Factors contributing to the integration of global capital markets include the reduction in
trade barriers, removal of capital controls, the growing disparity in tax rates among
countries, floating exchange rates, and the free convertibility of currencies. True or
False
Answer:
Poorly defined roles and responsibilities are an important factor contributing to the
failure of many alliances to achieve their objectives. True or False
Answer:
Unlike the European Economic Union, a decision by U.S. antitrust regulators to block a
transaction may be appealed in the courts. True or False
Answer:
The timing of a divestiture is important. If the business to be sold is highly cyclical, the
sale should be timed to coincide with the firm’s peak year earnings. True or False
Answer:
Free cash flow to equity is calculated using operating income. True or False
Answer:
An LBO model helps define the amount of debt a firm can support given its assets and
cash flows. True or False
Answer:
The loan agreement stipulates the terms and conditions under which the lender will loan
the borrower funds. True or False
Answer:
Differences in the way the management of the acquiring and target firms make
decisions, the pace of decision-making, and perceived values are common examples of
cultural differences between the two firms. True or False
Answer:
Premiums paid to LBO target firm shareholders often exceed 40%. True or False
Answer:
Growth rates can be calculated based on the historical experience of the firm or
industry. True or False
Answer:
For capital markets to function smoothly, disputes involving the legal rights of all
participants (both debtors and creditors) need to be resolved quickly and equitably by
the courts. True or False
Answer:
Confidentiality agreements usually also cover publicly available information on the
potential acquirer and target firms. True or False
Answer:
In the absence of a voluntary settlement out of court, the debtor firm may seek
protection from its creditors by initiating bankruptcy or may be forced into bankruptcy
by its creditors. True or False
Answer:
Pro forma financial statements rarely deviate from those compiled in accordance with
GAAP. True or False
Answer:
A target firm’s high employee turnover is often considered a destroyer of value. True or
False
Answer:
The use of convertible preferred stock as a form of payment provides some downside
protection to sellers in the form of continuing dividends, while providing upside
potential if the acquirer’s common stock price increases above the conversion point.
True or False
Answer:
Since an LBO’s debt is to be paid off over time, the cost of equity decreases over time,
assuming other factors remain unchanged. Therefore, in valuing a leveraged buyout, the
analyst must project free cash flows, adjusting the discount rate to reflect changes in the
capital structure. True or False
Answer:
Preferred dividends are tax deductible to U.S. corporations. True or False
Answer:
In a one-tier offer, the acquirer announces the same offer to all target shareholders. True
or False.
Answer:
In calculating the value of net synergy, the costs required to realize the anticipated
synergy should be ignored because they are difficult to forecast. True or False
Answer:
If the form of acquisition is a statutory merger, the seller retains all known, unknown or
contingent liabilities.
True or False
Answer:
Revenue may be inflated by booking as revenue products shipped to resellers without
adequately adjusting for probable returns. True or False
Answer:
Language barriers, different customs, working conditions, work ethics, and legal
structures create a new set of challenges in integrating cross-border transactions. True
or False
Answer:
It is impossible for a leveraged buyout to make sense to common equity investors but
not to other investors, such as pre-LBO debt holders and preferred stockholders. True or
False
Answer:
A single asset is often used to collateralize loans from different lenders in LBO
transactions. True or False
Answer:
The primary forms of proxy contests are those for seats on the board of directors, those
concerning management proposals, and those seeking to force management to take a
particular action. True or False
Answer:
How ownership interests will be transferred in a business alliance is a relatively
unimportant deal structuring issue. True or False
Answer:
Valuations of target firms based on the comparable companies and recent transactions
methods must be adjusted to reflect control premiums. True or False
Answer:
The capitalization rate is equivalent to the discount rate when the firm’s revenues are
not expected to grow. True or False
Answer:
An affirmative covenant is a portion of a loan agreement that specifies the actions the
borrowing firm cannot take during the term of the loan. True or False
Answer:
Joint ventures sometimes represent good alternatives to an outright merger. True or
False
Answer:
The use of market-based valuation methods usually reflect actual demand and supply
considerations at a moment in time. True or False
Answer:
Interest rates and expected inflation in one country compared to another country seldom
affect exchange rates between the two countries. True or False
Answer:
If cash flows are in terms of local currency and the U.S. Treasury bond rate is used to
estimate the risk free rate, the analyst should add the expected inflation rate in the local
country relative to that in the U.S. to convert the U.S. Treasury bond rate to a local
country nominal rate. True or False
Answer:
If the regulatory authorities suspect that a potential transaction may be anti-competitive,
they will file a lawsuit to prevent completion of the transaction. True or False
Answer:
Corporate governance refers to a system of controls both internal and external to the
firm that protects stakeholders’ interests. True or False
Answer:
Confidentiality agreements often cover both the buyer and the seller, since both are
likely to be exchanging confidential information, although for different reasons. True or
False
Answer:
In general, the appropriate marginal tax rate used in calculating cash flows and the
discount rate should be that applicable to the country in which the cash flows are
produced. True or False
Answer:
The analyst should be careful not to mechanically add an acquisition premium to the
target firm’s estimated value based on the comparable companies’ method if there is
evidence that the market values of these “comparable firms” already reflect the effects
of acquisition activity elsewhere in the industry. True or False
Answer:
Asset oriented approaches to valuation involve the use of tangible book value,
liquidation value, discounted cash flows, and break-up values. True or False
Answer:
Which of the following is generally true about financing JVs and partnerships?
a. Lenders rarely require guarantees from the parents
b. Bank loans are commonly used to meet short-term cash requirements
c. Participants must agree on an appropriate financial structure for the organization
d. Contributions by the partners of intangible assets are usually easy to value
e. Corporations are an uncommon form of legal structure
Answer:
GENERAL MOTORS BUYS 20% OF SUBARU
In late 1999, General Motors (GM), the world’s largest auto manufacturer, agreed to
purchase 20% of Japan’s Fuji Heavy Industries, Ltd., the manufacturer of Subaru
vehicles, for $1.4 billion. GM’s objective is to accelerate GM’s push into Asia. The
investment gives GM an interest in an auto manufacturer known for four-wheel drive
vehicles. In combination with its current holdings, GM now has a position in every
segment of Japan’s auto market, including minivans, small and midsize cars, and trucks.
