. Buyer and seller agree to a collar, which has a low trigger of $15.00 and a high
trigger of $40.00. Thus, the cash payment will be $30.00 for each share of the seller’s
stock, unless the buyer’s stock price falls below $15.00, in which case the exchange ratio
would be equal to 2 shares of stock; or unless the buyer’s share price is greater than
$40.00 in which case the exchange ratio will equal 0.75 shares of stock. Please calculate
and graph the number of shares issued for each share of the seller’s stock, assuming the
following share prices for the buyer: $0.01, $5.00, $10.00, $15.00, $30.00, $40.00,
$50.00, and $60.00. Also, calculate and graph the value of the bid with the collar at these
Insert the parameters into the model. You should obtain the following results:
Number of Buyer
Shares Issued Per
Buyer's Stock Value of Bid Target Share
Price With Collar With Stock Collar
"Fixed" Value per Target Share $30.00 $ 0.01 $ 0.020 2.00
Collar upper strike $40.00 $ 5.00 $ 10.00 2.00
Exch. Ratio above upper strike 0.75 $ 10.00 $ 20.00 2.00
Collar lower strike $15.00 $ 15.00 $ 30.00 2.00
Exch Ratio below lower strike 2.00 $ 30.00 $ 30.00 1.00
$ 40.00 $ 30.00 0.75
$ 50.00 $ 37.50 0.75
$ 60.00 $ 45.00 0.75
$50
Buyer Shares per
2.5
Target Share
$40 2.0
Share
$30 1.5
$20 1.0
0.5
$10
The diagrams of the combined position given in the above figures correspond to the fixed
collar.
7. Assume you as the CEO of a publicly listed company have just agreed to acquire a target.
You agree on an exchange ratio of two shares of your firm’s stock for one share of the
target’s stock, based on today’s market prices of both companies: $25 for your firm and $40
for the target. The deal needs to be approved by a government regulatory agency – this
process will take one year. To reduce the risk for the target arising from possible fluctuations
in your stock price, you agree to a collar. The collar would give the target’s shareholders cash
equal to the difference between $22 and your firm’s share price one year later, with a
maximum cash payment of $5 for each share of buyer’s stock. The annualized volatility for
the risk-free rate is 15%. Given a risk- free rate of 5% and 22% volatility for your stock, how
much is this offer truly worth to the target’s shareholders in term of share price? (For
simplicity, start by using the Black-Scholes Option Pricing model found in “Option
Valuation.xls” to get an approximate figure, then see what the simulation analysis reports in
“Collars Analysis.xls.”
To arrive at the true value of the deal, one needs to calculate the value of the collar. This
collar is assembled by a long put with the strike price at $22 and a short put with the strike
price at $17, which allows a maximum cash payment of $5 -- $22-$17. By using Option
Valuation.xls, one can arrive at the option value of the individual put options. The net value
of one collar comes out to $0.55. Since each target share will be exchanged for two shares of
your firm’s stock, the offer in terms of one target’s share is worth $51.10, which is equal to
$50.00 + $1.10.
The results from “Collars Analysis. XLS” suggest that the collar has an expected value of
$0.51. this is close to the value estimated using the Black-Scholes model, $0.55 per share.
The difference between the two values is likely due to the interdependence between the two
embedded options. The interdependence exists because when one option is “in-the-money,”
interdependence.
Life of the collar:
Life of collar: 365
Structure of the collar:
If one component is a long call:
Strike price: $ -
Payoff formula (text): Maximum of (stock price minus strike price) or zero
Payoff calculated: 0
If one component is a short call:
Strike price: $ -
Payoff formula (text): Zero minus the maximum of (stock price minus strike price) or zero
Payoff calculated: $ -
If one component is a long put:
Strike price: $ 22.00
Payoff formula (text): Maximum of (strike price minus stock price) or zero
Payoff calculated: $ -
If one component is a short put:
Strike price: $ 17.00
Payoff formula (text): Zero minus the maximum of (strike price minus stock price) or zero
Payoff calculated: $ -
Buyer's share price today: $ 25.00
Annualized v olatility of buyer's share price: 22.0%
Forecast of return of buyer's share price at closing of deal: -12.5%
Forecast of buyer's share price at closing of deal:$ 22.06
Risk-free rate of return today 5%
Annualized volatility of risk-free rate of return 15%
Standard deviation of annualized risk-free rate of return 0.8%
Forecast of risk-free rate of return: 5%
Statistics: Value
Trials 5000
Mean $0.51
Median $0.00
Mode $0.00
Standard Deviation $1.39
Variance $1.94
Skewness 3.89
Kurtosis 22.20
Coeff. of Variability 2.72
Range Minimum $0.00
Range Maximum $13.58
Range Width $13.58
Mean Std. Error $0.02
.596
.398
.199 993.7
.000 0
8. Refer to question 7. Suppose the approval period is not certain. Your best guess is that the
approval process will take one year, with a minimum time of half a year and a maximum
time of two years. The annualized volatility for the risk- free rate is 15%. Please use the
Monte Carlo simulation method to calculate the probability of a cash payment and the
Solution:
By defining a triangular distribution for the expected time period, one can value the collar
Statistics: Value
Trials 1000
Mean $0.64
Median $0.00
Mode $0.00
Standard Deviation $1.72
Variance $2.94
Skewness 3.64
Kurtosis 18.11
Coeff. of Variability 2.66
Range Minimum $0.00
Range Maximum $11.96
Range Width $11.96
Mean Std. Error $0.05
.584 583.5
.389 389
.195 194.5
.000 0
A trial run of 1,000 times results in a mean value of the collar of $0.64 per buyer’s share.
Therefore, the total worth of one share of the target’s stock is $51.28 ($50 + (2 * $0.64)).
The probability of zero cash payment in the future can be read from the risk profile as
77.8%, therefore the probability of any cash payment can be computed by subtracting 77.8%
from 1 to arrive at 22.2%, which may motivate the buyer to accept this deal.
9. Assume you are negotiating a deal with company ABC. Your current bid price is $56 per
share but ABC asks for $60 per share. To resolve the difference, company ABC proposes
that besides the $56 cash payment, there will be a contingent va lue right that will give ABC’s
shareholders the right to some cash payment at the end of three years if Newco’s stocks do
not perform well during this period. Assume one share of Newco is worth $40 today. The
contingent value right will permit a holder of Newco to receive a cash payment equal to the
difference between $50 and the stock price of Newco after three years, if Newco’s stock
trades below $50. The cash payment will be capped at $15. The annualized volatility for the
risk- free rate is 20%. Given a risk free rate of 6% and estimated volatility of 18% for
Newco’s stock, what does the deal cost the buyer in terms of each share of ABC’s stock?
(Again, as an experiment, use the Black-Scholes Option Pricing model to estimate the value
of the collar. The n estimate the answer using the simulation model in “Collars
Analysis.xls.”)
To arrive at the true cost of the deal, one needs to calculate the value of the collar. This
collar is assembled by a long put with the strike price at $ 50 and a short put with the strike
price at $35, for a maximum cash payment of $15 – within the boundaries of $50-$35. By
using the spreadsheet Option Valuation.xls, one can arrive at the option value of the
individual put options. The net value of one collar is computed at $5.12. Since shareholders
will receive $56.00 for each target share now, the offer in terms of one target’s share is
Turning to the simulation analysis, the results reveal that the collar is worth $4.33 per
share—again, the lower estimate compared to the Black-Scholes result is probably due to the
interdependence of the two embedded options, which the simulation captures, but which the
.348
.232
.116 579.2
Mean = $4.33
.000 0
10. Refer to question 9. Assume you would like to renegotiate with ABC the time period for this
contingent value right. Your best guess is that the final agreement will be 2.5 years with a
minimum of 2 years and maximum of 3 years. The volatility of interest rates is 20%. Please
use the Monte Carlo simulation method to calculate the expected value of this right and the
probability that you will have to make another cash payment in the future.
