12/10/2012
2013 2014 2015 2016 2017 2018
Net sales 60.00 90.00 112.50 127.50 139.70
Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
a.
Break-up value: Assets would be more valuable if broken up and sold to other companies.
Chapter 22. Mini Case for Mergers and Corporate Control
Hager’s management is new to the merger game, so Zona has been asked to answer some basic
questions about mergers as well as to perform the merger analysis. To structure the task, Zona has
developed the following questions, which you must answer and then defend to Hager’s board.
Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax
considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5)
synergy, and (6) globalization. In general, which of the reasons are economically justifiable?
Which are not? Which fit the situation at hand? Explain.
Hager’s Home Repair Company, a regional hardware chain, which specializes in “do-it-yourself”
materials and equipment rentals, is cash rich because of several consecutive good years. One of the
alternative uses for the excess funds is an acquisition. Doug Zona, Hager’s treasurer and your boss,
has been asked to place a value on a potential target, Lyons’ Lighting, a chain which operates in
several adjacent states, and he has enlisted your help.
Zona estimates the risk-free rate to be 9 percent and the market risk premium to be 4 percent. He also
estimates that free cash flows after 2018 will grow at a constant rate of 6 percent. Following are
projections for sales and other items.
Interest expense 5.00 6.50 6.50 7.00 8.16
Total Net Operating Capital 150.00 150.00 157.50 163.50 168.00 173.00
Investment in net operating capital 0.00 7.50 6.00 4.50 5.00
risk free rate 7%
market risk premium 4%
pre-merger beta 1.3
pre-merger % debt 20%
pre-merger debt 55.00$ million
pre-merger debt rd9%
Tax rate 40%
Diversification
Purchase of assets at below replacement cost
Acquire other firms to increase size, thus making it more difficult to be acquired
b.
Friendly merger:
The merger is supported by the managements of both firms.
Hostile merger:
c.
d.
2013 2014 2015 2016 2017 2018
Net sales 60.0$ 90.0$ 112.5$ 127.5$ 139.7$
Cost of goods sold (60%) 36.0 54.0 67.5 76.5 83.8
Selling/administrative expense 4.5 6.0 7.5 9.0 11.0
Taxes on EBIT (40%) 7.8 12.0 15.0 16.8 18.0
Total net operating capital 150.0 150.0 157.5 163.5 168.0 173.0
Investment in operating capital 0.0 7.5 6.0 4.5 5.0
Free Cash Flow 11.70 10.50 16.50 20.70 21.94
Interest expense 5.00 6.50 6.50 7.00 8.16
Tax savings from interest 2.000$ 2.600$ 2.600$ 2.800$ 3.264$
e.
FCFs at the unlevered cost of equity.
the individual tax shields.
1. Project FCFt ,TSt until the target is at its target capital structure for one year and and is
expected to grow thereafter at a constant growth rate.
Conceptually, what is the appropriate discount rate to apply to the cash flows developed in Part c?
What is your actual estimate of this discount rate?
Use the data developed in the table to construct the L division’s free cash flows for 2014 through
2018. Why are we identifying interest expense separately since it is not normally included in
calculating free cash flows or in a capital budgeting cash flow analysis? Why is the investment in
net operating capital deducted in calculating the free cash flow?
What are the steps in valuing a merger?
When the capital structure is changing rapidly, as in many mergers, the WACC changes
from year-to-year and it is difficult to apply the corporate valuation model in these
cases. The APV model works better when the capital structure is changing. The steps
are:
Briefly describe the differences between a hostile merger and a friendly merger.
When debt levels are changing rapidly, as they do with many mergers, it is difficult to apply the
corporate value model or standard capital budgeting techniques to merger valuation because the
discount rate changes as the debt level changes. Instead, the APV method is easier to apply.
Often, mergers that start out hostile end up as friendly, when offer price is raised.
f.
Beta = 1.3
(2018 Free Cash Flow)(1+g)
40%
rsU = 11.56%
g = 6%
Unlevered Horizon Value = $ 418.3 million
Free Cash Flow $ 11.7 $ 10.5 $ 16.5 $ 20.7 $ 21.94
Unlevered Horizon Value $ 418.3
Unlevered Value = PV at rsU = $ 298.9 million
(2018 Tax Shield)(1+g)
TS. Horizon Value = $ 62.2 million
Interest tax shield 2.0$ 2.6$ 2.6$ 2.8$ 3.264$
Tax shield horizon value 62.23$
Tax Shield Value = PV at rsU = $ 45.462 million
– Debt $ 55.00
= Equity $ 289.4 million
Would another potential acquirer obtain the same value?
rsU – g
Horizon Value =
g.
Estimated Value of Target = $ 289.4
Target’s Current Value = $ 220.0 20 million shares x $11/share
What is the estimated horizon, or continuing, value of the acquisition; that is, what is the estimated
value of the L division’s unlevered cash flows and tax shields beyond 2018? What is Lyons’ value
to Hager’s shareholders? Suppose another firm were evaluating Lyons’ as an acquisition
candidate. Would they obtain the same value? Explain.
Assume that Lyons’ has 20 million shares outstanding. These shares are traded relatively
infrequently, but the last trade, made several weeks ago, was at a price of $11 per share. Should
Hager’s make an offer for Lyons’? If so, how much should it offer per share?
Unlevered
Horizon Value =
rsU – g
Unlevered value (From before. This doesn’t change) $ 298.9 million
New tax shield in 2018 = Debt in 2018 x new interest rate x T
Interest in 2018 $ 22.16
Tax shield in 2018 $ 8.864 million
Tax shield horizon value = $ 169.0 million
2014 2015 2016 2017 2018
Interest tax shield 2.0$ 2.6$ 2.6$ 2.8$ 8.864$
Tax shield horizon value 169.0$
Total tax shield cash flows $ 2.0 $ 2.6 $ 2.6 $ 2.8 $ 177.9
Tax Shield Value = PV at rsU = $ 110.5 million
– Debt 55.0
= Equity $ 354.4 million
Increase in value due to increased tax shields 65.02
Lyons’ Lighting is worth $ 65.02 million more to Hager’s at 40% debt
than at 20% debt. The difference is the added benefit of a larger tax shield.
This amounts to
i.
Shareholders of target firms reap most of the benefits, that is, the final price is close to full value.
There has been considerable research undertaken to determine whether mergers really create
value, and, if so, how this value is shared between the parties involved. What are the results of
this research?
According to empirical evidence, acquisitions do create value as a result of economies of scale, other
The free cash flows and the unlevered cost of equity would be unchanged. If we assume that the
interest payments in the first 4 years are unchanged, and the intention is to use $221.6 million in debt
from year 5 on, then the horizon value of the tax shield would increase.
h. How would the analysis be different if Hager’s intended to recapitalize Lyons’ with 40 percent debt
costing 10% at the end of 4 years? This amounts to $221.6 million of debt at the year prior to the
horizon.
such synergies has been problematic in many mergers.
j.
Pooling of interests has been eliminated. Only purchase accounting may be used.
Purchase:
k.
Identifying targets
Arranging mergers
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
l.
Sale of an entire subsidiary to another firm.
Spinning off a corporate subsidiary by giving the stock to existing shareholders.
Carving out a corporate subsidiary by selling a minority interest.
Outright liquidation of assets.
A firm divests assets:
Because the subsidiary worth more to buyer than when operated by current owner.
To settle antitrust issues.
To change strategic direction.
To shed money losers.
To get needed cash when distressed.
m.
Advantages:
Control with fractional ownership.
Isolation of risks.
Disadvantages:
Partial multiple taxation.
Ease of enforced dissolution.
What method is used to account for mergers?
A holding company is a corporation formed for the sole purpose of owning the stocks of other
companies. In a typical holding company, the subsidiary companies issue their own debt, but their
equity is held by the holding company, which, in turn, sells stock to individual investors.
What are the major types of divestitures? What motivates firms to divest assets?
What are holding companies? What are their advantages and disadvantages?
The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the net
asset value.
What merger-related activities are undertaken by investment bankers?
Goodwill is often created, which appears as an asset on the balance sheet.
Common equity account is increased to balance assets and claims.
See the Web Extension to this chapter for a complete explanation of how to project
consistent interest expenses.
2018
Free Cash Flow 21.94
growth rate at horizon
6.0%
Step 1: Calculate the WACC at the horizon:
rsL(Target) = 12.2%
wd =20.0%
Horizon Free Cash Flow)(1+g)
$ 480.50
Note: we can discount the FCF and Horizon Value at the WACC for this year because we’ve assumed the
capital structure is constant in the last year of projections.
to set the debt level in the next to last year of projections so we can set the interest expense in the last year
of projections.
Horizon Value + Horizon Free Cash Flow
Debt 2017 = Vops 2017 xwd
Debt 2017 = x 20.0%
Debt 2017 = $ 90.66
Interest 2018 = Debt 2017 xrd
453.31
Step 5: Calculate the interest expense in the last year that corresponds to the debt calculated in the
previous step.
This worksheet shows how the debt and interest were projected at the end of the horizon.
Step 2: Calculate the horizon value using the Corporate Valuation Model. This is ok since the capital
structure is constant once the horizon is reached.
Horizon Value =
WACC – g
Step 4: Calculate the amount of debt that is consistent with this value of operations and the assumed debt
percent.
Horizon Value =
rd =9.0%
rsU(Target) = 20% 9% +80.0% 12.2%
rsU(Target) = 11.56%
Step 1: Calculate the new WACC at the horizon:
Calculate a new levered cost of equity:
New wd =40%
New rd =10%
New WACC(Target) =
New WACC(Target) =
New WACC(Target) =
Calculate a new Horizon Value of Operations
Horizon Free Cash Flow)(1+g)
$ 587.28
capital structure is constant in the last year of projections.
Debt 2017 = Vops 2017 xwd
Interest 2018 = Debt 2017 xrd
Horizon Value =
New WACC – g
Step 2: Calculate the horizon value using the Corporate Valuation Model. This is ok since the capital
structure is constant once the horizon is reached.
Horizon Value =
Step 3: Calculate the value of operations as of the year before the horizon. We need this because we need
to set the debt level in the next to last year of projections so we can set the interest expense in the last year
of projections.
Step 4: Calculate the amount of debt that is consistent with this value of operations and the assumed debt
percent.
Step 5: Calculate the interest expense in the last year that corresponds to the debt calculated in the
previous step.
This is the amount of interest expense we projected for the last year of projections.
This is exactly the same as above, but we use the new capital structure and new cost of debt to calculate a
new WACC, which is used in Steps 2 and 3 above. The new cost of debt is used in Step 4.