GM already owns 10% of Suzuki Motor Corporation and 49% of Isuzu Motors Ltd.
GM can now expand in Asia more quickly and at a lower cost than if it developed
products independently.
GM has been collaborating with Fuji on various products since 1995. The move
underscores GM’s commitment to expanding its current modest position in the Asian
market, which is expected to be the fastest growing market during the next decade. GM
has sold less than 500,000 in the Asia-Pacific region in 1999, including about 60,000 in
Japan. In 2002, GM bought the remaining outstanding stock of Subaru.
Discussion Questions:
1) What other motives may General Motors have had in making this investment?
2) Why do you believe that General Motors may have wanted to limit initially its
investment to 20%?
Answer:
The share exchange ratio is impacted by all of the following except for
a. The current share price of the target firm
b. The current share price of the acquirer
c. The offer price for the target firm
d. The number of shares outstanding for the target firm
e. A and D
Answer:
Successfully integrated mergers and acquisitions are frequently those which
a. Communicate candidly and continuously
b. Appoint an integration manager and team with clearly defined goals and
responsibilities
c. Establish well defined lines of authority
d. Focus on issues that have the greatest near-term impact
e. All of the above
Answer:
Which of the following are examples of cost-related synergy?
a. Spreading fixed costs over increased output levels
b. Eliminating duplicate jobs
c. Discounts from suppliers due to bulk purchases
d. Paying termination expenses
e. A, B, and C only
Answer:
Which of the following is true about integration planning? Without integration
planning, integration is not likely to
a. Provide anticipated synergies
b. Proceed without significant disruption to the target business’ operations
c. Proceed without significant disruption to the acquirer’s operations
d. Be completed without experiencing substantial customer attrition
e. All of the above
Answer:
Which of the following is generally not true of a financing contingency?
a. It is a condition of closing in the agreement of purchase and sale
b. Trigger the payment of break-up fees if not satisfied.
c. Protects both the lender and seller
d. Primarily protects the buyer
e. Primarily protects the seller
Answer:
Using the cost of capital method to value an LBO involves which of the following
steps?
a. Projection of annual cash flows
b. Projection of annual debt-to-equity ratios
c. Calculation of a terminal value
d. Adjusting the discount rate to reflect changing risk.
e. All of the above
Answer:
An equity carve-out by a parent of one of its subsidiaries is often a precursor to a
a. Complete divestiture or spin-off of the subsidiary
b. An acquisition
c. A merger
d. Joint venture
e. The creation of a tracking stock
Answer:
Which of the following is not true of an equity carve-out?
a. Creates cash infusion for the parent
b. Change in equity ownership of the unit involved in the carve-out
c. New shares issued to the public
d. Taxable if proceeds returned to shareholders through a dividend or stock buyback
e. Parent ceases to exist
Answer:
Merck and Schering-Plough Merger: When Form Overrides Substance
If it walks like a duck and quacks like a duck, is it really a duck? That is a question
Johnson & Johnson might ask about a 2009 transaction involving pharmaceutical
companies Merck and Schering-Plough. On August 7, 2009, shareholders of Merck and
Company (“Merck”) and Schering-Plough Corp. (Schering-Plough) voted
overwhelmingly to approve a $41.1 billion merger of the two firms. With annual
revenues of $42.4 billion, the new Merck will be second in size only to global
pharmaceutical powerhouse Pfizer Inc.
At closing on November 3, 2009, Schering-Plough shareholders received $10.50 and
0.5767 of a share of the common stock of the combined company for each share of
Schering-Plough stock they held, and Merck shareholders received one share of
common stock of the combined company for each share of Merck they held. Merck
shareholders voted to approve the merger agreement, and Schering-Plough shareholders
voted to approve both the merger agreement and the issuance of shares of common
stock in the combined firms. Immediately after the merger, the former shareholders of
Merck and Schering-Plough owned approximately 68 percent and 32 percent,
respectively, of the shares of the combined companies.
The motivation for the merger reflects the potential for $3.5 billion in pretax annual
cost savings, with Merck reducing its workforce by about 15 percent through facility
consolidations, a highly complementary product offering, and the substantial number of
new drugs under development at Schering-Plough. Furthermore, the deal increases
Merck’s international presence, since 70 percent of Schering-Plough’s revenues come
from abroad. The combined firms both focus on biologics (i.e., drugs derived from
living organisms). The new firm has a product offering that is much more diversified
than either firm had separately.
The deal structure involved a reverse merger, which allowed for a tax-free exchange of
shares and for Schering-Plough to argue that it was the acquirer in this transaction. The
importance of the latter point is explained in the following section.
To implement the transaction, Schering-Plough created two merger subsidiaries (i.e.,
Merger Subs 1 and 2) and moved $10 billion in cash provided by Merck and 1.5 billion
new shares (i.e., so-called “New Merck” shares approved by Schering-Plough
shareholders) in the combined Schering-Plough and Merck companies into the
subsidiaries. Merger Sub 1 was merged into Schering-Plough, with Schering-Plough the
surviving firm. Merger Sub 2 was merged with Merck, with Merck surviving as a
wholly-owned subsidiary of Schering-Plough. The end result is the appearance that
Schering-Plough (renamed Merck) acquired Merck through its wholly-owned
subsidiary (Merger Sub 2). In reality, Merck acquired Schering-Plough.