Solution:
By defining a triangular distribution for the expected time period, one can value the collar
.311
.208
.104 519
Mean = $4.76
.000 0
A trial run of 5,000 draws results in a mean value of the collar of $4.76 per share. Therefore,
the total worth of one share of the target’s stock is $60.76 ($56 + $4.76). The probability of
zero cash payment in the future can be read from the risk profile as 41.5%, therefore the
probability of any cash payment can be computed by subtracting 41.5% from 1 to arrive at
58.5%.
Chapter 24 Questions and Answers
True or False
1. Social issues usually relate only to a narrow group of people, which includes senior
2. Highly visible executives, such as CEOs, turn over more quickly than less visible ones,
3. While important, social issues do not directly affect the probability of successfully
equal influence. Industry specialists, however, often claim that the structure of MOEs
5. The MOE structure is believed to increase the resistance of target managers to a merger,
6. Research studies reveal that there is no significant difference in top management turnover
management team of the new company will want to create a strong brand identity;
8. Social issues often stimulate deal-related transactions such as side payments and complex
trade-offs.
9. There is a strong positive correlation between the size of firms and the compensation they
pay to senior executives (such as CEOs): the larger the firm, the greater the executive
compensation.
10. Social issues do not surface in early discussions of M&A; rather, executives wait until
after they have discussed the economics of a deal to see if it is even worth considering.
Answers to True or False Questions
affect a vast number of stakeholders, this narrow group of people has the decisive role in
2. T.
3. F. Settlement of social issues does directly affect the probability of reaching agreement
on an M&A deal. Social issues help to obtain the support of the target firm’s
management.
4. T.
7. F: The costs of a corporate name change can be material. These costs could include: new
signage and stationery, corporate identity advertising, and legal expenses associated
9. T.
10. F. Actually, social issues are routinely discussed first in negotiations of mergers and
acquisitions.
1. What are retention payments? In what form are they paid? What determines the size and
Retention payments are the terms of compensation for managers continuing with the new
company. They come in varying forms: ordinary salary and bonuses, and extraordinary
retention bonuses that pay managers for fulfilling specific terms of employment set over a
period of time. The market value of the executive’s skills outside the firm (i.e. what he/she
might be paid or offered by a competing firm) often determines the choice of payment size
2. What are Golden Parachute payments and when are they paid? Who determines and pays
target company’s board of directors determines the golden parachute payments; but the
entity surviving from the merger is obliged to make the payments under the parachute.
The key functions of the golden parachute payments with respect to a target company are
expensive hurdle for any buyer who might contemplate acquiring the target, and 3) to
hinder competing firms from making employment offers to their employees and dissuade
employees from leaving the firm if and when competing firms do present them with
attractive offers.
3. If target shareholders bear the cost of the MOE structure, how can one calculate an
To approximate the cost, one would take the difference between the acquisition premium
of a company under the MOE structure and the acquisition premium that would have
been necessary to complete the deal without the MOE structure, and then multiply by the
market capitalization of the target ex ante—this estimates the cost of the lost opportunity
The benefit of determining the leadership succession early in the merger agreement is
that it can encourage the named successor to stay with the firm. However, a drawback to
early determination is that the other potential contenders for the CEO position that were
not chosen may leave the firm prior to the deal closing.
5. In a merger transaction, what are three key considerations for determining the new
teams.
synergies at Newco.
c. The strategic fit of business units and individuals within the new
organization structure.
6. In a merger transaction, the buyer or target’s corporate name can be retained or a blended
name can be created. What message does each option convey about the ongoing firm?
Retaining the target’s name conveys a sense of continuity of the target, even if major
changes are taking place within the firm. Retaining the buyer’s name conveys both
continuity and dominance of the acquirer. This might not be appropriate or feasible in
an MOE transaction. Creating a blended name portrays equality between the target and
7. Explain why Daimler and Chrysler decided that a new public parent company should be
The parties realized that if they created the combined parent as a German corporation,
they would be better positioned to win the approval of important German constituencies,
teams of the two firms believed that organizing the new company under the laws of the
Federal Republic of Germany would help in their endeavor to structure the deal as a
Merger of Equals.
8. In the Hewlett-Packard (HP) and Compaq merger contest, how did Walter Hewlett use
This case shows that social terms could create a negative backlash among the firms’
shareholders, who may not see the payment terms as fair or appropriate.
9. Consider the vignette on Wachovia Bank’s acquisition plans in 2001, provided in the
chapter. Wachovia agreed to a Merger of Equals with First Union Corporation for $12.5
billion, but then SunTrust bank appealed directly to Wachovia’s shareholders with an
unsolicited offer of $13.7 billion. Why did the Wachovia-SunTrust negotiations not
succeed?
Wachovia’s management opposed the SunTrust bid on the grounds that the two firms had
Journalists and securities analysts suspected that the attractive social terms offered by
a. Why was there a retention plan for employees of BankBoston Robertson Stephens?
c. How and why did they differ from the retention plans created when BankBoston
a. The retention plan for employees of BankBoston Robertson Stephens was a deal term
of the Fleet Bank and BankBoston merger that was created to retain the various top-
performing executives, up to and after the deal closing. The plan was particularly
intended to retain the key executives who were instrumental in the continued success of
b. The retention plan was worth $800 million, which would be paid to the key
BankBoston Robertson Stephens employees if they remained with the firm though the
c. The value of this retention plan was significantly greater than the $200 million
retention plan created for 1996 merger between BankBoston and Robertson Stephens.
Since payment of the 1996 retention plan was scheduled to pay off within 18 months of
the 1998 Fleet BankBoston merger, the new retention plan was structured to extend the
tenure of key Robertson Stephens employees to 2001, three years after the closing of the
Fleet BankBoston merger. The sizable increase in the retention plan reflected the
importance of not only retaining the key employees who would benefit under the 1996
plan, but also fostering the rapid growth of Robertson Stephens and its continued
success.
Chapter 25 Questions and Answers
a. A deal usually originates from a search process identifying targets that will fit the
strategic goals of a buyer. The search process may take place from within the
consultant.
b. Once a target is identified, the buyer approaches the target to “pitch” the
proposal.
c. If the target is willing to consider the proposed deal, the broad outlines of the
deal are sketched. Financial and legal advisors are called in. Information is
confidentiality and exclusivity agreements, term sheets, engagement letters, etc. are
drafted.
d. At this point, the CEOs may brief their boards about negotiations, and a letter of
e. When the due diligence process is fairly complete, detailed negotiations of the
terms of the deal takes place, and the definitive agreement is drafted. The boards
2. Are parties to a deal obligated to issue a Letter of Intent during merger negotiations?
Does the Letter of Intent represent a binding agreement? Why are LOIs used?
No to both questions—parties are not obligated to issue LOIs, and LOIs are not binding
agreements. Despite this, LOIs are used to create momentum between the two sides and help
3. What are some of the first-round documents that may be drafted in a merger? In general,
Examples of first-round documents include the term sheet, the exclusivity agreement, the
engagement letter, the confidentiality agreement, the standstill agreement, and the letter of
intent. First-round documents are usually issued after the buyer and target have initiated
talks and are open to the possibility of a merger, but before a definitive agreement is
reached. Thus, these documents are risk-management devices that are usually meant to
ensure confidentiality and exclusivity while the parties are gathering and verifying
4. What factors might parties to a deal consider when deciding whether or not to issue a
when making this decision. If trust between parties is low and the probability of leakage is
high, it is best to draft first-round documents. If trust is high, the probability of leakage is
low, and speed and secrecy are crucial, some first-round documents may be unnecessary.
