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Answers and Solutions: 22 - 1
Chapter 22
Mergers and Corporate Control
ANSWERS TO END-OF-CHAPTER QUESTIONS
22-1 a. Synergy occurs when the whole is greater than the sum of its parts. When applied to
mergers, a synergistic merger occurs when the postmerger free cash flows exceed the
sum of the separate companies' premerger free cash flows. A merger is the joining of
two firms to form a single firm.
c. A friendly merger occurs when the target company's management agrees to the
merger and recommends that shareholders approve the deal. In a hostile merger, the
management of the target company resists the offer. A defensive merger occurs when
one company acquires another to help ward off a hostile merger attempt. A tender
offer is the offer of one firm to buy the stock of another by going directly to the
stockholders, frequently over the opposition of the target company’s management. A
target company is a firm that another company seeks to acquire. Breakup value is a
firm’s value if its assets are sold off in pieces. An acquiring company is a company
that seeks to acquire another firm.
Answers and Solutions: 22 - 2
f. Under purchase accounting, the acquiring firm is assumed to have “bought” the
acquired company in much the same way it would buy any capital asset. Any excess
of the purchase price over the book value of assets is added to goodwill, which may
be expensed for Federal income tax purposes, but may not be expensed for
shareholder reporting.
i. A divestiture is the opposite of an acquisition. That is, a company sells a portion of its
assets, often a whole division, to another firm or individual. In a spin-off, a holding
company distributes the stock of one of the operating companies to its shareholders.
Thus, control passes from the holding company to the shareholders directly.
j. A holding company is a corporation formed for the sole purpose of owning stocks in
other companies. A holding company differs from a stock mutual fund in that holding
companies own sufficient stock in their operating companies to exercise effective
22-2 Horizontal and vertical mergers are most likely to result in governmental intervention,
22-3 A tender offer might be used. Although many tender offers are made by surprise and over
22-4 An operating merger involves integrating the company's operations in hopes of obtaining
synergistic benefits, while a pure financial merger generally does not involve integrating
the merged company's operations.
22-5 The three models—APV, FCFE and corporate valuation (CV) all do the same thing.
They value a firm’s operations and its equity. When implemented under a scenario that is
consistent with the assumptions of all three models, they will all give the same answer.
The CV model discounts free cash flows at the WACC to obtain the value of operations.
Answers and Solutions: 22 - 4
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
22-1 FCF1 = 2.00(1.05) = $2.1 million; g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd = 30%; T =
40%; rd = 8% Vops = ? P0 = ?
rsL = rRF + RPM(b)
= 5% + 6%(1.4)
= 13.4%.
22-2 FCF1 = $2.5 million, FCF2 = $2.9 million, FCF3 = $3.4 million, and FCF4 = 3.57 million;
Interest in the 4th year = $1.472 million. g = 5%; b = 1.4; rRF = 5%; RPM = 6%; wd =
30%; T = 40%; rd = 8% Vops = ? P0 = ?
rsU = wdrd + wsrsL Note: rsL was calculated in problem 1 to be 13.4%
= 0.30(8%) + 0.70(13.4%)
= 11.78%
Answers and Solutions: 22 - 5
Tax shield horizon value = TS4(1+g)/(rsU-g)
= 0.5888 (1.05)/(0.1178-0.05)
= 9.12
Value of operations = unlevered Vops + value of tax shields
= 44.69 + 7.67
= 52.36 million
Corporate Valuation Model Horizon Value = FCF4(1+g)/(WACC-g)
= 3.57(1.05)/(0.1082 – 0.05)
= 3.7485/(0.0582)
= $64.41 million
Value of operations =
432 )1082.1(
41.6457.3
)1082.1(
4.3
)1082.1(
9.2
1082.1
5.2 +
+++
= $52.19 million
Answers and Solutions: 22 - 6
22-4 The difference between this problem and Problem 2 is the tax shield in year 4, which
reflects the 45% debt capital structure. TS4 = (new debt level)(interest rate on debt)(tax
rate) = 30.6(0.085)(0.40) = $1.04 million. rsU = 11.78% was calculated in the earlier
problems.