Former shareholders of Schering-Plough and Merck become shareholders in the new
Merck. The “New Merck” is simply Schering-Plough renamed Merck. This structure
allows Schering-Plough to argue that no change in control occurred and that a
termination clause in a partnership agreement with Johnson & Johnson should not be
triggered. Under the agreement, J&J has the exclusive right to sell a rheumatoid arthritis
drug it had developed called Remicade, and Schering-Plough has the exclusive right to
sell the drug outside the United States, reflecting its stronger international distribution
channel. If the change of control clause were triggered, rights to distribute the drug
outside the United States would revert back to J&J. Remicade represented $2.1 billion
or about 20 percent of Schering-Plough’s 2008 revenues and about 70 percent of the
firm’s international revenues. Consequently, retaining these revenues following the
merger was important to both Merck and Schering-Plough.
The multi-step process for implementing this transaction is illustrated in the following
diagrams. From a legal perspective, all these actions occur concurrently.
Step 1: Schering-Plough renamed Merck (denoted in the diagrams as “New Merck”)
a. Schering-Plough creates two wholly-owned merger subs
b. Schering-Plough transfers cash provided by Merck and newly issued “New Merck”
stock
into Merger Sub 1 and only “New Merck” stock into Merger Sub 2.
Step 2: Schering-Plough Merger:
a. Merger Sub 1 merges into Schering-Plough in a reverse merger with Schering-Plough
surviving
b. To compensate shareholders, Schering-Plough shareholders exchange their
shares for cash and stock in “New Merck”
c. Former Schering-Plough shareholders now hold stock in “New Merck”
Step 3: Merck Merger:
a. Merger Sub 2 merges into Merck with Merck surviving
b. To compensate shareholders, Merck shareholders exchange their shares for
shares in “New Merck”
c. Former shareholders in Merck now hold shares in “New Merck” (i.e.,
a renamed Schering-Plough)
e. Merger Sub 2, a subsidiary of “New Merck,” now owns Merck.
Concluding Comments
In reality, Merck was the acquirer. Merck provided the money to purchase
Schering-Plough, and Richard Clark, Merck’s chairman and CEO, will run the newly
combined firm when Fred Hassan, Schering-Plough’s CEO, steps down. The new firm
has been renamed Merck to reflect its broader brand recognition. Three-fourths of the
new firm’s board consists of former Merck directors, with the remainder coming from
Schering-Plough’s board. These factors would give Merck effective control of the
combined Merck and Schering-Plough operations. Finally, former Merck shareholders
own almost 70 percent of the outstanding shares of the combined companies.
J&J initiated legal action in August 2009, arguing that the transaction was a
conventional merger and, as such, triggered the change of control provision in its
partnership agreement with Schering-Plough. Schering-Plough argued that the reverse
merger bypasses the change of control clause in the agreement, and, consequently, J&J
could not terminate the joint venture. In the past, U.S. courts have tended to focus on
the form rather than the spirit of a transaction. The implications of the form of a
transaction are usually relatively explicit, while determining what was actually intended
(i.e., the spirit) in a deal is often more subjective.
In late 2010, an arbitration panel consisting of former federal judges indicated that a
final ruling would be forthcoming in 2011. Potential outcomes could include J&J
receiving rights to Remicade with damages to be paid by Merck; a finding that the
merger did not constitute a change in control, which would keep the distribution
agreement in force; or a ruling allowing Merck to continue to sell Remicade overseas
but providing for more royalties to J&J.
Discussion Questions
Discussion Questions:
1) Do you agree with the argument that the courts should focus on the form or structure
of an agreement and not try to interpret the actual intent of the parties to the
transaction? Explain your answer.
2) How might allowing the form of a transaction to override the actual spirit or intent of
the deal impact the cost of doing business for the parties involved in the distribution
agreement? Be specific.
3) How did the use of a reverse merger facilitate the transaction?
Answer:
What happens to the outstanding shares of the target firm when the acquirer
purchases 100% of the target’s outstanding stock?
a. They are added to the number of shares of Acquirer stock outstanding
b. They are cancelled.
c. They are converted into preferred stock.
d. They are shown as treasury stock on the books of the combined companies.
e. They are swapped for debt in the new company.
Answer:
Which of the following statements are true about due diligence?
a. The seller should perform due diligence on its own operations.
b. The seller should perform due diligence on the buyer.
c. The seller should perform due diligence on the lender used by the buyer to finance
the transaction.
d. A & B
e. A, B, & C
Answer:
News Corporation of America announced its intention to purchase shares in another
national newspaper chain.
Which one of the following terms best describes this announcement?
a. Divestiture
b. Spinoff
c. Consolidation
d. Tender offer
e. Merger proposal
Answer:
Which of the following is not true of a 338 election ?
a. It applies to asset purchases only.
b. It applies to stock purchases only.
c. It allows a purchase of stock to be treated as an asset purchase for tax purposes.
d. The buyer must adopt the 338 election.
e. The seller must agree with the adoption of the 338 election.
Answer:
Bank of America Acquires Merrill Lynch
Against the backdrop of the Lehman Brothers’ Chapter 11 bankruptcy filing, Bank of
America (BofA) CEO Kenneth Lewis announced on September 15, 2008, that the bank
had reached agreement to acquire megaretail broker and investment bank Merrill
Lynch. Hammered out in a few days, investors expressed concern that the BofA’s swift
action on the all-stock $50 billion transaction would saddle the firm with billions of
dollars in problem assets by pushing BofA’s share price down by 21 percent.
BofA saw the takeover of Merrill as an important step toward achieving its long-held
vision of becoming the number 1 provider of financial services in its domestic market.
The firm’s business strategy was to focus its efforts on the U.S. market by expanding its
product offering and geographic coverage. The firm implemented its business strategy
by acquiring selected financial services companies to fill gaps in its product offering
and geographic coverage. The existence of a clear and measurable vision for the future
enabled BofA to make acquisitions as the opportunity arose.
Since 2001, the firm completed a series of acquisitions valued at more than $150
billion. The firm acquired FleetBoston Financial, greatly expanding its network of
branches on the East Coast, and LaSalle Bank to improve its coverage in the Midwest.
The acquisitions of credit cardissuing powerhouse MBNA, U.S. Trust (a major private
wealth manager), and Countrywide (the nation’s largest residential mortgage loan
company) were made to broaden the firm’s financial services offering.