Executing the first-round documents may trigger public disclosure obligations, the news from
5. What, according to the Supreme Court, are the factors a company must consider in
The factors that must be considered are a) the significance of the transaction to the company,
A standstill agreement is one in which the buyer commits to not purchasing shares of the
target for a specified period of time. Loss of control is the risk that it helps the target
manage. By limiting the buyer’s shares, a standstill agreement helps prevent the buyer from
7. Give an example of a material adverse change. How might it derail the deal process?
A change in business conditions is an example of a material adverse change. For instance, if
oil prices suddenly drop, two oil companies that are in merger discussions might postpone or
8. How might a sudden change in share prices derail the deal process? Explain.
If shares are used as the medium of exchange in a merger, a sudden change in share prices
may derail the deal process by affecting the value of the transaction. For instance, if the
acquirer’s share price drops, the seller may view the acquirer’s effective purchase price as
inadequate, and demand a higher exchange ratio. The buyer may refuse to accede to the
seller’s demand to avoid severely diluting its equity stake. For more on this, see Chapter 23.
Chapter 26 Questions and Answers
exercises governance through the processes of executive hiring and firing, compensation,
Agency costs destroy value and arise when an agent (e.g. management) acts in conflict with
the interests of the fiduciary (e.g. shareholders). Conflicts arise because of breakdowns in
among investors and directors to influence a firm’s board and managers. “Exit” simply
shareholders
shareholder wealth
financial contracting.
is known as jawboning.
Yes. In general, firms with stronger governance practices are more highly valued by the
Investors can influence managers and directors through mechanisms such as proxy fights,
votes) for a non-voting share that pays a higher dividend. A few special shareholders retain
The duty of loyalty states that directors must make decisions in the interest of shareholders
and must avoid conflicts with other interested parties. Directors should not participate in
any self-dealing.
The duty of care states that directors must be careful in considering all aspects of issues
before them; they must be well informed. Directors must not shirk from their responsibilities.
Under the business judgment rule, courts are unlikely to intervene if directors and officers
fulfill their duties in good faith, i.e. if they are not conflicted, are informed, and act in
rational belief.
10. What is the enhanced business judgment rule? When does the enhanced business judgment
takeover bid. In cases where the business judgment rule is applicable, courts are unlikely to
intervene as long as directors exercise their duties in good faith. In contrast, when the
enhanced business judgment rule gets triggered, directors are held to a higher standard of
scrutiny before the protections of the business judgment rule are conferred on directors.
Steps taken to evaluate directors’ actions may include obtaining opinion letters, forming an
detail.
11. What two tests must be met for courts to rule that directors have performed their duties in
a. The board must show it had reasonable grounds for believing a danger existed to the
The “Revlon Rule” requires boards to maximize shareholder value (e.g., by auctioning the
firm) when it is evident that the firm is to be sold and there are multiple bidders. The Revlon
rule gets triggered when a sale of the firm is inevitable. The directors’ role changes “…from
defenders of the corporate bastion to auctioneers charged with getting the best price for the
3
Revlon, Inc. v. MacAndrews & Forbes Holdings, Supreme Court of Delaware, 1986 506 A. 2d 173.
Chapter 27 Questions and Answers
The aim of securities laws is to inform investors, prevent manipulation, produce more
One determines whether a fact is material by asking the question, “Would you want to know
The Securities Act of 1933 requires that new securities be registered with the SEC. Through
The registration statement is a document submitted to the SEC that contains the prospectus
and other forms. The prospectus describes the business of the issuer, the issuer’s financial
condition, the capitalization, the purposes for raising the new funds, etc. A red herring is a
preliminary prospectus meant to inform investors while the registration is being approved by
the SEC.
A registration is declared to be effective by the SEC when it is satisfied with the completeness
The Securities Act of 1934 lays out rules regulating securities exchanges and the securities
traded in the public markets. It also requires corporations with assets greater than $10
million and more than 500 shareholders to register with the SEC. These companies are
7. What is the Williams Amendment to the Securities Exchange Act of 1934? What are the
The Williams Amendment requires hostile bidders to disclose any information to target
shareholders in connection with a bid. The four “rules of the road” are:
• Early warning. A buyer must notify the SEC within 10 days upon the accumulation of 5
• Equal treatment. All target shareholders must be treated equally by the buyer.
• Cash offers too. Cash tender offers are also subject to the anti-fraud and registration
8. Do states have jurisdiction over securities registration? What are “blue sky” laws?
States are permitted to have jurisdiction over securities registration as long as they don’t
conflict directly with the provisions of the ’34 Act. The “blue sky” laws allow states to bar
transactions that federal laws would permit. Still, the SEC/federal laws are the supreme
authority – one must register stock for sale in every state where the stock is to be marketed.
9. What are the two theories of insider trading liability? Explain each.
The two theories of insider trading liability are the classical theory and the misappropriation
theory. The basis for prosecution in classical theory is deception, defined as a failure to
disclose information, or to abstain from trading. Under misappropriation theory, the basis
the SEC?
The waiting period is the time between the filing of a registration statement, and the date
when the registration becomes effective. One cannot buy or sell securities during this period,
but can make oral offers and receive preliminary indications of interest in buying the
securities.
Chapter 28 Questions and Answers
production agreements. Trusts might harm consumers by charging prices higher than those
A contestable market is one in which only a few firms exist in an industry, yet oligopoly
pricing does not result because the firms behave competitively in anticipation of easy entry
by firms outside of the market. Prices are kept low enough so that potential new entrants do
3. What two conditions are necessary for a merger to have an anticompetitive effect?
The two conditions necessary for a merger to have an anticompetitive effect are:
b. the merger must raise barriers to entry by new firms into the market in the near term,
The Sherman Act outlaws anticompetitive behavior. It considers the following illegal:
a. contracts that attempt to restrain trade or commerce among the different states and
The Clayton Act specifically addresses mergers and acquisitions, preventing combinations
that would restrain trade. The Clayton Act forbids acquisitions whose effect may be
The Hart-Scott-Rodino Act requires combinations above a certain size threshold to submit
information to the DOJ and FTC in advance of consummating the deal. This law grants the
The agencies that enforce antitrust laws are the Antitrust Division of the Department of
Justice (DOJ) and the Federal Trade Commission (FTC). The DOJ prosecutes violations of
the Sherman Act as criminal felonies. The FTC enforces the Federal Trade Commission Act
and parts of the Clayton Act, both of which do not entail criminal sanctions.
8. Define what horizontal, vertical, and conglomerate mergers are. What motivates each type of
merger?
o Horizontal mergers occur among peer competitors in an industry (such as two shoe store
chains for example). Horizontal mergers can help firms achieve greater market power
o Vertical mergers occur among firms within the value chain (such as a supplier and a
customer). They may help firms increase revenue through greater product offerings and
o Conglomerate mergers occur among firms unrelated by value chain or peer competition.
They help firms increase sales within the conglomerate. They may also be motivated by
the belief that the central office has key know-how in allocating capital and running the
The two quantitative measures are the cross elasticity of demand and the Herfindahl-
Hirschman Index. The cross elasticity of demand measures how closely related demand is
for two different goods. The relationship is measured as the change in demand for one good
measures market concentration based on market shares of players in the relevant market.
