Finance Chapter 10 Mergers And Acquisitions Mergers And Acquisitions John Mccormack Points Out

Chapter 10 – Mergers and Acquisitions

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CHAPTER 10

Mergers and Acquisitions

1. John McCormack points out that instead of relying on DCF for valuation, investors rely on

the P/E valuation heuristic that takes P/E as given and overfocuses on E. He points out that

2. The acquisition of Compaq by H-P might have resulted in higher fees for McKinsey

3. For Patricia Dunn, the “representative” successful acquisition overcomes key challenges in

4. Is the technique H-P executives used the same, or comparable, to traditional DCF?

Suppose that beginning two years from now, H-P expects to save $1.5 billion after tax every

year into perpetuity. If H-P discounted those savings at 5 percent, then the present value of

Chapter 10 – Mergers and Acquisitions

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incremental earnings that extend into perpetuity. Since H-P’s P/E ratio at the time was about

20, they valued the incremental earnings stream by multiplying the $1.5 billion by 20.

Because the incremental earnings would occur in the future (two years out, one to complete

the merger and a second to generate the cost savings), H-P discounted the associated $29.4

billion by about 15 percent per year.

Notice that there is no attempt to ascertain what value of P/E makes fundamental

sense. In addition, was the expected cost savings stream as risky as the other components of

Did H-P pay a reasonable premium for Compaq? There are several ways to look at

this question. First, if H-P used a discount rate of 15 percent, why are they implicitly

Second, the original $2.1 billion premium that H-P perceives that it paid for Compaq

stems from the nature of the sharing rule. Effectively, the sharing rule provided H-P

shareholders with 64.4 percent of the combined entity. At the time the deal was agreed, H-P’s

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Third, H-P does appear to have been generating the cost savings they anticipated, and

if continued, the value of those savings would exceed the perceived premium.

Are there any valuation implications attached to H-P’s P/E ratio being at 16 rather

than 20? In the eyes of H-P managers, it means that the market’s judgment of the value of

5. As the chapter text makes clear, the $11 billion Autonomy acquisition turned out to be

value destructive, not only in hindsight, but also in foresight. Consistent with confirmation

6. Reuben Mark is described as overconfident by the media, is a longholder, and has engaged

in major acquisitions. Yet his firm has thrived. Behavioral phenomena are about general

7. In 2005, Case wrote a Washington Post article arguing that AOL should be split from

Time Warner. He argued that the merger failed because the two firms were never integrated,

Chapter 10 – Mergers and Acquisitions

with Time Warner having slowed AOL’s progress in building upon its existing social

8. Analysts judgment of the deal was favorable because they viewed MGM Grand’s

management to be more efficient than Mirage Resorts’ management in respect to cost–

containment and profitability. That is, perhaps, an income statement perspective, rather than

a discounted cash flow perspective. The market response to the announcement was negative,

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1. Microsoft’s past success left it with unfulfilled aspirations, and its offer for Yahoo! reflects

aspiration-based risk seeking. The minicase states that “during the prior decade Microsoft

2. The Yahoo! board concluded that Microsoft’s offer to pay a 62 percent premium over

market value was insufficient, suggesting that they viewed Yahoo! stock as being at least 62

percent undervalued. See the section about overconfident targets on page 236. The key issues

pertain to excessive optimism, overconfidence, possibly illusion of control, and possibly

value expressiveness on the part of CEO Jerry Yang who was a co-founder. In this regard,

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3. The Chapter next mentions evidence of reference points effects involving peak prices for

the target over various horizons, most notably the 52-week high, and also the 13-week high

and 26-week high. In this regard, the text states the following: “[T]arget firm boards that are

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4. The issue in this question is similar to the discussion on page 245 involving the magnitude

of the synergy in the HP- Compaq deal. Use the constant growth perpetuity formula PV =

C/k, where C denotes annual cost saving and k is the discount rate. If we use the value of

WACC stated in the case for k, namely 10 percent, then PV = $1.5b/0.1 = $15b. The $1.5b

$17.1b.

Microsoft offered a premium of $11.82 per share (=$31.00 – $19.18), which when

multiplied by 1,337,165,000 shares amounts to a $15.8b total premium. (The minicase notes

Chapter 10 – Mergers and Acquisitions

The riskiness of the cost savings stream is also an issue. In this regard, if the cost

savings stream were to be very low in risk, the appropriate discount rate might be close to the

yield on its debt.

These computations suggest that the discount rate is important and that the synergy

Microsoft perceived is consistent with the associated cost savings.

Length of horizon is opaquely framed when valuing the intrinsic value of the synergy

by multiplying cost savings by P/E. In this regard, a multiplying annual after-tax cost savings

by a P/E of 20 is equivalent to using an infinite horizon with a discount rate of 5%.

5. Microsoft’s offer conforms to the definition of a bad merger, as its stock fell by more than

3 percent in value on a risk adjusted basis during the three day period. Specifically,

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Microsoft’s stock fell by 9.7 percent, which cannot be explained by a beta of 0.31, given the

market decline of 3 percent during this period.

6. In respect to capital budgeting, Microsoft sought to develop a significant upgrade to

its core product line, the Vista operating system. However, in line with the discussion in

Chapter 4, Vista was late to be delivered and had far fewer features than its customers

expected.

7. As Chapter 10 notes, the executives of acquiring firms are reluctant to use what they

regard to be undervalued equity to purchase targets, which induced them to prefer to use

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cash. In addition, untrusting target firms prefer being paid in cash, rather than take the risk of

being paid in overvalued equity of acquiring firms. The minicase notes the following:

8. The key point involves Steve Ballmer’s comment about Carol Bartz having driven a hard

bargain, along with his comment (in American baseball slang) about the “opportunity to

swing for the fences in search.” Swinging for the fences can be interpreted as aspiration–

based risk seeking.

The opportunity to swing for the fences, and possibly excessive optimism and

overconfidence on Ballmer’s part, would be reflected in Microsoft’s BPV, with value V in

Therefore, the negotiations between Microsoft and Yahoo! featured more than a

debate about financial value, but also the psychological issues motivating Ballmer and Yang.

Ballmer was willing to pay a substantial premium to indulge his need to swing for the fences,

but the minimal amount Yang was willing to accept reflected an even higher premium.

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the -3 percent decline in the S&P 500 over that period.

Media coverage of the proposed acquisition was negative, with some characterizing it

as having the feeling of being an “AOL–Time Warner 2.0,” or in other words an example of a

11. As backdrop to answering this question, the minicase points out that after 2011 Yahoo!

continued to drift as a business. The hiring of Marissa Meyer as CEO led to the development

of her MAVEN strategy, and this became the main focus of her attempt to provide a clear

strategic focus that would capitalize on the company’s core assets. The issue of dealing with

cybersecurity threats was in tension with Meyer’s MAVEN-based strategy for generating

growth. The resulting conflicts between the firm’s executives and its cybersecurity team raise

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