The acquisition of Merrill makes BofA the country’s largest provider of wealth
management services to go with its current status as the nation’s largest branch banking
network and the largest issuer of small business, home equity, credit card, and
residential mortgage loans. The deal creates the largest domestic retail brokerage and
puts the bank among the top five largest global investment banks. Merrill also owns 45
percent of the profitable asset manager BlackRock Inc., worth an estimated $10 billion.
BofA expects its retail network to help sell Merrill and BlackRock’s investment
products to BofA customers.
The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not
allow for proper due diligence. The extent of the troubled assets on Merrill’s books was
largely unknown. While the losses at Merrill proved to be stunning in the short run$15
billion alone in the fourth quarter of 2008the acquisition by Bank of America averted
the possible demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S.
government had injected $45 billion in loans and capital into BofA in an effort to offset
some of the asset write-offs associated with the acquisition. Later that year, Lewis
announced his retirement from the bank.
Mortgage loan losses and foreclosures continued to mount throughout 2010, with a
disproportionately large amount of such losses attributable to the acquisition of the
Countrywide mortgage loan portfolio. While BofA’s vision and strategy may still prove
to be sound, the rushed execution of the Merrill acquisition, coupled with problems
surfacing from other acquisitions, could hobble the financial performance of BofA for
years to come.
When Companies OverpayMattel Acquires The Learning Company
Mattel, Inc. is the world’s largest designer, manufacturer, and marketer of a broad
variety of children’s products selling directly to retailers and consumers. Most people
recognize Mattel as the maker of the famous Barbie, the best-selling fashion doll in the
world, generating sales of $1.7 billion annually. The company also manufactures a
variety of other well-known toys and owns the primary toy license for the most popular
kids’ educational program “Sesame Street.” In 1988, Mattel revived its previous
association with The Walt Disney Company and signed a multiyear deal with them for
the worldwide toy rights for all of Disney’s television and film properties
Business Plan
Mission Statement and Strategy
Mattel’s mission is to maintain its position in the toy market as the largest and most
profitable family products marketer and manufacturer in the world. Mattel will continue
to create new products and innovate in their existing toy lines to satisfy the constant
changes of the family-products market. Its business strategy is to diversify Mattel
beyond the market for traditional toys at a time when the toy industry is changing
rapidly. This will be achieved by pursuing the high-growth and highly profitable
children’s technology market, while continuing to enhance Mattel’s popular toys to gain
market share and increase earnings in the toy market. Mattel believes that its current
software division, Mattel Interactive, lacks the technical expertise and resources to
penetrate the software market as quickly as the company desires. Consequently, Mattel
seeks to acquire a software business that will be able to manufacture and market
children’s software that Mattel will distribute through its existing channels and through
its Website (Mattel.com).
Defining the Marketplace
The toy market is a major segment within the leisure time industry. Included in this
segment are many diverse companies, ranging from amusement parks to yacht
manufacturers. Mattel is one of the largest manufacturers within the toy segment of the
leisure time industry. Other leading toy companies are Hasbro, Nintendo, and Lego.
Annual toy industry sales in recent years have exceeded $21 billion. Approximately
one-half of all sales are made in the fourth quarter, reflecting the Christmas holiday.
Customers. Mattel’s major customers are the large retail and e-commerce stores that
distribute their products. These retailers and e-commerce stores in 1999 included Toys
“R” Us Inc., Wal-Mart Stores Inc., Kmart Corp., Target, Consolidated Stores Corp.,
E-toys, ToyTime.com, Toysmart.com, and Toystore.com. The retailers are Mattel’s
direct customers; however, the ultimate buyers are the parents, grandparents, and
children who purchase the toys from these retailers.
Competitors. The two largest toy manufacturers are Mattel and Hasbro, which together
account for almost one-half of industry sales. In the past few years, Hasbro has acquired
several companies whose primary products include electronic or interactive toys and
games. On December 8, 1999, Hasbro announced that it would shift its focus to
software and other electronic toys. Traditional games, such as Monopoly, would be
converted into software.
Potential Entrants. Potential entrants face substantial barriers to entry in the toy
business. Current competitors, such as Mattel and Hasbro, already have secured
distribution channels for their products based on longstanding relationships with key
customers such as Wal-Mart and Toys “R” Us. It would be costly for new entrants to
replicate these relationships. Moreover, brand recognition of such toys as Barbie,
Nintendo, and Lego makes it difficult for new entrants to penetrate certain product
segments within the toy market. Proprietary knowledge and patent protection provide
additional barriers to entering these product lines. The large toymakers have licensing
agreements that grant them the right to market toys based on the products of the major
entertainment companies.
Product Substitutes. One of the major substitutes for traditional toys such as dolls and
cars are video games and computer software. Other product substitutes include virtually
all kinds of entertainment including books, athletic wear, tapes, and TV. However, these
entertainment products are less of a concern for toy companies than the Internet or
electronic games because they are not direct substitutes for traditional toys.
Suppliers. An estimated 80% of toy production is manufactured abroad. Both Mattel
and Hasbro own factories in the Far East and Mexico to take advantage of low labor
costs. Parts, such as software and microchips, often are outsourced to non-Mattel
manufacturing plants in other countries and then imported for the assembly of such
products as Barbie within Mattel-owned factories. Although outsourcing has resulted in
labor cost savings, it also has resulted in inconsistent quality.
Opportunities and Threats
Opportunities
New Distribution Channels. Mattel.com represents 80 separate toy and software
offerings. Mattel hopes to spin this operation off as a separate company when it
becomes profitable. Mattel.com lost about $70 million in 1999. The other new channel
for distributing toys is directly to consumers through catalogs. The so-called direct
channels offered by the internet and catalog sales help Mattel reduce its dependence on
a few mass retailers.
Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The
number of grandparents is expected to grow from 58 million in 1999 to 76 million in
2005.