10. Firm A, a manufacturer of butter, wants to acquire Firm B, a manufacturer of margarine. The
Federal Trade Commission wants to determine the economic relationship between butter and
margarine. A review of prices over the last 20 years reveals that the demand for margarine
rises 3% for every 1% increase in the price of butter. Calculate the cross elasticity of demand
Values greater than 1 indicate elastic demand. In this case, demand for margarine is highly
11. Listed below are the top ten book publishers, ranked according to fiscal year 2000 revenue:4
2000
Revenue
(in $ MM)
McGraw Hill Cos. Inc. 4,281.0
Scholastic Corp. 1,402.5
Houghton Mifflin Co. 1,027.6
John Wiley & Sons Inc. 594.8
Thomas Nelson Inc. 265.5
Hungry Minds Inc. 243.3
Marvel Enterprises Inc. 231.7
Golden Books Family Ent. 148.9
Information Holdings Inc. 73.3
Millbrook Press Inc. 21.4
companies are given below. Calculate the HHI indices pre- merger and post- merger. Do you
Scholastic Corporation
“Selling more than 325 million books annually, Scholastic Corporation is a leading
the Babysitter’s Club and Clifford the Big Red Dog series, as well as on newcomers,
most notably the wildly popular Harry Potter series…Scholastic also specializes in
educational materials, publishing 35 magazines that are read by more than 20 million
4
Jack W. Plunkett, Plunkett’s Entertainment & Media Industry Almanac 2002-2003, p.87.
company operates in the licensing, comic book publishing and toy businesses in both
Spiderman, X-Men, Captain America, Fantastic Four and the Incredible Hulk…”6
Summary
Market HHI before the deal 3,188.9
Market HHI after the deal 3,283.4
Change in market HHI 94.6
5
Ibid., p. 411
HHI Indexes after the contemplated transaction
Based on Revenues
2
Revenues % Market Share (Market Share)
Market Players
McGraw Hill Cos. Inc. 4,281.0 51.6 2666.7
Houghton Mifflin Co. 1,027.6 12.4 153.7
John Wiley & Sons Inc. 594.8 7.2 51.5
Thomas Nelson Inc. 265.5 3.2 10.3
Hungry Minds Inc. 243.3 2.9 8.6
Golden Books Family Ent. 148.9 1.8 3.2
Information Holdings Inc. 73.3 0.9 0.8
Millbrook Press Inc. 21.4 0.3 0.1
Scholastic + Marvel 1,634.20 19.7 388.6
Total 8,290.0 100.0 3283.4 HHI
There may be valid reasons for both permitting and not permitting this transaction.
Although both pre- and post-transaction HHIs suggest a high degree of concentration, it
could be argued that information is provided only on the top ten book publishers whereas in
reality there may be many more book publishers such that the HHIs when all book publishers
are considered might reflect a much lower degree of concentration. In addition, while
Scholastic and Marvel overlap somewhat in their target markets (i.e., the children’s market),
their product offerings are markedly different. Marvel’s target market segment seems much
broader than just the children’s market. Perhaps the most important takeaway from this
exercise is that one cannot make a decision to approve or disapprove a transaction based
only on HHIs.
12. What other guidelines do the regulatory agencies use to determine whether to approve or
6
Ibid, p. 326.
Other guidelines used by the regulatory agencies are:
a deal. The purpose of first-round documents is to deal with risks that may arise before a
information received from the target and to use it for no other purpose than consummating
the transaction. The agreement also lays out the information to be provided and the
channels through which it is to be accessed. The target may seek relief in the event that the
agreement is violated.
An exclusivity agreement binds a target to not share information or seek discussions with
other potential buyers over a specified period of time during which the merger agreement is
approval from the target’s board of directors. Its objective is to prevent the buyer from
pressuring the target by short-circuiting merger negotiations through open market purchases
5. What information does a term sheet contain? What is the purpose of having a term sheet?
A term sheet contains a brief summary of terms of the deal such as price, form of payment,
structure, social issues, etc. Although not a binding agreement, the term sheet establishes a
sense of alignment between the two parties, and provides a framework upon which to draft
6. What is a letter of intent? Why do some M&A advisors advise against issuing an LOI?
A letter of intent is an agreement to agree on the intent of the deal negotiations up to that
point. Some M&A advisors advise against signing an LOI because it is not contractually
consummating a deal. It is a risk management device that binds both parties to carry out
steps leading to the consummation of a deal, and to abide by certain rules of conduct.
Breaches of the terms of agreement subject the offending party to penalties, and may bring
about litigation. Unlike the Letter of Intent, a definitive agreement is binding (subject to
The “Parties to the Deal” component clearly indicates who the parties to the transaction
are. Defining who is in the deal is important for delineating who exactly has commitments to
perform under the contract. Also, defining who is in the deal establishes exclusivity, the
The “Recitals” component conveys what the parties to the deal want to accomplish. This
component helps readers understand the motivations for the deal. It sometimes also provides
a general idea of the transaction by offering information such as the structure of the merger,
11. What information is contained in the “Description of the Basic Transaction” section?
The “Description of the Basic Transaction” section contains information about how the deal
will be consummated. Details provided in this section will usually include the form of
exchange, the price or the exchange ratio, information about the treatment of options and
warrants, the merger structure, the targeted closing date and social issues. This section
might also specify the future registration rights of any non-registered shares issued by the
12. What are the three ways in which the sellers’ rights to register shares might appear?
Provide an explanation for each of the ways. Why is it important to include a provision in
The three ways to register shares are 1) on demand, 2) shelf, and 3) piggy-back. On demand
registration permits the seller to require the buyer to register shares when the seller wants.
Shelf registration requires Newco to maintain an effective registration statement with the
SEC for a relatively long time period, and permits the target shareholders to register under
these documents. Piggyback registration allows the seller to demand registration only when
Newco is registering other shares. Provisions for registering shares are important because
13. What is in the “Representations and Warranties” section? What is the difference between
important?
The “Representations and Warranties” section contains disclosures about the condition of
the buyer and seller at the time of the transaction. In effect, this section provides a snapshot
of the buyer and seller as of a certain date. A representation is a statement of fact while a
warranty is a commitment that a fact is or will be true. The reps and warranties can trigger
an exit with no liability if the other party’s representations and warranties are shown to be
false. By the same token, this section gives a foundation for indemnities after the closing of
the deal.
a. Sellers are less concerned about the condition of the buyer if the buyer pays in
b. If a representation or warranty is found to be false after the closing of the deal, the
b. False. Reps and warranties expire at the closing of the transaction, unless explicitly
In the covenants section, the buyer and seller promise to do or not do certain things between
the signing of the agreement and the closing date. Covenants prevent opportunistic behavior
by either party.
This section lists the conditions that each side must observe in order to consummate the
approvals, absence of material litigation, consents from third parties, and opinions from
professional advisors. The failure of one party to meet the closing conditions allows the
The termination section lists the circumstances under which the parties can unilaterally or
mutually terminate the transaction. Some provisions may include termination fees.
The indemnifications section specifies damage payments in the event of losses discovered
A proxy is an authorization to act for another. Corporations send out proxy statements to
21. What is a merger proxy statement? What information does a merger proxy statement
usually contain?
