1/15/2015
2015 2016 2017 2018 2019 2020
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
a.
Chapter 26. 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
The table below indicates Zona’s estimates of LL’s earnings potential if it came under Hager’s
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 2020 will grow at a constant rate of 6 percent. Following are
projections for sales and other items.
Selling/administrative expense 4.50 6.00 7.50 9.00 11.00
Interest expense
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%
Economically justifiable reasons:
Synergy: Value of the whole exceeds sum of the parts. Could arise from:
Operating economies
Questionable reasons for mergers:
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:
Often, mergers that start out hostile end up as friendly, when offer price is raised.
c.
d.
2015 2016 2017 2018 2019 2020
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
Use the data developed in the table to construct the L division’s free cash flows for 2016 through
2020. 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
Briefly describe the differences between a hostile merger and a friendly merger.
Financial economies
Differential management efficiency
Taxes (use accumulated losses)
Break-up value: Assets would be more valuable if broken up and sold to other companies.
e.
f.
Beta = 1.3
(2020 Free Cash Flow)(1+g)
40%
rsU = 11.56%
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
Unlevered
Horizon Value =
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.
rsU – g
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?
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 2020? 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.
These estimated cash flows are unlevered flows plus the tax shelter from interest payments. Because
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
Interest expense
Tax savings from interest 2.000$ 2.600$ 2.600$ 2.800$ 3.264$
(2020 Tax Shield)(1+g)
TS. Horizon Value = $ 62.2 million
g.
Estimated Value of Target = $ 289.4
such synergies has been problematic in many mergers.
Unlevered value (From before. This doesn’t change) $ 298.9 million
New tax shield in 2020 = Debt in 2020 x new interest rate x T
Tax Shield
Horizon Value =
rsU – 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?
The free cash flows and the unlevered cost of equity would be unchanged. If we assume that the
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 $221.6 million of debt at the year prior to the
horizon.
Interest tax shield 2.0$ 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?
Interest in 2020 $ 22.16
Tax shield in 2020 $ 8.864 million
Tax shield horizon value = $ 169.0 million
2016 2017 2018 2019 2020
Interest tax shield 2.0$ 2.6$ 2.6$ 2.8$ 8.864$
Tax shield horizon value 169.0$
Tax Shield Value = PV at rsU = $ 110.5 million
Vops = Tax shield value + Unlevered value = $ 409.4 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.
j.
Pooling of interests has been eliminated. Only purchase accounting may be used.
Purchase:
k.
Identifying targets
The assets of the acquired firm are “written up” to reflect purchase price if it is greater than the
What merger-related activities are undertaken by investment bankers?
What method is used to account for mergers?
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
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:
Disadvantages:
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
What are the major types of divestitures? What motivates firms to divest assets?
What are holding companies? What are their advantages and disadvantages?
Developing defensive tactics
Establishing a fair value
Financing mergers
Arbitrage operations
See the Web Extension to this chapter for a complete explanation of how to project
consistent interest expenses.
2020
Free Cash Flow 21.94
growth rate at horizon
6.0%
Step 1: Calculate the WACC at the horizon:
rsL(Target) = 12.2%
Horizon Free Cash Flow)(1+g)
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
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
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.
Step 4: Calculate the amount of debt that is consistent with this value of operations and the assumed debt
percent.
rd =9.0%
rsU(Target) = 20% 9% +80.0% 12.2%
rsU(Target) = 11.56%
Interest 2020 = Debt 2019 xrd
This is the amount of interest expense we projected for the last year of projections.
Calculations with a change in capital structure
Step 1: Calculate the new WACC at the horizon:
Calculate a new levered cost of equity:
New wd =40%
New rd =10%
Calculate a new Horizon Value of Operations
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 2: Calculate the horizon value using the Corporate Valuation Model. This is ok since the capital
structure is constant once the horizon is reached.
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.
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.
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.
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.