Interactive Media. As children have increasing access to computers, the demand for
interactive computer games is expected to accelerate. The “high-tech” toy market
segment is growing 20% annually, compared with the modest 5% growth in the
traditional toy business.
International Growth. In 1999, 44% of Mattel’s sales came from its international
operations. Mattel already has redesigned its Barbie doll for the Asian and the South
American market by changing Barbie’s face and clothes.
Threats
Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items
are now more likely to include athletic clothes and children’s software and video games
rather than more traditional items such as dolls and stuffed animals.
Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A
quality problem with the Cabbage Patch Doll could cost Mattel more than $10 million
in returns and in settling lawsuits.
Shrinking Target Market. Historically, the toy industry has considered their prime
market to be children from birth to age 14. Today, the top toy-purchasing years for a
child range from birth to age 10.
Just-In-Time Inventory Management. Changing customer inventory practices make it
difficult to accurately forecast reorders, which has resulted in lost sales as unanticipated
increases in orders could not be filled from current manufacturer inventories.
Internal Assessment
Strengths
Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of
its toys manufactured in low-labor-cost countries like China and Indonesia, and its
established distribution channels. Moreover, licensing agreements with Disney enable
Mattel to add popular new characters to its product lines.
Weaknesses
Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been
slow to reposition these core brands. The lack of technical expertise to create
software-based products limits Mattel’s ability to exploit the shift away from traditional
toys to video or interactive games.
Acquisition Plan
Objectives and Strategy
Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys
segment into high-growth segments. Mattel believed that it had to acquire a recognized
brand identity in the children’s software and entertainment segment of the toy industry,
sometimes called the “edutainment” segment, to participate in the rapid shift to
interactive, software-based toys that are both entertaining and educational. Mattel
believed that such an acquisition would remove some of the seasonality from sales and
broaden their global revenue base. Key acquisition objectives included building a
global brand strategy, doubling international sales, and creating a $1 billion software
business by January 2001.
Defining the Target Industry
The “edutainment” segment has been experiencing strong growth predominantly in the
entertainment segment. Parents are seeing the importance of technology in the
workplace and want to familiarize their children with the technology as early as
possible. In 1998, more than 40% of households had computers and, of those
households with children, 70% had educational software. As the number of homes with
PCs continues to increase worldwide and with the proliferation of video games, the
demand for educational and entertainment software is expected to accelerate.
Management Preferences
Mattel was looking for an independent children’s software company with a strong brand
identity and more than $400 million in annual sales. Mattel preferred not to acquire a
business that was part of another competitor (e.g., Hasbro Interactive). Mattel’s
management stated that the target must have brands that complement Mattel’s business
strategy and the technology to support their existing brands, as well as to develop new
brands. Mattel preferred to engage in a stock-for-stock exchange in any transaction to
maintain manageable debt levels and to ensure that it preserved the rights to all
software patents and licenses. Moreover, Mattel reasoned that such a transaction would
be more attractive to potential targets because it would enable target shareholders to
defer the payment of taxes.
Potential Targets
Game and edutainment development divisions are often part of software conglomerates,
such as Cendant, Electronic Arts, and GT Interactive, which produce software for
diverse markets including games, systems platforms, business management, home
improvement, and pure educational applications. Other firms may be subsidiaries of
large book, CD-ROM, or game publishers. The parent firms showed little inclination to
sell these businesses at what Mattel believed were reasonable prices. Therefore, Mattel
focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc.,
Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two
Interactive Software. Of these, only Acclaim, Activision, and The Learning Company
had their own established brands in the games and edutainment sectors and the size
sufficient to meet Mattel’s revenue criterion.
In 1999, TLC was the second largest consumer software company in the world, behind
Microsoft. TLC was the leader in educational software, with a 42% market share, and
in-home productivity software (i.e., home improvement software), with a 44% market
share. The company has been following an aggressive expansion strategy, having
completed 14 acquisitions since 1994. At 68%, TLC also had the highest gross profit
margin of the target companies reviewed. TLC owned the most recognized titles and
appeared to have the management and technical skills in place to handle the kind of
volume that Mattel desired. Their sales were almost $1 billion, which would enable
Mattel to achieve its objective in this “high-tech” market. Thus, TLC seemed the best
suited to satisfy Mattel’s acquisition objectives.
Completing the Acquisition
Despite disturbing discoveries during due diligence, Mattel acquired TLC in a
stock-for-stock transaction valued at $3.8 billion on May 13, 1999. Mattel had
determined that TLC’s receivables were overstated because product returns from
distributors were not deducted from receivables and its allowance for bad debt was
inadequate. A $50 billion licensing deal also had been prematurely put on the balance
sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially
exaggerated the amount of money put into research and development for new software
products. Nevertheless, driven by the appeal of rapidly becoming a big player in the
children’s software market, Mattel closed on the transaction aware that TLC’s cash
flows were overstated.
Epilogue
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring
charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion.
TLC’s top executives left Mattel and sold their Mattel shares in August, just before the
third quarter’s financial performance was released. Mattel’s stock fell by more than 35%
during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel
announced that its chief executive officer (CEO), Jill Barrad, was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself
of what had become a seemingly intractable problem. This ended what had become a
disastrous foray into software publishing that had cost the firm literally hundreds of
millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the
unit to an affiliate of Gores Technology Group for rights to a share of future profits.
Essentially, the deal consisted of no cash upfront and only a share of potential future
revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of
any future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could
not do in a year. Gores restructured TLC’s seven units into three, set strong controls on
spending, sifted through 467 software titles to focus on the key brands, and repaired
relationships with distributors. Gores also has sold the entertainment division and is
seeking buyers for the remainder of TLC.
Discussion Questions:
1) Why was Mattel interested in diversification?
2) What alternatives to acquisition could Mattel have considered? Discuss the pros and
cons of each
alternative?
3) How might the internet affect the toy industry? What potential conflicts with
customers might be
created?
4) What are the primary barriers to entering the toy industry?