In most cases a merger proxy statement is a document that asks shareholders to vote for (or
against) a merger. At their most basic level, merger proxy statements contain information
about terms of the proposed deal (e.g. price, form of exchange, organizational structure),
rationale and background of the deal, financial and tax impact of the deal, requirements for
consummation, proof of financing on acquirer’s part, fairness opinions, regulatory matters
22. Infant World and Busy Bee have agreed to a merger of equals. Busy Bee has an
Employees Stock Option Plan (ESOP) with options unexercised on 923,000 shares, 2.0% of
the company’s total outstanding shares. The ESOP had a clause that would allow shares to
vest automatically if Busy Bee were acquired or became party to a merger. The merger
proxy statement made no mention of the unexercised options on the shares. Should this
The unexercised shares could have a material impact on the accretion or dilution of the deal
This information is important to investors and should have been disclosed. If the two firms
are publicly held corporations, the SEC would review the proxy statement and probably
require disclosure.
23. Does having a fairness opinion from a financial advisor mean that a deal is good for
shareholders? Explain.
Not necessarily. All that a fairness opinion suggests is that the consideration paid is “fair”
from the standpoint of shareholder welfare, not that this deal is “best” in comparison to
24. Why do proxy statements disclose the number of shares held by directors and officers?
This is to disclose fully the potential personal interest of officers and directors in a deal.
25. Why do proxy statements often contain information on financing arrangements for the
Assurance of funding is an important signal that the deal can be consummated and of the
credibility of the bid. Acquirers will want to prove that the funding necessary to back up the
26. Why are the target’s Articles of Incorporation and By-Laws often amended in connection
with a merger?
A target’s articles of incorporation and by-laws are often amended to remove obstacles (such
as anti-takeover defenses) to a merger. By-laws are often amended to reduce the size of the
board, to change voting procedures and terms of directorship, and to eliminate other defense
mechanisms.
27. Companies often have what is called a “Rights Agreement.” What is this and what is its
purpose?
A rights agreement gives shareholders the right to buy shares at a given exercise price
(usually below market) in the event of a takeover. It is also known as a poison pill. Poison
pills are meant to discourage unwanted offers by making the acquisition more expensive for
the buyer, and by diluting whatever equity stake the buyer has already accumulated.
A keepwell covenant is a promise by the acquirer to meet all obligations of the target as they
come due should the target be unable to meet them. This pledge is important for assuaging
29. What is the purpose of the “Conditions to the Offer” section of a proxy statement?
The Conditions to the Offer section enumerates the conditions under which the acquirer has
no obligation to make good on its offer to acquire shares. This section therefore is a risk
ZOPA stands for “Zone Of Potential Agreement.” It exists when there is an overlap between
the ranges of values a buyer is willing to pay and a seller is willing to accept.
2. What is BATNA? Why is it important to have one during negotiations? Please give an
example of BATNA.
important because it helps set the walk-away price for buyer and seller, and therefore
prevents either party from getting caught up in deal frenzy when the price is outside of either
party’s feasible range. A classic example of BATNA would be one that involves a make
As buyer (seller), to anchor is to open with a price high enough (low enough) to motivate the
counterparty to lower (raise) expectations about the likely settlement price. It is generally an
effective strategy to anchor, although one must be careful not to do so with an unreasonably
What does the occurrence of these two phenomena suggest about behavior in deal making?
The endowment effect is a phenomenon where people tend to ask more in selling an asset
than they would offer to buy it. The status quo bias is involved in situations where people
stick to their current situation because the disadvantages of changing seem larger than the
advantages. Both phenomena are due to loss aversion. The occurrence of these phenomena
suggests that parties to a negotiation do not always behave “rationally” in economic terms
o Assess the current strategic position and alternative strategic actions for buyer and
target.
o Anticipate tradeoffs.
o Reflect on persuasion.
If either buyer or seller (or both) invests significant amounts of time and money to prepare
for negotiations, they may feel compelled to complete a deal at all costs. Another example,
in the seller’s case, is being unwilling to take a loss on the asset being sold. For instance, if
a seller is disposing of an asset in which it invested $100 million but which is worth only $20
million today, the seller may insist on being able to reclaim the $100 million.
7. Why is it advisable to conduct multi- issue, parallel bargaining rather than single- issue, serial
bargaining?
Multi-issue, parallel bargaining allows both parties to give and take on different issues,
likely to cause a stalemate when the parties are completely at odds about the issue.
Creating, rather than claiming, value means to enlarge the pie for the benefit of all parties
rather than to aim for as large a slice of a fixed pie as possible at the expense of other
parties. In other words, creating value means transforming a situation from a zero-sum
Three ways to address a stalemate are to change the rules of the game, change the players,
1. What are the five methods of sale discussed in the chapter? Describe each method and
Beauty contest Interested buyers Judges have greater Slow, opaque, and
Choice of buyer is
doors.
competence, etc.
other criteria.
draws more
potential buyers.
2. Auctions can be classified as open versus sealed, single versus double, common value versus
In an open auction bids are made public while in a sealed-bid auction, only the seller sees
the bids. In a single auction only the buyers bid, while in a double auction buyers bid and
sellers offer prices at which they would be willing to consummate a deal. In a common value
auction, the asset being sold has similar use to all buyers. In a private value auction values
price sealed bid auction? What are the advantages and disadvantages of each method?
seller. buyer.
• Transparency. • Reduces
seller. No
chance to
evaluate buyer
on other criteria
such as fit,
competence, etc.
• Vulnerable to
collusion.
• “Winner’s
curse”
on other
criteria.
maximized.
disadvantages?
Auctions allow sellers to maximize revenue, motivate buyers to bid with speed and at higher
prices, and are relatively faster, fairer and more transparent. But auctions reduce the
flexibility and discretion of the seller by committing the seller to decide on a process.
Auctions may also be subject to manipulation by buyers. Finally, auctions may discourage
entry by prospective bidders because auctions are so successful in maximizing revenue to the
seller.
The “Winner’s Curse” refers to overpayment by a winning bidder for an asset put up for sale
in an auction. Since the winner makes the highest estimate for the asset, the implication is
that everyone else had a lower estimate of the asset’s value. Deal frenzy often gives rise to
7. Why must the effective M&A practitioner master the art of multi- attribute bidding in
auctions?
The effective M&A practitioner must master the art of multi-attribute bidding because
auctions are not always settled solely by price. Price is just one consideration within the
Yes – if an asset is unique, selling by auction is advisable. Since a unique asset is scarcer,
bidders are likely to compete more fiercely – an auction will pit bidders against each other
and will be likely to drive up the price, maximizing revenue for the seller.
Chapter 32 Questions and Answers
A hostile takeover is one in which an unfriendly buyer offers an unsolicited bid for a majority
2. The investment opportunities hypothesis says that takeovers are motivated by the buyer’s
desire to purchase a target at a low valuation, improve its operations and gains in efficiency,
The inefficiency hypothesis, which holds that takeovers are motivated by a desire to improve
operational inefficiencies and profit from them. The investment opportunities hypothesis
suggests that targets simply present attractive investment opportunities owing to strong
3. What is an M&A arbitrageur? How might M&A arbitrageurs define the outcome of a
takeover contest?
the target’s shares and a short position on the seller’s shares. This hedged position exposes
the arb only to the risk that the deal will not be completed, i.e. the risk that the arb sees to
take. Arbitrageurs may define the outcome of a takeover contest if they accumulate a large
An M&A arbitrageur’s returns are most sensitive to the price offered per share, and to the
length of the holding period. The price offered determines the payoffs on the investment, and
therefore affects the returns. The length of the holding period affects the arb’s returns
because of the time value of money. The longer the holding period is, the greater the interest
for a large one-time dividend to all shareholders and/or a large one-time share repurchase.
A target may use a leveraged recapitalization as an anti-takeover defense, in the hope that
the added leverage and payment of cash to shareholders will make the target less attractive
to a hostile bidder.