The unlevered horizon value and the unlevered value of operations is the same as in
Problem 3:
Unlevered horizon value = FCF4(1+g)/(rsU-g)
= 3.57(1.05)/(0.1178-0.05)
= $55.29 million
Although not necessary for the problem, you could calculate the new WACC that will
prevail after the 45% target capital structure is reached.
rsL = rsU + (rsU –rd)(D/S)
= 11.78% + (11.78% - 8.5%)(0.45/0.55)
= 14.46%
22-5 a. The appropriate discount rate reflects the risk of the cash flows. Thus, it is Conroy’s
unlevered cost of equity that should be used to discount the free cash flows and tax
shields in years 1-5 and at the horizon. The horizon value should be calculated using
Conroy’s tax shields at the stable target capital structure, which are provided for Year
5. Since Conroy’s beta = 1.3, its current cost of equity, rsL = 6% + 1.3(4.5%) =
11.85%. Since its percentage of debt is 25% and the rate on its debt is 9%, its
unlevered cost of equity is
rsU = wdrd + wsrsL
= 0.25(9%) + 0.75 (11.85%)
= 11.14%
The value of the tax shields =
5432 )1114.1(
28.15741.0
)1114.1(
735.0
)1114.1(
980.0
)1114.1(
595.0
1114.1
42.0 +
++++
= $11.50 million
Answers and Solutions: 22 - 8
The unlevered value of operations is
5432 )1114.1(
74.4312.2
)1114.1(
0.2
)1114.1(
75.1
)1114.1(
5.1
1114.1
3.1 +
++++
= $32.02 million
b. The value of operations is the sum of the interest tax shields and the unlevered value
= 11.50 + 32.02 = $43.52 million.
structure can be calculated. At the new capital structure of 40 percent debt with a rate
of 9.5 percent, the new levered cost of equity and WACC will be:
rsL = rsU + (rsU –rd)(D/S)
Answers and Solutions: 22 - 9
22-6 a. BCC’s unlevered cost of equity depends on its pre-merger cost of equity and its pre-
merger capital structure:
b. The free cash flows are NOPAT – investment in net operating capital = (Sales – CGS
– selling expenses)(1-T) – investment in net operating capital. CGS is 65% of sales:
2013
2014
2015
2016
2017
2018
Net sales
$450.00
$518.00
$555.00
$600.00
$643.00
Cost of Goods Sold
$292.50
$336.70
$360.75
$390.00
$417.95
TSn = Interestn(Tax rate)
TS1 = 40(0.35) = 14.00, TS2 = 45(0.35) = 15.75, TS3 = 47(0.35) = 16.45,
TS4 = 52(0.35) = 18.20, TS5 = 54(0.35) = 18.90
d. Value of tax shields = PV of tax shields and the PV of the horizon value of the tax
shields at rsU.
The unlevered value of operations = PV of the FCFs and the PV of the unlevered
horizon value at rsU. The cash flows for both are summarized below:
2014
2015
2016
2017
2018
1. Tax shield
$14.00
$15.75
$16.45
$18.20
$18.90
2. TSHV
$510.68
The NPV of the FCF yearly values and horizon value (shown in row 6) is
$444.27, which is the unlevered value of operations.
The sum of the value of the tax shields and the unlevered value of operations is
the value of operations: 364.30 + 444.27 = $808.57.
Less the value of debt, $300, is the value of equity:
808.6 – 300 = $508.57 million.
Answers and Solutions: 22 - 11
SOLUTION TO SPREADSHEET PROBLEMS
Mini Case: 22- 12
MINI CASE
Hager’s Home Repair Company, a regional hardware chain that 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 (LL), a chain that operates in several adjacent states, and he has enlisted your
help.
The table below indicates Zona’s estimates of LL’s earnings potential if it came
under Hager’s management (in millions of dollars). The interest expense listed here
includes the interest (1) on LL’s existing debt, which is $55 million at a rate of 9 percent,
and (2) on new debt expected to be issued over time to help finance expansion within the
new “L division,” the code name given to the target firm. If acquired, LL will face a 40
percent tax rate.