5) What could Mattel have done to protect itself against risks uncovered during due
diligence?
Answer:
All of the following are true except for
a. Chapter 15 deals with international or cross-border bankruptcies.
b. Chapter 11 deals with reorganizing the firm.
c. Chapter 7 defines the process and priorities of the liquidation process for commercial
businesses.
d. Chapter 11 also addresses issues pertaining to personal bankruptcy.
e. A and B
Answer:
Which of the following is not true of a divestiture?
a. May create cash infusion for the parent firm
b. Parent ceases to exist
c. Proceeds of sale taxable if returned to shareholders through a dividend or stock
buyback
d. A new legal subsidiary may be created
e. B and C
Answer:
Which of the following represent important shortcomings of using industry
concentration ratios to
determine whether the combination of certain firms will result in an increase in market
power?
a. Frequent inability to define what constitutes an industry
b. Failure to measure ease of entry or exit for other firms
c. Failure to account for foreign competition
d. Failure to account properly for the distribution of firms of different sizes
e. All of the above
Answer:
Empirical evidence suggests that forecasts of earnings and other value indicators are
better predictors of firm value than value indicators based on historical data. True or
False
Answer:
Which of the following factors is excluded from the calculation of free cash flow to the
firm?
a. Principal repayments
b. Operating income
c. Depreciation
d. The change in working capital
e. Gross plant and equipment spending
Answer:
Valuing a Privately Held Company
Background
BigCo is interested in acquiring PrivCo, whose owner desires to retire. The firm is
100% owned by the current owner. PrivCo has revenues of $10 million and an EBIT of
$2 million in the preceding year. The market value of the firm’s debt is $5 million; the
book value of equity is $4 million. For publicly traded firms in the same industry, the
average debt-to-equity ratio is .4 (based on the market value of debt and equity), and the
marginal tax rate is 40%. Typically, the ratio of the market value of equity to book value
for these firms is The average ß of publicly traded firms that are in the same business is
2.00. Capital expenditures and depreciation amounted to $0.3 million and $0.2 million
in the prior year. Both items are expected to grow at the same rate as revenues for the
next 5 years. Capital expenditures and depreciation are expected to be equal beyond 5
years (i.e., capital spending will be internally funded). As a result of excellent working
capital management practices, the change in working capital is expected to be
essentially zero throughout the forecast period and beyond. The revenues of this firm
are expected to grow 15% annually for the next 5 years and 5% per year thereafter. Net
income is expected to increase 15% a year for the next 5 years and 5% thereafter. The
10-year U.S. Treasury bond rate is 6%. The pretax cost of debt for a nonrated firm is
10%. No adjustment is made in the calculation of the cost of equity for a marketability
discount. Estimate the shareholder value of the firm.
Note: To estimate the WACC for a leveraged private firm, it is necessary to calculate
the firm’s leveraged . This requires an estimate of the firm’s unleveraged ß which can be
obtained by estimating the unleveraged ß for similar firms in the same industry. In
addition, the value of debt and equity in calculating the cost of capital should be
expressed as market rather than book values.
Answer:
The Sarbanes-Oxley bill is intended to achieve which of the following:
a. Auditor independence
b. Corporate responsibility
c. Improved financial disclosure
d. Increased penalties for fraudulent behavior
e. All of the above
Answer:
Pfizer Acquires Wyeth Labs Despite Tight Credit Markets
Pfizer and Wyeth began joint operations on October 22, 2009, when Wyeth shares
stopped trading and each Wyeth share was converted to $33 in cash and 0.985 of a
Pfizer share. Valued at $68 billion, the cash and stock deal was first announced in late
January of 2009. The purchase price represented a 12.6 percent premium over Wyeth’s
closing share price the day before the announcement. Investors from both firms
celebrated as Wyeth’s shares rose 12.6 percent and Pfizer’s 1.4 percent on the news. The
announcement seemed to offer the potential for profit growth, despite storm clouds on
the horizon.
As is true of other large pharmaceutical companies, Pfizer expects to experience serious
erosion in revenue due to expiring patent protection on a number of its major drugs.
Pfizer faced the expiration of patent rights in 2011 to the cholesterol-lowering drug
Lipitor, which accounted for 25 percent of the firm’s $52 billion in 2008 revenue. Pfizer
also faces 14 other patent expirations through 2014 on drugs that, in combination with
Lipitor, contribute more than one-half of the firm’s total revenue. Pfizer is not alone,
Merck, Bristol-Myers Squibb, and Eli Lilly are all facing significant revenue reduction
due to patent expirations during the next five years as competition from generic drugs
undercuts their pricing. Wyeth will also be losing its patent protection on its top-selling
drug, the antidepressant Effexor XR.
Pfizer’s strategy appears to have been to acquire Wyeth at a time when transaction
prices were depressed because of the recession and tight credit markets. Pfizer
anticipates saving more than $4 billion annually by combining the two businesses, with
the savings being phased in over three years. Pfizer also hopes to offset revenue erosion
due to patent expirations by diversifying into vaccines and arthritis treatments.
By the end of 2008, Pfizer already had a $22.5 billion commitment letter in order to
obtain temporary or “bridge” financing and $26 billion in cash and marketable
securities. Pfizer also announced plans to cut its quarterly dividend in half to $0.16 per
share to help finance the transaction. However, there were still questions about the
firm’s ability to complete the transaction in view of the turmoil in the credit markets.
Many transactions that were announced during 2008 were never closed because buyers
were unable to arrange financing and would later claim that the purchase agreement had
been breached due to material adverse changes in the business climate. Such
circumstances, they would argue, would force them to renege on their contracts.
Usually, such contracts contain so-called reverse termination fees, in which the buyer
would agree to pay a fee to the seller if they were unwilling to close the deal. This is
called a reverse termination or breakup fee because traditionally breakup fees are paid
by a seller that chooses to break a contract with a buyer in order to accept a more
attractive offer from another suitor.