6. All things equal, should a bidder make a tender offer with a shorter or longer holding
period? Explain.
The bidder has a greater chance of winning if it chooses a shorter holding period. A longer
holding period gives the target time to execute anti-takeover defenses or to look for other
buyers. In addition, a shorter holding period is favored by arbs since it increases their
returns. The vote of the arbs could determine the outcome of the deal. Therefore, a shorter
7. What should a bidder consider in determining its highest or walk-away bid and its lowest
bid?
The walk-away price should be determined by the bidder’s reasonable estimate of the “high”
end of the target’s intrinsic value. For the low bid, the bidder may need to consider factors
other than the target’s current market price. For instance, the bidder needs to consider the
possibility of competing bids, or of self-initiated restructuring that the target might take on.
This is a merger of the target with the buyer (or subsidiary of the buyer) that forces an
unwilling remainder of shareholders in the target company to give up their shares in return
for payment from the target. Target shareholders are said to be “frozen out” of the target by
the compulsory nature of a merger in which the majority of target shareholders approve the
merger.
EVNT stands for the “Expected Value of Not Tendering” (i.e., the value to target
shareholders if they do not tender shares to the hostile bidder). Share prices are estimated
under two scenarios: (a) if no shares are tendered to the raider and share prices subside to
the ex ante price; and (b) if no shares are tendered to the raider, but they are tendered to a
higher competing bidder who buys the firm. These prices are then multiplied by their
10. In economic terms, what needs to happen for target shareholders to tender their shares?
The value of tendering (i.e. the bid price) must be greater than the expected value of not
tendering (EVNT).
Like the stub of a movie ticket that remains with a viewer after entering a theatre, stub shares
are the shares of a company that remain in the hands of shareholders after a
recapitalization.
12. What is a bear hug? What is the advantage of using this strategy?
A “bear hug” refers to a high initial bid. This strategy deters competitors and pressures the
target’s directors to accept the offer. Knowing this, arbs will tend to support the bid.
Accordingly, the high bid strategy raises the probability of winning the contest.
A low bid strategy would be appropriate when the bidder is patient and/or confident that
14. Scott Siegel, manager of an M&A hedge fund, watched the tape go across his Bloomberg
screen at 4:00 p.m. on June 13, 2001. Celera Genomics, a Rockville company known for
mapping the human genome, announced it would acquire AXYS Pharmaceuticals Inc., an
integrated small molecule drug discovery and development company. The deal was
structured as a stock swap in which AXYS shareholders would receive 0.1016 Celera
share for each AXYS share. Celera had closed the previous day at $41.75, and AXYS at
Based on Celera’s last closing, the effective purchase price for AXYS would be $4.24. As an
M&A arb, Siegel would immediately take a long position in AXYS and a short position in
Celera on the bet that the seller’s share price would decline while the buyer’s share price
would rise.
15. Assume that the acquisition was completed in 5 months (150 days). Assume further that
Siegel purchased 300,000 shares of AXYS at an average cost of $4.15, and shorted
29,800 shares of Celera. Siegel funded 70% of his purchase with debt. Celera’s share
price on the closing date was $27.43. Assuming a borrowing cost of 8%, calculate the
return on Siegel’s investment for the holding period and on an annualized basis.
Days in Holding
Period
Assumptions 150
Position and Payoff in Target Shares
Buy Target shares at $ 4.15
Payoff on Target shares at end $ 2.79
Gross Spread Per Share on Target shares $ (1.36)
Total value of Gross spread on Target Shares (Times # shares =) 300,000 $ (408,933.60)
Results
Return on capital for holding period only 1033%
Return on capital annualized 2514%
16. Healthy Land, Inc. (HLI), a waste management services company, wants to acquire
Spitzer’s Environmental Services (SES). HLI has determined that its purchase price
should not exceed $44 per Spitzer share. The shares currently trade at $28.50 apiece.
Members of the Spitzer family (which owns 40% of the company) occupy all board seats
and are determined to keep the company within their control. Their consultants have
drawn up a restructuring plan that, by their estimates, could raise the value of Spitzer to
$42 a share. An aggressive raider named Mathias Martin is reportedly going to join the
bidding contest. HLI thinks Mathias will place a bid of $35.00. HLI estimates a 50%
chance that the Spitzer family will win the bid, a 30% chance that Martin will win, and a
20% chance that neither scenario will materialize. Should HLI put in a bid? If so, how
much should HLI bid? Please draw a decision diagram facing the investor.
To decide on its bid price, HLI should consider things from the investor’s point of view. The
investor has to decide whether to tender to HLI or not. If the investor decides not to tender to
HLI, he/she is faced with three scenarios, as illustrated in the investor’s decision diagram below:
Tender to HLI
.50
The expected value of not tendering (EVNT) = (.50*$42) + (.30*35) +(.20 *28.50) = $37.20.
Therefore, HLI must bid a price above $37.20 to increase its chances of winning, and below
$44.00.
Chapter 33 Questions and Answers
True or False
1. Whether defensive tactics create or destroy value for target shareholders depends on both
2. Research evidence shows that targets of hostile bids have higher debt and inside
4. The “Saturday Night Special” is a surprising offer to the target board that is left open
5. A godfather offer is a cash offer that is accompanied with an implied threat, which
6. Golden parachutes grant target managers generous payments if they decide to stay at the
1. T. The effectiveness of defense tactics depends on the degree of uncertainty regarding the
target’s intrinsic value, as well as the quality of the target firm’s corporate governance.
2. F. As mentioned in the chapter, the research findings reported in the August 1985 issue
of Securities Regulation and Law Reporter (page 1479, “Merger, Takeovers Increasing
Pressure on Outside Directors”) show that targets of hostile bids have lower debt and
3. T.
4. T.
5. F. A godfather offer is a cash offer that is so high that the directors feel unable to refuse
it.
they are terminated following an acquisition that changes control. If managers are given
generous payments to stay at the firm, those are probably “retention payments.”
7. T.
8. F. The poison pill is a detachable shareholder right to obtain shares at nominal cost
9. T.
1. If most public corporations have not been subject to a hostile takeover contest, why are
• It offers flexibility to a company’s board and management in the case that the
A “street sweep” is the purchase of a target (and thus control of the target) via the open
market. A “drop and sweep” is a street sweep that follows a withdrawal of a buyer’s
tender offer.
Toehold purchases seek to obtain a material position of the target’s equity shares in order to:
d. Earn a consolidation profit in the event that the target is won by another
higher bidder.
The Williams Act stipulates that a bidder must notify the SEC upon surpassing a five
percent stage in the target. It is important because it takes out the element of surprise of
sizable open market block purchasing of shares, and puts an effective “cap” on using the
5. What is the key difference between a proxy contest and consent solicitation?
A proxy contest is one in which a buyer submits an acquisition approval request to the
literally a legal document by which shareholders can vote an absentee ballot). A proxy
contest can be run in a fashion similar to that of a political campaign, with investment
a. Attitude of target management and board. The strength with which the target
management and board of directors will resist an unsolicited bid will dictate how much
time and effort a bidder will need to devote to win their support.
