CFA Level Two – Session 5 Financial Statements: Mergers, LBOs, Divestures and Holding Companies

Types of merger and key merger principles

There are four principle kinds of merger: Horizontal mergers are a combination of two firms in the same sector Vertical mergers occur when a firm merges with either a customer or a supplier Congeneric mergers involves firms that are somewhat related but are not true horizontal or vertical

mergers Conglomerate mergers occur when two entirely different firms combine

Mergers may be friendly or hostile: Friendly mergers have all terms agreed by management of both parties Hostile mergers involve the acquiring firm directly approaching the target firms shareholders with

the tender offer; managers may resist a merger in an attempt to extract a greater deal price or better deal and post-deal terms for the company and themselves

There are five primary rationales for mergers: Synergy – occurs when the value of the combine firm > value of component parts; this is generally

driven by ability of the combined firm to reduce costs or generate additional revenue

NB – synergies are usually greatest for horizontal or vertical mergers, however, these are the most likely to be challenged by the Justice Dept under competition rules

Tax Consideration – Profitable firms can gain immediate benefit by acquiring a firm with significant tax losses and offsetting this against income; alternatively cash rich firms may make cash acquisitions rather than paying dividends or repurchasing stock since this prevents the firm’s shareholders from having to pay taxes on dividends but still converts excess cash into assets

Purchase of Assets below replacement cost – typically only a relevant factor for natural resource firms or companies with significant PP&E (e.g. heavy industry) where cost of replacing assets is substantially higher than the market value of the firm

Diversification – contentious; managers may believe that diversification benefits shareholders by stabilising earnings, however, investors tend to prefer to do this themselves

Managers personal incentives – e.g. managers may wish to run larger firms (since these tend to pay better)

Key sources of synergy in Mergers: Operating economies – economies of scale, scope, management, marketing, production or

distribution Financial economies – lowering of financing costs and / or improving analyst stock coverage

(analysts tend to cover larger firms) Differential efficiency – could result if there is management weakness in one half of the merger; the

weaker firms’ assets should be more productive after the merger when the stronger company’s management take control of the merged entity

Increased market power – ability to control the market for a product and hence raise prices (tend to be blocked by regulators)

Finally, mergers could be described as either a financial or an operating merger: Financial mergers occur when combining firms will not be operated as a single unit; this means that

there will be no synergies and the financial analysis of the merger is straightforward Operating mergers occur when the combining firms will be integrated into a single entity; synergies

will result and financial analysis of the merger must estimate these synergies

Financial Analysis of Mergers using DCF

Three step process to estimate the value of the target firm:1. Projecting future cashflows of target firm after the merger2. Estimating the appropriate discount rate3. Calculate the NPV

The equity residual method is used in the exam – here the estimated cashflows are those that belong to the shareholders after the merger:

NCF = Net Income + Depreciation – Capex

Where Capex = Capital expenditure and additions to working capital

NB – Stowe also includes principal repayments and new debt issues in defining FCF to Equity (use this in the exam unless told otherwise

For the exam the DCF analysis involves a detailed projection of cashflows (up to 5 years) at the end of this is a detailed forecast. Usual assumption thereafter is a constant growth rate and the terminal value is calculated as a growing perpetuity:

E.g. if the terminal value is calculated as of year 5: Terminal Value

The value of the firm is then the PV of the terminal value and the PV of the cashflows from the preceding five years. The discount rate is usually the cost of equity of the target firm.

Example:

Company B is considering the acquisition of company P on 1st January 2003. The following data is available:

Company P Pre-Acq. Post-Acq.Debt Ratio 30 % 0.8Equity 50% 1.0

Tax Rate = 40%Rf = 7%Rp = 8%g = 5% from 2006

Year-end cashflows are:

2003 2004 2005 2006Sales $20m $24m $28m $30mCOGS 10 12 14 15Depreciation 2 2 3 3EBIT 8 10 11 12Interest 3 3 4 4EBT 5 7 7 8Taxes 2 2.8 2.8 3.2Net Income 3 4.2 4.2 4.8+ Depreciation 2 2 3 3- Capex 4 4 5 5Net Cash Flow $1.0.m $2.2m $2.2m $2.8m

Valuation of the target company:

First, calculate the discount rate, given that components for the CAPM are provided in the question and that the discount rate should be the cost of equity of the target firm after the merger we can us:

Ke = rf + (rp + rf) = 0.07+1x(0.08) = 0.15 or 15%

Then calculate the terminal value as at 2006:

Terminal Value = $29.4

NB – we multiply the final year cashflow by the growth rate (5%) to get CFn

Finally, value the company by discounting the cashflows:

Value of Target Company P = $22.4m

Financial Analysis of Mergers using Market Multiples Valuations

Three step process to estimate the value of the target firm:1. Constructing a group of comparable firms (comps) typically in the same industry2. Selecting an appropriate multiple, e.g. P/E, Price-to-book, price-to-sales, price-to-EBITDA, etc,

based on comparable firms3. Multiplying the target firm’s characteristic (i.e. earnings in the case of P/E) by the average multiple

of the comps

A challenge is forecasting the appropriate level of earnings for the target since post-merger there will be synergies which means that the target firm’s earnings pre-merger are not necessarily a clear guide. Synergy effects are estimated and added to the target’s current earnings before the multiples are applied. A common approach is to take an average of the forecast net income (inc. synergies) for the next few years and feed this into the multiple.

Example

Using the previous example, assuming the comps to target company P have an average P/E of 8x earnings in 2002.

First, take an average of the forecast net income (which includes effects of synergies):

[$3.0 + $4.2 + $4.2 + $4.8] / 4 = $4.05

Then multiply by the average P/E for the sector from the comps:

Value of firm = $32.4m

On exam expect to have to justify forecasting assumptions (in this case average of net incomes is used to capture the synergistic effects)

The i-bankers role in mergers

Mergers tend to be arranged by investment bankers who take on several roles: Arrangement of Mergers – on behalf of firms or, where shareholders wish to eliminate poor

management, the shareholders Defending Hostile Takeovers – working on behalf of a firm that feels it may be subject to takeover

but that does not want to be acquired; defence strategies can include:- Changing the firm’s bylaws to prevent acquisition- Repurchasing stock to drive price up- Adopting a poison pill to make the merger economically unappealing (e.g. contracting

large cash payments to management in event of a takeover, arranging debt covenants for immediate cash repayment in event of a takeover or selling assets below market value)

- Identifying and approaching a white knight Valuing target companies – establish a fair market value for the target Financing mergers – capital raising and deal financial structuring Investment in merger targets – known as risk arbitrage and is very profitable for the i-bank

Other forms of corporate restructuring

There are several corporate restructuring methods which don’t involve mergers: Corporate Alliances – legal, cooperative agreement; can range from simple sharing of technology to

full JVs and joint asset ownership Joint Ventures – occurs when two firms combine certain assets to achieve specific limited

objectives Leveraged Buyout – Involves taking a firm private by enabling a small group of investors to

purchase all the company’s shares using debt to finance the transaction – hence the company has a high degree of financial leverage after the deal

Divesture – Where a firm sells some of its assets; occurs for a number of reasons, e.g. better concentration of business objectives, asset stripping to raise cash or service debt, sale of loss-making assets, typical divestures include:

- Sale of an operating unit to another firm- A spin-off where a unit is set up as a separate corporation- Liquidation where assets are sold individually rather than as part of an operating unit

Holding Companies

A company whose sole purpose is to own the shares of other companies; depending on the level of shareholding the holding company may have either control or significant influence over a subsidiary

Advantages of a holding company: Working control can be gained with as little as 10% of the target’s shares - typically ownership of

>25% signifies working control Risk Isolation is achieved since all the companies owned by a holding company are separate legal

entities with respect to losses, and legal issues

Disadvantages of a holding company Partial Multiple Taxation, if the parent owns:

- > 80% dividends received from the subsidiary are not subject to tax- 20% - 80% then 80% of dividends received from the subsidiary are not subject to tax- <20% then 80% of dividends received from the subsidiary are not subject to

Forced dissolution can be invoked by regulators if the company is found guilty of an anti-trust violation