Negotiations, which had begun in earnest in late 2008, became increasingly
contentious, not so much because of differences over price or strategy but rather under
what circumstances Pfizer could back out of the deal. Under the terms of the final
agreement, Pfizer would have been liable to pay Wyeth $4.5 billion if its credit rating
dropped prior to closing and it could not finance the transaction. At about 6.6 percent of
the purchase price, the termination fee was about twice the normal breakup fee for a
transaction of this type.
What made this deal unique was that the failure to obtain financing as a pretext for exit
could be claimed only under very limited circumstances. Specifically, Pfizer could
renege only if its lenders refused to finance the transaction because of a credit
downgrade of Pfizer. If lenders refused to finance primarily for this reason, Wyeth
could either demand that Pfizer attempt to find alternative financing or terminate the
agreement. If Wyeth had terminated the agreement, Pfizer would have been obligated to
pay the termination fee.
Using Form of Payment as a Takeover Strategy:
Chevron’s Acquisition of Unocal
Unocal ceased to exist as an independent company on August 11, 2005 and its shares
were de-listed from the New York Stock Exchange. The new firm is known as Chevron.
In a highly politicized transaction, Chevron battled Chinese oil-producer, CNOOC, for
almost four months for ownership of Unocal. A cash and stock bid by Chevron, the
nation’s second largest oil producer, made in April valued at $61 per share was accepted
by the Unocal board when it appeared that CNOOC would not counter-bid. However,
CNOOC soon followed with an all-cash bid of $67 per share. Chevron amended the
merger agreement with a new cash and stock bid valued at $63 per share in late July.
Despite the significant difference in the value of the two bids, the Unocal board
recommended to its shareholders that they accept the amended Chevron bid in view of
the growing doubt that U.S. regulatory authorities would approve a takeover by
CNOOC.
In its strategy to win Unocal shareholder approval, Chevron offered Unocal
shareholders three options for each of their shares: (1) $69 in cash, (2) 1.03 Chevron
shares; or (3) .618 Chevron shares plus $27.60 in cash. Unocal shareholders not
electing any specific option would receive the third option. Moreover, the all-cash and
all-stock offers were subject to proration in order to preserve an overall per share mix of
.618 of a share of Chevron common stock and $27.60 in cash for all of the 272 million
outstanding shares of Unocal common stock. This mix of cash and stock provided a
“blended” value of about $63 per share of Unocal common stock on the day that Unocal
and Chevron entered into the amendment to the merger agreement on July 22, 2005.
The “blended” rate was calculated by multiplying .618 by the value of Chevron stock
on July 22nd of $57.28 plus $27.60 in cash. This resulted in a targeted purchase price
that was about 56 percent Chevron stock and 44 percent cash.
This mix of cash and stock implied that Chevron would pay approximately $7.5 billion
(i.e., $27.60 x 272 million Unocal shares outstanding) in cash and issue approximately
168 million shares of Chevron common stock (i.e., .618 x 272 million of Unocal shares)
valued at $57.28 per share as of July 22, 2005. The implied value of the merger on that
date was $17.1 billion (i.e., $27.60 x 272 million Unocal common shares outstanding
plus $57.28 x 168 million Chevron common shares). An increase in Chevron’s share
price to $63.15 on August 10, 2005, the day of the Unocal shareholders’ meeting,
boosted the value of the deal to $18.1 billion.
Option (1) was intended to appeal to those Unocal shareholders who were attracted to
CNOOC’s all cash offer of $67 per share. Option (2) was designed for those
shareholders interested in a tax-free exchange. Finally, it was anticipated that option (3)
would attract those Unocal shareholders who were interested in cash but also wished to
enjoy any appreciation in the stock of the combined companies.
The agreement of purchase and sale between Chevron and Unocal contained a
“proration clause.” This clause enabled Chevron to limit the amount of total cash it
would payout under those options involving cash that it had offered to Unocal
shareholders and to maintain the “blended” rate of $63 it would pay for each share of
Unocal stock. Approximately 242 million Unocal shareholders elected to receive all
cash for their shares, 22.1 million opted for the all-stock alternative, and 10.1 million
elected the cash and stock combination. No election was made for approximately .3
million shares. Based on these results, the amount of cash needed to satisfy the number
shareholders electing the all-cash option far exceeded the amount that Chevron was
willing to pay. Consequently, as permitted in the merger agreement, the all-cash offer
was prorated resulting in the Unocal shareholders who had elected the all-cash option
receiving a combination of cash and stock rather than $69 per share. The mix of cash
and stock was calculated as shown in Exhibit 1.
If too many Unocal shareholders had elected to receive Chevron stock, those making
the all-stock election would not have received 1.03 shares of Chevron stock for each
share of Unocal stock. Rather, they would have received a mix of stock and cash to help
preserve the approximate 56 percent stock and 44 percent cash composition of the
purchase price desired by Chevron. For illustration only, assume the number of Unocal
shares to be exchanged for the all-cash and all-stock options are 22.1 and 242 million,
respectively. This is the reverse of what actually happened. The mix of stock and cash
would have been prorated as shown in Exhibit 2.
It is typical of large transactions in which the target has a large, diverse shareholder
base that acquiring firms offer target shareholders a “menu” of alternative forms of
payment. The objective is to enhance the likelihood of success by appealing to a
broader group of shareholders. To the unsophisticated target shareholder, the array of
options may prove appealing. However, it is likely that those electing all-cash or
all-stock purchases are likely to be disappointed due to probable proration clauses in
merger contracts. Such clauses enable the acquirer to maintain an overall mix of cash
and stock in completing the transaction. This enables the acquirer to limit the amount of
cash they must borrow or the number of new shares they must issue to levels they find
acceptable.
Discussion Questions
1) What was the form of payment employed by both bidders for Unocal? In your
judgment, why were they
different? Be specific.
2) How did Chevron use the form of payment as a potential takeover strategy?
3) Is the “proration clause” found in most merger agreements in which target
shareholders are given several ways in which they can choose to be paid for their shares
in the best interests of the target shareholders? In the best interests of the acquirer?