(institutional investors and founding families) or a disparate group will dictate the
effectiveness of different tactics. For example, a tender offer would probably work better
c. Strength of target defenses in place. Different target defenses have different degrees
of defensive power. For example, the poison pill is typically viewed as a “showstopper.”
make it more difficult for a company to make a successful takeover attack. When there
are competing bidders and a white knight, (any of whom may be favored by target
management), a hostile buyer will need to appeal directly to shareholders through a
7. Where do deal-embedded defenses appear and what are they intended to do? Do they
intended to raise the ante for a hostile bidder. In addition, they are also intended to deter
8. What is the fair price provision and does it have much of a presence in the U.S. markets?
The fair price provision is an amendment requiring that all selling shareholders receive
the same offer price from a buyer. This prevents a discriminatory offer from a bidder
(i.e. greenmail) that seeks to induce target shareholders to sell. Many states in the U.S.
now require that takeover bids carry a “fair price” for shareholders.
A white knight is a company sought by a target company for the purpose and intention of
a friendly merger (often as a defense against an unsolicited bid from a hostile raider).
Unlike a white knight, a white squire merely purchases a large block of stock in the
target.
True or False
1. A crash in the stock market might serve to temporarily remove a takeover threat for a
company.
4. The special rights afforded by a poison pill can be amended and rescinded by a board of
6. With the MBO, managers are absolved from having to concern themselves with the
7. “The Revlon Standard” stems from a 1986 case in which the court ruled that when a
company puts itself up for sale, stakeholder interests can be considered only in light of
9. A leveraged recap can be particularly effective when the initial hostile bid is high.
1. T.
2. T.
4. F. The special rights afforded by a poison pill can be amended and also rescinded by a
5. F. In a leveraged recapitalization, the equity remains in the hands of the original owners
and thus, the company will remain a public entity. An MBO results in a privately owned
company.
6. T.
7. T.
8. F. The target company needs to have low leverage: with very little debt and substantial
9. F. Only the contrary, a leveraged recap can be particularly effective when the initial
hostile bid is low. In the case of American Standard, the company performed valuation
analysis based on an LBO that showed a higher valuation than the initial low bid made
by Black and Decker. Because Black and Decker’s initial hostile bid was low, it was
clear to the company that the bid was unacceptable based on its leveraged recap
financial analysis.
10. T.
Short Answer Questions
1. The diverse nature of American Standard was thought to be a deterrent to many potential
buyers. Why can business diversity make a company less attractive for acquisition?
Business diversity can make a company less attractive for acquisition because the
company may have little to no concentrated focus from which the acquirer could obtain
synergies. Even if the target does have a core business, the potential buyer may not be
interested in acquiring non-core business assets that it would end up divesting after
acquisition.
It is also true, however, that a highly diversified firm might be acquired at a price less
than the sum of the values of its parts. Thus, a hostile bidder might acquire the target,
sell the pieces, and pocket a gain—such is the theory of the “bust up” acquisition.
2. What does the Delaware Anti-Takeover Statute stipulate? Why was it designed?
incorporated in Delaware may not combine with any “interested stockholder” for a
b. The interested stockholder owns at least 85% of the common stock outstanding
c. At least 66.67 percent of the shares outstanding not owned by the interested
The Statute was designed to encourage full and fair offers and to discourage abusive
takeover tactics.
3. Aqua Toys Inc. wanted to acquire Toy Land Company (“TLC”) and thus made a tender
offer to the shareholders of Toy Land at $45, a price that represented a significant
premium to TLC’s current stock price. The offer was set to expire on January 31.
Aqua Toys then decided to raise its bid to $60 and extend the deadline because only a
small fraction of shares had been tendered as of January 30. How might you explain why
The low response rate could be an indication that arbitrageurs were buying up large
blocks of Toy Land in expectation of subsequent higher bids made by Aqua Toys or other
interested buyers.
4. If there has been no instance in which a company’s golden parachute has defeated a
hostile bid, why do over 350 firms of the Fortune 500 have golden parachutes in place?
Even though a golden parachute has never defeated a hostile bid to date, golden
parachutes still offer a couple of key benefits to companies. They raise the takeover costs
for buyers while also providing the incentive to keep key employees at a target firm.
Like other defenses, the provision will not completely protect a company from
5. Why might a white knight pay for a hostile bidder’s tender offer expenses?
A white knight might pay for a hostile bidder’s tender offer expenses in exchange
for the bidder’s agreement to make no subsequent takeover attempts of the target
company.
directors
b. Filing a lawsuit
Black and Decker made this two-pronged assault on American Standard’s poison pill.
due to exemption from public reporting; liberation from public shareholder concerns and
Drawbacks: Equity shares become illiquid since they are no longer traded in the
shareholders in the buyout negotiations and to seek a third-party fairness opinion for
8. How can the substantial increase in corporate leverage resulting from a restructuring
b. Send a positive signal to the capital markets about the company management and
lenders’ confidence that future cash flows will be able to service the new debt
load.
9. What are some key differences between an MBO and a leveraged recapitalization?
securities.
d. Under the MBO, all owners are insiders. With a recap, some equity investors are
e. There is greater potential for conflicts with an MBO than for a leveraged recap,
more difficult given the change in ownership and control of the “going-private”
company.
Restructurings are inherently complicated and difficult to develop. Moreover, they are
Poor presentation can break a deal. The presentation shapes understanding and
expectations, which if done poorly, can haunt a manager later on. A deal that is not
presented well to a CEO and/or board of directors may be rejected. Or, a deal that is not
presented well to shareholders and capital markets may fail to receive shareholder approval.
Finally, a deal may fail to pass government scrutiny if it is not presented well to regulators.
2. Reflecting on the classic challenges to preparing an effective presentation, what steps should
First, establish clear objectives for your presentation. What are you trying to accomplish
with it? Second, clarify the perspective and “bandwidth” of the audience. Knowing your
the balance between secrecy and disclosure. Fourth, consider the mixture of objectivity and
advocacy—what does the mission of the presentation call for? And finally, consider the
adjustment in expectations that may be required. Executives and markets do not like
negative surprises. Consider carefully the signals your presentation might give and whether
Good deal presentation is objective, focuses on what is important, addresses strategic issues,
highlights key drivers of success, explores “what-if” scenarios, presents only the needed
information, and is tailored to meet the demands of the specific audience. By being all of the
above, a good deal presentation gives senior management and directors tools to ask the right
4. What are the four classic kinds of deal presentations discussed in the chapter? For each type,
motivate.
public
5. When first announcing a deal to the public, is it advisable to say as little as possible? Why or
why not?
The first public announcement represents an opportunity to shape the thinking of investors
and to advocate the deal; therefore, the announcement should provide enough information
for investors to evaluate the deal. Saying too little could turn investors away. It is advisable
to include in the first public announcement details about payment terms, timing of the deal,
6. Explain how an investor estimates the new share prices for target and buyer upon the
announcement of a deal. In this context, what is the specific objective that the deal presenter
hopes to achieve?
Upon announcement of a deal, the investor will form a probabilistically weighted average of
the share prices of both target and buyer based on assessments of the bid price and the
New Target Price = prob (Bid value) + (1-prob) (target share price if bid fails)
New Buyer Price = prob(buyer price if bid succeeds) + (1-prob)(buyer share price if bid
fails)
The deal presenter seeks to increase the investor’s estimate of “prob,” justify the bid value to
the target and investors, and explain benefits of the bid to the buyer.
7. What kind of decision is a CEO making when he/she evaluates a deal? In this light, how
a deal. The CEO seeks to determine whether the returns from the deal will be worth its
financial and social costs. Therefore, deal presenters must argue their case based on a cost-
benefit analysis.
8. Explain the guiding principles by which board directors make their decisions. In view of
Directors seek to fulfill the duties of care and loyalty. The duty of care requires directors to
be as fully informed as possible, and the duty of loyalty requires the first loyalty of directors
to be to the shareholders. Directors will seek to justify deals based on these standards.
Therefore, deal presentations to boards must anticipate the kinds of questions directors will
ask in order to fulfill their duties. Usually these questions concern high-level issues around
Planning for post-merger integration should begin early, even before a definitive agreement
has been reached. In fact, it is advisable to do some post-merger integration planning in the
analytic phase of the transaction, before getting to the bargaining table. Integration
The integration strategy should flow from the business rationale for the deal. It should be
consistent with and supportive of all the strategic choices that motivated the deal in the first
3. How are autonomy, interdependence, and control defined in the chapter, in the context of
post-merger integration?
Autonomy refers to the preservation of a culture, the continuation of a leadership team, and
operations and value chain with that of the buyer. Control refers to the imposition of rules,
procedures, and operating systems (such as financial and quality control systems) on the
target.
4. What are the four types of integration strategy presented in the chapter? Describe the degree
Interdependence
5. When might none of the four models be advisable but instead might a totally new
It is advisable to impose or merge cultures when the success of the merger hinges upon
complete or near-complete integration between target and buyer. This is usually true in
scale-driven deals, i.e. those that are efficiency-driven. On the other hand, it is usually
advisable to keep cultures separate or devise a totally new culture in scope-driven deals –
those that broaden a product range – particularly when there is limited overlap between
merger integration planners should realize that modifying one part of the system will
systemically.
“jump the gun” and risk exposure to regulatory penalties. Regulatory approval should be
Employees of the buyer and target firms will be most in need of direction in the early days of
a merger, so it is important to “strike while the iron is hot” – to set clear direction and to
implement changes while momentum is running. Many mergers have failed to achieve stated
goals because integration was not executed speedily. Along with speed, communication is a
key determinant of success. Communication needs to go beyond the typical short memo – a
real effort must be made to bring employees on board. Communication needs to set high
• Excessive planning
• Under-communicating/content-free communications
True or False
2. A company’s larger business units are always the least acquisitive; the smaller business
units are often the most acquisitive because of their need for growth and expansion.
3. Employing a “bottom- up” deal pipeline is the best approach for developing M&A
business.
4. The first contact between a potential buyer and target should be a cold call from a sales or
5. Lawyers are the only functional experts that become a part of a business development
team.
6. Antitrust and other regulatory filings are submitted to the U.S. federal and state
governments, (and as required in certain cases, to foreign governments) upon entering the
7. Merger integration planning becomes rigorous between the signing of the definitive
flow.
9. It is beneficial when integration teams get involved early on in the due diligence because
they can access information that will help steer the integration planning process.
1. T.
2. F. As of 2003, GEPS was one of the largest business units of General Electric,
accounting for $23 billion in revenues in 2002, as well as the most acquisitive division.
approach only yields a limited set of ideas. However, by implementing a top-down deal
pipeline in addition to the bottom-up deal pipeline, the division produces a wider range
4. F. The first contact by a potential buyer is indeed usually a cold call, but by a business
6. F. Antitrust and regulatory filings are submitted upon completion of the merger
definitive agreement, which occurs after the initiation of the LOI stage.
7. T.
8. T.
9. F. As depicted at GEPS, an integration team can “get in the way” during due diligence
process. While they ask for information that may help them with the integration process,
they can distract the focus of the due diligence process and negatively impact the merger
negotiations.
1. Identify the two sources from which GEPS discovers new acquisition opportunities.
staff come together with operating unit managers to assess the unit and design a
broad new vision for it. Together, Business Development and operating unit
generate a list of potential target firms, and then prioritize the list.
b. Annual Planning Cycle commitments: At the beginning of every calendar year, GEPS
operating managers create a “business plan” for the year: a lengthy document that
identifies and outlines the organic and growth goals for revenues and profits.
2. What are GEPS’ four key criteria for screening acquisition opportunities?
a mere addition.
b. Technology: GEPS sought targets with a strategic rationale for employing and
double-digit revenue growth rate, sales greater than $50 million annually, etc.
3. What are the three “buckets” of information that GEPS sought from a target firm?
a. Initial business overview and summary: GEPS’ initial request was for a one page
b. Due diligence: During the due diligence state, GEPS would request substantial
in-depth information.
c. Post-merger integration related: After the definitive agreement was signed, GEPS
integration planning.
The Centers of Excellence were small teams developed to guide the integration
process of specific functions, such as getting on the GE payroll and intranet, connecting
with firm benefits, etc. As with other processes, GEPS found that there were repetitive
activities that could be streamlined and coordinated by the organization of small teams.
5. Why does the Business Development unit of GEPS perform post-acquisition audits on all
of their deals? What is the main purpose and focus of the post-audit?
structured well and is completed. The audit includes an examination of whether the new
Integrity Policy, which requires training, understanding, and adherence. The post-audit
6. – 15. For the following questions, please identify the corporate development stage in
which the stated GEPS activity takes place: Initial planning stage (IS), LOI development
stage (LOI), Definitive Agreement phase (DA), and Post-Merger Integration (PMI).
7. _____GE Operating Unit Leader and Business Development Leader review recent GEPS
9. _____GEPS evaluates the target firm to see if it meets certain quantitative criteria.
10. _____GEPS Business Development Leader, a GE M&A lawyer and outside counsel
begin drafting a standard contract and tailoring it to the particular needs of the
transaction.
11. _____The comprehensive due diligence report is near completion.
15. _____The CEO of GEPS gives his internal support for the deal.
Answers
6. LOI
7. IS
8. IS
9. IS
10. DA
11. LOI
12. DA
13. PMI
14. IS
15. IS
Chapter 38 Questions and Answers
True or False
1. Given the inherent variability in M&A, it may not be worthwhile to formulate an opinion
2. The increasing automation of analytical techniques will allow deal designers to focus less
on number crunching and more on the creative task of shaping good deals.
3. Any potential advantage gained from real option valuation will likely diminish over time.
forward-looking view is to risk always looking behind, and thus being left behind as
from focusing (more) on number crunching. If the deal designer chooses to involve
creates is the option to focus less on number crunching. It frees up time for the deal
4. F. Learning from current events is active learning—you must do your own analysis on
5. F. The more that research reveals, the more questions that get raised.
information in a proactive manner. To simply contemplate the past and present, one
risks falling behind while others move forward. To follow other people’s opinions over
developing one’s own carries the great risk of making other people’s mistakes and
To keep pace with ongoing improvements in the field of technology, M&A professionals
must continually invest not only in new kinds of technology but also in technology
training. There will be an increasing need for all employees to have higher proficiencies
3. Why can the application of real option valuation in the field of M&A be both a “curse”
and a “blessing”?
Applying real option valuation is fairly un-charted territory in M&A. Thus, it could be a
blessing in allowing talented deal makers to successfully “blaze their own trails” but a
curse if practitioners attempt to trail blaze but get lost, stuck without an established path
to follow.
To translate the metaphor above into more concrete terms: real option valuation is a
blessing if it enables practitioners to model and quantify terms aspects of deals that
previously could not be valued. Business practitioners who can adeptly incorporate real
the importance and relevance of options is not well known or understood in many
4. Why is it a good idea for serious M&A professionals to get “professional help”?
Given the breadth, depth, and complexity of the field, it is hard to be a specialist in all
areas of M&A. This is the reason why it is a good idea to leverage business contacts and
to develop professional relationships with top advisors and specialists in various areas of
M&A.
An M&A deal leader is someone who knows how to manage not only the individual parts
of a merger transaction, but also the entire process: a deal leader knows how to bind and
fit the pieces together into a harmonic whole. The deal leader has an elevated view: the