Security analysts estimate LL’s beta to be 1.3. The acquisition would not change
Lyons’ capital structure, which is 20 percent debt. Zona realizes that Lyons’ Lighting’s
business plan also requires certain levels of operating capital and that the annual
investment could be significant. The required levels of total net operating capital are listed
below.
Zona estimates the risk-free rate to be 7 percent and the market risk premium to be
4 percent. He also estimates that free cash flows after 2018 will grow at a constant rate of 6
percent. Following are projections for sales and other items.
2013 2014 2015 2016 2017 2018
Net sales $60.00 $90.00 $112.50 $127.50 $139.70
Cost of goods sold (60%) 36.00 54.00 67.50 76.50 83.80
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
Interest expense 5.00 6.50 6.50 7.00 8.16
Total net operating capital 150.00 150.00 157.50 163.50 168.00 173.0
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.
Mini Case: 22- 13
a. Several reasons have been proposed to justify mergers. Among the more
prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase
of assets at below-replacement cost, (5) synergy, and (6) globalization. In
general, which of the reasons are economically justifiable? Which are not?
Which fit the situation at hand? Explain.
Answer: The economically justifiable rationales for mergers are synergy and tax
consequences. Synergy occurs when the value of the combined firm exceeds the sum
of the values of the firms taken separately. (if synergy exists, then the whole is
greater than the sum of the parts, and hence synergy is also called the "2 + 2 = 5"
effect.)
A synergistic merger creates value, which must be apportioned between the
stockholders of the merging companies. Synergy can arise from four sources: (1)
operating economies of scale in management, production, marketing, or distribution;
(2) financial economies, which could include higher debt capacity, lower transactions
costs, or better coverage by securities' analysts which can lead to higher demand and,
hence, higher prices; (3) differential management efficiency, which implies that new
management can increase the value of a firm's assets; and (4) increased market power
The motives that are generally less supportable on economic grounds are risk
reduction, purchase of assets at below replacement cost, control, and globalization.
Managers often state that diversification helps to stabilize a firm's earnings stream
and thus reduces total risk, and hence benefits shareholders.
Mini Case: 22- 14
Sometimes a firm will be touted as a possible acquisition candidate because the
replacement value of its assets is considerably higher than its market value. For
example, in the early 1980s, oil companies could acquire reserves more cheaply by
buying out other oil companies than by exploratory drilling. However, the value of
an asset stems from its expected cash flows, not from its cost. Thus, paying $1
million for a slide rule plant that would cost $2 million to build from scratch is not a
good deal if no one uses slide rules.
b. Briefly describe the differences between a hostile merger and a friendly merger.
Answer: In a friendly merger, the management of one firm (the acquirer) agrees to buy
another firm (the target). In most cases, the action is initiated by the acquiring firm,
but in some situations the target may initiate the merger. The managements of both
Mini Case: 22- 15
c. What are the steps in valuing a merger?
Answer: 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:
d. Use the data developed in the table to construct the L division's free cash flows
for 2014 through 2018. Why are we identifying interest expense separately since
it is not normally included in calculating free cash flow or in a capital budgeting
cash flow analysis? Why is investment in net operating capital included when
calculating free cash flow?
Answer: The easiest approach here is to calculate the free cash flows for the L division,
assuming that the acquisition is made (in millions of dollars).
2013 2014 2015 2016 2017 2018
Net sales $60.0 $90.0 $112.5 $127.5 $139.70
Mini Case: 22- 16
The free cash flows and interest tax savings are discounted separately at the unlevered
cost of equity. This is more convenient to use than the corporate value model because
the unlevered cost of equity can be used even when the capital structure is changing.
include the interest tax shield and use the APV.