Explain your answer.
Answer:
Form of payment can involve which of the following:
a. Cash
b. Stock
c. Cash and stock
d. Rights, royalties and fees
e. All of the above
Answer:
Determining where a firm should compete requires management to consider which of
the following factors?
a. Determining the firm’s current customers only
b. Determining the firm’s potential customers only
c. Determining the needs of current and potential customers, as well as suppliers
d. Determining the needs of potential suppliers only
e. A and D only
Answer:
News Corp.’s Power Play in Satellite Broadcasting The share prices of Rupert
Murdoch’s News Corp., Fox Entertainment Group Inc., and Hughes Electronics Corp.
(a subsidiary of General Motors Corporation) tumbled immediately following the
announcement that News Corp had reached an agreement to take a controlling interest
in Hughes on April 10, 2003. Immediately following the announcement, shares of Fox
fell by 17 percent, News Corp.’s ADRs (i.e., shares issued by foreign firms trading on
U.S. stock exchanges) by 6.5 percent and Hughes by 9.8 percent.
Hughes Electronics is a world leader in providing digital television entertainment,
broadband satellite networks and services (DirecTV), and global video and data
broadcasting. The News Corporation is a diversified international media and
entertainment company with operations in a number of industry segments, including
filmed entertainment, television, cable network programming, magazines and inserts,
newspapers and book publishing.
News Corp.’s Chairman Rupert Murdoch, had pursued control of Hughes, the parent
company of DirecTV, for several years. News Corp.’s bid valued at about $6.6 billion to
acquire control of Hughes Electronics Corp. and its DirecTV unit gives News Corp a
U.S. presence to augment its satellite TV operations in Britain and Asia. In one bold
move, News Corp became the second largest provider of pay-TV service to U.S. homes,
second only to Comcast. By transferring News Corp.’s stake in Hughes to Fox, Fox
gained control over 11 million subscribers. It gives Fox more leverage for its cable
networks when negotiating rights fees with cable operators that compete with DirecTV.
In negotiating with film studios or sports companies over pay television rights, News
Corp. is now the only global customer, with satellite systems spanning Europe, Asia,
and Latin America. Moreover, News Corp. can cross-promote among DirecTV and its
others businesses (e.g., packaging DirecTV subscriptions with subscriptions to TV
Guide).
General Motors was motivated to sell its investment in Hughes because of its poor
financial performance in recent years and GM’s need for cash. GM and Hughes had first
agreed to a deal with rival satellite broadcaster EchoStar Communications Inc.
However, the deal was blocked by antitrust regulators. Subsequent discussions between
GM/Hughes with SBC Communications and Liberty Media proved unproductive with
these firms offering primarily a share for share exchange. GM’s desire to quickly pull
cash out of Hughes made News Corp.’s offer the most attractive. Consequently, they
chose to accept News Corp.’s proposal rather than pursue a riskier proposal for a
Hughes’ management-sponsored leveraged buyout.
News Corp. financed its purchase of a 34.1% stake in Hughes (i.e., GM’s 20%
ownership and 14.1% from public shareholders) by paying $3.1 billion in cash to GM,
plus 34.3 million in nonvoting American depository receipts (ADRs) in News Corp.
shares. Hughes’ public shareholders will be paid with 122.2 million nonvoting ADRs in
News Corp. Each ADR is equivalent to four News Corp. shares. The resulting issue of
156.5 million shares would dilute News Corp. shareholders by about 13%. Immediately
following closing, News Corp.’s ownership interest was transferred to Fox in exchange
for a $4.5 billion promissory note from Fox and 74 million new Fox shares. This
transfer will saddle Fox with $4.5 billion in debt. This debt would need to be serviced
by Fox’s cash flow and could limit Fox’s access to new capital.
Now that News Corp. controls DirecTV through its 81 percent ownership in Fox, it
must find away to revitalize DirecTV. Against tough cable-TV competition, DirecTV
has experienced a 20% turnover rate among its subscribers, due in part to GM’s benign
neglect while it looked for a buyer. News Corp. will now have to compete against
larger, better financed cable operations, as well as the nimble, low cost EchoStar
Communications Corp’s Dish Network. As an indication of the extent to which Hughes
has stumbled in recent years, News Corp. made a formal bid to acquire all of Hughes
for about $25 billion in cash in 2001. News Corp.’s current investment stake implies a
valuation of less the $20 billion for 100 percent ownership of Hughes (i.e., $6.6
billion/.341).
Discussion Questions:
1) Why did the share prices of News Corp., Fox, and Hughes fall precipitously
following the announcement? Explain your answer. 2) How did News Corp.’s proposed
deal structure better satisfy GM’s needs than those of other bidders? 3) How can it be
said that News Corp. obtained a controlling interest in Hughes when its stake amounted
to only about one-third of Hughes outstanding voting shares? Explain your answer.
Answer:
Which of the following represent options available to managers in making investment
decisions?
a. Delay initial investment
b. Accelerate cumulative investment
c. Abandon the investment at a later date
d. A & B only
e. A, B, & C
Answer:
Which of the following are ways to implement a firm’s business strategy?
a. Merge or acquisition
b. Joint venture
c. Going it alone
d. Asset swap
e. All of the above
Answer:
Greenfield operations represent an appropriate entry if which of the following is true?
a. Entry barriers are low
b. Cultural differences are high
c. Entrant has limited multinational experience
d. Entrant is risk adverse
e. A and B only
Answer:
State “blue sky” laws are designed to
a. Allow states to block M&As deemed as anticompetitive
b. Protect individual investors from investing in fraudulent securities’ offerings
c. Restrict foreign investment in individual states
d. Protect workers’ pensions
e. Prevent premature announcement of M&As
Answer:
Leveraged employee stock ownership plans are frequently used by owners of private
businesses to
a. Hide assets
b. Motivate employees
c. Sell the firm to the employees
d. B and C
e. A, B, and C
Answer: