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CHAPTER 26

Merger Analysis

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Justifications for Mergers

Valid justifications: Break-up value exceeds value as

going concern Synergy

Questionable justifications: Diversification Increase firm size

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Types of Mergers

Friendly vs. Hostile merger Cash vs. stock swap

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Analysis of mergers

Discounted cash flow approach to merger valuation requires: Estimation of cash flows Determine the discount rate

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Analysis of mergers

The correct cash flows and discount rate depend on the evaluation technique used.

We will use the “Corporate Valuation Model” (from Chapter 11) based on Free Cash Flows, discounted at the WACC

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Corporate Valuation Model: Discount Rate

To use the corporate valuation model to value a merger target, we must estimate the post-merger WACC of the target firm.

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Free Cash Flow Valuation

The FCF approach estimates the total firm value, rather than the value of equity or per share value directly.

The value of equity (& per share value) can be obtained from the total value of assets by netting out other claims.

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Corporate Valuation: A company owns two types of assets.

Operating assets Nonoperating assets (securities)

NOWC

Operating assets include Net Fixed Assets and Net Operating Working Capital (NOWC).

NOWC = Operating CA – Operating CL

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Operating current assets

Operating current assets are the CA used to produce and sell the firm’s products. Op CA include cash, receivables,

inventory Op CA exclude securities (interest

earning current assets)

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Operating current liabilities Operating current liabilities are the

CL resulting as a normal part of operations. Op CL: accounts payable and accruals

(current liabilities that do not charge interest)

Op CL excludes notes payable because this is a source of financing, not a part of operations.

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Applying the Corporate Valuation Model Free cash flow is the cash flow

available for distribution to investors after all necessary additions to operating assets:

FCF = NOPAT – net investment in operating assets

NOPAT = EBIT (1 – tax rate)

Corporate value

The PV of their expected future free cash flows, discounted at the WACC, is the value of operations (VOP).

Total corporate value is sum of:Value of operationsValue of nonoperating assets

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Steps in Corporate Valuation Model

1. Identify a planning period of t years.

2. Project FCF for years 1 thru t.3. Estimate the horizon growth rate.4. Calculate the post-merger rSL and

WACC of target firm.

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Steps in Corporate Valuation Model (Cont.)

5. Calculate horizon value using constant growth corporate valuation model and WACC.

6. Calculate Vops as PV of FCFs years 1 thru t and horizon value, all discounted at post-merger WACC.

7. Calculate the value of equity by adding financial assets, subtracting existing pref. stock & debt from the value of operations.

Alternative valuation techniques

Another method of estimating firm value is based valuation multiples. Examples include value as a multiple of: Earnings (P/E) Book value Sales revenue

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Merger winners & losers

Target firm shareholders receive an average premium of:Friendly merger 20%Hostile takeover 30%

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Merger winners & losers

Long-run (five year) stock performance of acquiring firms:

Abnormal returnsCash acquisitions 18.5%Stock swaps -24.2%

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Leveraged buyout (LB0) In an LBO, a small group of

investors, normally including management, buys all of the publicly held stock, and takes the firm private.

Purchase often financed with debt. After operating privately for a

number of years, investors take the firm public to “cash out.”

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Major types of divestitures

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.

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Motivation to divest assets

Subsidiary worth more to buyer than when operated by current owner.

To settle antitrust issues. Subsidiary’s value increased if it

operates independently. To change strategic direction. To shed money losers. To get needed cash when distressed.