In regards to retentions, all of the cash flows from an individual project are
available for use throughout the firm, since capital expenditures are explicitly
accounted for. Similarly, we account for capital expenditures within the acquired
firm when we calculate free cash flow. There are two equivalent ways to calculate
free cash flow:
NOPAT
+ Depreciation
Mini Case: 22- 17
The steps to apply the APV model are:
(1) Calculate the unlevered cost of equity, rsU, using the pre-merger levered cost of
equity and the pre-merger capital structure; (2) calculate the horizon value of the
unlevered firm as the present value of the free cash flows after the horizon discounted
at rsU; (3) calculate the horizon value of the tax shields as the present value of the
interest tax shields after the horizon discounted at rsU; (4) calculate the value of the
unlevered firm as the present value of the horizon value of the unlevered firm plus the
present value of the free cash flows until the horizon, discounted at rsU; (5) calculate
the value of the tax shields as the present value of the horizon value of the tax shields
Mini Case: 22- 18
e. Conceptually, what is the appropriate discount rate to apply to the cash flows
developed in part c? What is your actual estimate of this discount rate?
Answer: As discussed above, the free cash flows, tax shields and horizon value should all
be discounted at the unlevered cost of equity. This cost should be calculated based on
f. What is the estimated horizon, or continuing, value of the acquisition; that is,
what is the estimated value of the L division's cash flows 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.
Answer: The 2018 cash flow is $20.7 million, and it is expected to grow at a 6 percent constant
growth rate in 2018 and beyond. We will find the unlevered horizon value and the
horizon value of the tax shields:
Mini Case: 22- 19
Now, the value of Lyons’ operations is the sum of the unlevered value and the
value of the tax shields:
Value of operations = Unlevered value of operations + value of tax shields
= $298.9 million + 45.5 million
= $344.4 million
The value of Lyons’ equity is this value of operations less its current debt of $55
million, for an equity value of $289.4 million.
Mini Case: 22- 20
g. Assume that Lyons’ has 20 million shares outstanding. These shares are traded
relatively infrequently, but the last trade, made several weeks ago, was at a price
of $11 per share. Should Hager’s make an offer for Lyons’? If so, how much
should it offer per share?
Answer: With a current price of $11 per share and 20 million shares outstanding, Lyons’
current market value is $11(20) = $220 million. Since Lyons’ expected value to
Hager’s is $289.4 million, it appears that the merger would be beneficial to both sets
of stockholders. The difference, $289.4 - $220.0 = $69.4 million, is the added value
to be apportioned between the stockholders of both firms.
Mini Case: 22- 21
h. How would the analysis be different if Hager’s intended to recapitalize Lyons’
with 40% debt costing 10% at the end of four years? This amounts to $221.6
million in debt as of the end of 2017.
Answer: The free cash flows and the unlevered cost of equity would be unchanged. Thus the
unlevered horizon value and the unlevered value of operations will remain the same.
If we assume that the interest payments in the first 4 years are unchanged, and the
intention is to use 40 percent debt costing 10 percent throughout 2018 and thereafter
at the horizon, then the horizon tax shield will be larger, as will the tax shield in 2016:
New Tax Shield horizon value =
gr
g)Shield)(1Tax 2018 (New
sU −
+
=
06.01156.0
)06.1(864.8$
−
= $169.0 million.
Mini Case: 22- 22
i. 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?
Answer: Most researchers agree that takeovers increase the wealth of the shareholders of
target firms, for otherwise they would not agree to the offer. However, there is a
j. What method is used to account for mergers?
Answer: Mergers must be accounted for using purchase accounting, in which the acquired
k. What merger-related activities are undertaken by investment bankers?
Answer: The investment banking community is involved with mergers in a number of
ways. Several of these activities are: (1) helping to arrange mergers, (2) aiding target
Mini Case: 22- 23
l. What are the major types of divestitures? What motivates firms to divest
assets?
Answer: The three primary types of divestitures are (1) the sale of an operating unit to
another firm, (2) setting up the business to be divested as a separate corporation and
m. What are holding companies? What are their advantages and disadvantages?
Answer: Holding companies are corporations formed for the sole purpose of owning the
